Pegasystems Inc. (PEGA) Q1 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Pegasystems Inc. Q1 2012 Earnings Conference Call. [Operator Instructions] And as a reminder, today's conference is being recorded. Now I would like to turn the call over to your host, Pegasystems' Chief Financial Officer, Craig Dynes.

Thank you. Good evening, and welcome to the Pegasystems' 2012 Q1 Earnings Conference Call. With me here in Cambridge is Alan Trefler, Pegasystems' Founder and CEO. Before I hand it to Alan, I will start with our Safe Harbor statement and then provide my financial commentary. Certain statements contained in this presentation may be construed as forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. The words anticipate, project, expects, plans, intends, believes, estimates, targets, forecasts and could and other similar expressions identify forward-looking statements, which speak only as of the date it was made. Because such statements deal with future events, they are subject to various risks and uncertainties. Actual results for fiscal year 2012 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 forward-looking statements are contained in the company's press release announcing its Q1 2012 earnings and in the company's filings with the Securities and Exchange Commission, including its report on Form 10-K for the year ended December 31, 2011, and other recent filings with the SEC. The company undertakes no obligation to revise or update forward-looking statements as a result of new information since these statements may no longer be accurate or timely. Q1 was a solid start for the year. At $111 million of revenue, it was the second-highest in our history, and bookings were strong enough that we didn't need any backlog. It's pretty normal in the enterprise software business to build backlog in the second half of the year and use backlog in the first half. So maintaining license backlog, where it was following the bookings bloat that we had in Q4, is a good start to the year. License signings were up in Q1 of last year, even though Q1 of last year is a tough compare. I say tough compare because, if you remember, license signings in Q1 of 2011 were up approximately 85% over Q1 2010. Q1 also saw us close a major deal with an oil and gas producer. This is a vertical, which we think holds great potential for us and so I'm pleased to see us get some traction in this market. In the quarter, the meter swung back towards perpetual licenses as compared to the large number of termed deals we did in Q4. Many of the perpetual licenses had extended payments or other terms that put the deals into backlog rather than on the P&L. Page 23 of our Q details off-balance sheet backlog of signed noncancelable licenses. The backlog of $210.4 million increased by approximately $0.5 million in Q4, primarily due to the $7.8 million increase in perpetual licenses. We look at our business over a time period longer than a single quarter. So when you compare the backlog of $210.4 million at the end of Q1 this year to Q1 last year, it shows in 1 year, an increase of $93.4 million, almost an 80% growth. Our maintenance business continues to be very strong at $30.8 million per quarter. Since Q1 of last year to Q1 of this year, our renewal rate on maintenance agreements was approximately 95%. This was also a very good quarter for Professional Services. It has been our pattern for a few years now to see significant Q1 ProServ revenue growth following strong Q4 booking. In addition to the revenue, it was a good quarter for services' gross profit. Three larger projects ended in the quarter, which drove services' gross margin to 18%. Our partners continue to lead in the majority of the new projects, however, the dramatic increase in Q4 bookings drove our ProServ business to higher revenue levels, where we expect to stay until the summer, when consulting hours drop due to customer vacations. Q4 bookings also pushed training revenue to its highest level in approximately 2 years. However, as we said in our last call, our new online training capability, Pega Academy, will roll out this year. This is a far more effective way to deliver training. We expect that with Pega Academy, we will be able to faster grow the Pega ecosystem by training more customers and partners using online delivery. It's also a more cost-effective training and we'll have a new fee structure. We think that growing the number of trained customers and partners is more valuable than the reduction in training revenues that we are expecting. Operating expenses for the quarter decreased from the Q4 run rate by about $5.3 million. This is almost entirely due to a decrease in sales and marketing costs. While bookings were good in Q1, they were, as expected, less than the record Q4 bookings. The resulting decrease in commissions was partially offset by the cost of our Q1 sales kickoff meeting and an increase in headcount. During Q1, we added 25 employees to sales and marketing, of which 19 were in the sales organization. R&D headcount cost increased slightly in Q1 from Q4, as headcount increased by 8 employees. Since 2006, we've been investing heavily in R&D, as well as in sales and marketing. In 2011, we added 87 new employees to the sales and marketing organization. In order to cover more named accounts, geographies, verticals and partners, we need to increase our sales headcount. We believe that the last 6 years of near 30% revenue growth are due to these investments and we plan to stay the course on this growth strategy. In Q2, we plan to further increase headcount and we will hold PegaWORLD 2012, our largest and most expensive marketing