Pegasystems Inc. (NASDAQ:PEGA) Q1 2024 Earnings Call Transcript

Pegasystems Inc. (NASDAQ:PEGA) Q1 2024 Earnings Call Transcript April 25, 2024

Pegasystems Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Thank you for standing by. My name is Jeanie and I will be your conference operator today. At this time, I would like to welcome everyone to the Pegasystems 1Q 2024 Earnings Call and Webcast Conference. [Operator Instructions] Thank you. I would now like to turn the conference over to Peter Welburn, Vice President of Corporate Development and Investor Relations. You may begin.

Peter Welburn: Thanks, Jeanie. Good morning, everyone and welcome to Pegasystems Q1 2024 earnings call. Before we begin, I would like to read our Safe Harbor statement. Certain statements contained in this presentation maybe construed as forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. The words expects, anticipates, intends, plans, believes, will, could, should, estimates, may, forecast and guidance or variations of such words and other similar expressions identify forward-looking statements, which speak only as of the date the statement was made and are based on current expectations and assumptions. Because such statements deal with future events, they are subject to various risks and uncertainties.

Actual results for fiscal year 2024 and beyond could differ materially from the company’s current expectations. Factors that could cause the company’s results to differ materially from those expressed in forward-looking statements are contained in the company’s press release announcing its Q1 2024 results and in the company’s filings with the Securities and Exchange Commission, including its annual report on Form 10-K for the year ended December 31, 2023 and in other recent filings with the Securities and Exchange Commission. Investors are cautioned not to place undue reliance on such forward-looking statements and there are no assurances that the matters contained in such statements will be achieved. Although subsequent events may cause our views to change, except as required by applicable law, we do not undertake and specifically disclaim any obligations to publicly update or revise these forward-looking statements, whether as a result of new information, future events or otherwise.

And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Alan Trefler: Thank you, Peter and thank you to all who have joined today’s call. We are off to a strong start in 2024. Our results reinforce the soundness of our go-to-market strategy and we continue to improve execution, resulting in strong cash flow and significant expansion of Pega Cloud gross margins. This quarter, we continued to grow by deepening and expanding client engagement throughout our targeted cap model and to drive our GenAI strategy forward with significant new and enhanced technology. The reaction we’ve seen from clients as they begin to experience and fully understand the potential impact of Pega GenAI is tremendous. It’s opened up whole new avenues for collaboration between us, our clients and our partners as well as inside our client organizations across their teams and functions.

I am even more excited than when we last talked about the incredible opportunity to leverage GenAI to drive success in 2024 and beyond, for Pega and for our clients. Now to talk about the strategy, as a reminder, when we applied GenAI, we are not using it to generate code, we are using it to optimize the business outcomes and best practices that our customers are able to follow. Our unique technical structure is built around business concepts and enterprises, processes, their rules, data models, UI all organized into layers that can be built on or reused. It’s turned out that this is a perfect architecture for GenAI. And I think it gives Pega a unique advantage, because we directly offer, enhance and optimize the business concepts themselves in a way that both business and IT can understand and collaborate on.

And it’s a patented architecture underneath it all that I don’t think can be readily copied or reproduced. Now, you may remember on our last call, I talked about the major areas where we believe our unique approach to GenAI will drive massive impacts for our clients and for us. Delivering solutions that will first double developer productivity and bring Pega skills to the fingertips of our customers that will ignite enterprise innovation through a blend of industry expertise, Pega expertise, Pega technology and client insights that will maximize revenue efficiency with real-time optimization and personalization of customer interactions and we will streamline work processes and customer experiences by giving the right people, instant access, not just to real-time enterprise knowledge, but to the processes that are necessary to get the results they want.

We have continued to deliver on that strategy to help our clients unlock business transforming outcomes. This amazing technology will be showcased in PegaWorld, our 10,000 square foot innovation out, featuring more than 200 interactive demos that will be shown off the latest of the AI advances and how it will drive the future. It’s an experience you can only have if you are there in person. Now here are just a few highlights of the newest technology you’ll see and hear at PegaWorld. First, we announced Pega GenAI blueprint in mid-February and began immediately testing it with partners and clients and we have now made it available to anyone who wants to use it since like March, whether you are a Pega client or not. All you have to do is your search on Pega for Pega Blueprint, and you’ll find our website that really just has everything you need to get started.

