Pegasystems Inc. (NASDAQ:PEGA) Q4 2022 Earnings Call Transcript

Pegasystems Inc. (NASDAQ:PEGA) Q4 2022 Earnings Call Transcript February 15, 2023

Operator: Good day, and welcome to the Pegasystems Fourth Quarter and Fiscal Year-End 2022 Earnings Results Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Kenneth Stillwell. Please go ahead.

Kenneth Stillwell: Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems Q4 and full year 2022 earnings call. Before we begin, I’d like to read our safe harbor statement. Certain statements contained in this presentation may be construed as forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. The words expects, anticipates, intends, plans, believes, will, could, should, estimates, may, targets, strategies, projects, forecast, guidance, likely and usually or variations of such words or other similar expressions identify forward-looking statements, which speak only as of the date the statement was made and are based on current expectations and assumptions. Because such statements deal with future events, they are subject to various risks and uncertainties.

Actual results for fiscal year 2022 and beyond could differ materially from the company’s current expectations. Factors that could cause the company’s results to differ materially from those expressed in the forward-looking statements are contained in the company’s press release announcing its Q4 2022 and full year earnings and in the company’s filings with the Securities and Exchange Commission, including its annual report on Form 10-K for the year ended December 31, 2022, 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 to publicly update or revise these forward-looking statements, whether as the result of new information, future events or otherwise.

And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Alan Trefler: Thank you, Ken, and thank you to everyone on today’s call. I’m proud of how our team adapted leveraged our strengths and executed in 2022, downtrading exceptional resiliency. We ended the year at 16% ACV growth right, where we said we were, despite multiple significant distractions and challenges. And we’re making progress to become a Rule of 40 company, which will drive greater value for our shareholders and opportunities to further invest in our business our technology and our people. Our results reinforce the effectiveness of our strategy to target customers where we know we have tremendous opportunities for growth. Ken will discuss in more detail later in the call. The market dynamics here, I think, are very positive for us in some key ways.

Digital transformation continues to be a driving force for our clients and we expect it to be even more important in 2023, given the economic indicators. The type of uncertain environment we’re in and — well, we’re going to continue to being Enterprise automation is top of mind for clients who are looking to optimize their investments, increase efficiency and improve effectiveness. According to IDC’s 2022 Worldwide CEO survey, the number one skill CEOs think will be most critical to their success over the next three years is digital know-how. At the same time, there was a growing scarcity of developer skills, which helps drive increasing use of low-code and no-code solutions. According to the latest forecast from Gartner, the worldwide market for low-code development technologies is projected to total $27 billion in 2023, an increase of nearly 20% from 2022.

And IDC projects that by 2025, of all application developers worldwide will be low-code or no-code developers. This theme is consistent with what we’re hearing from clients. I recently came back from Davos, met face to face with CEOs of some of our largest and most strategic customers. They told me they are focused on digital transformation as key to success, and it’s going to be especially true in what they expect will be a challenging year. They know they need better and faster ways to do things, driven by the economic environment and scarcity of resources, and Pega is perfectly positioned to leverage these dynamics. We have a long history in this space and a clear strategy to focus us this year and beyond. Our strategy is very much vested in our technology.

Pega technology provides the most powerful and scalable low-code platform for AI-powered decisioning and workflow automation is designed to help clients maximize value, simplify service and boost efficiency, free to adapt to change. Our product leadership is proudly recognized by industry analysts and has led to dramatic successes with many of the world’s most recognized and sophisticated organizations and their partners. Header Cloud innovation has accelerated adoption, and we’ve made tremendous progress on modernizing our clients who now more than ever are able to make use of our latest advancements. We are strengthening deep strategic relationships with our clients and their trusted partners. And we believe that they are more likely to consolidate their technology choices with proven and trusted providers in this uncertain environment.

Finding accelerated value for these clients will translate directly to significant growth for us. And we are building a healthy, agile and efficient organization so that we can work closely with our clients and inspire innovative ideas and creative solutions to their biggest challenges. Now to truly good going into the year, we do expect it will be a tough year based on all the economic indicators, and we’ve taken steps and planned accordingly. As we announced in early January, that means having had to make some tough decisions to help set us up for both long-term and short-term success. These changes were focused on our go-to-market organization where we’re driving alignment to further improve our go-to-market operating model. To drive role clarity and accountability, enable greater efficiency and sharpen our client focus, especially where our historical investment outpaced our growth.

