Pegasystems Inc. (PEGA) Q2 2015 Earnings Report, Transcript and Summary

Greetings and welcome to the Pegasystems’ Second Quarter Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Rafe Brown. Thank you, sir. You may begin.

Good evening, ladies and gentlemen, and welcome to Pegasystems’ second quarter 2015 earnings call. Before we begin, I’d like to read our Safe Harbor statement. Certain statements contained in this presentation, including but not limited to, statements related to future earnings, bookings, revenue and mix of license revenue, may be construed as forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. The words expects, anticipates, intends, planned, believes, could, estimates, may, targets, strategies, intends to, projects, forecasts and guidance, and other similar expressions, identify forward-looking statements, which speak only as of the date the statement was made. Because such statements deal with future events, they are subject to various risks and uncertainties. Actual results for fiscal year 2015 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 second quarter 2015 earnings, and in the company’s filings with the Securities and Exchange Commission, including its quarterly report on Form 10-Q for the quarter ended June 30, 2015, its annual report on Form 10-K for the year ended December 31, 2014, and other recent filings with the SEC. Although subsequent events may cause the company’s view to change, the company undertakes no obligations to revise or update forward-looking statements, whether as a result of new information, future events or otherwise, since these statements may no longer be accurate or timely. With that, I’ll turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Thank you, Rafe. Q2 was a very strong quarter making for the excellent first half. We exceeded our revenue goals while building backlog demonstrating strong execution throughout the organization. Our first half non-GAAP license and cloud revenue grew $135 million, a 16% increase year-over-year and over a pretty tough compare with the previous first half. North America showed very strong performance and Asia performed well. There is still room for improvement in Europe but it performed much better this quarter. My recent visit made me optimistic for continued improvement in the second half. So given those summer sales, vacation season, it may be more in Q4 than Q3. We continue to focus on helping our clients become more customer-centric and that they connect their front-end customer facing applications to their backend operations. This enables clients to go end-to-end from engagement to fulfillment, something we feel uniquely qualified to do. And as we’ve been discussing, we’re working to mitigate the intrinsic lumpiness of our business and our strong first half is an indication that we’re making some progress on this goal. To give you some context, as we’ve discussed for the past several quarters, Pega is embarking on some ambitious efforts to more deeply build out our strategic applications and to bring our solutions to a broader market. This includes new programs we launched in Q1 to raise our name recognition with both existing and new audiences and to start to institute what we thought was a more repeatable sales model. And this also includes packaging our capabilities as easier to deploy application that address the critical needs our clients have to improve their responsiveness and engagement with their customers. And overall, we’re very pleased with the results to-date and believe we’re seeing early signs that this progress is taking hold. We continue to have confidence that this focus on a broader market will lead to improved sales repeatability and strong long-term growth. And we are promoting our Pega Cloud offering as a way to speed client adoption. We actually think that our "have it your way" approach which allows clients to move between cloud and on-premise is a powerful positive differentiator compared to vendors who are cloud-only. We’ve driven a number of initiatives to speed adoption of Pega 7 and our application. Importantly we announced Pega 7 Express at PegaWORLD. This is an intrinsic part of the platform but it simplifies the design and development experience and allows business and IT users to get started without a formal training. Pega 7 Express allows our clients to start building applications quickly, knowing they can evolve those applications to the full richness of Pega 7. Think about it as on ramp to Pega. Feedback we’ve had from clients and prospects is very positive. And it also interestingly indicates they see this as a platform where we’re sitting would many call UDBAs, so called user developed business apps, sometimes they call them rogue apps or things that people ran off and did. These apps were built by users on non-enterprise quality platforms, but old ones that are still running on Lotus Notes or newer limited ones like SharePoint or even simple cloud apps that have now run out of runway that have been starting to create problem. Pega Express lets these now be redone on an enterprise capable platform powered by the enormously simplified application development process that we’re now able to provide. I what’s interesting? At PegaWORLD, a Pega 7 customer on the cloud, the state of Maine talked about an initiative in which they build what they call 40-hour apps. Pega 7 Express brings this capability to our broad