Great. Good afternoon, everyone. I'm Tom Blakey , the KeyBanc infrastructure technology and software analyst at KeyBanc. We're happy to have with us the COO and CFO of Pegasystems, Ken Stillwell. Pega, for those of you who don't already know, is a low-code platform for AI-powered decisioning and workflow automation. Pega was founded in 83, 1983 that is, by current CEO and founder Alan Trefler, at the age of 27 years old, and public company since 1996. Most recently, Pega ended 2022 with $1.3 billion, up 9%, led by 28% strong growth in their Pega Cloud SaaS solution, which we'll get into in a little while. With that, thank you very much, Ken, for coming and, you know-
Thanks, Tom.
Pega, I just would like to, you know, start with a generic overview of the platform. You know, and instead of going too long about it, I think it's best given, like, you have some great tier one examples in terms of where the platform is being used to kind of help people understand, what a, what a software solution and platform like Pega can do in terms of helping, you know, bring, you know, automation to workflows, as just an example.
Sure. I think probably one of the best examples. I'll give two examples that are very different use cases. One example is you have a large organization that has a common fragmented intellectual or information technology stack. They might have, you know, they might buy one solution for lead gen, one for pipe management, one for onboarding a customer, one for customer service. And that's pretty natural because they wanna buy best in breed for each of the different solution areas.
Additionally, they may have divisions or business units which may use some common technology or may use different technology depending on how much they may kind of interact or how much they may actually have their own technology decision, like their own CTO or their own CIO and be able to make that decision. When you have a situation like that, where you have a big company, complicated technology stack, which is in lots of customers and lots of transactions, which is pretty much any company in the Global 1000, Pega can play an orchestration role. Essentially, that end-to-end workflow automation is helping certain transactions that are not like open ticket, close ticket. They're things that tend to progress through different steps and stages through the...
It could be onboarding, it could be managing of an underwriting of a policy, could be a loan origination, things like that that might happen in different industries. That's an example where Pega would be kind of that, the orchestrated workflow where we would manage in, we have a kind of container technology. We call it a case, which is basically a container to manage the work. Then when the execution is done, whether that's a minute, a day, a week, a month, a year, we would then write back to the systems of record any information and essentially keep track of, you know, a lot of our clients have to do audits and have compliance requirements around their process to make sure that they followed certain ISO standards.
Another completely different use case would be, when clients are using a desktop, customer service, type, legacy application, and they go to people working remote, and they wanna actually use self-service with consumers, they might deploy a customer service application that is a little bit more of a kind of virtual desktop, right? Something that clients can access from anywhere. You can actually configure and think of, kind of the UI would essentially be a dashboard of all of the different places where customer data might actually be held. In that situation, Pega's not really the orchestration engine. Pega may actually be the UI that is used by the client, and it's pulling information from all the other systems. It might do things like automate certain steps.
It might actually use our AI engine to be able to drive decisions and next best offers. A voice AI to actually help to translate what might be happening and give, and even with the new generative AI, be able to serve up a suggestion, like, "We suggest that you say this to the client." It doesn't mean you can make it so that in a digital channel it might actually, on a phone, it might text that answer back, or it might just serve that answer up for the customer service representative to then make a decision whether they actually wanna say it in their own words. Those are two different, very different use cases where our platform helps clients to digitally transform.
No, I think it was important to make sure we kind of flushed that out too because Pega, you know, from a conception perspective, can do a lot, and has a very broad applicability.
Yeah.
That's very helpful, Ken. You know, similarly, in terms of the Pega story, you've been within a couple of transitions the last five years. You know, one perpetual to subscription transition, which a lot of software companies have been under, and also you with the SaaS solution that you've offered with the Pega Cloud, which has been growing very dynamically of late. Could you just maybe bring us up to speed with a little bit of history in terms of why especially with the Pega Cloud, these decisions were made and where we are in terms of maybe wrapping up some of these transitions?