You can be up and running in minutes. I think that no other competitor has anything that can do what we do. And we think it’s a major competitive advantage. In the last month, hundreds of clients have generated thousands of blueprints. Together, we, our clients and our partners are finding new ways to leverage this technology everyday and stretching the boundaries of what’s possible. Based on user feedback, we are enhancing it continuously. And because of the SaaS application, we are releasing new versions every 1 to 2 weeks. In just the last few weeks, for example, we added new capabilities that allow you to import blueprints directly into a Pega application to allow you to really do game changing work in seconds that otherwise would have taken weeks.

And this enables people to iterate on application requirements and we generate blueprints as they have new ideas and experience what’s going on in their collaborative efforts. Now more enhancements are planned in the coming weeks and months. And as more alliance and partners use it, we are getting an extreme of additional ideas that are both being met with great excitement by the partners and customers and great excitement by us. For example, we think that we are seeing many customers looking to use Blueprint to be able to rethink and to modernize your legacy stake. These are large collections of ancient applications that all customers want to try to drive down in terms of complexity and quantity. And Blueprint makes envisioning and designing for the replacement of legacy apps, a completely different experience.

It incorporates design thinking and best practices from both Pega and [indiscernible] integrates them and uses GenAI to synthesize the information and make recommendations on how they can improve. This is where our use of GenAI, I believe, is truly groundbreaking as we allow enterprises to explore entirely new ways in envisioning their business processes, building on what is known on the Internet and what we have done over our decades of experience, making it dramatically easier to align business and IT. We think it’s a great opportunity for us and we will be talking much more about it at PegaWorld. Now in addition to Blueprint, we continue to introduce and enhance our Infinity suite of solutions. Last week, we launched Infinity 24.1 with transformative capabilities to help our clients become self-optimizing enterprise, incorporating enterprise-grade AI and automation, this newest release empowers organizations to optimize service, sales, marketing and their business operations, with new capabilities, including via Pega GenAI Knowledge Buddy, which helps you to synthesize knowledge scattered across content libraries to quickly answer employee and customer questions.

There are hundreds of thousands of chatbots out there these days. Everybody has a couple of chatbots, but they don’t include the kind of robust enterprise-based capabilities organization state to audit what’s going on, provide the right security, the right control and be able to have confidence in the answers. That’s what we focused our Knowledge Buddy on. We are also introducing the Pega GenAI Coach, which serves as a real-time mentor, analyzing employee workflows and providing actionable insights to optimize productivity. And we have new accelerated bundles what we call Pega GenAI Automate and Pega GenAI Analyze which surface and summarize insights about cases, data, meetings, conversations to make it easier and faster for salespeople and service agents to follow-up and engage with prospects and customers as well as many, many other answer.

We see a terrific long-term growth opportunity as these capabilities are the ones that are coming, help clients adopt our software more quickly and find new use cases for Pega. Now I have talked about PegaWorld a bit and I want you to really consider strongly coming to Las Vegas and joining us, because it is going to be terrific. As exciting as the new product announcements we will be showing are what really separates PegaWorld from many other tech conferences are the incredible real-world very, very deep examples of how our clients are using the software that they themselves bring to the PegaWorld and talk about in ways that well, candidly, we couldn’t talk about them, because we have to maintain our clients’ confidentiality. But when they get up and speak about it, we think it’s wonderful.

And we are honored that they are willing to discuss some of the amazing things that they are doing. Some of the customers who are coming will be, for example, T-Mobile who will talk about their focus on customer centricity, the customer service overhaul that not just led to improve efficiency, but massively improve customer satisfactory and how AI-driven insights are empowering your frontline staff to build stronger relationships. We will also talk about the key success metrics that they have achieved and provide insights into their ambitious AI plans. Booking.com will describe how we are leveraging Pega capabilities to meet evolving traveler needs while also maintaining their super high customer satisfaction levels. Pega supports their customer-centric approach, ensuring that thousands of agents around the globe can deliver unparalleled experiences to traveler worldwide.

