Hey. Good morning. My name is Sheldon McMeans, and I help support RIMO covering the U.S. enterprise software space. I'm excited to have Ken Stillwell, CFO and COO of Pegasystems, here today. Ken, thank you for being here.
Thanks for having us.
Appreciate it.
Great. So Pegasystems has been around for many years, but has gone through a bit of a transformation, going through a subscription transition, coming out with a cloud product, and through that attracting new investors. So for those who are new to the Pega story, can you introduce them to the company? What solutions does Pega offer?
Sure. So in any enterprise, really of any scale, there's a tremendous amount of work that needs to be done. And that typically is done through applications that have a foundation of workflow, which is typically taking volumes of transactions or events and managing them through a very structured workflow. There are lots of things that happen in the company that don't require workflow, like things like sending an email is not really a workflow solution. There are also large vendors like ERP that have workflow-type solutions, but are very commoditized, meaning they're very structured. And so we don't compete in the spaces where the activities don't really require workflow, like an email. And we don't really displace companies like ERP, where there's a very almost a regulated, structured way that the application needs to be built.
We tend to solve problems on all the other use cases that sit around those types of things, things like that sit around like an SAP or Oracle ERP system, like collections in AR, managing purchasing requests, or managing things like customer disputes on a credit card, or issuing a new card, or address changes, or even more sophisticated ones like loan origination and banking, or onboarding participants in a health care plan so we tend to, there's lots of things that probably people don't realize are actual workflow activities that need to have a structured way of managing that and that's what Pega does.
Great. And could you speak to some of the factors that differentiate Pega? And I would love to hear maybe how those factors have changed in a new world where you have AI and generative AI, which creates new requirements and perhaps demand on the underlying architecture?
Sure. So I think a fundamental difference or differentiator for Pega is the way that our product is architected. The architecture, the structure of our workflow, the use of a case or a container to isolate information, but to create relationships one to many or many to one with the different types of events, the real-time ability for us to real-time integrate with all of the different systems that need to share information so that you can make that workflow be real-time, instantaneous, but yet containerized, and from a regulatory and quality control standpoint, you can manage all of the activity. You can look at the variances.
And putting that into a UI experience that allows an everyday person of customer service or a customer actually using that application in a way that feels very out of the box, that feels like it's something that is very structured and commercialized when behind it is a very powerful platform. If you look at the Gartner and the Forrester rankings and you look at Pega, we've always been top right and top and to the right on pretty much every ranking over the last 25 years in terms of in our space. And we've either been top or certainly at the top. So I think that we've earned a certain level of brand recognition of being when you're doing workflow solutions, Pega is the most powerful platform to use. And certainly when you think about some of the verticals that we're in that are B2C verticals.
Now, what's interesting is when you say, well, how does that play with GenAI? What changes? What's the same and what's different? And I'll take a stab at maybe trying to articulate maybe what's the same and what's different. What GenAI, or quite frankly before that, RPA didn't change is, and I'm using RPA as an example because it was also a technology that questioned workflow providers and said, well, maybe RPA is the way that you get work done. The problem with GenAI, which is also the advantage, is that GenAI is very good around unstructured information. That's actually the intent of why it was created. When you have structured information, things that need to be the same each and every time, you can't put the same one in 50 times and get 50 different answers or even two different answers. It has to be the same.
GenAI doesn't do that well. When you actually try to look at the transactions and say, tell me exactly how you arrived at this decision, GenAI doesn't do that well. It points to different information. It says, "I formed my opinion based on X, Y, and Z." So in a structured world where you want to look at which loans were approved and which loans were denied, and are you following the fair lending practices? Do you have discriminatory lending or predatory lending? These are things that are very serious things in all of the major countries. So you can't just say, "well, I asked GenAI and it told me I should decline the loan from Ken Stillwell." That's not going to fly. So there has to be a level of structure.
Where GenAI will really advance workflow-type applications is all the periphery of that workflow application. There is human interaction. There's human interaction with the consumer. There's human interaction with employees. There's human interaction with exception handling. There's documentation that needs to happen. People write notes, and those are all things that GenAI can really help to streamline and advance in terms of writing an automated call wrap-up after you're working on customer service or listening to the conversation and determining what the customer service person should say to that customer. Or even imagine a scenario where the customer's talking to a virtual agent, not a real person, and actually having a conversation and solving the problem. That's where I think GenAI can be really powerful around workflow solutions.