client base. We’re also continuing to invest in our ecosystem to increase the number of Pega served by professionals. Our current partners have accelerated their investment and delivery capacity through the first half with the pace much faster than 2014. And we have plans to continue working with them to facilitate this rapid growth throughout the rest of the year. We’ve rolled out a new mentored self study program that combines the flexibility and convenience of self study video training with the support of a mentor training expert. And we recently surpassed a major milestone with more than 2 million lessons delivered through our online Pega Academy. We’ve also become ecosystem development program with several universities. And with programs like gear up, it will add training on Pegasystems software to be a terrific skills enhancement program and this advantage to you. From an investment point of view, we’re at the stage where we have a tremendous product, but we see some areas that we think can help leverage us to grow and be more effective. And we’re going to continue to invest in our products, the talent and our marketing initiatives to achieve our goals of faster growth. And we’ll be increasing this investment in a few areas. We believe our strategy to focus on delivering more finished applications is working. As a result, we will be increasing our investment to continue to provide the solutions our clients require and to provide us and them with a competitive advantage, knowing that they can start from a better faster place and still build for change. We’re also increasing our investment in our cloud offering as we see the interest growing at an unprecedented rate especially as we target a broader group of enterprises in the Global 2000. As mentioned, our ability to deliver our software in the cloud and on-premise is an important differentiator and we see actually that many large global organizations want to be able to start on the cloud, get moved on-premise later or vice versa. We believe our marketing initiatives are beginning to bear fruit and we need to increase our efforts and increase our visibility and exposure to both prospects and new areas of existing customers. We will be extending our Peg Can advertising campaign in North America through Q4 and expanding it into Europe beginning this fall with an initial focus on Germany, France, and the UK. And we’re also going to be looking for targeted opportunities for high level media visibility. Interestingly on Friday, I’m slated to join the term at Squawk Box at around 6:20 am. If you’re idem to, get up and listen, I hope you’ll tune in. Regarding the execution of the strategy, in the first half we made significant progress in communicating on new positioning, shifting to being more of a strategic apps company and raising awareness among a broader range of clients we believe represent a significantly long term -- larger long term revenue opportunity. And as you heard on the last call, we have achieved leadership ranking and very, very strong one in some of the most important industry analyst reports in 2015 for our industry. And I’m very pleased to be able to tell you that just today Forrester published their new, what they call it a Wave, evaluating real time interaction management offering. Now real time interaction management is at the heart of the Pega philosophy, which brings together the intelligence you could add to technology by bringing analytics and data and process altogether. And Forrester defines it as core technology that delivers contextually relevant experiences, value and utility at the appropriate moment in the customer life cycle via preferred customer touch point. Given this important area and something that we think is critical to our offering, I’m thrilled to say that we are ranked as providing the best cloud offering in the industry. Actually one of only two vendors positioned as a leader, very, very impressive. In discussing our leadership ranking, Forrester noted “merging powerful analytics with business rules management, Pegasystems has expanded the next best action capabilities in the contact center, through the sales, service and marketing channels.” The report also noted that “references from our growing user base represent some of the largest interaction management environment in this study and provide favorable reviews for customer data management, recommendation engine functionality and offer optimization”, a major win for us and always nice to get that sort of objective, positive assessment. We’re also seeing some nice trends regarding deal flow. We think actually more deals sourced and closed within the first half of the year than we’ve ever seen in the past. We closed two wells [ph] in the first half of this year versus one in the first half of 2014. And happily that difference is not, it was not the basis of our strong performance, it was strong regardless. We’ve also see the meaningful pick up in business coming from our partners and we’re seeing an increase in the number and size of deals from new logos. In Q2 we added, significantly more new logos compared to Q2 of 2014. These include companies such as Plusnet, a wholly owned subsidiary of British Telecom that selected Pega to transform the customer experience, streamline and automate critical processes and ultimately improve business agility. Société Générale Commercial or the largest banks in France who is