Pegasystems Inc. (NASDAQ:PEGA) Q3 2023 Earnings Call Transcript

Pegasystems Inc. (NASDAQ:PEGA) Q3 2023 Earnings Call Transcript October 26, 2023

Operator: Greetings, and welcome to the Pegasystems Third Quarter 2023 Earnings Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Peter Welburn, Vice President, Corporate Development and IR for Pegasystems. Please go ahead.

Peter Welburn: Thank you, Priscilla, and good morning, everyone, and welcome to Pegasystems Q3 2023 Earnings Call. Before we begin, I would like to read our safe harbor statement. Certain statements contained in this presentation may be 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, forecasts 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 2023 and beyond could differ materially from the company’s current expectations.

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Our press release announcing our Q3 2023 earnings and our SEC filings, including our most recent annual report, describe factors that could impact our results and cause them to materially differ from those expressed in forward-looking statements. Investors should not place undue reliance on forward-looking statements, matters contained forward-looking statements may not occur. Later events, new information or other factors may cause our views to change, but we will not publicly update or revise forward-looking statements unless required by law to do so. And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Alan Trefler: Thank you, Peter, and to everyone who’s joined today’s call. It’s great to see us improve performance in an uncertain macroeconomic environment. Now more than ever, we are focused on running a business that balances growth and free cash flow. And it’s especially good to see record cash flow as we come out of our subscription transition, and we’re just getting started. Ken will go into more detail on our financial results in a moment. As I mentioned last quarter, we’ve been finding additional ways to engage effectively and efficiently with our clients. The transformation of our go-to-market model is delivering on our goal of deepening client relationships. This helps drive more meaningful engagement across multiple teams as those relationships strengthen.

And I was excited to spend most of Q3 on the road, meeting with clients, prospects and partners globally. Coming off the tremendous momentum from PegaWorld and the launch of Infinity ’23, it was terrific to spend this direct time with these constituencies. And we recently had around the world trip, and it was good to see folks I have not had a chance to see at PegaWorld. I met face-to-face with over 100 clients and partners and had terrific conversations across the board, across the U.S. with Amazon, Bank of America, UnitedHealth Group, and even to India with Verizon where they, like many of our clients, are establishing global competency centers, and we’re having a chance to engage our Indian team directly with them. Going down to APAC with ANZ Bank, National Australia Bank, multiple government agencies across APJ, and in London with HSBC, Lloyds and Vodafone.

As well as with the thousands of our partners around the world, including Accenture, Capgemini, Cognizant, EY and Infosys. So what I’ll tell you also is our U.S. briefing center, continues to be extremely busy this year. We’ve had hundreds of meetings with clients like ING, Mondelez, Navy Federal Union and Scotiabank with their staff have really come in to deal with deep dive on topics ranging from Pega Strategy to Pega Cloud. We have many more plans for Q4. And in Q3, we kicked off a series of account-based marketing client events, to continue the momentum of PegaWorld with 75 regional and clients specifically as planned, and we’re going to have even more before the end of the year. I’m really enjoying being back on the road in a significant way.

And I’m terrifically excited about the level of engagement and dialogue we’re having. And even though you can accomplish a lot remotely, meeting in-person provides a different type of opportunity to dig in and understand what’s top of mind for our clients. Now, as I’ve done this, I have had a chance to really hear firsthand what the client interest and questions are about what Pega can do and does Pega have a unique advantage in this product environment. And what I’ll tell you is that AI, no surprise, has become central to nearly every client conversation. And their questions are following into a few categories. First, what should their AI strategy be? And where does Pega fit? Second, how can they protect and govern their proprietary customer data?

And third, how can they address the risks associated with GenAI, [indiscernible] hallucinations where the AI provides a response not backed up by data or best process. And this — these places are where Pega technology experience gives us a unique competitive advantage in my view. Let me elaborate. First, in terms of strategy. We have decades of hands-on experience helping clients leverage AI, and we can use it to help them with their strategy. We have terrific insights into the most successful early use cases for GenAI, and those we believe will deliver the highest return on investment. And we’re showing them to our clients and getting tremendous, tremendous positive feedback. One of the best things that actually any of you to try is this interactive demo on pega.com that shows how we have linked generative AI into the core thinking of how Pega workflow should work, and how it’s going to help you create all the necessary elements using the knowledge of the Internet to be able to bring best practices into a business.