Yeah, interesting. Yeah, I feel like that deterministic versus undeterministic aspect is something that's a little underappreciated. So great. Moving a little bit more to financials here in the short term. So in Q3, ACV accelerated nicely for the second consecutive quarter. And you talked about broad-based execution being the primary driver. And I would love to hear some color on the sustainability of that acceleration. And then maybe one thing we are hearing some pockets of macro improving. So if you can just help contextualize whether or not the macro improved, or is it more execution on Pega's side?
Sure. So we have not personally seen much change in the macro over the last couple of years, for good or for bad. So we feel like the macro has been OK, not great, for the last probably since 2022. I think I'll touch on that point a little bit. I think it would be naive to believe that given the outcome of the election that we won't have less regulatory headwinds in the future. I think that's a fair assumption to make. That should then allow a more active M&A environment. That should also have people probably take more risks in terms of infrastructure investment and modernization. And GenAI may play into that. So I would say that should be generally bullish in terms of the coming few years, in terms of people's confidence level.
I think you can see, just quite frankly, the uncertainty of the election just being over, regardless of the outcome. I think that there's definitely a kind of it's much more calm now than the anxiety that we felt through the last year. I'm not sure that that would have been my prediction. I still thought it would have maybe taken a little longer. But it is good to see things kind of settling in. So I do think there's a level of confidence. I think inflation is still a risk, and for many of our businesses, a big factor that they have to consider. I think government spending is still. That's a big unknown. There's a lot of very bold comments that the administration's making about what they plan to do. Some of those make a lot of sense, like getting the government off of old costly systems.
I think that's very aligned with our strategy, but where those dollars will go is, I think, still a little bit gray, but overall, I think the outlook looking forward certainly looks to be a touch better than what we've seen in the last couple of years. In terms of our performance, we've been very transparent around in our business, not every year has linear performance, and last year, we had a little bit of an easier compare in Q2 and Q3 and a harder compare coming up here in the current quarter, and that played out as we expected, that you would see a little bit of a potential to accelerate growth in quarters where the compare is a little easier, so that's just being fully transparent.
That said, when you look at where we were at the end of Q3, net ACV growth year over year, it's pretty healthy. And we really feel good about how we've executed through three quarters. Q4 is always an important quarter for us. But that's kind of the general framework of how we're thinking about the economy and our performance. We were very happy with our execution. Still, even with three weeks left, there's still a lot of work to do, as there is with probably any software company at the end of a fiscal year.
Right, right. And Pega Cloud ACV reached 30% reported, 26% on a constant currency basis. Can you talk about the drivers of Pega Cloud ACV growth?
Sure. I mean, so like I said, just being very transparent, a little bit of that has to do with some of the comparisons that we had in Q3 over other quarters. But I think in general, Pega Cloud is our future. And it's our primary selling motion. We're working with clients to talk about how they can migrate to Pega Cloud if they're not on Pega Cloud and trying to do that in a partnering way as we can with our clients so they can achieve that value without having unnecessary pressures on them. I know other vendors take different approaches. But with our retention rate and the stickiness of our product and how long our clients have been with us, we want to be on that journey kind of hand in hand as opposed to forcing them to do things unnaturally.
But I think what's really interesting about the business is our sales teams took a couple of years to get comfortable with Pega Cloud. The market kind of took a couple of years to get comfortable with Pega Cloud, the maturity of Pega Cloud. Our margins were really not great when we were at subscale. And now they're kind of approaching 80%. So it's all kind of coming together where the sales team is really, really skilled at it. The clients view us as a cloud provider. The cloud technology is very advanced. The margins are. It's kind of the right time for us to push down on that. So you're starting to see that happen where Pega Cloud will continue to grow faster than overall ACV. In any quarter, I don't worry too much about what happens in one quarter, positive or negative.
But over the next few years, Pega Cloud's got to grow 20% or above to help our ACV have upside potential. If we don't get that growth from Pega Cloud, you're not likely to get the growth from ACV overall. So we think it's a critical part of our growth story.
Great. And so one thing you did note, the tougher compare in Q4. And one of the other things that we've seen is a strengthening of the U.S. dollar since the election. So thinking about those two factors, I know you don't give quarterly guidance. But when you think about your 11% ACV growth guide for the full year, do those factors put the reported level at risk? How should we think about those impacts there?
