Earnings Call: Q1 2018

May 10, 2018

Good day, everyone, and welcome to the Pegasystems First Quarter 2018 Conference Call. Today's call is being recorded. At this time, I would like to turn the call over to Kenneth Stilwell, Chief Financial Officer, Chief Administrative Officer and Senior Vice President. Please go ahead. Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems Q1 2018 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, 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 of 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 the fiscal year 2018 and beyond could differ materially from the financial 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 2018 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, 2017, and other recent filings with the SEC. 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 view to change, except as required by applicable law, we do not undertake and specifically disclaim any obligation publicly update or revise these forward looking statements, whether as a result of new information, future events or otherwise. And with that, I'll turn the call over to Alan Trefler, Founder and CEO of Pegasystems. Thanks, Ken. As a highlight, I'd say we're off to a strong start in 2018. As we've been discussing, a key element of our strategy is to move more and more to recurring revenue and these quarters results demonstrate the strategy is working. It's always important to look at our results in context, especially as we're now reporting under the new quite different 606 accounting standards. These new rules have the potential to further exacerbate what we've described as the lumpiness of our quarters, especially with term license sales or renewals. And this may result in quarter to quarter comparisons looking odd. For instance, while our quarter to quarter comparison looks down relative to the re cast Q1 2017 number, the Q1 of 2018 actually represents about 25% of our revenue target for 2018. Thus, we began over a year ago to talk about growth in annual contract value or ACV as an important indicator of our financial performance. This quarter, our term license and cloud ACV grew by 22 percent year over year and our total ACV, which also includes maintenance on perpetual licenses, grew by 15%. Ken will provide additional financial details later. Let me take a moment and dig into some of the strategy and differentiators. Though we still have a lot of work to do, we're pleased with how our strategy is playing out. Most importantly, we continue to see clients existing and new adopting our software to achieve real measurable business outcomes. We believe successful digital transformation demands both effective customer engagement and the ability to automate digital processes. And we continue to focus on delivering the best technology in those areas and they're both healthy growth markets. Organizations continue to choose us because we offer real value through a unique combination of our real time omni channel artificial intelligence that can embed itself seamlessly into work across channels. Our end to end robotic automation that includes robots, process automation, case management and e mail bots and software that actually writes our client software, which lets clients focus on designing customer journeys using a model driven architecture that lets them target the right outcomes instead of writing and maintaining programming code. Pega applications are developed faster, adapt more easily and allow clients to innovate more effectively. We're the only provider in our space to truly unify real time omnichannel AI and end to end robotics with CRM on top of a future proof architecture. Pega's AI and machine learning capabilities are woven in from detecting the behavior of users on the front end to providing diagnostic oversight of system itself. Throughout the system makes recommendations and even updates the code to continually evolve. Thus, clients can optimize for customer behavior, employee behavior and optimize the software itself. This is a powerful combination implemented on a coherent architecture and we think provides unique advantages our competitors can't easily replicate. These differentiators continue to pile business. And as we see our clients and prospects progress in the digital transformation journeys, they are recognizing that it takes this type of software to be successful. We're in a great position to capitalize on that opportunity. Now in terms of client success, during the Q1, these key differentiators help drive new business from both existing and new clients, both in the area of digital process automation and CRM customer engagement. For example, we drove new business in the quarter with the marketing arm of Ford, which chose Pega to give dealers a competitive advantage in their sales and marketing programs. Using our customer decision hub as the brains behind their digital dealer solutions, they ensure a unified brand experience for the customer. This is a great advantage of our cloud choice offering as they're running on a private cloud. FleetCor Technologies is a technology services company and selected Pega to optimize the customer service rep agent desktop with Pega Robotics and the Pega platform with a goal to improve customer experience and customer retention. Singtel Office, an existing Pega marketing client bought additional Pega Cloud software to support their device services transformation, including the development of digital self-service to improve customer engagement. The new app will leverage our case management capability, robotic process automation and mashups in the cloud. And finally, Willis Tower Wopsen, a group health and benefits organization, bought Pega Cloud Software to improve customer engagement across the Group Health segments, they were particularly impressed with our ability to support a rapid development environment and provide seamless customer Since our last call, we've received awards