using our Know Your Customer applications, the new client onboarding in the sales and onboarding and customer service areas. Chevron, using Pega to build a strategic application to manage their and their affiliates’ procurement request and related approval processes. It’s going to run across 35 operating companies in 180 companies. Moody’s Corp using Pega as part of broad business transformation to being a core platform for their rating services that enhance and drive efficiencies as well as customer service. And a major new Fortune 500 insurance company, they’ll be using Pega as a key component of enterprise transformation to bring product faster to market and improve the ease of doing business. Moving over briefly to the UK, we won a terrific deal at their AA, so the real version of our AAA, the Automotive Association. They selected Pega for a technology transformation put customers at the centers of the business and improve customer service, be able to offer products better and adapt to wrap with customer needs. So it was terrific to be able to have lots of strong wins. We also had terrific wins for example in Asia at Commonwealth Bank of Australia and also Standard Chartered for example. I’d also like to highlight that this year’s PegaWORLD once again attracted a record number of attendees, over 3,000 from over 30 countries that highlighted success stories from several thousand firms including global leaders like AIG, Cigna, GE Healthcare, New York Life, Royal Bank of Scotland, UnitedHealth Group of Vodafone. And you can actually see many of these sessions on the PegaWORLD 2015 page on our website and it’s a really, really terrific way to get exposed to what Pega can do and the successes our customers are experiencing. At PegaWORLD we also announced the Pega 7 Express, I mentioned earlier. And we actually have long lines of people lined up to be able to get their hands on it and experience firsthand and got great reviews. Now additionally in Q2, we announced enhancements to several of our strategic applications including industry first enhancements to our customer service for healthcare, which integrates service and care management to provide a single view and approach to customer interaction and customer engagement. We also added in the life sciences area and enhanced customer engagement application. And we continue to build out our products such as Pega Sales Automation to optimize sales performance and reduce time from lead to revenue. Our Sales Automation product was highlighted at PegaWORLD by AIG, where they chose Pega to automate sales and underwriting in AIG Japan used by 180,000 agents across Japan, a terrific win and a terrific story. You can see the four minute video on the website, I strongly recommend it. We also have terrific go lives around the world because that’s so important to us and to keep the value system the firm where we want to make sure we’re not just selling things but working with clients to gain value from them. Brand names like Sainsbury, the terrific supermarket chain in the UK, National Australia Group, Sprint, TalkTalk, GM OnStar lots of firms and many industries as you’ve heard now using Pega. Some of the return business we got from firms who have been using us and rolling us out include additional wins at companies like PNC, T-Mobile, Toyoda, Mondelez, JPMorgan Chase, Allianz. What I’d like folks to take away from this. As well as many years ago, we were basically in the banking business; today we are very, very strongly positioned with winning applications in many verticals. And this I think is the business a level of improved stability but also a terrific opportunity, particularly now that we’re opening up the market and going to work with less than the Fortune 200 which we have typically focused on. So in summary, we’re very pleased with our performance in the first half of 2015. We continue to be pleased with the progress we have made in the transition that we discussed with you last year in terms of both the applications and the movement of much, much more sort of marketing. We continue to think that our software has an unusually high number of spectacularly referenceable customers. And then if you compare the customer story, the customer quotes, the customer videos on our site to the others, you hear a lot of hot air on the others. On ours, you hear tremendous statistics. One of the really cool ones, and this is another one you should check out is a Işbank which is the largest commercial bank in Turkey, which is undertaken a transformation with Pega for last two years. They came to PegaWORLD and on video they talk about how they improved productivity across the board 30% and they’ve doubled the assets that the bank handles without adding a single new staff member. And these folks are on fire. This is a system they believe they have and are using to take strategic share from other competitors in that market. We believe that this unified platform offers clients a solution with its end to end focused ability to go from point of contact all the way to fulfillment and move across channels that is unrivaled in the space. And by continuing to invest in these initiatives and in growing our business, both from a marketing and a quality of product and delivery ecosystem perspective that we can achieve our goals of accelerating our growth rate. With that I’m going to turn over back to Rafe Brown to talk about financials.

