Pegasystems Inc. (PEGA) Q1 2016 Earnings Report, Transcript and Summary

Thank you for standing by. This is the conference operator. Welcome to the Pegasystems' first quarter 2016 earnings conference call. As a reminder, all participants are in a listen-only mode and the conference is being recorded. After the presentation, there will be an opportunity to ask question. [Operator Instructions] I would now like to turn the conference over to Max Mayer, Chief Administrative Officer and Senior VP of Corporate Development. Please go ahead.

Thank you. Good evening, ladies and gentlemen, and welcome to the Pegasystems' Q1 2016 earnings call. Before we begin, I would 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 maybe construed as forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. The words expects, anticipates, intends, plans, 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 the fiscal year 2016 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 2016 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 March 31, 2016, it's Annual Report on Form 10-K for the year ended December 31, 2016 and other recent filings with the SEC. Although subsequent events may cause the company's view to change, the company undertakes no obligation 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. And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Thanks Max. I think we are off to a really good start to the year. Q1 non-GAAP license and cloud revenue grew 20% year-over-year to $77 million. Q1 non-GAAP total revenue grew 16% year-over-year to $179 million and we grew cloud revenue year-over-year by 38%, so very, very pleased. Max will discuss the extremely strong EPS that we received as well. I think it's because our strategy is working. We're continuing to execute on our strategy of powering digital transformation to our clients to delivering strategic applications that help these enterprise better serve their customers. We're focused on four areas. First, continuing to deepen the capabilities of our strategic CRM applications in marketing, sales automation and customer service, to make our solutions of greater value to our buyers, especially in areas like speed of implementation and increased ease-of-use. We continue to gain recognition for leadership in CRM. And our product has received Product of the Year Award for Pega Customer Service from a leading technology publication who are ranked one of the top players by Ovum in their CRM report, actually ahead of Salesforce.com, Microsoft and SAP. We also received the maximum scores in process automation, customer analytics and mobility. In this area, we've launched two new applications we're going to be highlighting in our PegaWORLD show next month. The first is Pega Field Service for use across multiple industries to extend customer service capabilities to field technicians and mobile agents. And Pega Client Lifecycle Management, which streamlines and automates client onboarding, enhancing customer experience while reducing cost. This fixes a major issue, especially for financial services institutions, 88% of which say that know your customer regulations are negatively impacting expense and client onboarding time. We're also increasing our partnerships, for example, with our alliance with DocuSign to provide Pega CRM clients a convenient and secure way for customers to sign, send and manage documents, to reduce cost and hassles of working with paper. Now, the second area is we continue to enhance our unified Pega platform with significant focus on mobile, analytics and cloud. It's the foundation on which our applications are built and a critical competitive differentiator. As you may have heard me mentioned, there were three core capabilities that we think we are uniquely positioned to bring together in this market. The first is case management; being able to create a context and organize and manage work. The second is decisioning; being able to create the next best action in every situation, so that we can guide people when they are dealing with the systems on their own or support agents who are working with customers. And then finally, BPM, business process management, which is where you actually execute and fulfill and drive work to done. We're category leaders in each one of these areas, but consistent with our vision, we are on a single unified coherent platform and it's this platform, which we see as powering and driving our push into CRM and enabling our customers to do things that otherwise they could never do. I think of a case as kind of like a memory in a lot of ways, I think of decisioning as intellect and I think of business process as muscle. And just like with people, with automation you need all three of this to deliver something that's coherent and responsive. The third strategic