Earnings Call: Q2 2019

Aug 7, 2019

Good day, and welcome to the Pegasystems Second Quarter 2019 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Kenneth Stilwell, Chief Financial Officer, Chief Administrative Officer and Senior Vice President. Please go ahead, sir. Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems' Q2 2019 earnings call. Before we begin, I'd 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, targets, strategies, intends to, projects, forecasts, guidance, likely and usually 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 2019 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 Q2 2019 earnings and in the company's filings with the Securities and Exchange Commission, including its annual report on Form 10 ks for the year ended December 31, 2018 and other recent filings with the SEC. Investors are cautioned not to place undue reliance 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 view to change, except as required by applicable law, we do not undertake and specifically disclaim any obligation 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. Thank you, Ken. At mid year, I'm excited with the progress we're making. We showed strong growth in ACV and remarkable growth in Pega Cloud, which was 60% of our new business for the first half. I'm pleased with how our strategy is playing out as we continue to gain traction in seizing the huge opportunity in front of us. At the same time, our cloud transition makes it harder to easily understand our progress by looking at revenue, which is why we focus on ACV metrics that more accurately reflect the health of our business. Ken will provide more context on this in a few minutes. Now I spend a lot of time with clients and prospects talking about what's working and what's not as they pursue their digital transformation initiatives. It's clear that the level of hype regarding some technologies is intensifying and creating confusions and missteps in the industry. Now over 3 plus decades in the software industry, I have seen how easy it is to get distracted by what's trending. My focus is always on what's going to work for clients now and in the long run. The emerging and accelerating market themes we see regardless of geography or industry are representative of what clients want to be successful and to demonstrate tangible value, start fast, but be able to pursue full and broad digital transformation. We deliver several key technologies that significantly drive digital transformation by leveraging them correctly as part of an end to end strategy. Now let's start with process automation, which is interesting that many have equated with so called RPA or Robotic Process Automation. Now RPA can provide value to an organization interested in automating isolated tasks, But the amount of hype and confusion in this market is staggering. We believe that RPA needs to be part of a digital process automation approach, which uses robots in the right context. It's critical to move from thinking robots first to thinking end to end automation, where ARPA is part of a coherent digital process automation or DPA strategy, not robots being the entire strategy. Now importantly, we were recently ranked as a leader in DPA, digital process automation for deep deployments by Forrester. And we were number 1 or number 2 rated out of 10 providers in all three of the reports main scoring categories. And we see our clients embracing this message with positive results and we believe the broader industry is beginning to catch on to this as well. For example, Gartner's recent Magic Quadrant for RPA Software notes that RPA tools deliver more sustainable solutions when combined with an intelligent business process management suite. We were named the visionary of this MQ, which reported that Pega is in a good position to gain from its long term vision of integrating RPA tightly with its BPM suite and related CRM applications. And it's interesting, there was a report from just last month where Gartner actually said that, By 2021, task centric RPA offerings in their current form will be obsolete. Task automation has been masquerading as process automation. The rise of true end to end processing makes RPA's capabilities and limitations more visible. So we feel really good that in having acquired OpenSpan nearly 3 years ago and being able to really pull it in as a core part of the Pega solution is absolutely the right strategy and lets us have both a different take on this market, but also a much, much more effective one. It's worth noting that Pega is the only unified product in Gartner's Business Process Management and Robotic Process Automation Magic Quadrant. And it's interesting that recently one of our clients, a top automaker, requested we replace the rogue RPA robots they deployed from 1 of the standalone robotics companies. Now let's look at low code where a model driven approach is critical to allowing lots of constituencies to participate in app development. Now many of the low code tools that exist today are being used to create disconnected non IT compliant apps that will eventually become a problem for the organization, kind of like the RPA phenomenon. And for those of us who have been around before, we've seen this movie. It's what happened to businesses that depended on Lotus Notes or PowerBuilder and then ended up with a real headache. Without the end to end connections, clients risk creating disjointed experience for their