event of the year, in Dallas. The increased headcount in PegaWORLD will result in increased sales and marketing expenses in Q2. G&A expenses decreased slightly from Q4 due to reduced professional fees even though the headcount increased by 4. In order to provide normalized run rate financial information, and to allow comparisons to those building or publishing financial models, we provided supplemental information in our press release to reconcile to a non-GAAP model. Following the same format that was used when we provided guidance as part of our Q4 earnings release, there are 3 reconciling items. FAS 123R charges for stock-based compensation for Q1 were about $1.8 million or $0.05 per share on a post-tax basis. The amortization expense at the intangible assets created by purchase accounting for the Chordiant acquisition was also approximately $1.8 million or $0.05 per share on an after-tax basis. And lastly, as we explained in our Q4 call, we are in the process of moving our offices. GAAP accounting makes us accelerate depreciation and straight-line the new lease cost. This results in double or overlapping noncash rent expense for both offices, while in reality, we have free rent for our new office until the old office lease term ends a year from now. As we did in Q4, we've added back this overlapping noncash lease expense, as well as the onetime cost of moving the offices, to present a more normalized our run rate model. In Q1, we recorded $1.2 million or $0.03 per share on an after-tax basis for these nonrecurring expenses associated with the office move. The supplemental GAAP to non-GAAP reconciliation shows a non-GAAP EPS of $0.23 per share. We ended the quarter with $88 million in cash as Q1 cash flow from operations was a use of $17.8 million. This is similar to last year, as Q1 is the quarter when we pay out our annual corporate-wide bonus plan, 401(k) contribution matches and the large Q4 sales commissions. As detailed in Note 6, trading accounts receivables decreased slightly from $77.1 million at December 31 to $74.8 million at March 31. The age of these receivables dropped from 65 to 62 days. However, due to the increase in consulting volume and some contractual payment terms on new perpetual licenses, our unbilled accounts receivable increased by more than $11 million from December 31. This increase is why on the face of the balance sheet, total accounts receivables increased from year end. Q2 collections are very strong. In fact, in the beginning of Q2 through today, we have already collected approximately $15 million of the March 31 accounts receivable balance. During the quarter, we purchased 27,383 shares or $830,000 at an average price of $30.34. At quarter end, we had a balance remaining of approximately $13.1 million available for future repurchases. Deferred revenue shows up in 2 places on our balance sheet, short term and long term. The sum of the 2, which is $94.2 million, is an increase of almost $5 million from the end of 2011 as a result of the sizable increase in deferred maintenance revenue, partially offset by slight decreases in deferred license and Professional Services revenue. On our 2011 Q4 conference call, we gave our annual guidance. We have only -- given only annual guidance and follow the policy of not commenting on it through the year. We also gave guidance for the first half of the year to provide visibility to the timing of our annual results so to provide additional milestone to chart our progress. Commenting further on this guidance would represent quarterly guidance, which is something we do not do for several reasons. First of all, we saw both term and perpetual licenses and the mix between the 2 can cause quarters to be lumpy and unpredictable. The recent swing to term licenses in Q4 then back again to perpetual licenses in Q1 illustrates this fact. Secondly, customers have annual budgets, not quarterly budgets. We were reluctant to offer large discounts to incent a customer to purchase in a particular quarter because our business model is to sell additional purpose-based licenses into our existing accounts. A big discount this quarter will set unreasonable customer expectations for the following quarters, when we are selling follow-on deals. As a result, we don't manage to the quarters and so we don't give quarterly guidance. We're reluctant to even discuss any guidance during the year as we see our objective as to maintaining the tremendous growth that allow us to grow from the $100 million a year software company that we were as recently as 2005. So while we don't give our managed quarterly numbers, I would like to point out to those building models that historically there have been quarters where revenues have not grown sequentially. In fact, in the high growth years of both 2006 and 2007, we had down quarters during the year, but on an annual basis still put up growth numbers of approximately 30% in both years. Last year was another example. We followed a slow bookings and revenue in Q3 with a bookings blowout in Q4. Lastly, our profitability for the remainder of 2011 will be somewhat back-end loaded. As I said, we will continue to invest in our sales capacity, our partner ecosystem and our R&D team. In addition, in Q2, we will hold PegaWORLD, which is our largest and most expensive marketing event of the year. In summary, Q1 was a solid start to the year. Our profitability was good and we maintained our license backlog. With this start and PegaWORLD in Q2, we will continue to build momentum the rest of the year. With more detail in Q1 achievements, I would like to now turn the call over to Pega's Founder and CEO, Alan Trefler.

