Pegasystems Inc. (PEGA) Earnings Call Transcript

All right. I think we're ready to kick things off. I'm DJ Hynes, I'm the senior software analyst here at Canaccord. Thanks, everyone, tuning in. This is the 41st year that Canaccord's put this event on. We couldn't do it without the support of the investors and even more importantly, the support of the corporates like Pega. So we're delighted to have Ken Stillwell here. He's the COO and CFO of Pegasystems. We're going to do this as a fireside chat. We have 25 minutes. There is a Q&A bar on your webinar screen. So please use that, send in questions. We'd like to make this as interactive as possible given the virtual setting.

With that, let's hop right into it. Ken, thank you, as always, for being here. I assume we're going to have some investors tuning in who aren't perfectly familiar with Pega. So maybe just as a backdrop, give us a quick overview of the business, the problems you guys see, what you're doing to solve them and then we can dig in on some of the fundamentals.

Sure. I won't go back through the long history of how we were in the BPM space and some of the transitions that we've made. But right now, what we do is we help clients that are trying to get workloads accomplished in a -- typically in scale. So lots of events, lots of transactions, typically across different systems, you might -- something like a loan origination that might hop across different systems. Sometimes it's things like an exception management or dispute for a credit card for some type of service where you have to validate the credentials of the user and really help them through that journey. So what do they -- what do our clients want from that? They want to have a kind of a contained, consistent process flow. They want to be able to build that application in a way that it's scalable but also isn't a lot of code writing and constantly updating code and trying to deal with the mess of the way that systems were built over the years. And they want to be able to make that kind of engagement happen, hopefully, with as little human touch as possible, as fast as possible and leveraging robotics, AI, kind of all the best that technology has to offer. And they want it to be real time. So we help our clients really do end-to-end work automation in kind of almost as an orchestration engine where we're connecting and talking to the different engagement apps and the back-office systems and being able to pull that into a kind of almost a lightning-fast execution at scale and help efficiency but also help the client experience, which should lead to upsell, cross-sell retention. So that's kind of -- we call that -- some people call that digital transformation as kind of a generic framework. And I think that's probably a good characterization of where we sit.

Yes, yes. Obviously, lots happening on that front. Maybe that dovetails into kind of what you saw in Q2. Q2 looked like a really solid quarter to me. Can you just talk about kind of recent quarterly trends, what drove the momentum in the business?

Sure. Yes. I think Q2 -- really, any number you look at, Q2 was a blow-up quarter. I mean we executed really well. We had the biggest sequential ACV growth in a quarter, I think, for any quarter other than a Q4 ever. And I think it was maybe the third best quarter, even including Q4, which, as you know, are typically strong enterprise software quarters just because of the way the commissions and the buying cycle, et cetera. So I think we did -- ACV growth was great. Not only was that great, we actually continued to execute well on our Pega Cloud platform, both in bookings ACV and also margin. We built -- we had a ton of revenue, which actually is kind of promising because it means we're coming out of the transition and we're starting to normalize. We demonstrated we're still doing very significant expansion deals with our larger customers. One of the questions that people ask me all the time is, "Well, aren't you sold out in your clients? How much more could you sell them?" And I think there was a deal in Q2 that just highlighted that we're not even remotely close to sold out in any of our clients. And then lastly, in addition to having strong revenue, strong EPS, great sequential ACV add, our backlog grew in a Q2. And typically, backlog in the middle of the Q2, Q3 might even decline in some cases for us because of the cycle of when renewals are and when new deals are. So I think when you put all that together, I would say you can't look at Q2 any other way than to say it was really strong. Now why was it strong? I think a couple of things are working -- work in our favor. First, the demand environment for us, for our solutions, have been very strong. They weathered the beginning of COVID when it was -- we were all a little unsure. And I think that they've just been strong ever since. And they're not episodic demand needs. They're not I have a COVID tracker or things that were more popular back in the spring and the summer of last year. These are real nonpandemic-related but pandemic-influenced digital transformation kind of evolutions. And the reason why I think I'm kind of feeling so good about the momentum that we have in Q2 is we have a brand-new sales team that we brought in. We brought in Hayden Stafford as our Head of Sales probably around the same time you and I talked last year. We actually have new leaders in some of our theaters. And they've really only been in seat for a few quarters. And you typically see that transition take some time. And the fact that Q2 was such a strong execution quarter is really promising that maybe we're not going to see much of a transition. We've already seen it maybe in Q3, Q4, Q1 and that we're really off and running. So that's kind of exciting to see Hayden really taking the reins and having such a good Q2. Every region in Q2 was above plan. Americas was, EMEA was, and APAC was. And I got to be honest with you, I'm not sure that I remember -- certainly not in my time at Pega. I'm not sure there may have been a quarter where we were above plan in all 3 territories.