initiative we're focusing on is to move to more digital marketing ourselves consistent with the way today's clients want to buy coupled with awareness marketing to make people of our digital platform. Based on our 2015 success, we've extended and broadened our Pega Can campaign in North America and Europe, and we'll be continuing to run this throughout 2016 along with additional work to drive additional leads and broadened the number of customers that we're doing business with and selling too. And this is entirely consistent with initiative four, which is to invest in broader market coverage, to go deeper into enterprise accounts where we go to market vertically and to allow additional sales teams to focus on the Global 3000, really moving beyond our traditional very, very high end part of the market. This so called corporate markets team was launched in 2015 and continues to do well and we're very, very pleased with the growth. Still restively small, but growing, and we think a wonderful compliment to the mainstream business. Now, in terms of customer wins and go-lives it's clear this investment in broader market coverage is paying off. The types of organization I'm going to talk about today actually would be very different than the only world's largest companies that I would have talked about historically. We're still working with them, of course, but we were thrilled that we saw wins across our applications and platform with organization such as Credit One, the official credit card of NASCAR using Pega Marketing to increase customer retention, improve speed to market, and maximize customer lifetime value. Agios Pharmaceuticals, where they're using it for pharmacovigilance to reduce the time and expense associated with processing feedback in adverse events, and to deliver more medical insight. And Nielsen, which is using Pega 7 to help them more officially acquire and retain their penalists that they use for their ratings. Now, of course, we also maintain strong momentum with existing client base, with additional sales including of Sprint will be at PegaWORLD this year describing how they build a world-class retention solution in three months with Pega Marketing for Communications, improving their churn rates, reducing cost and driving improved MPS scores. Aegon Insurance Pega Customer Service for an omni-channel solution that improves experience for [indiscernible] customers and independent financial advisors. Air France using Pega Customer Service and Pega Marketing to handle customer claims; Air France-KLM, and some of the low cost airlines they have. And as was recently announced in a major press release in State of New Jersey, which is using us to support the historic criminal justice reform programs, creating a fairer criminal justice process for its citizens, while reducing jail populations and associated tax payer costs. You should check out the press release on that that came out during the last week. We always relish the go-lives where companies like JPMorgan Chase rolled us out to manage retail customer directions and complaints; whereas The AA, the English Automotive Association is using service and marketing and Pega underwriting for insurance to transform their business, increase retention and increase the product holdings for customer. And Nissan, which is using Pega 7 to streamline their warranty claim system and provide proactive diagnostic recommendations to dealers. It's a privilege to work with these clients. And I'll talk a little bit more about how you can hear from many of those and many others at our upcoming PegaWORLD conference. Now, as you probably saw really this month, we acquired OpenSpan. This is a pioneer in the very hot space of robotics. Now, we're very, very selective acquirer. We really do a lot of diligence to make sure that whatever we do will make a great sense to our customers, will be coherent, and will enable us to continue and advance the vision that we have. And OpenSpan is a terrific example of where we know this will work, because we've worked with them in existing clients, and we did lot of work with them prior to bringing the firms together. They're currently running at about 200,000 call center desktops in about 150 companies. So this is immediately going to expand our presence in the CRM market and we think it provides some very nice cross-sell opportunities in the future. What this software does, it provides a very modern approach to a traditional problem, the challenge of integrating multiple and disparate desktop applications. What OpenSpan is able to do is make it possible to integrate these applications behind the scenes, even if they don't have APIs and other computed computer ways of being able to hook the systems together. It's a perfect adjunct to our process automation capabilities in