Thank you, Alan. For the second quarter of 2015, we are reporting both GAAP and non-GAAP results. A full reconciliation of all GAAP to non-GAAP measures is provided in the financial tables of the press issued earlier today and is available on the investors section of our Web site. As we’ve discussed in the past, quarter-to-quarter comparison do not necessarily reflect the underlying momentum of our business as the timing of a small number of large transactions and the mix of license types can significantly impact our results. To provide the best look at how our business is performing, let me run through our results on a year-to-date basis. We’re pleased to report that year-to-date non-GAAP total revenue was $316 million, up 10% year-over-year. Equally important, we achieved these results by building backlog which I’ll discuss in a few moments. Our year-to-date non-GAAP license and cloud revenue stood at $135 million up 16% over the prior year. From a mix of revenue perspective, we were pleased to see that for the first half non-GAAP license, cloud and maintenance revenue stood at 74% of total revenue, up from 72% for the same period of 2014. This increase is a result of our stated strategy of growing our higher margin software revenue items faster than professional services and training. As we’ve discussed in the past, we offer our customers a number of options when purchasing our software including perpetual and term license arrangements, as well as the choice of installing the software on-premise or using our cloud offering. In an effort to improve revenue visibility, our sales compensation programs encourage the sale of term and cloud arrangements as they drive revenue recognition over a period of time. To this end, when one combines term, subscription and cloud and maintenance revenue for the first half, you will note that we had over 50% of our revenue coming from ratable sources. This speaks to real progress in the company’s efforts to build a more predictable revenue model. Non-GAAP professional service revenues for the first half of 2015 were $80 million, an increase of approximately 4% over the prior year. Looking at our geographic revenue split, the Americas continue to stand out with the first half non-GAAP revenue of $218 million on a year-to-date basis, representing 69% of total revenue. Revenue from EMEA was approximately $76 million on a non-GAAP basis, representing 24% of total revenue. And year-to-date, Asia-Pacific revenue totaled $22 million or 7% of the total. Turning to our non-GAAP gross margin. We finished the first half with the gross margin of 69% compared to 70% for the first half of 2014. This slight decrease reflects the combination of a one-time charge impacting cloud margin as well as the performance of our professional service margin which is with as we have been discussing in recent calls are trending lower than last year. Turning to the rest of the income statement. We posted year-to-date non-GAAP operating margin of 11% compared to 12% for the same period of 2014. First half operating expenses totaled $184 million on a non-GAAP basis, an increase of 12% over the prior year. In reviewing our operating expenses, there are few points I would like to discuss. First, as a backlog number once again revealed, we had a strong sales quarter, delivering an increase in license and cloud revenue that exceeded our internal objectives while also building backlog. This additional sales activity drove commissions and other variable compensation expenses higher in the quarter and in the first half of the year. Second, we’re continuing to invest in developing our strategic application which is driving an increase to our R&D line. And finally, as Alan noted earlier, PegaWORLD was a fantastic success. This event coupled with our first half brand awareness campaigns, has raised marketing cost on a year-over-year basis. Turning now to earnings. On a year-to-date basis, we posted non-GAAP earnings totaling $21 million; on a non-GAAP fully diluted EPS basis this totaled $0.27 per share. Now, to discuss license and cloud backlog. We compute license and cloud backlog by totaling two elements; deferred license and cloud revenue as posted on our balance sheet and off-balance sheet license and cloud contractual commitments that are signed, but as yet unbilled. As a reminder, you can find detail of both elements in our 10-Q and a summary table in our press release, both of which were filed earlier today. We finished the quarter with $391 million of total license and cloud backlogs. For year-over-year comparison purposes, it is important to remember that Q2 last year presented a very tough comparison. Even with this said, total backlog rose $38 million over the prior year, an increase of 11%. From a cash flow perspective, year-to-date the company has produced $39 million of operating cash flow, free cash flow which we define as operating cash flow less CapEx to $32 million, and we finished the quarter with a total cash and marketable securities balance of $227 million. In summary, we have had a strong start to 2015, exceeding our first half revenue goals, building backlogs and seeing strong progress in developing our strategic application. With the benefit of strong first half and additional backlog, we now believe we’ll modestly exceed our previously issued non-GAAP revenue guidance of approximately $653 million for the full year 2015. Given the investments we’ve discussed in this and earlier calls, we reiterate our non-GAAP earnings guidance for the year of approximately $0.78 per share. And with that operator, we’ll open the call to questions.