National Australia Bank will explain how they are bringing together the left brain of analytics and the right brain of creative thinking to build real relationship-led personal experiences, relevant in the moment and end channel. I believe a fascinating story about how the blend of data, rated experimentation and Pega technology are disrupting conventional approaches communications and how they have used us to deliver 91 million customer engagements and a 40% increase in customer successful engagements in just over a year. And finally, just to pick another one, the Department of Veterans Affairs will discuss how they are modernizing their benefits program, the veteran’s spouses, children and caregivers to improve responsiveness in the essential program.

As a reminder, we have scheduled our investor session from Monday, June 10 local time and we are hoping to see you there. You should have received the invite by now, if you haven’t go to site [ph] and be sure to register. It’s going to be a fabulous event. So in summary, our go-to-market strategy and focused model are deepening relationships and driving good results, including a healthy balance of growth and profitability. We continue to focus on leveraging the latest GenAI capabilities to deliver advantages to our clients. Pega has been through massive technology transitions to our full year history. We have done five complete re-architectures of what we have done, and I believe we are perfectly positioned to incorporate GenAI into the architecture we have and the way that we are going to deliver to our clients.

This experience of being able to manage through and well in extreme change in the technical environments is I think one of the reasons that GenAI is going to be especially advantageous to us. Our newest offerings are truly enhancing the relationships with our customers and our clients’ relationships with their customers. I think we have a huge opportunity to drive success in 2024 and beyond and it’s going to be very transformative. Now, to provide color on our financial results, let me turn it over to our COO and CFO, Ken Stillwell. Ken?

Ken Stillwell: Thanks, Alan. I am very excited about our start to 2024. Annual contract value, or ACV, increased 9% year-over-year, which is where we thought it would be in Q1. As I explained on our last earnings call, ACV growth faced a tough year-over-year compare in the first quarter of 2024 because the net ACV add in Q1 of 2023 was unusually strong. And as a result, we knew the ACV growth rate would be at the lowest point as the year began. Pega Cloud drove the majority of net new ACV add in the first quarter and Pega Cloud ACV, which is approaching $600 million, continues to be the largest and fastest growing portion of ACV. Moving to free cash flow. When we started our subscription transition in late 2017, we knew the transition would, over time, result in more predictable subscription billings and free cash flow.

Now that the transition is complete, it’s great to see that vision become reality. We generated $180 million of free cash flow in the first quarter, a record by far for any quarter in the history of the company. Our strong free cash flow performance was driven primarily by three factors. First, ACV grew by about $100 million year-over-year. ACV had strong proxy for subscription billings. So an increase in ACV will naturally drive a material increase in subscription billings. Second, we are doing really well in our cost management initiatives, which improved operating leverage again in the quarter. For example, sales and marketing expenses decreased by about 15% year-over-year in the first quarter of 2024 versus the same period 1 year ago.

Third, many of our deals closed and renew in the last quarter of the year, which means collections often occur through the first quarter of the year. Our fast start on free cash flow generation maybe a little surprising to many of you and it’s quite frankly a little better than we had even expected. But naturally, starting off strong gives us that much more confidence in our progress to improve margins and our cash flow momentum. Moving on to margins. Pega Cloud gross margin increased to 77%, a 500 basis point increase from a year ago, and that’s just awesome to see the continued improvement. The improvement was driven by three factors. First, the increasing scale of Pega Cloud, which grew 21% year-over-year to $131 million in revenue in Q1; second, more active planning and management of our global cloud capacity to optimize performance and to reduce cost; third, an increasing use of Kubernetes for cloud scalability and efficiency.

Now that we have released Pega GenAI Blueprint in Q1, I’d like to share some thoughts on the timing of GenAI monetization. In 2024, we expect Pega GenAI Blueprint will both change the way we engage with our clients and also decrease the time it takes for clients to envision and build new applications on the Pega platform and we are already seeing evidence of that. Though we are still in the early days of GenAI, we can see that this innovation is going to be central to our clients’ buying decisions. And it beautifully complements the statistical AI that we have delivered for decades. We expected GenAI would be central to our products as we put our 2024 plan together and that’s what we are seeing. Thus, monetization will be as a result of improvements in the selling cycle, which we believe will be fully realized in 2025.