Thank you, Craig, and good evening to those on the phone. Pega is gaining market share in the BPM, Business Process Management, and CRM, Customer Relationship Management, markets. It's a very exciting time. Abbreviations in tech terms can be muddy, but the power delivered by our technology is indisputable. Pega software revolutionizes how organizations serve customers and automate work by empowering businesspeople to create and evolve their critical business systems. This produces staggering returns. We provide the world's leading platform for organizations to unify their business applications, unifying business rules, business processes, user interface, integration with external systems, reporting, decisioning and mobile, in one architecture that can be deployed on-premise, on a private cloud, or on the public cloud. This is incredibly powerful, and the underlying technology empowers businesspeople to create and evolve these mission-critical business apps for customer centricity, for saving money, and for building for the future. These are really the central value propositions of BPM and CRM. Pega enhances this core with capabilities to deliver and drive Next-Best-Action marketing automation. We also build industry-specific frameworks with preconfigured industry best practices, industry specialized rules and processes, preconfigured industry standard data models and preconfigured UI and reports. Customers enjoy the speed to market and best practices in these models and frameworks and because our CRM products and our industry frameworks are built on a unified platform, they automatically inherit the powerful benefits of business agility, business specialization and multichannel work automation, all accomplished with no or little manual coding. Our continued investment in R&D has enabled us to stay ahead of the market. And we plan to continue to invest a higher-than-average percentage of revenue in our industry-leading software as we continue to grow it and focus on delivering customer success. We achieved our Q1 revenue plan while also increasing backlog over Q4 2011, a very good quarter for Pega. At the same time, our pipeline increased very significantly from the end of Q1 2011 to over $1.5 billion at the end of Q1 2012. And consistent with our increasing focus in relationship with our partners, 59% of our pipeline at the end of Q1 was sourced or leveraged by our partners. It's a good, good set of progress that we're seeing. And as Craig said, it can be a lumpy business. But I'm very excited about where we are and where we're going. We've had tremendous successes in CRM, winning significant business in multichannel contact centers. Customers love the developed once, deploy everywhere capabilities of our technology. They can create an application and set of processes regardless of the channel to which they want to interact with clients, contact center Web, voice response, mobile devices, social media, inbound, outbound. Well, the rules and processes just work for all of them. If you're a credit card company and you wanted to treat your gold customers a specific way, you tell the system once how you want to deal with them, and regardless of how a gold customer interacts with you, that customer will be treated appropriately. In April, the Gartner report on CRM for customer service was published, and Pega is positioned in the leader's quadrant in that publication, a testament to our customer-centric approach in our business growth in this area. We've been seeing tremendous wins with our Next-Best-Action marketing solution. Instead of a traditional campaign marketing approach, where a company picks a product and markets the product to a group of customers, and you know how much you love seeing those sort of brain-dead marketing messages come. With our unified marketing solution, Pega clients are able to define much more sophisticated strategies using predictive and adaptive analytics and really taking advantage of the big data that's becoming so popular and helping to drive better and better decision-making across the channels. So for example, a telecommunications company does the analysis and sees high usage customers who have a text plan for their children tend to stay about twice as long as other customers. They can execute a strategy by which these customers will be offered a special deal to help make sure that their kids become hooked on that mobile provider. This is terrific, it actually helps grow business and can massively improve attention. Just an example of how the Pega technology makes the right decisions and then even better, when the customer accepts, we operationalize the implementation. We actually handle the order processing, the provisioning, all the things it takes to go from A to Z and really deliver the right propositions and execute appropriately. There's nothing like it in the market. We also have great wins in Q1 for the use of our technology in straightforward operational improvement. A global energy company selected us to dramatically improve the speed and productivity in how they respond to issues and incidents, a situation that impacts billions of dollars and can impact millions of people. We wanted to go to traditional stack vendors who's software could not handle the specialization for each business unit of this global company, coupled with the need to operate in many countries on a