Nearly all of the changes have been completed. So there are some markets that we’re working through evaluations in adherence to local regs and processes. Now I know this is a challenging time for many whose roles are changing or being eliminated as well as those saying that buy to colleagues, we care deeply for them. And we’re working to take great care to support those who lead backup with transitions afford in keeping with our values. Like many other companies, we’re planning for more conservative growth in 2023, which Ken will talk about more later in the call. Our overall approach and strength will continue to serve us well as we go beyond this year and into future years where we will continue to adapt. And we’re in a position where whether our clients are focused on rapid growth or whether our clients are focused on efficiency and cost cutting, we’ve got the technology and the approach to do either as we’ve shown over the years.

I’m also excited to see that our subscription transition is coming to completion. And you can see the related impact on our financial results and projections. Combined with the organizational changes we are making, we are well positioned to be a more significant cash generator over time, which gives us the flexibility to invest in growth opportunities for the business. Now Pega, I think, has always had a focus on innovation and provide the most innovative and effective solutions for our clients has, I think, been central to our success. In 2022, we continue to enhance Pega Infinity to give clients the best low-code platform in the industry. Some of the highlights included launching a new version of Pega Infinity, which lets organizations develop apps faster, create smarter workflows and improve experiences for customers and employees.

We continue to focus on Pega Cloud and have significantly increased adoption. We’re also finding that our global operation center, which uses extensive workflows built on Pega Infinity can bring automation, availability, reliability and scale to our out cloud operation. And we’re seeing this as a reason where clients are choosing Pega Cloud over running on their own cloud because they can see how well we could do. We introduced new low-code templates, forces and services to help organizations improve productivity while reducing strain on IT teams, all while still maintaining good governance. With the demand for professional developers exceeding count availability, organizations want to be able to tap citizen developers to get work done. But citizen development can also create silos and increase risk and costs if there isn’t proper governance or if the tools are not sanctioned or supported by enterprise IT.

Many of the lower-end low-code tools in the market today are contributing to that challenge. Pega’s low-code factory approach empowers citizen developers while providing technology support and governance to automate the enforcement of best practice, ensuring security, scalability and maintainability. We’ve also enhanced our robotics capabilities to make it even easier for users of any skill level to quickly build robotic automations that help make business processes more efficient when robotics makes sense. And we acquired Everflow to add intuitive process mining capabilities to create what we believe is the industry’s most complete hyper automation solution, enabling Pega clients to uncover and fix hidden processing efficiencies that would otherwise log down in organization’s operations.

There’s also a lot of interesting tactic elements we’re tracking. For example, we’re looking carefully at the latest generative AI technologies and how they can position themselves inside our offering to make them better. We’re looking at model-driven approaches that help dramatically tackle business models. And all of this, I think, plays on historical strength of Pega. Pega is terrifically positioned to take advantage of these strengths. We see lots of potential to provide more value to our clients and enhance their relationship with customers. I expect we will have some very exciting news to share at PegaWorld in June as a result of this work. We also announced Pega LaunchPad, a new cloud-based low-code application development platform, designed to empower users to build and monetize new business-to-business SaaS applications.

And this has the potential to provide new revenue streams and an interesting new market for us. Our goal is to sign up several early adopters during 2022 in anticipation of launching in 2023, and we’re right on track with where we want to be. I’d like to touch on some client highlights because ultimately, that’s what this is, from our point of view, all about for us to be successful with the grower business. We need to make sure our clients are successful. The innovation for innovation’s sake has never been our strategy. Whether homegrown and required, we’ve always thought first about how a new feature or technology or product would support our clients’ goals and contribute to their success. That’s why we continue to see impressive results from our clients and why so many are willing to talk publicly about how they are leveraging our software.