customers and for their staff. You have staff bouncing between applications like we used to do alt tab in the old days to go from one window to another. It's not a way to have sustainable transformation of success. Now Pega pioneered low code with our model driven development approach, which is at the core of what we deliver. It allows clients to quickly develop and deliver coherent applications so that they can work together, that they create a sensible insane experience. Now to better enable the citizen developer this past quarter, we announced the enterprise low code factory to guide citizen developers in making enterprise compliant applications. It provides tools, resources and training to allow anyone to build software while providing IT with the necessary controls to ensure consistency, auditability and governance. And finally, let's look at AI, another technology area with lots of hype. Now many of the solutions in this market are providing only limited results. And it's important to remember that AI isn't one thing, it's many technologies, machine learning, natural language processing, deep learning, pattern recognition, and it delivers value in many different ways. For example, our clients use Pega AI powered natural language processing to be able to parse and automatically process emails and turn them into end to end automations like I mentioned. But the biggest values our clients are getting from AI is that it can power 1 to 1 customer engagement that it can learn and adjust in real time. They want to make each contact with a customer tailored to just who that customer is, what they want and need with the ability to adjust as those needs and wants change. Through Pega's customer decision hub, our real time AI engine, we are handling millions of interactions every day for many clients, empowering experiences for more than 1,500,000,000 of their customers, tailored to those clients' customers' needs across multiple channels. RAI is what helps power our customer relationship management capabilities. Recently recognized by Gartner who named us a leader in their Magic Quadrant for customer engagement centers. We think our AI capabilities are world class, but just like we believe in a multi cloud world, we think we need to live in a multi AI world as well. So this past quarter, we introduced new AI connectors that plug into 3rd party AI engines, including Google and Amazon offerings. This new capability allows clients to enhance their Pega customer experience with other leading AI services. I'm more convinced than ever that our focus on delivering the best solutions for customer engagement and for digital process automation is the right approach. And we have the vision to drive our client success. Now I want to talk a little bit about some of the marketing work we've been doing. We discussed a lot of what I've just been talking about at PegaWorld just this past June, where we hosted more than 5,000 attendees from around the world are coming from more than 6 50 unique organizations and from more than 50 countries. We had some outstanding client stories for PegaWorld that brought these themes to life including for example Unum who showed how they use Pega RPA to create a full case management platform and replace a manual system for issuing policies in just 12 weeks. From PayPal, who is using Pega's low code capabilities to reduce their release cycles by 77%, so they can respond more quickly to competitive pressures and improve their time to market. And SiriusXM Radio, we talked about using Pega AI to help them move from a product focused marketer to a customer first approach. I also talked about Project Phoenix, our ongoing program to deliver and evolve a massively improved living underlying architecture for the Pega Infinity platform. We've been discussing technology shifts quickly and our model driven approach allows us tremendous latitude to evolve as technologies change. We have evolved our platform multiple times through our history and this is the latest set of advancements. It ensures that our clients will have access to innovative technical capabilities, including improved support of cloud native technologies. And we've already delivered new capabilities under this program and they're being used successfully by our clients. One of those is a new what we call digital experience API that allows seamless interoperability with the clients preferred mobile and web development environments to ensure a coherent experience across multiple applications. This capability was highlighted at TegaWorld by Rabobank, a Dutch bank who is using Tega to improve customer experience across channels. Their goal is to provide a completely digital experience for customers so that they can get the advice and help they need wherever they need it through whatever channel those customers prefer. This presentation as well as all PegaWorld keynotes and breakouts are available on pega.com. And if you couldn't join us live, I encourage you to check them out. We've also been increasing our investment in a global roadshow series we call the Customer Engagement Summits, where we typically register 700 to 1200 customers. At the most recent Amsterdam event, we had a great main stage set of presentations from our clients at Vodafone, EKMEA and ING. We've held 5 in the first half of twenty nineteen and have another 6 even bigger ones scheduled for the second half, including our government empowered event in Washington DC