and recognition from leading industry analysts like Gardner and Forrester. For example, our digital process automation capabilities for business process management, our multi channel marketing solution, our low code platform as a service solution, our cloud based dynamic case management, our AI customer engagement capabilities and the capability we call the T switch, which ensures that the right type of AI is used to keep customers in compliance with laws. We launched the 1st AI powered sales coach to teach smarter selling. We introduced the industry's first KYC CLM solution that uses AI to drive relevant offers to customers during the onboarding process, providing control and transparency need for regulatory compliance. And we introduced GDPR accelerators to help our clients fast track their regulatory readiness for these new European regulations. And perhaps most importantly, we've been working product launch in the company's history that we'll introduce at PegaWorld. Now PegaWorld 2018 is less than a month away. And from our point of view, it's the single most and Our keynotes include speakers from Aflac, Anthem, Commonwealth Bank of Australia, Genworth, Google, Liberty Global and JPMorgan Chase. You can see on pegaworld.com descriptions of the many sessions, including speakers who will talk about, well, like Dell EMC will discuss transforming its customer service organization using Pega Decisioning to handle a maze of legacy applications. Philips Healthcare will discuss the development of a mobile healthcare platform using Pega to help integrate applications for connecting with healthcare providers, healthcare professionals and others across the healthcare continuum. PayPal will describe how it's using Pega to deliver the next generation of customer service apps. And Raytheon will discuss its choice of Pega as its digital transformation platform to drive better business outcomes. Is going to be there to discuss their Internet of Things type use of is going to be there to discuss their Internet of Things type use of Pega Cloud in 5,000 schools across the state to accelerate access to free or subsidized travel to and from school for more than a 1000000 students. Our 92 1000 Square Foot Tech Pavilion will feature over 100 live demos, showcasing our software in real world situations and hosting more than 40 partners. Our product managers will be there to discuss our products and future directions and we will be launching a revolutionary advance in CRM through the industry's only offering that truly unifies customer engagement with digital automation. I hope you'll be able to perhaps join us at our investor meeting on Monday, June 4, stay for the train concert Monday night or perhaps even the rest of the event on Tuesday. So in summary, we're off to a solid start in 2018. We're confident in our strategy. We have a unique offering in the sweet spot of major growth areas and hitting client needs. And we're excited about how our software is being adopted and our long term growth opportunities. To provide more color on the financials, I'll turn it over to Pega's CFO, Ken Stilwell. Thanks, Alan. Pega's start to 20 18 really extends our momentum toward becoming a much larger recurring business. For Q1 of 2018, we experienced strong term and cloud ACV growth of 22% from a year ago. It's actually over 25% if you consider constant Our year over year growth in total ACV, which includes maintenance, was over 15%. Our maintenance revenue growth continues to be over 10% annually, which in our size highlights the very high retention rates of our customers and contracts. There's a reason why we began talking about SMB for the past year and a half. We've discussed the impact of 606 on revenue results from term arrangements including renewals. Historically, term licenses were taken ratably across the contract life. But as all of you know, under 606, the entire term license revenue is taken when the license becomes effective. This significantly increases the variability of term license revenue quarter to quarter. In addition, our business tended to have client commitments to be largest in Q4, though often with an effective date in Q1. Based on this, I think Q4s and then to a lesser extent Q1s will be the higher term license revenue quarters in the Pega business models. And accordingly Q2s and Q3s will have less term license revenue. Perpetual licenses, maintenance, cloud and professional services are taken to revenue in a similar manner under 606 as compared to the previous accounting standard. The summary takeaway, our perpetual business has been transforming to recurring with our recurring contract mix increasing and cloud becoming a much larger component. You see an example of the impact of this variability in term license in the recast Q1 2017 numbers. We had a large multiyear renewal of $35,000,000 which was previously committed, but became effective and recognized in revenue in Q1 of 2017 under ASC 606. This is an example of why we have provided ACV for the past year and a half or so. We have known that with the implementation of ASC 606, we would experience some unusual comparisons between prior quarters and years, both positive and negative. With that fact, we see ACV as the most relevant measure of our growth. To provide another useful piece of information, in Q1 of 2018, our year over year cloud ACV growth rate was more than double our term ACV growth rate. Contributing to this result are a few factors. The market continuing shift to cloud, the growing demand and relevance for Pega's cloud offering and our incentive which we view as a differentiator in their buying process. Our cloud revenue growth is impressive at 50% year over year from Q1 2017. We expect cloud to continue to be our fastest growing revenue component. Our Q1 consulting revenue growth of 12% year over year is much more in line with our long term expectations than what we experienced in 2017. We remain highly committed