You’ll see within seconds, the workflows, the users, the data model and the other key elements identified. We launched it when Pega Infinity went live in mid-September. And in the first month, thousands of people from around the world accessed the demo and did over 6,000 workflow generations, from employee onboarding to a cricket score board generator. Now I would suggest that anybody interested in understanding how this can be done really practically, I would go find it try it free. It’s on pega.com, just go to the site, either take the interactive tour that we have or just search for GenAI and check out the interactive demo, which is what I’ve just been talking about. Try building an app for your current firm or a business that you’ve been thinking about starting when you retire.

And I think you’ll be — you’ll share the excitement of how Pega is in a position to really bring this technology home in a very unique way. We had a lot of fun, and a lot of clients have gotten very jazz and interested in this. You can even try it on your mobile phone, and you can be building these sorts of things right from your mobile phone, and it’s also quite a good demo there. So when customers see what we’re able to do, see what we’re shipping in Infinity ’23, we get a very positive reaction in terms of how we can add powerful and pragmatic capabilities to their businesses. Now in terms of where Pega fits into their strategy, you need to remember that while most companies continue to think about GenAI as a cogenerator, Pega is core is based on the concept of a business model that brings a structure and system that could evolve as the client needs and the industry needs and the customer needs to evolve.

Instead of code with our GenAI, we generate business launching into a model that organizes the business objectives and lets the AI be understood, let it be reviewed, adjusted, curated and approved. And the center of this is what you’ve heard me refer to as our unique situation layer cake. This is something that organizes the way a business runs into layers, with some elements operating across the business as a whole, some on the division, some perhaps in the department and some for different customer segments or different regions and geographies. This unique structure organizes all the enterprise assets, the processes, the rules, the data models and UI into these layers, which are designed for BUs. There are the perfect architecture for using GenAI with.

And it’s what gives Pega a unique, and I believe standing advantage because you’ll plug GenAI in when the rules and workflows are defined and there’ll be able to complement what already exists, they’ll be able to let you change pieces of your business or workflow at a time, and they provide, I think, a power that’s very, very different than a lot of the hype that’s out there, because users are looking at our model versus looking at code. They can actually collaborate it, the business users of transparency working with IT. It provides that vehicle for governance when changes are introduced and makes them all manageable. So in short, it takes the output from the AI and organizes it in a way that really helps businesses build for change. And it’s proprietary to Pega.

I don’t think it can be readily copied or reproduced, and we don’t see anybody else taking this approach. We really feel good about what this means for us. So we’ve also created about 20 GenAI boosters with Pega Infinity that makes the GenAI practical, that makes it all real. And you can also see those described at pega.com. Now secondly, relative to data, we will be able to help clients protect and govern customer data through the powerful capabilities in our software. Pega’s audit trail capabilities, which have been described as the best in the industry, are robust and comprehensive. And third, we addressed GenAI risks by leveraging a platform which is designed to help customers deploy all of their processes and their AI effectively and responsibly.

[indiscernible] can see what’s happening and help identify where AI is working in their models, and help them understand when the AI is doing something that makes sense and when it’s generating nonsense. Our robot capabilities also help clients confirm that the data that powers AI decisioning is unbiased and comprehensive using our unique ethical bias check, which helps identify and eliminate biases hidden in the AI, are flagging possible discriminatory offers and messages generated by AI before they reach the customer. This unique capability helps clients pinpoint any offending elements and adjust the algorithms to ensure fair outcomes. Now the client response we’re having to this is very, very exciting and inspiring. And it’s wonderful to see our clients now beginning to work on this and taking it very, very much apart.

I think as we move into 2024, we’re going to complement what we’ve already released here in ’23 with a great new pipeline of features that are going to very, very aggressively continue to extend the power of these game-changing capabilities but also leveraging our unique architecture. Before I wrap up, I also want to provide a quick update on Pega Launchpad, our new cloud-based low-code application development platform for building business-to-business SaaS applications that we announced last year. It’s a gorgeous piece of software, and the team has done a tremendous job in staying focused and supporting our early adopters, and we now have our first handful of Launchpad clients. We’re really excited to ramp this business up in 2024 and beyond.