single architecture. We frequently hear, as clients need the ability to specialize by the business unit, by the client, by jurisdiction, and that's one of the only Pega, only Pega has a technology designed specifically for those types of problems. We also had a great Q1 win with a major electronics manufacturing company, who selected us to ramp and renew their SAP systems for significant operational productivity improvements. This is actually very common. We have about over 60% of our clients use SAP. And we find that we can add tremendous values to those clients and really get them to be much more process-efficient and customer-centric while taking advantage of the investment that they already have. It is clear from these examples, we're seeing business wins in extended set of industries, going beyond our traditional strong verticals of financial services, healthcare and insurance, to energy, manufacturing, travel and transportation, communications and IT services. It was a great quarter for go live as well in Q1, with wonderful customers, such as GM, Deutsche Bank, American Express, Express Scripts, France Telecom, INZ, Zürich Financial, Highmark and Barclays, also some great clients going live with our products. It was really tremendous. So in Q1, the demand for our software was exceptional and we're really excited as we continue the year. We think that we will continue to win the kudos of industry analysts, and that we will continue to be able to wow customers with the speed and effectiveness of our technology. We're doing things and bought its adoption. As I've often spoken about our partner program continues to be a source of a great focus. And I'm also pleased that this quarter, we will be introducing the Pega Academy, which is a major self-study style of enablement where people can take world-class lessons through video, through exercises they execute on their own machines at their own time, and really learn our products through self-study. We think that this will reduce the cost of education by more than 2/3 and we're seeing that you can achieve high certification and pass rates, which gives us confidence with customers' end prospects, and partners will be able to learn well through this technology. This is exciting and we were able to launch it using our technology and on our Pega Cloud public cloud, so it's blazingly fast. In closing, I want to spend a moment or 2 talking about an event that's coming just one month from now, that I think is a great way to understand what Pega is about, what we really do, and why we're so excited by our charter. In early June, we'll be holding our PegaWORLD 2012 Conference in Dallas. We expect record attendance and have more than 75 enterprise customer and partner speakers standing up to talk about what they're doing with Pega and really telling enormous and terrific stories of achievement and of customer-centricity. One of the thing that's interesting is we chose to have an outside speaker join us as well. We decided to have Fred Reichheld, who is a noted customer experience expert and the author of a book called The Ultimate Question, which talks about how organizations can really gauge and enhance the loyalty of the customers. And what I love about the book, which was actually directed to me by a customer, is that about more than half of the examples of excellence in service and loyalty in that book are actually Pega customers. Companies that have chosen Pega to achieve, to maintain or to extend the loyalty and the relationships with their customers. And we're going be able to hear that in spades at PegaWORLD. We're thrilled, for example, that Jim Bush, the head of World Service at American Express, a 5-time J.D. Power award winner and great Pega client, has chosen to come and sort of talk about the journey that they're on around customer excellence. United Healthcare Group is talking about how they're doing massive revisions across the organization to really improve both the quality of care and its efficiency. Other clients like PNC Financial, which is an award-winning customer, is using us to actually do more than 1 million offers in decision requests every day to be able to optimize the way they interact with their customers and they'll be talking. Health Net is talking about how they're using us across their healthcare environment. Vodafone Germany is talking about how they increased operational efficiency. GE Healthcare is discussing how they're using us to do regulatory management and spend management, which is very, very important based on the recent healthcare laws. State of Texas, talking about the many initiatives we have working down there. [indiscernible] a large manufacturer is talking about how they're using us to get a realtime process improvement across the organization. Prudential Insurance, talking about how we're creating consistency across product groups. State Farm, Tenet Health, Zurich, there are so many who are willing to come and speak. It really makes us proud, it really reinforces what a great, great collection of customers we have been privileged to work with and what an awesome group of partners are now increasingly driving business with us and achieving excellence with those clients. So I'll tell you, we're working hard and we're pleased that we're making progress. And with that, let me open it up for questions. Thank you very much.