Yeah, it's a great point and probably something that's not talked about that much as it maybe should be. Our business is 60% in the U.S. dollar and 40% in other currencies, which if you look at other companies, that's pretty average. If you go to other enterprise companies that you might see around our scale, like a Dynatrace or someone like that, they probably have the same mix in terms of the revenue outside the U.S. And the dollar against the euro, which is the primary currency we sell to outside the U.S., has moved 8%-9% in the last month in terms of, so we went from at the end of Q3 where we had a 2% tailwind or something like that for currency, and we could end up with a 2% headwind at the end of the year.
That optically, I think all investors understand constant currency is much better than reported. But I do think that over time as all of the analysts update and people give guidance, I think that's something that is kind of not being paid that much attention to, which is that the dollar continues to strengthen through the end of the year. Now, they're going to make interest rate decisions, I believe, next week. So that could actually impact currency rates. But yeah, for us, it's like a 4% impact or something like that. So that's, I don't know, what, $50 million. So it's not a, and just to remind, for us, revenue is reported monthly and not that impactful from a change like that. But things that are balance sheet items like ACV or ARR are only measured at a point in time.
And so that's why ACV could have a bigger impact. I think wherever we land on that, that's something we can easily explain with constant currency. But I think it is something for investors to just remember. The dollar has strengthened pretty aggressively in the last three to four weeks.
Understood. And during your investor day, you laid out a few scenarios to reach $2 billion in ACV in the next three to five years. So that implies about 10%-17% growth. And how are you thinking about this? Is there any reason that you shouldn't be in the middle to the top end of that range? And how sustainable is that?
Yeah, I mean, that's a great question. The way that we've thought about it and are thinking now is really not noticeably different than when we talked about this in June. There's really three scenarios. There's a scenario where we really don't have much impact from Blueprint. We really don't win at any increased pace. People don't really move to Pega Cloud. But we continue to kind of execute with a level of NRR. That's kind of that 10% grower. It's certainly not the end of the world. But it's a disappointing outcome if we ended up there. I think that's kind of that low-end scenario.
And then there's the other scenario that we framed, which is, imagine if we have some good pace of migrations and that Blueprint drives new logo attach and drives faster sales cycles and a little bit more addressable market opportunity. And we execute reasonably well through that, you could see kind of us being the kind of company that saw the upper end of that range or quite frankly, even higher than that. And then there's kind of that base case, which was, assume that Blueprint is helpful but not transformative. Assume that there's some level of migrations, but not anything aggressive. And that's kind of that middle range. That's the way we thought about the different dimensions. I think that if we're a 10% grower, it would be disappointing. I think if we're a 20% grower, it would be great. I'm not going to say it would be surprising.
But I would say it would be a really amazing outcome for us. But I think we should be growing faster than we're growing. We have a great market, great opportunity, the best solution. And I think Blueprint could help us do better. But we've got to roll up our sleeves and execute on that.
OK. And on Blueprint, you recently issued a press release with some new capabilities of Pega GenAI Blueprint. So first, for some in the audience that may not understand what Blueprint is, could you just provide a quick overview of what that is and then talk about some of those recent enhancements?
Sure. So if you think about the number one problem that a company like Pega would have in terms of growing faster, it's selling, it's positioning, selling, and helping our clients digitally transform or build new applications. Because you have to architect it. You have to design it. You have to build out the workflow. You have to configure it. You have to test it. And you have to integrate it. So it's an enterprise application that needs to be deployed. One of the biggest challenges in that is the time to show the client something about what their app would look like and the design effort that is required to get there. And that takes implementation time, whether it's us, our client, or our partners paying for that.
So when we acted when we saw GenAI, we envisioned a different way of using GenAI, which is Blueprint, which is to take all of the information we have about the use cases that our clients have and build an experience layer where you could communicate with Blueprint. Blueprint would use GenAI to look at all of the content information that you have and build the application for you. It knows all the rules, the configuration, the best practices, the standards, the code, all of our technical documentation, all of our previous implementations. So if you say to it, I'm a bank and I'd like to do an exception handling process, it will build an application. Now, that doesn't mean that you have to accept that. You can still configure it. That's Blueprint.