Sure. I think it would be a mischaracterization to say that when I started at Pega, it was to drive the transformation that we went through. I would say when I started at Pega, it was pretty obvious that we had a transformation in front of us. We were perpetual based. We sold to a smaller number of enterprise organizations with a lot of, with very high or reasonably high NRR, and we engaged with those clients in very long-term relationships. A perpetual model doesn't make a lot of sense in that model from the Pega standpoint. It also became an impediment for our clients when they wanted to expand, but they had to go through a contracting exercise continually.
Naturally, in today's world, if you wanna, you know, consumption basis, flexibility and usage, being able to look at other use cases and leverage a technology with business users, you need to think about the contracting model as well as the technology. The first step in that was to really kind of finish perpetual license, the license model with Pega. We were already kind of over the years had transitioned some of our relationships, but with that big push in 2017, we said, "We're not, you know, we're basically we're way behind anyway." We said, "We're not gonna sell perpetual licenses anymore." We made this shift to subscription. Subscription to us at that time didn't mean SaaS, it didn't mean cloud.
It just meant a recurring relationship that was allowed clients an easier ability to be able to scale their usage, be able to. That relationship that was an evergreen relationship. What happened was, in 2017 and into the beginning of 2018, there just became a noticeable shift towards cloud in our clients. Some, you know, if you, if you were to talk to Salesforce, they'd probably say that was 2009. For us, we kind of saw it in the 2016, 2017, 2018, 2019, where the government started to push for cloud first.
Clients like, you know, I can remember, a large competitor of yours or probably the largest competitor of yours, where the CEO sat on stage in 2017 and said, "We will never go to the cloud." In 2018 he said, "Well, maybe we'll be 50/50." In 2020, he said, "Everything's gonna be on cloud." I think you could see just as an example, how quick the industry moved.
Okay.
In 2018, we said, "Listen, we... Our technology must manage our technology in a SaaS environment because clients are gonna force it." Right in the middle of a transition to subscription, we added on top of that the complexity of saying, "Let's move to SaaS." Fast-forward to now, we are done with that transition. I mean, I'm gonna say done because we're in the last kinda couple quarters, so let's just call it done. When we think about what does the business look like on the other side of that, we had originally said, when we're done with the subscription transition, the 12 months following the completion of that, we will measure ourselves under a Rule of 40 standard. If we're growing at 20%, we wanna get 20% free cash flow margin.
If our growth is 15, we want 25%. We made a strategic bet a couple years ago that is to accelerate our growth by accelerating our go-to-market spend. Admittedly, I think we struggled a little bit of that, mostly because of the product market fit of going down market with an enterprise platform. I think we've kinda recognized that misstep, and we've really kind of leaned hard into the Global 1000, Global 2000 existing organizations. Companies that really have the propensity to spend that our solution is a perfect fit to be able to solve the specific challenges of enterprise.
Where we land now is we're, you know, we're hitting the transition to SaaS actually has played out almost exactly as we had thought. You know, gross margins are 70%. They're going on their way to 75%. I think we have some real sight to see closer to 80% on our gross margins on SaaS in the next couple years. We've got, you know, two-thirds of our bookings or thereabout as Pega Cloud is SaaS versus one-third, which is the client manages that subscription license in their own cloud. What we're really unwinding now is this excessive amount of sales and marketing investment that we made. I mean, I think you could probably put us in the same camp as others to say we probably overhired, given what we saw during COVID.
I think COVID, there was a lot of digital transformation initiatives, but we probably, you know, maybe our eyes were too big, you know, it was too big for our stomach, so to speak, in terms of hiring, and That's the piece that we need to kinda correct.
Well, yeah, we'll get to that and I just wanna preface that by you're not in the worst camp there.
Yeah.
There's a lot of people that are laying off 10%, 20%, 30% of staff, so you're doing low single digits. Before we get to that, you mentioned a lot of things there. A strong NRR, focusing on the G1K, not even the G2K.
Yeah.