[Operator Instructions] And our first question comes from Nathan Schneiderman with Roth Capital.

I was hoping we could start with -- you did reference some success with bigger deals and you called out at one in oil and gas and the industry in particular. But I was curious if you could share with us maybe the number of deals you achieved over $10 million and maybe the number of medium-sized deals for you, $5 million to $10 million?

We had a few over the $5 million sort of mark. And some of the deals that are biggest actually had some contingencies in them. So we don't actually consider them fully bookings now. But it was really exciting to sign up with one of the world's largest companies in that space. I think it's a harbinger for a lot of good things.

And then -- I'm sorry, did you want to add anything else?

I don't. No.

You had referenced a pipeline of $1.5 billion. I was just curious if you could share with us, what percentage would you say that's up year-over-year?

I think, year-over-year, it's up about 40 -- high 30s, maybe 40%.

Final question area for you. I was just curious if you could share with us more statistics on the success you're having with the decision management product, the Next Best recommendation engine. Curious if you could share with us maybe the number of deals you've achieved in the quarter. What percent of your license bookings, you feel, are being driven by this particular product?

Sure. I've actually had a chance to look it up and the actual number was 43% year-over-year. But the Next-Best-Action bit, it's really starting to get excellent momentum. We, over the last 6 months, and including in the quarter, have won a couple of very significant pieces of business, where it's really a combination of Next-Best-Action, powering BPM and -- being powered by BPM. So it's not as easy to tease those apart. I actually think that the Next-Best-Action is probably a pretty good thing to have in the midst of most processes. So what I would tell you is we're seeing it probably start to play a role in 1/4 to 1/3 of the deals, and I think we're going to see that number in the second half grow to 50% or more.

Our next question comes from Laura Lederman with William Blair.

Can you talk a little bit about the contingency and why it's not booked, what type of things is it contingent on? And was that the big oil and gas deal? I'm just trying to understand the contingencies. And does that mean it doesn't show up anywhere even in the exhibits in your Q to talk about future revenue recognition?

Contingent is probably the wrong word. I think it was a deal sort of a multi-pump deal where they buy something with a commitment to buy more but certain things have to be achieved before they did. Anything that looks remotely like that doesn't show up in any of our numbers. We would never include something like that. But the sales effort in this case was commensurate with something that is truly whale-ish and the team actually delivered on it and I think we're in really, really good shape probably as it goes forward. The nature of the business, though, I'd just as soon not get into too many details on it.

Can you talk about that pipeline in terms of composition? How much of it is your traditional vertical financial services, insurance, healthcare versus new verticals?

We don't split them out to that level of detail. The pipeline is still meaningfully heavier towards our traditional businesses, because frankly, they've been doing really well, financial services, despite the economy, continues to grow. We continue to add staff and continue to deepen the relationships with companies like JPMorgan Chase and Lloyds and American Express and ANZ Bank. So that continues to do very well. So it's still the larger part of our pipeline, I would say, would be those 3 traditional verticals. Fast on its heels, though, is telecommunications, which has been really burgeoning forth over the last couple of quarters.

Can you talk a little bit -- final question from me, what you're seeing in EMEA? In other words, there's always been fear of what's happening in the economy there in terms of the demand there versus in the U.S.

The pipeline is good. It's a little scary to read the newspapers, to tell you the truth. But we're still getting the meetings, the engagement and the bookings from our clients, and we have some very significant transformation programs that are going on but it's difficult to predict what's going to happen in Europe. We're trying to make sure we're hedging our bets in North America and in Asia at the same time.

Our next question is from Raghavan Sarathy with Dougherty & Company.

I think Craig talked about license signings were flat year-on-year against a tough comp. I was wondering if you could give us some sense whether that the license signings were in line with your expectations, above or below expectations?