Some of the things that we've done to enhance Blueprint more recently is that we're really thinking about not just relayering the user experience of an old application, which is a lot of clients kind of thought about this kind of wrap and renew approach, which is you renew your old database and then we'll give you a new user experience, and we're really shifting away from the traditional wrap and renew approach to what we're calling rethink and replace, which is look at that application and figure out a way to get rid of it so that you can get a new modern application and you don't have to pay for two, which is one of the biggest challenges with digital transformation.
So in Blueprint, we've added things that will allow us to address not just the application layer, but also the database layer, the information, things like the data definition language, migrating the information, moving from potentially a mainframe or an older database over into PostgreSQL or a more modern architecture MongoDB et cetera. So that requires work that's not just building the application and the workflow and the integration. It also requires you to manage data, figure out how you're going to stream the data, where you're going to store the data. So we have partnerships with large hyperscalers like AWS and GCP. And we'll also leverage things like Databricks and Snowflake and BigQuery to basically store the cold storage data. So we're really going to become a system of record as we actually retire these applications.
We think that's critical for helping our clients move faster and also critical for us leveraging GenAI on the data. Blueprint is really maturing to help that true legacy transformation that we want our clients to experience.
Yeah. It makes sense to add those features to make the migration easier. And would love to hear.
To also ingest documentation as well, like screenshots, process documentation from the old application. So that's another feature. Sorry to interrupt.
OK. And yeah, so making the migration and modernization of legacy apps easier, that makes sense. What opportunity do you see there, and you also added a new Chief Cloud Officer position, which is something you didn't have before, and what does that add to your motion around cloud migration?
So, I actually hired Frank Guerrera in 2017 when we really started to move into the cloud. And Frank actually reported to me and ran our cloud operations team. So he helped us build out our cloud. Now, not the actual feature function of the capability, but the actual control plane, a lot of our certified clouds, our sovereign clouds in different countries. So Frank has a tremendous amount of experience and brought in a really amazing team to build that so that we could get to 80% or above gross margin. So not that we're at 80% yet, but I would say mission accomplished. We're at 78%. 80% is just around the corner. We then asked Frank to redirect his efforts to get out in the field more and help us with our clients that were thinking about that adoption.
His acumen for understanding the technical migration path and also understanding the customer use cases and environments is a perfect suit for actually getting him to help us move faster on that. So that's kind of the Chief Cloud Officer push.
Got it. And is it right that while a significant amount of Pega Cloud growth has come from existing customers, this is more new applications or new workloads as opposed to those legacy migrations? And how should we think about the uplift here when you go from legacy to Pega Cloud?
Yeah. So all of our growth, the overwhelming majority of our growth, has been new use cases of Pega Cloud to date, which is what you said. The next opportunity is the migration of clients that are not on Pega Cloud to Pega Cloud. The uplift there can be I mean, it could be a large range. It tends to land in the 25%-35%. It depends on whether they bought a perpetual license originally or a term license and where their pricing is. So there's a little bit of some arc to that in terms of each client. But in general, there's a slight uplift for that when clients move. The third one is net new logos, net new workloads.
That's really the legacy transformations, things that are not on Pega that quite frankly may not be in path to be migrated, that Blueprint and our new approach would help us maybe bring those in scope. Our Chief Cloud Officer role will be across all three of those. So he'll be helping our sales teams sell new, continue to sell new, help with clients to migrate, and looking at new applications that would be a little bit more the legacy transformation, which is taking the database with them, which is a little bit of the difference in this expanded approach we're taking.
Yeah, and it seemed like we talked about the 10%-17% range. You mentioned 20%, which would be a great scenario but not necessarily surprising, so it does sound like Pega Blueprint success is what's going to help you get to that 17% and potentially 20%. Is that fair?
Yeah. I think the simplest way to think about it is our NRR, our net retention rate with existing clients, has been relatively stable over the last five to eight years. It's been somewhere maybe 10%, maybe just slightly above 10%. For that to change, something has to change. And for us to attack new logos, we need a more efficient distribution model for new logos. Blueprint is highly relevant to both of those. And so that's where I think there is, I mean, I think it's not to say that we can't get it without Blueprint, but certainly we would think that Blueprint would be a big factor in us achieving the accelerated growth.
Right. And you brought up new logos. And you have been pursuing new logos more aggressively. So I mean, you've been around for many years and really leaned into your install base, selling more solutions. So I guess why now? Why is this the right time to pursue new logos?