Federal strong federal, strong in the federal vertical.
Yep.
You know, the question is around this next kinda phase in this weak macro or softer macro, folks focusing on TCO versus more digital transformation like they have been in the last couple years. Talk us through, like in the notion of or in the context of visibility, you know, when you look out to your 2023 guide, you know, in this kinda unique position, quite frankly, that you have in terms of focusing on your existing customers, strong NRR. You know, just what are the sales, what are the motions that are pushing demand today in terms of TCO and, you know, digital transformation?
I'll maybe start by characterizing that if the economy was much, much worse than it, than we think it is right now, which meant that there was literally little to no incremental investment other than existing spend, I think every company would be very smart to focus on their existing clients and making sure that they don't have any churn and that they're solving and helping their clients be successful with the investments that they've already made, in some cases that they haven't fully realized the value. Start there.
Yeah.
Now let's go to a, well, it's not, it's not a zero-cost increase, but you know, it's a little bit more, you know, a little bit more scrutinizing spend and trying to pick projects. What would be the projects that G1000 companies would pick? They'd pick ones that are gonna help them optimize their cost. They don't wanna have to be reliant on hiring a bunch of people back. They wanna get consumers to a great self-service experience. Not just self-service, but one that they can actually solve their problems. They wanna get rid of legacy systems and inefficiency and homegrown. If you think about all those, that's, those are all digital transformation initiatives that help the bottom line.
Pega's been, you know, we've been through, you know, because we were founded in 1983 and still have the same CEO, we've seen a lot of tough markets. A lot of tech companies haven't actually seen a tough market yet. We've seen them and we've leaned in to the cost savings efficiency play during those tough times, and it's worked for us. I mean, we grew in 2008, 2009 with over 50% of our customers in the financial services industry. We still grew through that time period. How did we do that? We helped them engineer a change in their technology strategy to get drive efficiency.
I don't think today's environment is anywhere near that, but it still has some of the same traits, which is companies, you know, value is, you know, return on investment, value, profitability, durability, they're critical in tech, but our clients are thinking about those, you know, at an increased pace as well. I think, I think that we can play into that value proposition really well.
No, it shows the flexibility of the platform. You know, it could be digital revenue-generating, or it can be digital TCO.
Absolutely.
That was a great, data point on the, growing the BFSI or, you know, BFSI, segment during the Great Recession, so. You mentioned very quickly just as a follow-up there on pricing.
Yeah
... what kind of pricing was embedded in the guidance? In general, what kind of pricing, let's just say it this way, what kind of pricing do you generally take, or typically take annually?
Are you just talking about price escalators[crosstalk] like CPI?
Yep.
Yeah. like for like solutions, we'll get, you know, we typically have kind of a CPI-type escalator in our contracts. We don't have the opportunity in all of our contracts to execute that increase every year. Sometimes it's at renewal, and it may be a multi-year adjustment, or sometimes it is every year. But we've been seeing kind of that number being, you know, in some cases in, like, some parts of the world, it's kind of closer to 10%. In some parts, it's 3% or 4%.
Wow.
There's some number. Just if you average all that out, it's probably in the 5% range.
Oh, wow.
We don't get that across every single customer, but when we get it's been kind of in the mid-single digits.
Okay. I mean, you mentioned earlier, when you were giving the preamble in terms of the overview of Pega about the subscription transition and especially obviously Pega Cloud maybe encouraging more usage, that flexibility being able to consume more Pega as opposed to having these contractual hangouts and hiccups and whatnot.
Yep.
Can you just maybe walk through any metrics that you can share, as we start kind of anniversarying? It might be too premature, but, you know, what you're seeing in terms of maybe a possible uptick in, you know, contract value from a net retention rate?