Actually they were up slightly in Q1 this year compared to last year. But it was a tough comp because last year, in Q1, they were up 85% over the Q1 the year before. We -- most of our expectations are built around periods that are longer than a quarter. Q1 is a pretty small snapshot to really get too excited about one way or the other. We are more interested in our annual goals than our quarterly goals.

In Q1, we have sales kickoff, where there's a lot of disruption, a lot of customers, for us anyway, did their -- we had such a staggering set of buys in Q4. Just blew the doors out. So I was actually pretty happy that we had a successful Q1 on the back of just such overachievements in Q4.

To be honest, I mean, anytime you can go through Q1 and build backlog, license backlog, that's great.

Yes. It's a little unusual for us.

So I guess the follow-up would be it looks like you have a tough compare coming up in the second quarter too where you, I think, last year second quarter, license signings nearly tripled. I was wondering whether we should have modest expectation again for the second quarter given a tough compare?

Yes, I mean, our quarters can be very lumpy. I mean, last year is a very good example. At the midway point in the year, we probably had done more bookings towards the front end of the year than we've ever done before and then things slowed down in Q3 and then we had a monster Q4. So quarter by quarter, the business is lumpy not just from financial statement revenue but also from license signings.

Just 2 more questions and I will jump offline. It looks like you added 25 headcount in your sales and marketing. I think, Craig, you said 19 in the sales as compared to 13 last year same quarter. It seem like you are kind of ahead this year in terms of hiring, I was wondering if how we should think about sales capacity increase for the full year and whether it's going to be front-end loaded or the trend is going to continue?

Well, I think we're going to continue to hire at a good pace. We're setting very aggressive targets as we think about our multiyear growth plans. And to be blunt, the people we hire in the second half of this year are going to be entirely aimed at 2013, it takes a couple of quarters for them to get trained and start to book business. So if we like the way the global economy is going, even though it's not going to affect our financials positively this year, we'll hire in Q3 and Q4.

And especially if we find good guys.

And then final question. Alan, you mentioned in the press release that you're expecting 2,000 attendees for the PegaWORLD. How does that number compare the year before?

We're thinking that attendance will be probably up something between 35% and 50%.

Our next question comes from Steve Koenig with Longbow Research.

I have one for Craig and then one for Alan here. Craig, I'm wondering you gave us some good color on the individual cost lines relative to Q4 run rate. There was a large amount of EPS upside kind of relative to the first half-second half split that you've talked about. Can you comment -- can you help us understand where did that -- all that upside come from on the earnings side relative to kind of your expectations?

Well, a lot of it had to do with the mix of license revenue, that's what is a major source of lumpiness. As I pointed out, the dial swung back a little bit towards perpetual licenses as compared to Q4, where it was significantly towards term licenses. So that always affect the profitability. We had some big expenditures in Q1 as well. We had our Sales Kickoff, which was very expensive exercising and training the sales force but well worth it. So I think...

Well I think we did a better job of -- I think we did a better job of expense management at the Sales Kickoff. And then some of the others, we were, the team worked hard and is working hard to try to make sure we're hiring as efficiently as we can.

And then Alan, one for you here. You guys have so many diverse use cases that you can address, that it's impressive, but also sometimes hard to get your arms around the totality of what you can do without addressing all the individual kinds of use cases. Wondering if you could generalize a little bit on CRM in particular. You talked a little bit about last year's PegaWORLD, about some interesting developments in your CRM roadmap. I almost got the sense that it was almost an application per se, kind of a Siebel-killer, if you will, or something of that ilk to help all those accounts that are settled with legacy systems. Can you comment on where the roadmap has gone in CRM? And if possible, where you're going with that?