For example, a number of our banking clients recently won awards for their use of Pega software, including NatWest the best banking tech provider for their use of know your customer and Pega customer life cycle management solutions. Invoice Banking Group awarded best use of IT in retail banking versus automation and streamlining of processes for customer credit cards, all built on Pega Cloud. And more than 40 clients have signed up to share their success stories at PegaWorld even iNspire this year in June, including Roche, Wells Fargo, Virgin Media and the FDA, just to name a few. We’re so excited to be going back to Las Vegas for our first in-person PegaWorld in four years. In addition to the many clients, we look forward to joining us there.

There are already more than 30 major partners signed up and sponsors, including Accenture, EY, Capgemini and others, and they’ll be demonstrating their services and solutions along with our latest technology in our Innovation Hub. Please check out the PegaWorld website register and join us live to hear these stories and see the amazing technology first half. I’d also like to note that that’s been really exciting in this new in-person world again to see a steady stream of our clients coming from Amsterdam to from Australia, visit our new executive briefing center in Cambridge for in-depth highly strategic conversations. So in summary, I think we’ve began shown our resiliency and ability to execute in challenging times. I’m excited to see our transition to a subscription business coming to completion and the positive effect is having on our results, and we are on pace to be a Rule of 40 company as we exit 2024.

We’re in the right space, with the right heritage and the right capabilities and the right strategy. and at the right time to leverage a significant opportunity in front of us, and we have the right team to deliver on that opportunity. To provide more color on the financial results, let me turn it back to you, Ken.

Kenneth Stillwell: Thanks, Alan. Nothing brings more stability to revenue, profitability and cash flow than our recurring business model, especially in times of economic uncertainty. That’s the major reason we embarked on our subscription transition five years ago. And our execution has been strong, thanks to the hard work and resiliency of our team in close collaboration with our clients and our partners. Over this five-year transition period, we’ve achieved a nearly 250% increase in our annual contract value and more than doubled our subscription revenue, which in 2022, I’m happy to say top $1 billion. And now the subscription revenue is represents 81% of Pega’s total revenue, up from just around 50% a few years ago, with the majority of the remaining revenue coming from professional services.

Our subscription model helps us build a more resilient business and improve profitability and scale through operating leverage, especially with our high client retention rates and massive client expansion opportunities. Growth in annual contract value is the key growth metric to measure our business momentum. During the transition, we almost exclusively focused on ACV because of its critical importance. So let’s talk about our ACV results. In Q4 2022, annual contract value increased 16% year-over-year in constant currency and 13% as reported, reaching $1.1 billion. Our ACV growth was driven by our go-to-market strategy where we focus heavily on cross-selling and upselling to our existing clients. Pega Cloud ACV reached $455 million, an increase of over $90 million.

Our 60% — over 60% of our new client commitments were from Pega Cloud deals in 2022. Another important metric to measure our success during our subscription transition is growth in remaining performance obligation or backlog. Total backlog reached $1.36 billion as reported. As we highlighted last year in our earnings call in Q4 of 2021, our subscription license backlog was unusually high, resulting in a tough compare this year. Focusing just on subscription services, which includes Pega Cloud and maintenance, backlog grew 13% year-over-year, in line with our reported ACV growth rate. We are currently in the final months of our subscription transition and our 2022 results demonstrate that we exited the year with improved profitability as we expected we would.

Let me give you a few examples. First, our non-GAAP EPS reached $0.72, an increase of over 200% year-over-year. Our non-GAAP EPS performance was primarily driven by more disciplined expense management, especially in sales and marketing. In fact, total sales and marketing costs were down slightly year-over-year. You’ll hear a little later that we expect to see another significant increase in profitability in 2023. Second, Pega Cloud gross margin improved approximately 300 basis points to 70%. The improvement in Pega Cloud gross margin was driven by increased scale as well as innovation in our cloud architecture that helped increase automation and further drive efficiency. When the subscription transition is complete, free cash flow generation will start to normalize a critical step on our path to becoming

Kenneth Stillwell: Apologies, everyone. We lost our phone connection here in our new office in Waltham. So apologies for that. I’m going to pick up where I think I dropped off, which was talking about profitability. We are currently in the final months of our subscription transition, and our 2022 results demonstrate that we exited the year with improved profitability as we expected we would. Let me give you a few examples. First, our non-GAAP EPS reached $0.72, an increase of over 200% year-over-year. Our non-GAAP EPS performance was primarily driven by more disciplined expense management, especially in sales and marketing. In fact, total sales and marketing costs were down slightly year-over-year. You’ll hear a little later that we expect to see another significant increase in profitability in 2023.