So in summary, we continue to improve our performance. And as we come out as a subscription transition, we see the cash improving despite the uncertain macro environment. The transformation of our go-to-market model is improving our sales efficiency and our engagement, focusing on really deepening the critical relationships that drive our business. And our unique technology architecture is a competitive advantage that lends itself to really leverage GenAI in a way that I don’t see our competitors easily replicating it, is going to be a big and long-lasting distinction. So we continue to make good progress. We continue to make good progress in becoming a Rule of 40 company, balancing growth with fiscal discipline and to provide more color on the financial results.

Let me now turn it over to our COO and CFO, Ken Stillwell. Ken?

Kenneth Stillwell: Thanks, Alan. Through the first 3 quarters of 2023, we’ve made meaningful progress improving our cash flow while maintaining double-digit ACV growth. We’re managing the company with a Rule of 40 mindset, the principal in a well-run firm’s growth rate and free cash flow margin should meet or exceed 40%. I’ve got some exciting news to share later on the call regarding our free cash flow. Now I’m going to start this morning with the most important metric to measure the success of our business. Growth in annual contract value, or ACV. This year, we’ve experienced a macroeconomic environment that’s not noticeably worse than last year, but it’s certainly not much better. Our clients are still buying, but they’re scrutinizing things more closely.

Sales cycles are a little longer than they’ve been for the last few years. Despite that, our sales team delivered a good Q3 with significant contributions from EMEA and from our financial services clients. Through the first 3 quarters of 2023, total contract value, TCV, bookings increased by about 20% year-over-year. And I think that’s just an important measure to complement our ACV and backlog performance. Given the strong level of activity we experienced in Q3, our new go-to-market strategy is clearly leading to deeper engagement with our clients. As a result, ACV grew 12% year-over-year with currency helping our growth by around 2%. We like numerous other companies received an SEC comment letter related to standardizing our free cash flow measures.

As you know, the more traditional way to calculate free cash flow is to take cash flow from operations and subtract capital expenditures. So going forward, this is the approach we will use. Going forward, we’re not adding back onetime cash items such as restructuring charges to calculate and adjust free cash flow. However, we will continue disclosing in our earnings release cash items that we believe are not representative of our ongoing operating performance. As we enter 2024, we do not anticipate onetime cash items being a big part or a big item of interest for investors. Over the first 3 quarters of 2023, Pega generated $138 million of cash flow from operations and $124 million of free cash flow. In Q3 alone, we added $24 million of free cash flow.

The $124 million is the highest amount of free cash flow dollars generated in the first 3 quarters of the year in the history of the company. We increased our cash and marketable securities by $60 million year-to-date, and that’s given our almost $100 million of convert repurchase. As we outlined during the most recent investor session at PegaWorld in June, our multiyear plan to improve our free cash flow features 3 key levers. First, we need to expand total gross margin. We’re confident we can continue to expand total gross margin by scaling our Pega Cloud business, increasing cloud automation, implementing Kubernetes and multi-tenancy. And our most recent results confirm that we’re making progress. In Q3, on a trailing 12-month basis, non-GAAP total gross margin increased to just over 74%, a 129 basis point improvement year-over-year.

Our key driver of our gross margin improvement is non-GAAP Pega Cloud gross margin, which increased 430 basis points from 69% to just under 73% on a trailing 12-month basis. Another lever to improve our free cash flow is to improve sales efficiency, which we view as the most important of the 3 levers. As you know, we made the difficult decision to reduce our headcount in the last year with the majority of those reductions coming from the sales and marketing organization. It’s difficult to deliver double-digit growth while at the same time improving sales efficiency. We spend more than $0.5 billion annually on sales and marketing. That’s a pretty big number, and we need to make sure that we’re leveraging that to drive our growth. The last lever is really just to as we improve our free cash flow is to enhance our operating leverage by growing total other costs like general administrative and R&D to make sure that those spend at a slower pace than our ACV growth.

At a company our size, we should definitely be able to exhibit operating leverage as we scale. Over the last year, we’ve taken action to simplify our go-to-market motion. For software companies like ours, the enemy of sales efficiency and effectiveness is often complexity. So we’ve eliminated layers of management, further clarify team roles, focused our sales team on cross-selling and up-selling into our existing clients, making sure that all of our teams are aligned. Taking together these actions are helping to improve our sales efficiency. And you can see the results in our financials. On a non-GAAP basis, total sales and marketing spend as a percentage of revenue declined from 47% and to 38% year-over-year in Q3 on a trailing 12-month basis.