BPM and it lets us now interact and automate and drive whole sets of systems that historically would have been high to interact and engage with. It also has a solution to provide insights to help optimize staff performance by providing deep visibility into the usage of the applications of the staff. So while we think OpenSpan will allow us to deliver even faster time-to-value, it can often be deployed within weeks. And we already have a working interface with it, and we'll be demonstrating it at PegaWORLD and are very excited about the combination of talent technology, client value and market opportunities this brings. I'd also like to point out that we recently appointed Sharon Rowlands to the Board of Directors. She is currently the CEO of ReachLocal, an online marketing services company consistent with our continued and increasing emphasis on bringing marketing talent and capability into Pega as a company. Sharon is an accomplished CEO with expertise in digital marketing and more than 20 years experience in leading, growing and complex multibillion dollar companies like Thompson, as well as experience-serving on public boards, we are very excited to have her joining us. Now, as I alluded to PegaWORLD, once again we're gearing up for our annual PegaWORLD conference, which is going to be on June 6 and 7. We're expecting about 3,500 attendees from around the world. And we've outgrown our past venues, and so we'll be heading west to Las Vegas this year at the MGM Grand. Our agenda was driven by a call for presentations and over a 100 speakers from many of the world's leading brands are eager to tell their Pega success stories and how they thought differently about digital, how they thought differently about going end-to-end in terms of engaging with clients and being able to go all the way to execution, and how they had tremendous success. You can see on the webpages the agenda and the descriptions, but firms like American Express, a long time Pega client will talk about how they build the customer service desktop portal. PayPal will talk about their proactive customer care solution, which is driving improved capabilities and improved NPS. Pfizer will be discussing how they're using us for clinical operations to accelerate and streamline the process for bringing new drugs to market. And RBS will be discussing the use of the Pega Decision Hub to fulfill their promise of providing a highly personalized customer service experience for every client, something they refer to as personology. And TalkTalk will be discussing their use of Pega to lead what they call a consumer revolution to make TalkTalk simpler for its customers through an omni-channel, self service model to this innovative telco. In addition, there will be a terrific line up of executives headlining our keynotes, including the CEO of Allianz Health, Germany; the COO of ANZ Bank; Gilles Leyrat, the SVP of Customer & Partner Services at Cisco; Jeroen Tas, the CEO of Philips Health; and Toine Straathof, the EVP of Rabobank Bank, all talking about the marriage of -- engagement with customers through better digital engagement and improving business operations through end-to-end process automation. We're also going to have some interesting additional guests on the main stage. One of the things that we've been engaging with personally for many years and as a company for several, is a firm called Year Up, which is a non-profit, which is, for example, partnered with one of our clients, American Express, to train their students to be Pega developers and putting students to work in new environments. And we see these sorts of education programs as something we're going to continue to invest in and drive in the future, both with firms like Year Up and also with the Pega University program, which we've rolled out, which is now training hundreds of students at four universities around the world to create a richer, better stream of Pega-enabled visionaries, who can then go in and help digitally transform companies. So in summary, a good start to 2016. We're pleased with the continued progress we're making to position Pega to be a leader in the CRM and strategic applications markets. We're very positive about how our software is being adopted and the long-term growth opportunities, and are also confident that our CRM applications and our unified platform provide clients with a solution that no other vendor can provide and is stronger today with the acquisition of OpenSpan. And with the confidence that comes from the strong performance we've been delivering in past quarters, we will be continuing to invest in these long-term growth initiatives and we believe we'll continue to deliver results. To provide more color on the financial metrics, I'll now turn it over for additional discussion to Max Mayer. Max?