Second, Pega Cloud gross margin improved approximately 300 basis points to 70%. The improvement in Pega Cloud gross margin was driven by increased as well as innovation in our cloud architecture that increased automation, which further drove efficiency. When the subscription transition is complete in 2023, the free cash — free cash flow generation will start to normalize a critical step on our path to become a Rule of 40 company as we exit 2024. As a reminder, we define Rule of 40 as the combination of ACV growth and free cash flow margin which adjusts for other items outside the ordinary course of business. The reason I say we will become a Rule of 40 company as we exit 2024 is because our bookings are skewed toward the end of the year. So our cash collections tend to bridge to the following year.

Once we exit 2024, our cash collections should be more normalized. That said, you should expect to see significant improvements in free cash flow in 2023 and in ’24. Moving to our fiscal year 2023 guidance. To start, I want to remind you of our guidance philosophy and approach. It’s our practice to provide annual guidance at the beginning of the year, we do not typically update guidance. For the last several years, we invested aggressively in sales and marketing to accelerate our ACV growth rate. And our guidance philosophy reflected our belief that our incremental investment in sales and marketing would result in significant ACV growth acceleration. As we thought about our 2023 guidance approach, we looked at the world events that we believe 2023 will be a tougher and less predictable year for everyone.

And our 2023 guidance is informed by this view. We know from experience that during uncertain times, focus is more important than ever, and we believe the changes we made to our go-to-market strategy will work extremely well in the current environment. In January, we announced a 4% reduction in our global workforce. We expect that action to result in over $75 million of net savings versus our original spending plan and we’re focused on improving our sales efficiency by further selling into our existing client base, which is made up of the largest and most respected global brands. We are pursuing new clients selectively. We often land new clients because a buyer from an existing client takes a role with a new prospect or because a partner recommends Pega as part of a major digital transformation project or because an industry analyst firm recommends Pega.

Obviously, there’s a reasonably high amount of uncertainty in this market. And we assume that there’s risk that enterprise software companies, including Pega, could experience longer deal sales cycles, lower close rates and deal value compression. Given these risks, we’ve decided to factor this into our guidance. So let’s get into guidance numbers for full year 2023. Total ACV will grow 11% to 13% year-over-year. We’re driving our execution to achieve the Rural of 40 SBX at 2024. We think of any such slowing of our ACV growth rate is reflective of the overall economic environment in 2023 and not indicative of the scale of the opportunity or our ability to accelerate growth efficiently in future years. But we will be hyper focused on efficiently accelerating our growth with our Rule of 40 focus.

We believe total revenue will be approximately $1.4 billion. We expect non-GAAP earnings per share of about $1.50 per share. Given our focus on increasing cash flow, we’ve added a new guidance metric this year, free cash flow. We project free cash flow of $150 million in 2023. From where we stand today, these are our best estimates of what we will deliver to our shareholders in 2023. A reconciliation of our GAAP and non-GAAP guidance is contained in our earnings release. We also thought it would be helpful to provide additional guidelines as to how people should think about modeling our business in 2023. So I’ll share a few of those thoughts. First, we believe Pega Cloud will represent between 60% and 70% of new client commitments in 2023, a 1% shift in the projected Pega Cloud mix would impact recognized revenue for the full year by approximately $3 million.

Second, 2023 is a more typical year in terms of renewal volume. And as it was in 2022, our renewal portfolio in 2023 is skewed to Q4 of 2023. This dynamic will likely result in a more significant portion of our ACV growth and revenue to occur in the second half of the year and a larger amount of our collections to straddle Q4 of 2023 into the beginning of 2024. Next, in Q4 of 2021, a term license backlog was unusually high at $172 million, and you saw that backlog significantly impact revenue in the first quarter of 2022. Given we did not have that dynamic happen at the end of 2022, we expect term license revenue for Q1 of 2023 to be more consistent with the pattern of historical first quarters of a year. In other words, the seasonality of term license revenue in 2022 was unusual, and we expect it to return to a more typical seasonality for 2023.