Our focused execution on balancing growth and profit is positively impacting our profitability, generating $124 million of free cash flow, as I mentioned, in the first 3 quarters of 2023, and it shows progress across all of our levers. The big change from the negative free cash flow of $36 million generated in the first 3 quarters of 2022. I’ve also got some good news to share regarding our free cash flow trajectory as we go forward. Based on where we are year-to-date that our global team’s successful execution on our plan, I’m confident that we’ve got a shot to deliver more than $200 million of free cash flow in 2023. I’m excited that our team is in a position to deliver the highest annual cash flow in the history of the company, and Q4 is typically our strongest cash flow generation quarter of the year.

To be clear, we do not update guidance quarterly, and I’m not creating any type of precedent or officially updating free cash flow guidance for 2023. I’m just sharing my current thoughts on our free cash flow trajectory as we approach the completion of 2023. In prior calls, we have shared some thoughts on modeling our business, and we’ve received feedback this practice is helpful. So I’ve decided to reinforce those again today. First, let me start with free cash flow. I know that making a change in how we present free cash flow might be considered somewhat unusual. So we’ve added a table in our earnings release to show the free cash flow quarterly, just to help with your modeling. The table also separately discloses items that affect our cash flow and are considered by management, not to be representative of the core business operations, such as restructuring costs.

Second, our prior 2023 annual free cash flow guidance included these adjustments. So going forward, our free cash flow guidance will be consistent with a more conventional methodology. Lastly, we did close more term license deals in the quarter than is typical. Our term license bookings are strongest in the first and the final quarters of the year. So a strong term license booking result in Q3 is not typical. However, we view the growth in ACV as the most critical measure. And our clients sometimes decide to use client cloud versus Pega Cloud, and we will support them when they make that decision. This year, we continue to make progress on our journey to improve our cash flow, while at the same time maintaining a double-digit ACV growth rate in what continues to be a more uncertain selling environment.

Our team is clearly embracing a Rule of 40 mindset and doing a much better job of managing the trade-offs between growth and profit. The world’s greatest software companies do not only achieve the Rule of 40 in a single year, but they do it consistently and over sustained periods of time. That’s our objective. To be the kind of company that balances growth and profit over the long term. And we look forward to closing out 2023 in the next few months. As I wrap up today, I wanted to announce that our annual investor session will be held on Monday, June 10, the MGM Hotel in Las Vegas, during PegaWorld. Please mark your calendars. I look forward to seeing you all on the road as we get out to meet current and potential investors in November and December.

One last point. The date for our oral argument in our Virginia appeal is now scheduled for November 15. Although it will likely be months before we know the result, it’s still great to have the appeal now scheduled and in front of us. With that, operator, please open the call for questions.

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Q&A Session

Operator: [Operator Instructions] And our first question comes from Steve Enders with Citi.

Steven Enders: Maybe to start, I just want to get a better understanding for — when you talk about uncertain macro and that kind of continuing, what that actually looks like in terms of the deal environment that you’re seeing out there? And maybe how are things maybe changed so far in October from the conversations and the deal environment that you’re seeing today?

Alan Trefler: Yes. I would say that the mood in a lot of clients has — for the last year, candidly, has been just more questioning again, it’s entirely consistent with organizations really doing candidly, a better level of scrutiny than when money was free. People are acting now across the board like they’re really respecting businesses that are in a position to deliver profitability. So you get more checking of types of deals and that can lead to slightly longer sales cycles. I will tell you, I’m not seeing anything that is troubling as we enter the fourth quarter. The reality is that customers also really, really want to set their businesses up for success in 2024. And I’ve had conversations with many clients that see us as being central to how they’re going to gain the real efficiencies, which isn’t around the cost of software, but it’s really around the cost of their operations and their ability to engage.

But I think I’ve said over the last year, we’ve been through lots of recessionary periods. And when things get a little tougher, even if we’re not in a recession, I think people are kind of acting a little like we are. When that happens, we sort of aim the needle as it were how do we deliver really tangible things for clients as opposed to focusing on generating revenue, which are the things are happier, everybody who wants to spend time on that. Does that give you some color?