I, so I will kind of tell you what we're seeing and how we see it playing out. I think the metric side of it, I think, is a little early in terms-
Okay
... of having credible metrics other than what we see the kind of anecdotally. If you look at the model for AWS, GCP, Azure, you know, Snowflake, I mean, company, they have consumption-based contracts, but they're not like consumption-based like it's 0, it's 1, it's 10. You get better economic pricing based on longer term commitments and the annual spend, but you have the variability to be able to surge, and you can get so if you spend more, you're gonna get increasing discounts on. If you spend less, your discounts start to go away. The more you commit to an annual usage or a multiyear, the better economics you get. The model that we're using is not unique. It's not innovative.
Other companies are doing it all the time. If you think about our relationship with AWS as a perfect example, you get there's 3 types of discounts you get. You get 1 discount for the total contract value commitment, you get another discount for the actual spend, and you get another discount if you actually pick efficiency spend models and locations that match where they need to actually get efficiency. Like, you're both saving in that. If you think about that, we're not dissimilar to that model.
Okay.
Now in terms of the new contracting model, the way we're thinking about this is instead of going out and signing a 5-year contract with a client where there's a fixed amount of usage at a fixed price or a price that may escalate CPI each year, we went out to our clients and said, "Let's not make it that rigid. How about we have a directional commitment of an amount that you tend to invest over multiple years, and you have a peg for how much you might actually spend in a year? And then you have complete flexibility to deploy the solution anywhere you want.
We will not measure your usage until your application is in production 90 days, 6 months, whatever that number is. What you're giving them is you're giving them certainty to go start an application, get it into production, see the value, and not have to immediately start measuring and paying you. Doesn't cost us much. Sometimes doesn't cost us anything, right? To be able to let them do that, but what you're doing is you're driving the client to self-adoption. The reason why we do that is because we know that once clients have the ability to test it out and use it, that they will adopt more. There are some things that we ask for from the client. For instance, we wanna set...
We believe you need a center of excellence for Pega, which means you need skilled resources inside your organization. We want an enterprise architect to be assigned to your organization to help you think about the right types of projects and how you roll that out. Those, we've had that relationship now with, you know, a handful of our very largest customers. They love it. They love it because they don't have to constantly be in a contracting mode.
Right.
They actually have some level of certainty. When they end a year, they're not just gonna wake up one month and say, "Oh, I just got a bill for $13 million for overage, which is the real negative that happened early on with AWS, right?" Same thing that's happening with Snowflake. They've talked about it. People get bills, you have to, like, they say, "What happened? Oh, I need to stop using you." You don't wanna have that scenario. You wanna have a level of predictability, that's really what we're trying to work with that model.
What the downside of that is that you, your things like your remaining performance obligation might actually be lower over time 'cause you're not, you're not in the business of just trying to book a lot of backlog commitments. You're trying to build a business that scales, that grows faster, the clients self-adopt. You have to, you have to think about that trade-off and also the pricing economics you have to think about.
Oh, very helpful. By the way, just as a point of clarification, that's not just subscription, that's with Pega Cloud as well.
That's right.[crosstalk] It's anything subscription.
Flexibility.
Yes.
Yeah, yeah.
Yes. Anything where there's a subscription arrangement, we're moving with all of our clients to have that flexible scaling.
As, as an adjunct to that and maybe even an expansion of that, you developed a new product called Launchpad recently. Just in the notion for everybody, it's, you know, even more so pushing Pega towards this platform status. Can you just maybe walk us through what that product is and how, you know, how that could expand many more applications being built on your platform?
Sure. Launchpad, we've been trying to really kind of downplay Launchpad internally.
Sorry
No, no, it's okay because it's kind of taken a life of its own. We've tried to downplay Launchpad a little bit because we don't want our sales teams to lack focus of Pega Infinity, which is the enterprise platform.
Right
... that's where we make all of our money, and that's where all of our enterprise clients are gonna be purchasing. That said, what we found out with Pega Launchpad is that there is a massive market. A market that wouldn't be addressable with our Pega Infinity architecture because our Pega Infinity architecture is single-tenant, it is enterprise scale, it's not built for multi-tenants, it's not built for ISVs or software providers to build on top of it. It doesn't. It has a fixed commitment of capacity. It's a little bit more like an enterprise model than it is like a traditional commercial off-the-shelf multi-tenant application. What we realized is that nobody else has what Pega has.