Sure. So our cut on CRM is, we're the technology that you want when you've got a somewhat complicated business and customer base that's demanding. And when you want to be able to provide service that cuts across the channels so that you can have somebody -- one of our European clients taking live loans over the Web, they're trying solicit credit card applications and other applications of personal loans. They were expecting when they ruled it out earlier this quarter or in the first quarter, that they would need about 70 a day. They're getting 70 an hour, and they were able to have somebody start in that channel, slip into the call center, and do all the stuff you'd like to be able to do. So that's an example of a company that previously had Siebel and is looking to sort of wrap, renew and eventually replace it. So you can think about this being the smart layer that makes it so the service reps don't have to go to 15 systems, we do it for them. And then allows them to plug right into the website, to Facebook, and really offer that multichannel experience. And I think we're highly differentiated in the market. I think we're able to do a level of sophistication that companies really need today as they're trying to improve loyalty and make money. And it fits beautifully with the Next-Best-Action and the core BPM technology around operationalizing things. So I think it's a great story.

Your next question comes from Richard Davis with Canaccord.

I mean, this may sound silly in a world where you have Splunk trading at 12x revenues. How do you -- Alan, how do you think about -- and I understand the concept of investing because you've got a great product and these things. But how do you think about intermediate term operating margins or is it just like you're sitting there -- sitting in your chair, saying, "Listen, our opportunity is so big, we just got to pedal to the metal and if our operating margins are 12%, that's perfectly fine. We're not losing money, and it may be 12% for a long -- several years." Or do you think to yourself, hey, this things all of a sudden is going to tip over on the margin side even if you're hiring people aggressively and operating margins kind of inch up to 20% or something that. I'm just trying to kind of -- I don't frankly know what the right answer is, but I just wonder how you think about it.

I think the opportunity is, as you described, massive. I think we need to be responsible in how we spend money and make sure we spend money wisely. I think the management team has been paying a lot more attention to that as we've grown. We do think that we should be able to get operating leverage. The reality is, over the next couple of years, I'm expecting that it will improve because we will become more effective at capturing those stories and having more referenceable customers that begin to create sort of more demand that we don't have to cultivate quite as hard. At some point, we're going to hit a that tipping point, and it will be less pushing and more pull. Until that happens, we've got to get ourselves in shape to be able to take advantage of that. So now, it's a terrific opportunity from our point of view. We continue to see that our competitors -- our pure play competitors were all actually gobbled up, one of them actually, it was just announced last week, is going to be now divested out of Progress. I think the market for us is terrific. We need to make sure we're ready to take advantage of it.

Our next question in queue comes from Brian Murphy with Sidoti & Co.

Did you comment on the sequential decline in maintenance revenue?

Yes. Some of our maintenance revenue can be lumpy from quarter-to-quarter based on when people's renewals come up. In the Pega model, the maintenance contracts are self-renewing. In other words, it renews automatically unless you tell us otherwise. Some of the maintenance contracts we had from Chordiant were not auto-renewing and so we had to run around and get paper from these people and get them to resign and oftentimes, getting something signed can move from one quarter to the other. When we look at our renewals, it doesn't mean they are not going to renew. When we look at our renewals, we're at a 95% renewal rate from Q1 to Q1.

Okay. And could you give us a sense of how much cloud revenue is in Professional Services now and maybe how fast that's growing?

It's growing at a pretty good clip. Most of the -- most of it is a lot of development, cloud environment, a lot of testing cloud environments. We do have people using it for production. A lot of people do development and then copy the application back behind their firewall when it comes time for production. But it's pretty large but it's not large enough yet to disclose on the financial statements.

And is that having any impact at all on the service gross margin? It's particularly strong during the quarter. I'm just wondering if over time, that should give the service gross margins a boost?

It will and we'll break it out when it gets to have an impact. The primary driver for the gross margin in the Professional Services in Q1 was the fact that we had 3 good contracts that ended in the quarter and we were able to recognize the revenue on them. So it was a good quarter for ProServ.

Okay. I see. And Alan, I know you made some comments on Europe. But your, on a regional basis, your other bucket, I think, bubbled. Can you just maybe comment on what drove the strength there?

So a lot of it was Canada, which has been very strong for us and looks like it's going to continue to be strong for us. And we're also seeing some good things happen in the APAC space, but that was primarily Canada.

And also, CapEx year-over-year, big jump there. I mean is that just timing or did you have some -- are you making some incremental investments there?

It's office build-outs. We opened an office in Paris in the quarter. We are about to open an office in Bangalore, we are building out the office in Cambridge in anticipation of a Q3 move. So that's where most of it goes.