Thank you, Alan. For the first quarter of 2016 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 release issued earlier today and is available on the Investors section of our website. We are pleased to report first quarter 2016 non-GAAP total revenue of $179 million, up 16% year-over-year. This performance is particularly remarkable when compared to an exceptional first quarter 2015. This strong revenue growth resulted in significant increase in our earnings per share. Our first quarter 2016 non-GAAP licensing cloud revenue was $77 million, up 20% year-over-year, despite a stronger dollar that somewhat reduced our revenue denominated in foreign currencies. From a revenue mix perspective, during the first quarter of 2016, non-GAAP licensed cloud and maintenance revenue was 73% of total revenue, consistent with prior year results. This mix reflects the strength of our software business, and we would expect the software portion of revenue to continue increase relative to our services business. Our professional services business is 26% of total revenue, which is in line with prior year. Professional services revenue increased 19% year-over-year. And this growth is higher than typical, because we are comparing to relatively weak professional services first quarter 2015. Also, the first quarter of 2016 benefited from the recognition of revenue on a large project, which had been delayed from the fourth quarter of 2015. As previously stated, we expect to grow our professional services business at high single to low double-digit rates, consistent with our strategy to have customers and partners deliver the majority of our implementation services. Looking at our geographic non-GAAP revenue split. For the first quarter of 2016, the Americas, inclusive of U.S., Canada and Latin America, produced two-thirds of total revenue, while non-Americas international generated the remaining third. This is consistent with the relative economic strength we see in the Americas. As we've discussed in the past, we offer our customers a number of options, when purchasing our software, including perpetual, term and cloud license arrangements. We continue to expect that our business will shift away from perpetual licenses towards recurring revenue streams. Although, the timing of a small number of larger-value transactions will continue to impact license mix results in any reporting period for the foreseeable future. Turning to our non-GAAP gross margin. Our first quarter 2016 gross margin was 70.7%, up slightly from the 69.6% recorded in the first quarter of 2015, despite the continued investment in our cloud business. Professional services margins for the first quarter of 2016 were 13%, atypically high, mainly due to revenue recognition on a large project during the first quarter of 2016, where the associated cost had already been incurred. We continue to expect professional services margins to be approximately 10% for the full year 2016. Our first quarter 2016 operating expenses totaled $99 million on a non-GAAP basis, an increase of 11% over prior year. Despite our continued investment in building out our strategic applications and improving digital engagement for our customers, as Allan talked about, and as we discussed on our last call, our non-GAAP operating margin improved 4 percentage points over the prior year to 15%. However, we expect our non-GAAP operating margin in the second quarter to decrease, due to the expected impact of our annual PegaWORLD user conference and the broader launch of our Pega Can marketing campaign. In terms of other non-GAAP operating expenses, we increased sales and marketing headcount by 118 net new employees year-over-year, the majority of which were in sales. We are pleased with the continuing progress we are making to add sales and marketing capacity for broader market coverage, as we've discussed in prior calls. R&D costs continue to run at about 18% of revenue, as we continue to enhance our leadership Pega 7 platform and deepen our CRM strategic applications. We expect this rate of investment to continue throughout 2016. Turning then to earnings. For the first quarter of 2016, we posted non-GAAP earnings totaling $18 million. On a per share basis, our non-GAAP fully diluted earnings were $0.23 per share compared to $0.13 per share for the first quarter of 2015. Moving on to backlog. We compute licensing cloud backlog by totaling two elements. Deferred licensing cloud revenue, as posted on our balance sheet; and off-balance sheet licensing cloud contractual commitments that are signed, but not yet recorded on our balance sheet. As a reminder, you can find details of both elements in our 10-Q on Page 24 and a summary table on our press release, both of which we filed earlier today. We finished the quarter with $390 million of total licensing cloud backlog, an increase of $16 million or 4% over the first quarter of 2015. As you may remember, backlog growth in the first quarter of 2015 was atypically high. As we have said in the past, large deals can impact the results of any single period. The backlog decreased $30 million or 7% in the first quarter of 2016 compared to the fourth quarter of 2015. Consistent with many software companies and with our experience in four of the last five years, we typically consume backlog in the first half of the year and build backlog towards yearend, when license signings tend to be stronger. In the upcoming quarters, we will focus our efforts on converting our strong pipeline to backlog, while continuing to grow revenue. Turning to cash flow. For the quarter, the company produced $9 million of operating cash flow compared to $28 million for the first quarter of 2015, primarily due to the timing of collections. We finished the quarter with total cash, cash equivalents and marketable securities of $204 million, which includes $10 million of securities sold, but not settled, recorded in other current assets on our balance sheet. For the quarter, the company repurchased approximately 518,000 shares for $12 million. And as of quarter end, we had a balance of $28 million available for repurchase this year. On headcount, we finished the quarter with approximately 3,400 employees, up 14% from March 31, 2015. As Alan discussed, on April 11, 2016, we acquired OpenSpan for approximately $52.3 million in cash. And as Alan noted, this acquisition provides Pega with another way to help our clients integrate multiple desktop applications in environments when other types of automation are either not possible or prohibitively expensive and/or time consuming. OpenSpan 2016 projected revenue is approximately $25 million, of which $20 million will benefit our combined revenue, largely in the second half of 2016. We expect the OpenSpan business to be accretive starting in 2017. With the benefit of our acquisition of OpenSpan, we are increasing our guidance for GAAP and non-GAAP revenue for the full year 2016 to be approximately $800 million. Consistent with the purchasing habits of our customers, we expect to achieve approximately 45% of annual revenue in the first half of 2016. With the cost of the OpenSpan acquisition, we now expect GAAP diluted earnings per share to be approximately $0.44 per share. We expect full year 2016 non-GAAP diluted earnings per share to be consistent with our previous guidance of $0.95 per share. Before I conclude, I would like to invite our analysts/investors to come to PegaWORLD 2016 at the MGM Grand in Las Vegas on June 6 and 7, with an investor focus session on June 6. For more information, please email us at pegainvestorrelations@pega.com. And with that, operator, we will open the call to questions.