Yes. Lots of good signals in there. Let's take a step back and talk about kind of the license transition that's going on and kind of where we are there. I mean obviously, we're moving from perpetual to subscription. Subscription growth is obviously now kind of driving the onus of growth that's outpacing the overall business. Just talk about that, like where we are in terms of your progress and what's left to do.

Sure. So given that I've done a few of these transitions, I would say that transitions typically go in 3 phases. Phase 1 is where you get your sales team armed and you start selling subscription. And that's the most important phase, to be honest with you, because you got to really get the kind of your solutions aligned with the market, your value propositions and not lose momentum in selling. I think we did really well through that. In fact, we accelerated our growth through the movement to subscription. So that's really behind us. We're selling 95% plus of our deals, of our new incremental growth are subscriptions. The second phase of that is where you get kind of the settling of the revenue impact. When we first started transition, your revenue can go down. It certainly, in many cases, goes down. It certainly doesn't grow as fast. And our revenue went flat for the better part of a few years as we pushed more of that future revenue into backlog and we made the transition to subscription. That's called -- I call that the revenue transition phase. And we are largely done with that. You're starting to already see our revenue growth, as you mentioned, our subscription revenue growth kind of even outpace ACV because it's kind of getting more -- the way it works is you have slower growth, then you have slightly accelerated growth compared to ACV and then it normalizes. It normalizes at the end of the transition, which we think is like right around the beginning of '23. And then the third phase is when your margin normalizes, your cash flow normalizes. That's the thing that takes the longest because you have to stop selling all your perpetual licenses. You don't get billings upfront. And you kind of put those in a bank to be collected later, but you're still investing in the business. And then you get about 5 years out, and that's when the numbers start to settle and become a little bit more meaningful. So we're not quite there yet to say that we're kind of in the middle of that transition. But as the revenue normalizes, naturally you get more profit and the billings continue to stack up, so you should get better free cash flow. So I would say we're probably just starting that whole kind of cash flow margin transition in '21 to the beginning of '22. So we're kind of done with one, almost done with the other and kind of just starting the third one.

Yes, yes. Makes sense. I mean everything troughs and then it's kind of a layered cake and you don't get back to cash flow until you almost -- you lap the term of your contract terms, right?

That's exactly right. You're going to get back to where you started from.

Yes, yes. Totally. Okay. And then that explains why the key metrics of the business, obviously, are ACV and RPO now in terms of kind of a measuring stick of bookings momentum, and that explains a lot of the reason why you're paying attention to those. Let's talk about the resellers. It seems like they're playing an increasing role in your success. Why is that? Why are the partners so important to accelerating growth?