Yeah. I think we had done about five or six years ago, we had pursued a more aggressive new logo strategy. And we actually had a lot of success getting new logos. The problem was we were getting the wrong logos. We were getting companies that didn't have the propensity to spend a lot, that may not have been right for the workflow, the enterprise workflow. And so some of those clients probably weren't the ones I would have targeted if I was actually targeting new logos. The difference now is that we are actually targeting very specific, precise, which vertical are you in, what's the scale, how much spend do you have, what's the relevance for our solution. And that's the way we're creating our new logo. There's thousands of companies that look just like the 200-plus that spend more than $1 million with us.
There's thousands more that look just like them, even in our verticals. So I think that that's really what we're going after with new logos. We just feel like it's time. We had put that a little bit on pause as we did our sales transformation a couple of years ago because we felt a lot of times a sales transformation will go faster if you can minimize other distractions. And we thought focusing on the target org model and getting that done quickly and anchored was better than trying to also do that while we actually targeted a lot of new logos. So since that sales transformation is anchored now and we see better productivity and better engagement, we're starting to now open up the aperture, so to speak, to go after new logos.
Understood. And I want to make sure we get to some free cash flow questions. So that's something that's picked up significantly quite quickly. And so what has been some of the key drivers of that momentum on the free cash flow side?
One of the things that we said when we started the cloud transition in 2017, we said we're going to blow up cash flow for a couple of years. The revenue is going to be messy. And that's just the model, transition. The good news was that almost every investor saw the Adobe model. Now, they started with a much higher margin, but they saw the decline in the margin. They saw what happens when you go through a transition. So because they were kind of a pioneer on that, so to speak, that it was very well established what a transition model looks like. So that helped us because the metrics and the explanation investors understood. But we knew that when we got to a point, the cash flow should start to inflect up.
And we probably missed that by about a year in terms of I thought it would happen a year earlier than it actually did. But what you're seeing now was we knew as we exited, cash flow would go from break even to maybe 150 to maybe 250 to maybe 350. And what happened is it went from $25 million to $200 million to three something to so it's actually tracking exactly as we would expect. What's happening underneath the covers, so to speak, is that we've managed to grow the business by not forcing ourselves to spend more on R&D, more on G&A, getting gross margins up in Pega Cloud. And our sales efficiency has actually come down, meaning our cost of sales compared to revenue or ACV growth has actually come down. So we've really, I would say, operationalized kind of a Rule of 40 mindset within Pega.
I think that has helped us get to where we are. I still think we have a ways to go on our free cash flow margin. I think we can be a mid-30s free cash flow margin company and still be a double-digit grower. We're not there yet.
OK, and we're close to wrapping up 2024. You guided to $350 million in free cash flow, touching over $400 million on an adjusted basis. So for 2025, how should we think about that $50 million in adjustment? Is $400 million on the table for next year?
Yeah, so I think the way to think about next year is that we know that we will not get any less efficient in any of our P&L items, and Pega Cloud does not have the ability to jump as much as it has in previous years because once you get close to 80%, 1% move is challenging, but we'll still see a little bit of accretion there, so when you go forward to next year, you're right, we had guided somewhere around $400 adjusted free cash flow. What we look at is free cash flow growth, and we're looking at free cash flow growth per share, so if you look at that number, our free cash flow should be growing by a number of 100 basis points faster than our ACV growth for the next few years.
And that ties to the room we have to get the free cash flow margin up. So we should be seeing our free cash flow grow 15% or higher for the next number of years. And that, depending on what that actually ends up being in terms of per share, is really played into how many shares we buy back using our cash. But we're going to have very healthy free cash flow growth in the coming years.
Great. And if I could slip one more in. So you talked about the board recently authorized $250 million in share repurchases. You talked about free cash flow per share. How are you thinking about the intrinsic value? Is that a framework you use, free cash flow per share, that you'll be more aggressive or less aggressive?
Yes. I look at our peer group multiples on free cash flow, kind of our growth-adjusted multiple, and based on where that sits, I think it's an objective way to accelerate your buybacks, or quite frankly, if you're overvalued, which we are far from being, you would decelerate your buyback, so we're using that as kind of a quantitative model to think about how much we buy, and where we are right now, we feel like we're a good investment.
Great. Thank you very much, Ken. It's been a pleasure.
Thank you very much. Thanks.