I have received feedback that is helpful when I provide thoughts on modeling our business. So today, I’ll continue to share some insights. First, we expect our ACV bookings will be more back-end loaded this year. And the majority of our subscription billings will occur in Q1 and Q4. So for the full year, we expect our cash flow to be strongest in the first and the last quarters of the year. Second, our sales and marketing expenses are slightly higher in the second quarter as a result of PegaWorld cost, our annual client conference, which occurs in June. Third, we expect term license revenue will decline year-over-year in 2024 as Pega Cloud continues to become an increasingly larger portion of our overall business and this is certainly connected to GenAI momentum.

As cloud accelerates an increasingly smaller part of our growth is coming from subscription revenue – subscription license revenue, excuse me, which is term and maintenance revenue. Both of those are expected to continue to decline as a percentage of our revenue and also subscription license, i.e., term revenue is going to decline year-over-year. In fact, term license revenue will likely be less than 25% of our full year revenue, and it will be back-end loaded. But that’s okay because it doesn’t impact cash flow timing, and we’ll gladly trade term license revenue variability and decline for having a business accelerate faster to the cloud. Turning to our capital structure. As many of you are aware, we have about $500 million of remaining outstanding convertible debt at 0.75% interest rate that matures in March of 2025.

We continue to evaluate alternatives. But at the end of Q1, our total cash and investment balance was about $619 million. So we are now in a net cash positive position when factoring in pay off of the convert. We are still waiting for the opinion from the Virginia Appeals Court. We don’t know when that court will issue opinion. But of the cases our panel of judges has heard the majority of those cases have been decided. I also would like to provide you with a brief update on the shareholder class action suit that was filed in 2022. We reached an agreement to resolve that shareholder suit for $35 million. We look forward to putting that distraction and the associated legal fees behind us. I’m looking forward to seeing all of you at PegaWorld, which is being held at the MGM Grand in Las Vegas again and starts on Sunday, June 9.

We’ll hold our investor session, as Alan mentioned, on Monday, June 10 at lunchtime. To register for the investor session, please e-mail pegainvestorrelations@pega.com or reach out to Peter Welburn. Featured speakers during our investor session will include our Founder and CEO, Alan Trefler, as well as other members of our senior leadership team. We will provide updates on our long-term strategy, our latest product innovation and our go-to-market approach. In conclusion, I feel really, really great about running a sound business. Our strong cash generation in Q1 demonstrates the power of a SaaS business. And we’re in a great position to accelerate our profitable growth from here. Operator, please open the line for questions.

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Q&A Session

Operator: [Operator Instructions] Your first question comes from the line of Raimo Lenschow with Barclays. Please go ahead.

Raimo Lenschow: Thanks. Congrats from me, I have two quick questions. One, Alan, for you, or maybe it’s actually for both of you. If you think about the monetization, if I understand you correctly, it’s going to accelerate client adoption of Pega quite nicely. Is that kind of the main things we had to – you should think about monetization? Or are there also kind of SKUs that have more AI versus, let’s say, the old kind of product monetization there? So that’s question one question. Two would be for Ken. On the cash flow, you obviously gave us last quarter like an annual cash flow idea with a very strong Q1. Was there like some timings that helped you? Or how do you feel about the full year number? Thank you.

Alan Trefler: So we’re permeating our products with GenAI. So that this is really becoming something that I think is going to be a reason that people say, Boy, we can get this to work faster, better, cheaper and more broadly in the organizations. And that’s the way we monetize thing and you want to get a feel for that, just try Blueprint, make perfect sense to you in 2 minutes.

Ken Stillwell: Yes. On the question about annual cash flow, I think that’s probably a very common question on the minds of lots of people listening to this call and is our results. That’s a great question. I’m generalizing a bit. But if you think about Q1 and Q4 being big cash collection quarters and Q2 and Q3 being more subdued and, quite frankly, not significant cash generation. To get more than half of your full year target in the first quarter is certainly a great. I wouldn’t go as far as to say that changes our view for the year. I would say what that does is really reinforce the momentum that we’re on and the confidence that we have for the full year. But it’s great naturally, you always want cash flow as soon as you can get it in the year. But it was expected that Q1 and Q4 would be bigger collection quarters.