We see Q1, Q2 and Q3 having a similar level of activity, but Q4, as usual, is expected to be significantly greater. When you are focused on selling to your existing clients, naturally, clients are likely to make incremental decisions commensurate with a contract renewal event. Fourth, we expect our sales and marketing expenses to be higher in the first half of 2023 because of PegaWorld, our annual customer conference being held in person in 2023. Last, irrespective of the seasonality of our business, we think the first half of 2023 would be — likely be the slower part of the year due to the expected economic softness and having fewer renewals. Our annual Investor Day which will be held during PegaWorld 2023 is scheduled for Monday, June 12 at the MGM Grand in Las Vegas, Nevada.

Please mark your calendars for this event. We’d love to have you join us in person after so many years away from PegaWorld. The agenda will include updates on our go-to-market strategy, our technology and our financials, including our long-term model. We will also host a Q&A section during this event. In conclusion, we’re driving toward becoming a Rule of 40 company, which will result in a significant increase in free cash flow generation as well as provide opportunities to further invest in our best-in-class technology, our clients and our people. I look forward to seeing many of you in early March as there are a number of investor conferences in the coming weeks. Operator, please open the line for questions.

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Q&A Session

Operator: And we will go first to Kevin Kumar with Goldman Sachs.

Kevin Kumar: It’s pretty solid results here, particularly on ACV. I guess how much of that resiliency is just a function of kind of the sales reorg that you did last year? And are you seeing the efficiency improvements that you’re hoping for?

Kenneth Stillwell: So Kevin, I’ll take the first part of that. So I think that — I think it’s not a surprise that we would expect to start to see better engagement with our target organizations, our existing clients because more — there’s so much more focus and capacity in the company around those clients, those clients are precious to us, not only because they actually — we got $1 billion of ACV from them, but also because there’s tens of billions of dollars of opportunity within those clients for the future. So I do think that, that was helpful that recalibration to the core of our client base. I don’t think I would necessarily play victory on efficiency and go to market at this stage if it’s so early. But I would say we do see a connection between efficiency and engagement with those exact works. Alan?

Alan Trefler: Yes, we’re very much still in the midst of the process of having the changes take growth. The good news is the changes have been architecturally made. So the allocation of resources to the organizations, the reallocation of resources to roles that we think make the most sense in this environment. Those things have been announced as part of the kickoff of the year. We spent a good chunk of last year figuring out exactly what we wanted to do because this was, I think, a pretty material change to the go-to-market. But I’m seeing the evidence both from the increased engagement that some of our staff is having, but also from the response from clients that this is all very, very positive. And I that is going to lead to the results we expect.

Kevin Kumar: And then just a question on the license — term license revenue in the quarter. I think that number was quite a bit higher than kind of where Street was at. Anything in terms of kind of anything to call out in terms of pull-forward deals? Or was that just kind of a return to kind of a natural cadence of kind of 4Q type dynamics?

Kenneth Stillwell: Yes. Good question. I think the last question — the last point you just made is absolutely true. At year-end, there tended to be in Q4 a little bit of a higher Client Cloud versus Pega Cloud mix. So I think that’s definitely a factor. We also, as I mentioned, last year, we had a number of our deals go into backlog at the end of the year, which then carried into revenue of Q1 of ’22. And this year, the timing of some of those deals just happened to be that the revenue came in Q4 versus Q1 of 2023. So — but I do think the mix was not unexpected. And I think the timing of it was just some — depending on whether a deal hits on December 31 or January 1, sometimes the difference between whether it comes into revenue or it goes into backlog.

Operator: And we’ll go next to Steve Enders with Citi.

Steve Enders: I guess I just want to clarify a little bit on what you are seeing on the outlook, particularly with regards to macro. If I’m interpreting it right, it seems like maybe to date, you haven’t really seen much of the impact in terms of deal cycle slowing down and those sorts of things that I think you typically think about it in tough macro, but it seems like it’s being embedded in the guide. I guess, is that fair to say? And I guess, how should we kind of think about some of the other underlying assumptions that you’re thinking about there?