[Operator Instructions] Our first question today comes from Steve Koenig of Wedbush Securities.

I wanted to ask a little bit about your ecosystem. You've made some really good progress in cultivating ecosystem partners, driving more service revenues to them, and likely helping you guys whether its deal cycles or kind of a bigger implicit market. But perhaps I wondered if you could talk a little bit about your sense of tangible benefits from having expanded that ecosystem? And also maybe just touch upon, what's the implication of making your applications easier to deploy with respect to your ecosystem. Does that make you a less attractive partner or more attractive partner or what's the implication for the ecosystems on your drive to sell at an application's go-to-market?

I think that's a great question. The reality is that the ecosystem is important to us, something we invest in and something we're very excited about continuing to build. And I think it's critical for clients to have available resources, and some of the work we're doing is actually intended to help our ecosystem grow. Things like this university program we've put out is actually for the benefit of our customers or partners to be able to bring trained, younger, Pega staff into their operations and really build up their pyramids in both environment. So we're doing many things at Pega Academy online training. Lots of other work to try to build it, and we think that a strong ecosystem is key. Relative to the implementation cost, I mean, on one hand it's logical that the system were really hard to implement that the ecosystem could make more money. But in fact the converse is really true. There is so much hunger in the client base, so many either solutions that they wish they had or solutions that they are putting in that aren't meeting their expectations. But they have something that really works like the Pega technology. Customers are anxious to find ways to get it in and get it in faster. And what we found working with our partners, and also for us, is the faster and easier it can be to put in the system, specifically facilitated by these applications that now really nicely build out. It actually increases the demand, because there is always continuous improvement and follow-on work that these clients want. And it's easier to afford, when every new installation and the benefits you get, costless to implement. So from our point of view and from the point of view of our partners, it's a real plus to improve the ease of use of our system and I think that that's going to continue.

Just to add a little bit of color to that. Our ecosystem continues to grow at about 30% rate. We see no slow down in that. And one of the more interesting aspects that's happening is, whereas traditionally our practices were focused on the BPM side of our partners, we're now seeing our partners embrace our strategic applications in CRM. And they are building strong practices in that CRM side of their business. We're particularly seeing big excitement and growth on Pega Marketing and a huge growth in our ecosystem, as our customers embrace our next best action marketing and decisioning products. We're seeing big growth on that side of their practices.

If I may ask one follow-up for you, Alan, I'm just wondering -- I assume you're making good progress headway with you CFO search. Any kind of change or tweaking of your thinking about what kind of person you're looking for, a blend of financial and operational talent, and any update on that search?