Thank you. [Operator Instructions] Our first question comes from the line of Brian Murphy with Merriman Capital. Please go ahead with your question.

Alan, when I look at the performance on a geographic basis, what really stands out is your other Americas bucket. Could you just give us some color about what’s going on there, is that Canadian banks or is that something else?

Well it’s interesting because we’ve had really a pretty amazing set of successes in Brazil. And the interesting thing is it’s been done entirely with partners and also Canada has been very-very strong. We’ve had some very good business in Canada last year, some of which just came into revenue this year. I think it’s been a little bit of South America so far, I think there’s going to be more of that coming. And Canada continues to just be a terrific place for us.

I guess that was where I was going with this is, do you see South America is having a lot more runway going forward? And if so what are you doing in terms of sort of building out sales and marketing infrastructure down there?

Thus far it’s a virgin territory for us. We’ve really been doing it in conjunction with a couple of our very, very large and successful strategic partners with large presences there. But I think inevitably we’re going to come up with a strategy to implement in 2016, just going to have to look at that and figure out where that wants to go. But right now we have not been building our infrastructure though. It’s actually [indiscernible] you should. Canada of course we have an infrastructure and we have success in everything from the banking, the insurance businesses, we have Dow [ph] Canada as a customer, we have Canadian government actually recently decided to budget from. So we’re pretty broadly distributed there.

And in Europe, I know the third quarter is typically pretty soft due to vacations in August et cetera, but I’m curious what particular made you optimistic on your recent trip that things might sort of bounce back a little bit in the fourth quarter?

We’ve made some -- there have been a number of management changes to that organization. They have happened over the last six to nine months, and we saw Société Générale which is obviously just a terrific brand name, signup and make a material purchase with us. And when I go to the customers, some of it is a bit suggestive, I get the sense that there’re now just more ready to move, but they’re almost sick of waiting in a malaise state. And I think the issue with the third quarter is that it’s really in parts of Europe, a one month selling quarter because it’s really September. So that’s what makes it a little less predictable. But once again, I’m feeling more optimistic about Europe than I have the last few years really.

Just one more and I’ll hop in the queue. And I don’t know if this is for Rafe, but how do we think about the service gross margin in the second half; is it more sort of -- is this a good run rate or are we back to sort of high-single digit expectations?

As we’ve been discussing in some of the recent calls, we are doing a number of things to help build up margins. I do think we’ll see an uptick from where we are, certainly that’s our internal plan, we need to go ahead and execute against that. We have, there’s been a couple headwind elements out there that we’re working through and I think we’re making real progress. It is going to take us a number of quarters to get back to the margins we really want to have but I think we’ll be a on a better trajectory soon.

[Operator Instructions] Our next question comes from the line of Steve Koenig with Wedbush Securities. Please go ahead with your question.

This is actually Jay, [ph] dialing in for Steve. You mentioned that your routable ratable mix was 50% for the quarter were pretty year-to-date, how do you expect this changing going forward? Is it still at 50% or you expect a mix shift going forward?

Thanks for the question. Obviously the numbers I gave were year to date and any one quarter things can move around a bit just due to revenue recognition of when some perpetual licenses come in. But I think the underlying trend we’re seeing is a gradual increase that has been going on for some period of time now and we’re up over the 50% threshold which we thought was noteworthy. So, we’re making an effort to continue to build up the ratable side of the business. Now obviously maintenance has always been part of that even off our perpetual licenses. But the focus on term and cloud and the fact that our sales team is rewarded for selling cloud and term a little bit better is driving the behavior that we think is better for our visibility going forward. So, I think that’s the best way to think about that.

And also you mentioned that you got two well deals on year-to-date. I’m guessing that one previous quarter and one this quarter. How has that impacted or how’s that reflected in Q2?

So the one of it was Q1, yes as you noted and then the second one is in Q2, which brought some revenue into the current quarter but also added some to backlog. So, it’s impacted, we did benefit from that second well in Q2, but so to backlog.

And not uncommon for wells to have a backlog effect, they almost always do because often there are sort of multiple chunks and stuff that are for the customer.

Thank you. [Operator Instructions]

Moderator, do we have any more questions?

No, sir. Ladies and gentlemen, there are no further questions at this time. I would now like to turn the floor back over to management for closing remarks.

Moderator, it does look like there is a couple of question that popped up on our screen.

Our next question comes from the line of Hal Barry with Graham Partners. Please go ahead with your question.