The LaunchPad was our way to kind of democratize all the capabilities of robotics, of AI, the case structure, the low-code platform, but be able to allow clients to be able to use that were subscale. They will use that on more common use cases through managed service providers. We will not sell directly to them. We will basically license our platform to a service provider that will then craft certain use cases and sell those to multiple. For example, a very simple example is, let's say that you had a medical device manufacturer that sold equipment to hospitals. The medical device manufacturer might actually buy Pega from an enterprise perspective, but they might want to build some type of a managed service to manage the maintenance on their equipment, the consumables for their equipment.
They would have to go and build that application on their own, or they'd have to try to outsource it to somebody else. What we will do is put the power of Pega's platform in front of them through Launchpad. We will work with them, maybe their own team, maybe a system integrator, to build that application and then license a subscription to all the hospitals to be able to manage all of their equipment. That's a kind of a subscription fee for service. A lot of companies that sell kind of fixed transactions wanna move to recurring. This is a way for them to transition part of their business into a subscription model. The automakers are another good example.
It just seems like a very unique channel to help Pega become more of a platform. We're kind of running up on time. Is there any questions from the audience? I have more. Just maybe and one final one, Ken. You know, you talked about the Rule of 40, exiting 2024. You've been very prudent in terms of OpEx, and you had a very good, most recent quarter in that regard. You also decided to add a new metric to the guidance in '23 with free cash flow. Just want a couple questions there. Why is '23 the right year to now start giving us free cash flow guidance? How confident are you in the firm's ability to deliver on that $150 million in free cash flow guide you gave for '23?
There were some adjustments there about investment in property and equipment and interest expenses, some other adjustments. Just, thirdly, you know, why are these adjustments important? Just share some thinking around that.
We've heard that the market cares about free cash flow.
I've heard that too.
No, I think what we when we had talked about Rule of 40 in 2017, we kind of talked about the, when it's relevant, we'll be a Rule of 40 company. Well, it's relevant now. Like, we're done with the subscription. It's time. We never produced a free cash flow measure. I mean, you could easily get it.
Right.
You can just look at our financials. It was not a measure that we talked about that we measured ourselves to and that we talked internally to employees. The Rule of 40 mantra is everywhere inside Pega, and because it's important, because we need everybody in the company to appreciate how important being a well-run business is. We wanted to first, we wanted to tell people externally that that mattered to us. We wanted to hold ourselves accountable to that free cash flow measure because it is a really important measure. It is, other than ACV, it is the second most important measure. Naturally, you can't have free cash flow without the ACV. On the adjustments, what we did was we basically said, "Let's take our operating cash flow, let's subtract our property, plant equipment, our CapEx.
CapEx.
There may be other things that are, that are not recurring things in the business, like the, like, you know, certain legal expenses, maybe acquisition expenses, other things that we felt like, you know. By the way, we're very transparent there. If an investor says, "I don't wanna add that back," they could very easily just take it out and model us without it. For us, we felt like there are things that are, I don't want to say out of our control, but I would say not really part of the business fundamentals. We don't expect like a restructuring charge if we did a layoff, things like that. That's the, those are the types of things that we kind of added back, so to speak.
Including interest expense. Is there any signaling you're there with regard to.
We don't.
You have a very healthy cash now.
Yeah, that's a great point. The reason why we looked at kind of unlevered free cash flow is we don't believe that a significant debt balance is part of our operating model. We, you know, we don't have a lot of interest expense.
Right.
It's only $5 million or $6 million, but we did take that out.
I was trying to highlight you have a great balance sheet. Anyway, very big platform with expanding use cases and cash flow. Thank you very much, Ken, and I appreciate your time.
Thanks, Tom. Thanks, buddy.
Thank you.