And Alan, you talked a little bit already about CRM. Can you just give us a sense of where you think we are in this kind of call center replacement cycle opportunity?

I think we're still early. I think there is an enormous opportunity driven by a couple of different things. One, a lot of the call center systems and CRM systems that are out there are really pretty lousy. They really don't do a good job of supporting the agent, particularly if the business is complicated. And then second is that we're having very significant multichannel conversations with our clients. Historically, people built too much business function and business process into each channel. So they would set up a group, a special group, to go after the Web and they would like build all the processes there. And then in the call center, we can build, it would inevitably be different and make it very difficult to roll out new products. And now some customers are going after mobile. A lot of them are saying, "Boy, this is crazy." We need to have processes that are largely horizontal but actually allow you to go across these channels, with just a limited amount you need to be built into the channel, built into the channel. So I think this is being driven by those, the normal replacement cycle that occurs on the back of a lot of those old Siebel and Clarify systems for people who were in that era. But it's also being driven by increasing need for people to adopt a more effective way to engage with clients, which is also why we're excited about some of these unified marketing and other pieces that we're bringing to the market this year and we'll be showing off at PegaWORLD.

Appreciate the color there. Just one more and I'll hop off. Just kind of similar question in the oil and gas sector. Obviously, we're kind of -- obviously, early innings there, too. But could you help us kind of size the opportunity in the oil and gas space? I mean, how big could that vertical be for you guys?

Oh I think that vertical could be as big as insurance or healthcare or many of our other major ones. Maybe probably not able to be as big as financial services, just because there's so many of them. But when we take a look at oil and gas, we see a business that is highly concentrated, which we like, that is global, which we like, that has complicated processes and the need to support both operational efficiency and operate with regulators. So it's really going to be a very good market for us. And the key is now we've got a couple of early clients, the key is to execute well, get those clients to radiate. And I think we could be looking at a strong year and a very, very, strong year next year.

[Operator Instructions] Our next question comes from Edward Hemmelgarn with Shaker Investments.

Just a couple of questions. One, I noticed that you've signed the agreement with the Texas Retirement -- County and District Retirement System. Is that -- are you changing your focus a little bit more to state and local governmental units away from trying to beating your head against the wall at the national level?

Well, I'll tell you, what we decided to do is complement our head beating with increased focus on the state or local and it's turned out great. We've won meaningful business now in half a dozen state agencies. And some of the states are very, very large and they really need operational improvement efficiencies and we're thrilled. We are actually feeling better about the federal government, too. So we're not -- the fact that we have not been, as of yet, as successful to have won in Federal, which I've spoken about repeatedly, doesn't mean we're giving up. It means we're trying different tactics and I'm actually liking what I'm seeing there to boot. But it's really clear that state and local is going to be very big for us.

The other thing is, any new industries that you think you might be able to break into and see more growth in 2012 versus where you've been at before?

Yes, we had a really excellent, great follow-on deal in the manufacturing space where we -- once again, it's kind of the way we work. We go in and sometimes customers will make a big buy upfront. We're just as willing to work with them and have them really understand what we do. And then they followed up to come up with a system, a multinational system is going to go in and wrap all their SAP implementation limitation so that they can actually get more business benefit out of it. So I think manufacturing, which frankly plays a bit to the types of things you find in oil and gas, is going to be an increasingly good market for us. And we're looking for that to grow.

And at this point, I would like to turn the program back to our presenters for any concluding remarks.

So thank you, everybody, for the call. I'm sorry if I sound a little hoarse, the pollen is getting to me here in Boston. But we've been working hard, we're thinking that PegaWORLD, which you're encouraged to look up and take a look at our website, see what's there, is just going to be spectacular. When you look at the people who are coming to speak and talk about what they do, we're expecting a really rousing event at the beginning of June. And if you're available, I'm sure Craig would be willing to entertain a number of you.

All right. Look forward to seeing all of you in Dallas at PegaWORLD. It will be a good event and I think you will really enjoy this year's presentation.

Thank you, everybody. Have a good night.

Ladies and gentlemen, thank you for joining today's conference. This does conclude the program and you may now disconnect.