on November 6. We're anticipating terrific line of speakers and we'll be announcing in the coming weeks and if an investor is interested in attending, please let us know. So in summary, I'm really excited about the strong progress we're making. I see it borne out by results, our client successes and by our 3rd party validation. We're in a hot market with the right products and I believe the right strategy to help our clients succeed. And though we're pleased with our progress, we're aware of how much more opportunity exists and how much more we need to do. To provide more color on financial results, I will turn it over to Ken. Thanks, Alan. We're very much where we wanted to be at this point in the year. We've experienced strong growth in ACB, a solid increase in new licensing cloud commitments and the continued shift to cloud arrangements. We continue our transition from a business that's largely sold its software on a perpetual on premise basis to a much larger company that sells the majority of our software on a recurring cloud basis. ACV growth continues to be the most important metric that reflects the successful execution of our strategy. Total ACV is the sum of recurring Pega Cloud and client cloud commitments, representing the recurring annual spend by our clients. For the first half of twenty nineteen, we experienced fantastic momentum with licensing cloud ACV up 33% and Pega Cloud ACV increasing an amazing 65% from the first half of twenty eighteen. During the same period, total ACV increased 21% on a constant currency basis, reaching 613,000,000 dollars an increase of over $100,000,000 from 1 year ago. This growth reinforces our confidence in our long term targets. And it's even more impressive given that we didn't change our sales model until the Q1 of 2018 when we moved from a total contract value or TCV approach to an ACV based one. Our continued positive momentum in ACV growth reflects solid demand around the world for digital transformation solutions. We continue to see companies engaging in digital transformation to modernize technology so their customers have a favorable experience and they build efficiencies across their organization. Pega continues to be at the center of this digital transformation, a massive market opportunity growing at an accelerated pace. So let me take a few minutes to update you on how well we're executing our plan to transform our business to a recurring model. We continue to move much more aggressively into selling software in the cloud on a recurring basis. For the first half of twenty nineteen, 60% of our new bookings were Pega Cloud. From just 2 years ago, Pega Cloud as a percentage of new client commitments was approximately 20% in the first half of twenty seventeen. That's a tremendous shift in just 24 months. Recall that we had anticipated Pega Cloud increasing to approximately 50% of our new commitments in 2019. So the acceleration to 60%, it's a welcomed variance and it's significant. As a result of solid execution quarter by quarter for the last several years, Recurring revenue increased to 65 percent of Pega's total revenue for the first half of twenty nineteen. You can also see further evidence of our transformation success by looking at remaining performance obligations also called backlog. Pega Cloud backlog increased by $148,000,000 to $362,000,000 at the end of Q2, a dramatic increase of 69% from 1 year ago. Total backlog increased 32% in the same period to $628,000,000 Our robust backlog is another benefit of our cloud transition. Historically, much of our bookings were taken as revenue in the current period, sometimes causing lumpiness in our quarterly results. These days, the largest portion of our bookings are cloud, most of which goes into backlog, creating a more predictable cash flow stream. Our ongoing transformation to a recurring business has been deliberate and intentional. That's because we have a high confidence that the long term benefits of recurring business model, including a more predictable future revenue and cash flow stream in the future far outweigh the short term optics around reported revenue growth and any impact to cash flow and reported EPS and margin. We're confident that a greater mix of recurring contracts is the correct long term strategy direction for our business. However, in the short term moving away from perpetual sales replaces large upfront cash and revenue with cash and revenue that will be received and recognized over multiple years, causing a lag between business we win and its revenue, thus a mismatch between revenue and cost. You can see the impact of the cloud transition on our reported results. Reported revenue for the first half of twenty nineteen totaled $418,000,000 a 3% decline from the first half of twenty eighteen. While ACV on a constant currency basis and RPO backlog saw over 20% 30% growth respectively during the same period. I want to reiterate that we started the year with an expectation that Pega Cloud commitments would make up about percent of new bookings versus the 60% we saw in the first half of the year. As a reminder, each 1% shift to Pega Cloud has the potential to reduce full year revenue by approximately $3,800,000 in 2019 as the economic value of new Pega Cloud deals is reflected in ACV, but it is largely not reflected in current period revenue. Therefore, if you adjust for the impact of the faster than expected cloud transition, revenue would be approximately $20,000,000 higher for the first half. Moving next to revenue components, maintenance revenue grew by 5% to $137,000,000 in the first half. Our consulting revenue was $114,000,000 a year over year decrease of 14% or $19,000,000 from the first half of twenty eighteen. This is consistent with our strategy to encourage an increasing share of implementation effort to our integration partners. Additionally, we had a very large government contract where we have significantly enabled the client reducing the necessary involvement from Pega, which we also consider strategic. You can also see the impact of Pega Cloud transition in our reported cash flow EPS and margin as we continue to accelerate our growth through investments in sales capacity to pursue the great digital transformation market opportunity. It's also worth noting that our marketing expenses are the largest in Q2 due to the PegaWorld event. And with demand for Pega Cloud exceeding even our expectations, we're building out our cloud infrastructure to continue scaling the significant growth engine, which also has near term impact on cloud margin improvement. Q3 costs should be largely in line with Q2 without the cost of PegaWorld but also reflecting the investments in our reporting both GAAP and non GAAP results, a full reconciliation of all GAAP to non GAAP measures is provided in the financial tables in the press release issued earlier today and those are also available on the Investors section of our website. So now let's turn to a few other details from our year to date financial results. We finished the period with total cash and marketable securities of over $155,000,000 In the first half of twenty nineteen, we returned about $44,000,000 to shareholders comprised of a little more than $4,000,000 in dividends and approximately $40,000,000 in share buybacks. We finished Q2 2019 with just over 4,900 employees worldwide. In summary, we're very much where we wanted to be at this point in the year with an even greater cloud demand than we anticipated. With this faster than expected move to cloud, we're continuing to invest and a little earlier than anticipated to support this growth. And while this impacts our near term profitability, it puts us in a much stronger position to drive scale and margin improvement over the longer term as Pega Cloud becomes a greater part of our business. We're pleased with our mid year execution against our strategy. We're focused on finishing 2019 strong and continuing that momentum into 2020. And with that operator, we'll open the call to questions. I'll take our first question from Rishi Jaluria from D. A. Davidson. Please go ahead. Hey, guys. Thanks for taking my questions. Appreciate the time. Let me start by talking a little bit or asking a little bit about partners. I think one thing that impressed me at PegaWorld was kind of the size of the practices that a lot of your partners have. So wanted to get a sense with as you've had more of this Pega Cloud business, how is the reception from your partners been? Have they embraced it? Or is there a worry that with more out of the box that maybe it's a headwind of the size of their Pega practices? Yes. I don't think that Pega Cloud is in any way a negative. I think it's only a positive because it's allowed us as you could just tell from the size of this PegaWorld, the number of organizations compared to the past. It's just made it easier for us to penetrate new organizations and that's what they like. They like to get foothold in new places. They like to build it up. And in reality, the sort of messy stuff around software on premise implementations, those weren't really done by our partners anyway. Those were typically done by the company's IT teams. So we haven't really replaced that. So we're seeing and I'm sure you saw it and I'm sure you did reference checks with partners, a tremendous amount of excitement across the board and we're looking to turn that into having them make even greater investments in building out their practice, which as you know can be several 1,000 trained and certified PegaPer people deep. Great. Thanks, Alex. That's helpful. And I think going to maybe a couple of the numbers, starting out, now we've got 2 quarters of this breakout of Pega Cloud versus Client Cloud and seems for 2 quarters in a row, we're now at about 10% type growth for the client cloud and then Pega Cloud, obviously, a lot faster than that. Is that kind of a normal way to think about how the growth rates of those two components of ACV are going to be? Or is that is it not fair to extrapolate from, I guess, a limited history you have so far of that? So, Rishi, if the mix of bookings that we're seeing, which is largely 60% Pega Cloud, 30% client cloud, 10% kind of perpetual licenses, if that mix stayed consistent, I do think your assumption is more right than wrong, because you would see the Pega Cloud growth accelerating much faster and you would see the term licenses, so to speak, component of our bookings be something kind of slightly below our overall bookings growth because cloud is a much more dominant piece. Okay. That's helpful, Ken. And then, Alan, another one for you. I wanted to go back to some comments you made in the prepared remarks. I mean, you talked a little bit about cutting through the noise. I mean, obviously, you've got people out there or competitors out there talking about low code, which you've been doing for a while. You have competitors and