to investing in our professional services ecosystem, which enables our partners to support an increasing amount of our client implementations. With such a significant amount of our new client commitments as cloud, approaching half of new business now is cloud, There would naturally be a short term revenue impact as cloud contracts are taken over the length of the contract versus upfront, unlike a perpetual or term arrangement. However, we are early in the year and although it would be great to see this level of cloud arrangement sustained, we are not certain this level of cloud bookings mix will continue for the full year 2018. For the Q1 of 2018, we're reporting both GAAP and non GAAP results. A full reconciliation of all GAAP to non GAAP measures is provided in the financial tables of the press release issued earlier today and is also available on the Investors section of our website. We are reporting that Q1 GAAP total revenue was $235,000,000 down 8% from last year if you consider the ASC 606 adjusted total of 2 $1,000,000 But as I mentioned earlier, this reduction should be viewed in the context of the $35,000,000 in revenue in the year ago period from that large renewal that became effective in Q1 of 2017. I'm pretty happy with the revenue performance considering that most new client commitments were cloud in Q1 2018. It's awesome to see such a noticeable move to cloud. Moving on to our balance sheet. The new accounting standard as mentioned previously requires Pega to book the total value of a term arrangement as revenue upfront, even though the billings under these arrangements will happen over the life of the arrangement. As such, we now have an asset called unbilled receivable. There's both the short term and a long term component. This primarily shows the significant future cash flows related to our recurring term arrangements. These balances will shift as invoices are created, new orders are received. No significant committed cloud cash flows are included in this unbilled receivable as cloud revenue is taken ratably over the duration of agreement. We had really nice improvement in build day sales outstanding and reduction to our accounts receivable driving very healthy operating cash flow in Q1 2018. In fact, it was the strongest operating cash flow for Q1 in our history producing $56,000,000 within the quarter compared to $31,000,000 for the Q1 of 2017. We finished the period with total cash and marketable securities $255,000,000 On headcount, we finished the period with approximately 4,300 employees, up 9% from March 31, 2017. The growth in headcount consistent with previous periods is disproportionately concentrated in lower cost territories as we expand our global client base and enter new markets. In summary, we're pleased with the solid start to the year and with the progress toward meeting our fiscal year 2018 and beyond financial goals. For those of you who have not yet planned to join us at PegaWorld, please reach out to me as you don't want to miss this awesome event. We have an Investor Day event planned at noon on Monday, June 4 as Alan mentioned and we look forward to seeing many of you there. As with that and with that, operator, we will open the call to questions. We'll take our first question from Steve Koenig from Wedbush Securities. Hi, gentlemen. Thank you very much. If you don't mind, I've got a multipart question for Ken and then a question for Alan. So starting with Ken, so just trying to make sense of the results here. If we were to replace the term and cloud revenue with term and cloud ACV on a quarterly basis, so dividing ACV by 4 and keep all the other revenue lines, we probably get a better picture of kind of your recurring revenue of your revenue run rate. And if I do that, what I calculated was you actually grew 4% year on year in the quarter. So not a fantastic result. Obviously, I mean, that's probably not what you were shooting for, but it was against a very tough comp, which we knew about. So maybe is that the right way to think about it? And do you think you can do better than this? And any thoughts on what you're shooting for business growth now? Yes. So Steve, so the way to do to do that type of comparison, what you want to do is you want to take last year's ACV for term and cloud and use that as a comparison for Q1 of 2017 and use this year's as a comparison for Q1 of 2018. You don't want to compare just this year to last year's numbers. So I think if you did that comparison, you would see a more significant growth because the ACV grew 22% year over year and our other revenue line items grew, say, maintenance, professional services, etcetera. The only impact that we have that is that actually skews the overall revenue growth that you're talking about is the movement away from perpetual licenses. And so if you take the perpetual licenses out, I think you got to make sure that you're factoring that in because it could skew the movement that we're actually moving largely to recurring and the perpetual has some headwind because we're moving away from perpetual licenses. Okay. So we'll circle back on that, Ken. But if I may just add then, how should we think about the recurring contract mix here? How would we model that? How can we think about that? We have the we used to have the bookings mix, but now how do we think about it? And then if you don't mind, I do have a follow-up question for Alan. So is your question, Steve, what was the recurring mix approximately in Q1? Yes. It was approximately 80% recurring. And how are you are you getting that by using 606 revenue? No. I'm using that based on ACV commitments and perpetual licenses normalized to be an ACV equivalent. Using what kind of duration there? We typically have a conversion from perpetual converted to recurring of about 3 to 1. Okay. That's very helpful. So thanks for answering all those questions. And I hope you can go back. No problem. Quick one for Alan, if I may. So