Steven Enders: No, definitely. There’s helpful context there, especially for the 4Q view. So I definitely appreciate the commentary there. And then maybe shifting gears a little bit more to the sales and marketing changes and initiatives. I guess, as we think about what that means for closing out the year and the improvement in productivity and efficiency there, I guess, what has been the feedback from customers that you talked to in terms of the impact that could potentially have? And as we think about the free cash flow impact, both in the quarter moving forward, I guess how should we be thinking about the impact that those changes would be having to the cash flow specifically?

Kenneth Stillwell: So there’s a couple of pieces to that question. So let me see if I can hit a couple of pieces, Steve. So the first is we made changes — we made some organizational changes in the last few months. And those are never easy, and we have a lot of empathy for the people that were impacted. Those changes have not actually resulted in any improvement in free cash flow for the business, yes, as you might imagine, and they will have a very small, if any, impact even in Q4 that the actions taken. However, they’ll have a full year impact in 2024. So that’s just something that’s almost kind of on the shelf for an improvement in 2024. I wanted to also clarify one thing. When I talked about achieving $200 million in free cash flow, I’m actually referring to the new more traditional measure.

If you were to take into account onetime items, et cetera, naturally under the way that we were previously talking about, that number would be much higher. So just to clarify that because I know that was maybe a little vague in my script.

Alan Trefler: I’d also say that we worked very hard, and I think the team did a great job to take and make the changes so that we could enter Q4 with the changes behind us. And we’ve basically done that. So I’m not expecting that we would tell you next year the Q4 has been materially implemented by change. Right now, I would say we’re at the heavy execution mode.

Operator: Our next question comes from Pinjalim Bora with JPMorgan.

Pinjalim Bora: Can I ask you about the term out performance? What drove that was federal part of it or anything else to kind of call out? Secondly, on cloud ACV growth, that seems to continue to decelerate. And I hear your point on overall ACV growth being more important. But as you launch Infinity ’23, which adds kind of a lot of GenAI capabilities on the cloud side, I believe, should we expect cloud ACV growth to kind of trough at some point going forward?

Kenneth Stillwell: Yes. So great question. So when you see quarters — so if you look at kind of newer organizations or even newer kind of activity that a client is doing, there is a higher amount of those that typically go Pega Cloud. That is kind of just because Pega Cloud — when you have clients that may expand existing workflows, existing relationships, they may put — bring on a new project and they already are managing Pega in a client cloud environment naturally, that’s the way that they would purchase or expand their relationship with Pega. So when you see quarters where you typically have a higher percentage of kind of term versus SaaS, the primary driver for that is probably just a little bit outsized expansion with existing clients that may not — now many of our clients have both.

So it kind of depends on which application environment there or which set of use cases they’re expanding. But that’s typically — it’s really not — it’s not a change in strategy or a change in buying behavior. It just comes down not to like how — kind of how you — how the difference between the 2. And in terms of like a net new workload versus existing workload. So that’s kind of why you might see the drop.

Alan Trefler: I would also say that based on just the vibrations in the market here as we enter Q4, I’d be surprised if we don’t see a pickup in the cloud rates as we go into the next quarter or 2.

Kenneth Stillwell: Yes. I think that’s — I mean you — Pinjalim, you know that the difference between a Q4 typically had a little bit more client cloud license. And that’s typically because that tends to be a period where you have clients kind of look at increasing their spend with us during a renewal period. So just think about that kind of same activity can happen sometimes in other quarters.

Pinjalim Bora: Yes, understood. Just to be clear, for this quarter in term, were there any very large deals that swung kind of the number towards the positivity 1 or 2 large deals or just…

Kenneth Stillwell: No, it wasn’t actually. No. We — in our movement, that’s a very fair question. But no, Q3 was not skewed by like 1 deal or 2 deals of that. And also as we move a little bit more towards as we refer to in a more consumption-based, you do actually have more repeatable growth and not as many very large kind of shock deals. Clients are increasing over time as opposed in our previous model, even in the perpetual model, they are tended to be kind of whales as we used to call them.

Operator: Our next question comes from Jake Roberge with William Blair.

Jake Roberge: Alan, when you’re talking to customers, where the dollars per AI spend coming from? Are they coming from existing IT budgets and maybe crowding out other areas of spend? Are you seeing customers create net new budget dollars and potentially actually expand their overall IT spend to account for those investments?