playing up the RPA capabilities, which is a hot space now. Just want to understand from your perspective, what can Pega do to help customers kind of cut through that noise and really get some clarity in terms of which technologies are real and which ones are a lot of marketing behind them? Well, I think it's a multipronged effort. One thing we need to do is continue to get some of these stories out there and continue to publicize some of the things which we're quite sure are correct and which we're seeing some receptivity from people who are understanding that sometimes this hype machine is not all that it's cracked up to be. A big part of it is continuing to invest and increase our on the ground footprint and make sure that we have more people who are both sellers and supporters of sellers who can go out and engage with the clients and engage with the partners and get them to be bought in to these sorts of concepts. So we have a lot that we can do and we're working hard on doing it. We just came off of an internal several day planning process, which is going to influence the work that we do this quarter as well as into next year. And being able to tell that RPA story in the right context, I think is really key. When you talk to customers and you say, would you ever use a robot when there was an API, a computer to computer application programming interface available, they universally say never. I mean, why would you in effect scrape screens when you had a more reliable, faster and auditable better way to do it? So you wouldn't do it. So the notion that you're building your systems around these robots, people actually are starting to understand that that's backward, which is why I was really sort of amazed last month when it's caught on to the point that Gartner in its picture showed RPA in its current form is crashing down to what they call the trough of disillusionment. It goes through what they call the peak of heightened expectations and then the trough of disillusionment and what they call their hype curve. So it was just pretty amazing to see that. I would have figured it would have been probably 6 to 12 months out before people were catching on that this thing is a lot of hype on top of some good stuff, but a lot of hype. Does that make sense? And then last one for me, I'll just hop off. Ken, I wanted to just ask about cash flow. Looks like it was a little bit of a light quarter in terms of collections, right, if we look at the networking capital. Just anything in particular to call out and how should we be thinking about cash flow for the full year? Thanks. Yes. So we don't we didn't think it was a light quarter. We fully expected that cash flow billings, let's say it that way, billings will take somewhat of a hit during this big move to cloud and away from perpetual. And so we are in only the 2nd year of that movement. So we fully expected it to billings to be kind of lighter similar to the way that revenue would actually be reduced as you move away from those larger front billings. I think in 2020, it's an important inflection point for us. 2020 is the time period when you start to really see ourselves coming out of that movement into cloud. And so I think that you should expect that cash flow for the full year would be lower in a year that you're making such a big movement to cloud and away from upfront billing. So that wasn't a surprise to us. Great. That's helpful. Thanks, Ken. Thanks, Alan. Thanks, Rishi. See We'll now take our next question from Austin Williams of Wedbush Securities. Please go ahead. Hey, guys. Thanks for taking my question. This is Austin on for Steve Koenig. Just wondering if you guys are sensing any change in spending trends. I know there's been a lot of concern over some of the macro backdrop, particularly in Europe. Just kind of wondering if you're seeing any softness there or any change? Yes. Look, it's hard not to be a little concerned about everything that's going on around the world. And Europe is a little softer than we'd like. But no, there's no concern that's changing the rate at which we are looking to go to market and to invest. There's a lot of businesses out there and we have a bountiful pipeline. One comment just to add a little bit of color to that Austin. Brexit is certainly being talked about more as the date approaches. We haven't we can't say that we've seen a noticeable shift in buying patterns because of it. But certainly Brexit is something that people are watching. We do not have a noticeable business in China, right? And so some software companies are different and they do have very large. So that impact of what's going on doesn't hit us as much as other soft, some other soft Yes, it barely touches us. Okay. Okay. That's helpful. And another one for me, just are you seeing any kind of any particular strength in certain verticals? And I'm also kind of curious just with Pega Cloud adoption, how does that vary per industry? So it's pretty much across the board. Some of our largest Pega Cloud customers are some of the world's largest banks who a couple of years ago would not actually contemplate doing something on the cloud and are now becoming much more enthusiastic. Also, other industries that you think of as being tough industries like healthcare are also really good adopters of Pega Cloud. So we're seeing across the board. I'm also just very excited that the government has very assertively moved to consider cloud. We recently got our