Alan, I'm curious, any thoughts on the transformation of your go to market model and how that's working? I know you've only got 1 quarter under the belt with a new sales comp plan, but I'm sure there's lots of components here. Any data points on achieving higher velocity? And then kind of the second part of the question is this new Gartner concept of a high productivity application platform as a service noted that Pega was top for data process and business logic functionality. What more do you need to do to get perceptions, get awareness and perception in the marketplace of Pega's the strength of Pega's technology there? Well, I think some of that's going to have to do with some of the marketing rollouts that we're going to be doing at PegaWorld in terms of getting visibility. We were pleased to for the first time have been included in that Gartner report. And entering the Gartner report, you rarely enter as the absolute number one though we set our goals as getting there and think we have the right sorts of things to do it. We've got to do some additional work here around improving some of our processes through which we upgrade and support customers. I think we can do things not for Gartner doing that, it's for once again just continuing this transition to being a true cloud company and being as a service company. So I think there are things that will just come from another couple of quarters of experience. I'm really quite happy with the leadership that we brought in, in the last year to really help us get our cloud capabilities and our high performance application capabilities up to be at the absolute highest levels. So a lot of this is simply execution. It is new. It's the shift of sales force in on one day from a total contract value model, which obviously over incentivizes duration and I think has its own collection of foibles to a much more ACV aligned model was a big change. I think we knew it was going to be a big change. I'm pretty happy with the way it's bedding down. So we've got to get those reflexive behaviors to change in particularly the folks who've been around for a while. Great. Thank you very much. Welcome. We'll go next to Rishi Jaluria with D. A. Davidson. Hey guys, thanks for taking my questions. It's good to see some continued improvement on the cash flow side. Couple kind of quick housekeeping and financial related stuff for Ken and then I have one for Alan. Ken, I think just starting out, we saw some good improvement in cloud gross margins on a year over year basis. I know you talked a little bit in your prepared remarks about that. But can you help us understand what's driving the cloud improvement other than general scale? And how should we be thinking about kind of the glide path to your longer term model of getting to I believe it was 60% gross margins on cloud at about $100,000,000 in revenue if I'm not mistaken? Yes. So I think I mean you really not to let you answer your own question, but you really hit the main point. I mean I've said for a while that one of the biggest factors that we need to expand margin in cloud is just more customers, right? I mean, it's just because there's a lot of fixed cost, the fixed headcount, the fixed AWS infrastructure cost. So it's just I think a lot of the scaling you see is just the natural scaling. Now are we going to be able to grow margin by 5% every single year? That would be nice see. I think it really depends on the volume level of cloud customers. It might excel. We might grow margin by more than that if cloud continues to grow at such a significant pace. The only caveat to that is as we get more customers on our cloud and we actually situations where there's a lesser experience for our customers on cloud and that's really important to us. So we're being thoughtful about not trying to force the cloud to over perform on gross margin at this smaller scale than it is. Yes. We're all set on implementing a lot of automation as you would expect and that obviously all helps in terms of both the customer experience and self-service, but also in terms of cost. By the way, your comment on cash flow, I think that increasingly looking at cash flows, which are going to be I think highly related to ACV is going to be the clearest way to see what's going on in many respects based on some of these 606 changes at least until we get the preponderance of that recurring revenue business to be on cloud. Okay. Got it. That's helpful. And Ken, kind of as I go through the Q and look at some of the new disclosures around metrics like long term unbilled receivables and other unbilled receivables, contract assets. How should we be thinking about these metrics relative to, I guess, kind of some of the older metrics we used to look at like license and cloud commitments not on the balance sheet and backlog and kind of different breakdowns within deferred revenue short term and long term? I'm going to be very honest with you. I think that there's little you can take out of the changes in the unbilled assets that are meaningful in the way that we used to think about looking at changes in backlog compared to revenue. I wish that weren't the case, but the reality is the unbilled doesn't have cloud in it and the performance obligation only has things longer than 1 year in it. That's another disclosure we do. So there's a lot of gaps in there. We are going to work hard on trying to produce an additional metric here in the future that actually gives a view into the changes in kind of next 12 months cash flows, which I think is really what is important to validate that ACV growth. So that's one that I think is very important. And also just one thought to consider Rishi as we as our duration may come down slightly as we move to faster deals and more kind of the agility of being a cloud company. Our duration coming down may alter some of those comparisons we had when you looked at total contract value. So that's one caveat that I would say even if