Alan Trefler: Well, I think that reflected in the selection of 11% to 13% is kind of the guidepost. I — it’s a bit schizophrenic candidly, because clearly, there are impacts I would tell you that the move talking to other CEOs is kind of a little bit down, but not about us, particularly for the ones that we’re most worried about, which is very large and candidly more sophisticated companies. I think that the market impact and the economic impact is going to be way more pronounced on the SMB type market, which we so — we did — as we entered last year, we did a conscious we pivot away from that market. which we had pivoted towards sadly, I think, wasting a lot of money. But we pivoted away from it. And that was a repivot that even began before the Ukraine action. And I think that’s going to be what gives us a lot more resiliency than many other firms in this market.

Kenneth Stillwell: I would also add just one additional point, which is — and I’m sure you’ve heard this from other companies like Pega. When you have time periods where budgets may be compressed, there is a tendency for clients spend to concentrate with known vendors or known value propositions in terms of the investment of that incremental budget. And so that plays into our strategy as well if that occurs.

Steve Enders: No, that’s helpful context there. And I guess maybe competitively, have you kind of seen any change in any kind of market dynamics out there? I know that one of your competitors has been putting out some more negative news out there. So just trying to understand what impact that’s potentially having at this point, some of the recent changes there.

Alan Trefler: Yes, I’m not going to rise to that pace as tempted as I might be. The reality is, I think the competitive dynamics are pretty much as we’ve seen them. There is a believe I’m seeing in particularly larger companies that they have a lot of risk of creating a new generation of technical debt with low-code and no-code approaches that are kind of these little stand-alone things. And this idea of enterprise app factory and the idea of having an architecture that could empower citizens but continue it in a way that it looks same to the folks in technology, we’re going to have to possibly maintain a long time. There’s a lot of appetite for that level of I would describe it as selectivity and sophistication. So I think that, that positioning helps us enormously and is really competitively advantageous compared to all the companies who use this language, the fact is we’ve been talking about doing this as an enterprise capability pretty uniquely for the last couple of years.

And so I would say the competitive dynamics are going to be much worse for organizations that are — I describe as kind of more low end or more femoral as opposed to organizations that are capable of doing really — you need to be able to — and want to be able to do easy things, but are also capable of doing more chain phase.

Operator: And we will move to our next question from Rishi Jaluria with RBC Capital Markets.

Richard Poland: This is Richard Poland on for Rishi Jaluria. I guess, one, just on some of the expansion with existing logos, I think in the past, you’ve mentioned somewhere in the range of 75% to 80% of growth comes from existing logos. As we look forward to next year, how should we kind of think about that mix? And on top of that, — what are some of the upsell drivers that you’re kind of encouraged by or that you see kind of driving that growth as we head into next year?

Kenneth Stillwell: I’ll take the first part of that, and I’ll let Alan take the upsell drivers. The first part of that is you’re absolutely right that a few years ago, we were getting 75% to 80% of our ACV growth from existing logos. If you go back and look at the last couple of quarters and then project out what we think that number will be in 2023, that number will be well in excess of 90% of our ACV that will come from our existing clients. That doesn’t mean that we won’t get new logos. It doesn’t mean that we won’t even decide the new logos or an opportunity that we want to push the accelerator on in the future. But for 2023, the new logos that we got to be very targeted and in many cases, not the average deal size of some of the upsell and expansion over our existing clients. So think about that number being in excess of 90%. And then Alan talked about some of the ways that the opportunities we see there are examples.

Alan Trefler: Yes. So — and what’s interesting about talking about logos is we don’t really generally consider it a new logo even when we go into an entirely distinct division of one of the major companies that we do business with. What I’m seeing, which is encouraging for the strategy and I think for what we can do in what might be a tough economic time is the level of engagement with very significant companies picking up despite travel restrictions in some cases, and wanted to comment to Cambridge for having a company coming from Australia for three days in the Cambridge office so we can work to help them redesign how we can spread into other areas of their business is exactly the type of thing that we wanted to have happened and was frankly not really happening as much.

But now we’re seeing that, and it’s — I just think a conscious result of the increased focus, the increased staff of understanding and really working to be more trusted advisers with these clients, which is an investment in a lot of energy and a much more consultative approach as opposed to a transactional approach. And we’re seeing that response from clients that make us believe this is working and will work.