Well, I think we are looking for somebody who's got some real strategic experience and vision, a broad collection of background to draw on, and somebody who'd be a good team member for the management team and for the company as a whole. So there is no change. We're very comfortable with the ability of us to run the company with the staff that we have. So we're in no great hurry though. It is my hope that by the time we do the next one of these calls, we will have brought this search to a conclusion. That would be a reasonable goal, I think, at this stage. Well, I'd like to believe that Max and [ph] Efstathios, Principal Accountant, is doing a spectacular job and you folks can see that good result.

Our next question comes from Matthew Galinko of Sidoti.

I guess, on the OpenSpan acquisition, can you talk about their go-to-market and sales strategy today? How you think you can improve on that through kind of the sales force that you're billing out in your strategic applications? And maybe how you see the market size for them and how frequently you see an opportunity to sell that product into just the customers of yours?

We think that there will be a lot of opportunity to bring that technology into a much broader customer base. Obviously, we've got a vastly larger footprint and channel. And this isn't some wild add-on, this is something that's a very natural fit with the parts of our applications we either want to get data, improve service by making certain things faster and better and I think we'll be a natural extension. We've already had a number of our joint customers engage with us pretty enthusiastically about this. And I think clients, when they're dealing with a small firm like that, are always kind of worried, where a company like that might end up. That can create a certain level of anxiety in the buyers, because let's face it there are acquirers that have reputation for being pernicious or perhaps less than customer-friendly. We don't have that reputation with our clients and I think they are going to see this is a very natural thing to do. And given the way that it fits beautifully with the rest of our technology, I think we're going to find actually good bidirectional opportunities to make things workout. So we're really quite excited about that team.

And I'm assuming they have some element of a direct sales force. And I'm wondering, do you see that as sort of acquihire almost where you can utilize them to sell your strategic applications and expand your footprint or is it relatively smaller than your sales growth ambitions at this point?

Well, look, just to put things in perspective, their order of magnitude, $25 million in revenue and where we were prior to that, in order of magnitude, $780 million. So the sales team they have is a direct sales team and they certainly -- we're going to be excited to train and cross-train both sales forces and integrate them over the next couple of quarters. The reality is, though, that this isn't going to massively move the needle on sales headcount. It's great, it's good, and we're excited particularly. We're retaining the senior management of OpenSpan, who we think can play very important roles at Pega. But I don't think its acquihire move the needle sort of thing. I think it's really sort of acquihire bring some nice special skills in that we'll complement. And we've seen in the field already, can compliment our products and the type of customers we have.

Last one from me. Just curious, if you're seeing anything different competitively in the CRM space, just given you've been at Pega Can campaign for a while now?

Yes. I mean, we're seeing ourselves be successful. And we know we are being seen as not just a credible candidate, but actually winning business in very competitive situations. I think one thing a number of our prospects like is the fact that we've got the positioning that you can either run on-premise around the cloud or go back and forth, can be very, very powerful. I mean, the cloud is enormously popular and terrifically important. But for some types of applications, where you particularly need to do lots and lots of integration, it can be very convenient to run some or all of it behind the firewall. And the fact that we have the exact same application capable of running in both environments and we can give our customers that choice and that flexibility, I think is an important competitive advantage for us. And it's one that I think will increase as time goes on. So we feel really good about competing in that market.

There are no further questions at this time. I would like to turn the conference back over to Alan Trefler, Founder and CEO, for any closing comments. End of Q&A

Thank you for joining us today. And in closing, we want to thank all of our staff for their continued efforts, as well as welcome the OpenSpan team to Pega. And I want to reiterate our excitement about the combination of talent, technology, client value and market opportunities that OpenSpan brings. And we look forward to seeing many of you next week in Miami at the Jefferies 2016 Technology Conference on Wednesday. We'll be both presenting and doing a very significant number of exclusive one-on-one. So with that, thank you very much, everyone, and have a good evening.

This concludes today's conference call. You may now disconnect your lines. Thank you for participating. And have a pleasant day.