you did look at it, that's one thing to not forget. Okay, that's helpful. And just from a housekeeping perspective, were there any whales or extraordinarily large deals in the quarter? So we're going to get away from the whale discussion because we're really focused on ACV and it's really not an apples to apples compare. We still do significant size commitments with our customers. So I don't want to say that we're changing our business model such that that won't be the case. But we're going at Investor Day, I'm going to supply I think some additional metrics that around the segmentation of our customer base that will be a little bit more consistent with how you might think of a recurring business. The trouble with WhaleSpeak is it strongly encouraged the kind of 5 7 year deals that built up the total contract value. So I think the accounting team here at Pega did an unbelievably good job in battling through the complete recast on the 606, which the alternative which a lot of companies are going to do would be to just put the 217 number in it with an asterisk next to it, which frankly is kind of useless. We still have to, I believe, do some work to figure out what some of those right metrics are to bring clarity. And I do expect under some new definition, you will hear us talk about the children of whales or whale relatives to describe the extent to which this concentration in what we're selling and the level of the customer investment. We just weren't in a position to put that all together on the back of this recast. That was just an enormous amount of work. Just to follow-up on the one last point that Alan was making. As we as our cloud business as a percentage of revenue is still less than 10% of our business. But as cloud and recurring contracts now are more than 50% of our business when you add all the recurring, we really need to add and augment some of our operating metrics that are much more relevant in a recurring business. So we started to do that and we'll continue to improve that through the year. Okay, got it. That's helpful. And then last one for you, Alan. I know you alluded to this on the last earnings call and obviously there was the 8 ks that came out a quarter ago. But you talked about kind of maybe looking at the landscape of potential M and A opportunities and issuing some new potential Class B shares for that. I just wanted to see if there were any updates on that end, if you had any thoughts for how the landscape in terms of strategic acquisitions, be it existing businesses or tuck in technological acquisitions might look? Yes, relative to that letter, which was really just an opportunity to let us talk freely with investors and others to get opinions about things. We're not on a timeframe for doing anything. I just want to say we've begun having a couple of conversations. I'll expect there'll be more over the coming months quarters. In terms of M and A, we have opened our aperture some, but most of stuff that we're looking at is still, I would say, in the more traditional smaller range that we've been able to finance with cash. And the one thing I will also say is nothing should be read into either that letter or discussion of M and A that we're going to lose our mind and become irrational about prices. I just want to state for the record because I had a couple of investors who asked me, does this signal some major personality shift? I will tell you, it does not. So you can consider yourself reassured if you were worried. Okay. That's super helpful. Thank you guys and looking forward to seeing you all at PegaWorld next month. We'll go next to Greg McDowell with JMP Securities. Hi, this is Pete Lowry in for Greg. Can you help us just a bit on the modeling side with respect to term and cloud ACV seasonality for the rest of the year? How should we think about the puts and takes there? The change in ACV and I kind of highlighted this a little bit when I talked about the term revenue where you would expect a Q2 and a Q3 to be lower in term revenue than a Q1 and a Q4. I think that that's a fair way to think about ACV change as well, right? That ACV changes would be kind of larger in the Q1 and Q4 periods and maybe less large in the Q2 and Q3. That's not to say that that will be every single year and every single quarter you'll see that. But I think that's just based on the way that software businesses typically have that, the unfortunate back end loading of new customer commitments and we are enterprise software and we have that same trend. So although we are trying to do things to not have that the bookings pushed towards the later part of the year, I think it's fair that ACV growth in Q2 and Q3 would be less impactful than Q1 and Q4? So I haven't seen anything that would cause me to change from the traditional expectation that given that our sales staff has their comp plans and at the end of the year that there is something of extra push expected by both them and customers that this was our 1st year into it of course, so we'll learn as we do. But there's no reason to believe that that's going to change. Great. That's helpful. Thank you. And with no further questions in the queue, I would like to turn the call back over to Alan Trefler for any additional or closing remarks. Well, I'd like to thank everybody and once again invite folks to PegaWorld, look at the speakers. We're very excited that organizations of these magnitudes, these credibilities and with this sort of exciting set of stories to tell about what they're really doing are going to be there. One thing I'll say about PegaWorld is I think that a lot of conferences are just kind of rah rah shows. This is a very content rich context for our customers and for our investors to come see what's really going on. And I'd encourage you to do that and I think you'll be psyched. See you there. Thanks everyone. This does conclude today's conference. We thank you for your participation. You may now disconnect.