So it's funny. We always had engagement with global SIs. It wasn't like we didn't respect the value that they brought to Pega, but we thought about the value in a different way. We thought about the value as we need Pega-certified skills in the marketplace to help our clients be successful with the use of their solution. But it wasn't really in our -- I would say, in our strategy or maybe even in our DNA to be able to leverage the selling aspect of what the system integrators can do. Some of that was probably just the pattern and the history of the way we operated with them. Some of that may be us not realizing the opportunity there. But when Hayden came in, he really focused us on, listen, the global SIs have better relationships with our clients than we do, right? They're in there as advisers with the executive team. And if they see an opportunity for Pega and they're incented and motivated to think of Pega when they're trying to solve that problem, and they know that Pega is going to make sure that we get the business we want and they get the business they want, they want the professional services revenue, we want the license revenue, there's no confusion there about the prioritization, then you can really have partners being much more friendly in terms of that engagement. It doesn't mean that they will kick deals to you that you shouldn't win or that they would make up things with the client just a bit. None of that. I just mean down the middle, somebody needs to replace the system, build a new one, the SIs will think Pega. So that's really our objective in Phase 1 of the partners. And I think the initial read on that, the initial feedback is amazing. Partners are -- if you ask anyone that's doing channel checks, the partners will say, "It's a different Pega. I no longer feel like I'm competing with them for professional services revenue." There were -- we did a partner town hall like I guess it was about a week or 2 ago, and we had something like 1,000 people on the town hall, right? Like so there's a lot of people engaged in terms of getting into the partner ecosystem with Pega. The second phase of that or maybe a later phase is when we start looking at partners that could be independent software vendors on top of the Pega platform. So as we release Project fnx, which is the next evolution of our architecture with micro services, more multi-tenancy, Kubernetes, kind of the modern cloud stack, you're going to see more people think about us as a platform that they might want to build a configurable app that they sell to their clients. And so I think that we're not at that stage yet, but I do think that's an opportunity in the future that could really expand our addressable market.

Yes, yes. Makes sense. I want to unpack something you alluded to earlier in Q2, which was the large existing client renewal. I think it was a multiyear contract. As part of that, they expanded their use of Pega. They extended the terms of their agreement, I think it came earlier than you guys were anticipating. Just talk about how that impacted revenue results for the quarter. And how did that deal contribute to ACV?

Sure. So the deal, as we disclosed it, was a little over $30 million of revenue. And if not knowing anything about our business, I think a reasonable person might think, well, that's $30 million. Their average number of -- average duration of a contract length is 3 years. That must have been $10 million a year, right? And although that is exactly a rational way to think about it, we typically have our clients ramp their usage, right? They start off with a certain amount of usage and they kind of expand as time goes on. This particular client was already using some of our solutions. And as part of that upsell, they kind of expanded and added some duration onto the existing agreement. When you put that all together, the calculation is -- for, I don't know, 606 is a little more complicated than it really needs to be, right, in terms of the carve-out. But -- so it was $30 million plus of revenue. In terms of ACV, it added more like $5 million of ACV. So although it was not insignificant, it wasn't the reason why -- or the sole reason why our ACV was so strong in Q2. Now the way those contracts are, which is the beautiful thing about SaaS, is they almost have an embedded expansion over time, right, which is why so many SaaS companies look at the net retention rate or the net expansion rate, whichever one you call it, because it really is focused on that kind of that increase in MRR over time. And so that's a really good example of a large client who already had a big installed base with us that significantly increased their investment and fit another area, right, another solution area. And it really highlights that there's probably 500 of those clients out there that we already have some spend with that we should be able to continue to expand. So that's really kind of a completely objective measure of what our opportunity is.

Yes, yes. Totally. So obviously, coming off a really strong Q2, well, how is it set up for the back half of the year? Like is it possible we see ACV growth accelerate from here?

So the -- couple of thoughts. One, I think we started off '21 with a view of the year. And I think through Q1, I would say Q1 was less than exciting performance quarter for us. And Q1s have not always started like that, we've started better than we did in Q1, but we certainly more than made up for it in Q2. So what that kind of gives me confidence is that the way we thought the year would play out, I think we're in good shape to have the year play out like that or hopefully better. I think that -- to think that the acceleration in ACV is going to go to 25% or 30% in the back half, I think that's probably not in the cards for us right now. But I certainly believe that ACV will continue to kind of chug along and grow in a constant currency way as we get to the end of the year. And really hoping to see that growth rate kind of get to that 20% constant currency, which is what we really wanted to start with, which we kind of thought when we started the year. When I think there's an opportunity to accelerate that further really is in '22 and '23. I could be wrong and maybe the back half of the year has opportunity to advance that acceleration. But I think the CFO in me kind of wants to be a little bit more thoughtful about what -- about how aggressive I see this transformation playing out. I think we had a great team, great quarter. I'm optimistic the market really is. The demand environment is great, but let's give this a reasonable time to really hit those higher growth rates. But I think Q4 is looking like we thought it was, which is strong opportunities out there.

Yes, yes. You get paid to set a low bar, and Hayden gets paid to jump over it, right?