Raimo Lenschow: Okay, prefect. Thank you.

Operator: Your next question comes from the line of Kevin Kumar with Goldman Sachs. Please go ahead.

Kevin Kumar: Hi, thanks for taking my questions. I wanted to touch on Blueprint. It appears that interest is pretty strong there, and I’ve gone on and demoed it as well, and it looks great. Alan, just curious about, I guess, the second order impacts of just being able to speed up the design process with Blueprint. Are you seeing any early indications that this could drive more applications being developed on the platform?

Alan Trefler: Yes, we are. I mean we’re seeing an enormous interest from clients and from partners and we see Blueprints being included now in RFP responses and in bids that are going to customers. So it’s – I think it’s a big step forward. And it’s candidly a step that’s only going to get bigger as we continue to add in some of the features that are planned for even now to PegaWorld. So we’re really, really seeing concrete uses with clients. I also think this opens the door to Pega being seen as an engine for legacy transformation. We talked to people in the tech world who have literally thousands of applications and being able to use a technology like this that help take them out faster and better. You have rid of some of that technical debt, put them all together in what we called a process fabric which is a technology we’ve talked about in the past that lets you have multiple Pega apps that act as one.

It’s – I think it’s a very appealing message even in its early days. So we’re pretty asked about this.

Kevin Kumar: That’s great. And then, Ken, one for you. You called out sales and marketing and seeing some year-over-year decreases in expenses there. And just curious kind of where you’re seeing opportunities to kind of reduce expenses within that organ should we expect that to kind of continue throughout the year?

Ken Stillwell: Yes. So we’re kind of a – we’re a little bit of a stabilization point in terms of the run rate of expenses right now, because we’ve essentially normalized some of the restructuring that we did last year. Gross margin definitely will continue to improve in Pega Cloud because there’s a lot of things that we’re implementing that are not actually not – have not been impacting margin to the positive yet and will continue to. I think about our go-to-market cost is less around where we can take cost out and more about leveraging that resource pool to accelerate growth, Kevin. We’re really – we have a great growth opportunity, acceleration through the rest of the year. We feel very confident that we will accelerate growth.

And GenAI is really just a massive catalyst for pushing productivity in our go-to-market teams because of that speed, the speed to getting clients see the vision, the speed to getting them to realize their architecture designs and their workflows and actually now with the latest changes to Blueprint, the improvements to Blueprint to actually get the Pega application started. So we feel like that is just such a tailwind, so to speak, to sales productivity. We’re focused on really putting those resources in the right place to accelerate scale and become more productive as opposed to a cost-cutting exercise.

Kevin Kumar: That makes sense. Thank you, both.

Operator: Your next question comes from the line of Pinjalim Bora with JPMorgan. Please go ahead.

Pinjalim Bora: Great. Thank you for taking the questions. Just two parts. One question for me. Are you starting to see some of the GenAI capabilities that you’re introducing in cloud drive customer conversations around cloud migrations from the self-managed product that you have? And then I guess, cloud ACV growth seems like has kind of reached a low point. Wondering if it is kind of at the cost level at this point as Blueprint and other GenAI capabilities drive consumption going forward?

Ken Stillwell: Let me take the second part of that. We do think Q1 was a trough for ACV growth. We had thought that, that was the case when we guided, we had said that really in Q1. I think most of you know that because we saw the models that all of you have built. And so I think you definitely hurt us on that. In terms of the ability for cloud migrations and GenAI and the connection, Alan, thoughts on that.

Alan Trefler: Yes. So we’ve looked our GenAI capabilities, which are unfolding so quickly to Pega Cloud which only makes sense because we’re able to roll out so much more efficiently and effectively. And we definitely see customers being interested in moving to Pega Cloud. They’ve been historically because I think it’s such a both cost effective but also offers some scalability and other features that they may have difficult emulating in other environments. So we’ve historically seen strong interest. We’re definitely seeing that the GenAI makes that interest even more critical for customers who weren’t already heading in that direction.