FedRAMP certification, which is a really exciting and very accomplishment. And I think that government modernization is enormously promising in general, but especially for Pega Cloud. And an interesting vertical that you wouldn't expect to adopt cloud is the public sector. And we just hired our Chief Information and Security Officer, Carlos Fuentes, who we announced started a few weeks ago. He was essentially in a similar role at the Federal Reserve Bank of New York. And his feedback was that not only is the government encouraging cloud, but they actually are requiring it because they believe that cloud is a more secure environment, that a public cloud is a more secure environment than the old traditional lock things in rooms on servers. So I do think that that's not a vertical you would expect to adopt, but it's very logical why they are. Okay, okay, great. And then just one last one. In terms of M and A activity, I think we've seen, I think, 2 this year so far. Just kind of wondering your approach to M and A at this point. Are you looking to grow the product offering inorganically through tuck ins at all going forward or should we not expect any more of that? We're continually looking at things. We have a high bar because two things are very important to us. 1 is that we'll be able to do a really good job of incorporating whatever it is that is acquired into our model driven architecture. That's a very important part of our decision criteria because we think the strategy of a lot of our competitors or other companies out there, which is they buy all this stuff, they unify it in their marketing messages and then they stitch it together isn't a very good or sustainable way to provide high quality product to customers. And the second part is we are very sensitive to firms that have people who have great cultures, who really want to work with us and that we really want to work with them. And those two things make us highly selective. So M and A is not central to our strategy, but it's something that we look at continuously. Okay, great. Thanks guys. Congrats on the quarter. Thanks. Thanks. See you Austin. We'll now take our next question from Pat Walravens from GMP Securities. Please go ahead. Hi, this is Mark on for Pat. Thank you so much for taking my question. So just want to touch on sales capacity. I think in PegaWorld you mentioned that for this year you're going to increase coverage of enterprise customers. So just want to get a sense of the progress there. Well, I'll let Ken talk to the numbers to the extent he's willing to and I'll talk to the sort of qualitative matters. We're putting a lot of effort into recruiting talent and it's not just in sales, it's across the company as a whole. And I'm finding enormous receptivity in the talent pool to come talk to Kaga. You can get a sense of this easily and objectively by just going on LinkedIn and seeing the people who are coming to us from the other people you would think of as being in our competitive sphere. And I'm both very impressed with the level of talent that we're finding extremely interested to come to us. And we, as I said, have really dialed up that engine and intend to continue doing it, not just for salespeople, but for the entire go to market ecosystem that you need to be able to pull that off. So the only piece of maybe qualitative comment that I might add to what Alan said is, we have very aggressive plans to grow our go to market team and we've talked about at the beginning of the year that it is a competitive environment in the hiring landscape. And so we view the fact that we're able to achieve our hiring plans as just a great positive that given how competitive the hiring market is. So we're seeing great people. We're getting great additional capacity and so we're continuing to move ahead. Okay. Thank you. And just one last one, I was wondering if you can provide maybe some of the most common use cases for government that is using Pega Cloud and how is the adoption there? Yes, sure. So the government is just a terrific place. It's interesting because we've got great examples of where they both use our cloud, but also they use client cloud as well where they're choosing to run it on their own cloud infrastructure, For example, in the Department of Commerce, they've got a very large implementation there that they're running on client cloud. One of the great FedRAMP Pega Cloud environment that we have is in the area of what's called grants management in which you're trying to control how these organizations distribute money, how they figure out who is qualified, how they get the right sort of approvals and review process is internally, how they follow-up. And I would describe that, I would describe huge swaths of government as being just enormously rich examples of case management, process automation tied to rules and intelligence to try to make things not just controlled, but efficient. And given how old some of the existing systems are, it's a very rich environment in which to be hunting and we're continuing to build that team out for you assertively as well. That's all for me. Thanks guys. Thank you. Thank you. Peter, do you have a So with that Go I was just jumping in. So let me tell folks that we're working hard on their behalf that we see enormous opportunities here. I'm really excited that we're making lots of good progress and look forward to seeing you all soon and talking to you in 3 months. Have a great day.