Great results here. You made a comment about the timeframe to close deals shrinking, which is interesting. And Alan, is that a function of smaller deals that you’re seeing or is it just a function of greater recognition in the market or peak more business? Is there any other color you can add to that comment?

I think, we’re making some changes to become a little more effective from the selling point of view. And that’s still going to mean that some deals take forever, particularly the very large companies but we go through extremely formal processes but we’ve seen some better dynamics. These deals are not super big ones but they are meaningful. I mean our average deal size has crept up year-over-year by couple of hundred K which is nice. But there will tend to be on the smallest size but still pretty material.

And then lastly just if you could give a little more color around, you mentioned partners accelerating growth and Pega certified architects that they employ. And quite frankly at PegaWORLD, pulling a lot of these folks, the growth rates that they were seeing in their fleet of Pega implementers were considerably higher than the growth rate that you’ve shown on your license software. And I’m just curious, is that a leading indicator or are there other projects that people are getting put on that won’t necessarily show up in your license growth or is this still a function of you pushing more deals their way versus focusing internally on that?

We think it’s actually a leading indicator because in reality, we cannot like massively over sell our customers these crazy enterprise licenses, where if they tripled their deployment, they don’t pay any more because they’ve already pre-bought. A lot of those end up being really disappointments to customers because frankly they end up buying software they don’t deploy which is not great for long-term relationships. So as you see our partners staffing up, I think it’s a reasonable assumption that that’s going to be in conjunction with either projects that are finished. And with the new projects or new business that will be highly correlated to our license growth. So we’re also excited that several partners have gone out and actually bought smaller partners, as we view as powerful because when you get companies like Accenture and other, Ernst & Young going out and buying small 100% Pega practices and using that to jump start their own, they’d only do that as they saw it as a leading indicator for a lot more business down the road.

And maybe just one last one, thanks for that, on for Rafe. For revenue growth, is there any kind of bucket, how much of that was from traditional implementation services versus how much of that is starting to see cloud revenue come through that line item?

It is worth noting, the professional services breakout, you can find it in our Q and so you can actually see the exact breakout of how was coming from consulting services revenue. We have started to breaking that out, you can find it out on page 19 of the Q. So the growth in services revenue I gave out is indeed the professional services revenue.

Our next question comes from the line of Edward Hemmelgarn with Shaker Investments. Please go ahead with your question.

You talked the last few quarters, or you’ve talked about trying to expand to kind of package your offering so that you can go after a smaller customer than the Fortune 300 that you in effect targeted in the past. How is that going? I mean I know you’ve upped your spending on R&D and so forth, I mean is that your starting to see any progress in that area?

Yes, great response from a prospect perspective. We’ve only really dialed that up. We only really started making the selling that way happen at the end of first quarter. So we’re four, months five months into it. But the pipeline is great; there is huge enthusiasm in that team. We’re focusing on especially the North America, so we can see that perfect the process and then we look to bring it more international. But we just went through a little two-day strategy review with extended leadership team here. And there is great enthusiasm about this. And the additional features we’re adding, things like this Pega Express, enhancements to distribution application, really play very, very well for that market. So I think it’s going to be something we can be very successful on. And we’ve already got a lot of history, even companies doing couple of hundred million of revenue can be successful with our technology and maybe very, very effective. Typically that’s common when somebody has left AIG or some other big company and goes to a smaller insurer and then says well we really need this Pega, that’s been the vehicle. Now we’re actually being able to do much more of a formal program. So, we’re going to keep it spill over the couple of billion plus in the Fortune 3000 is the way we’re thinking of it.

Have you been able to see an increase in the percentage of your revenue coming from the largest -- or from the non-largest companies or is that…?

That’s little of premature. I think that that would be more something we’re looking to see in 2016.

Ladies and gentlemen, there are no further questions at this time. I would now like to turn the floor back over to management for closing remarks.

Thank you everybody. We’re all working hard here. I think the team is doing the right things and we’re seeing strong results. We are excited about where we’re and where we’re going. And if it’s convenient, feel free to tune into Squawk Box on Friday morning. Have a great day.

Thank you ladies and gentlemen. This does conclude our teleconference for today. You may now disconnect.