Good day ladies and gentlemen, and welcome to the Pegasystems' Second Quarter 2020 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ken Stillwell. Please go ahead.

Thank you. Good evening ladies and gentlemen and welcome to Pegasystems' Q2 2020 earnings call. Before we begin, I would like to read our Safe Harbor statement. Certain statements contained in this presentation may be construed as forward-looking statement, as defined in the Private Securities Litigation Reform Act of 1995. The words expect, anticipate, intend, plan, believe, will, could, should, estimate, may, target, strategy, intends to, projects, forecasts, guidance, likely and usually, or variations of such words or other similar expressions, identify forward-looking statements, which speak only as of the date that this statement was made and are based on current expectations and assumptions. Because such statements deal with future events, they are subject to various risks and uncertainties. Actual results for fiscal year 2020 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 Q2 2020 earnings and in the company's filing with the Securities and Exchange Commission, including its Annual Report on Form 10-K for the year ended December 31, 2019 and other recent filings with the SEC. Investors are cautioned not to place undue reliance on such forward-looking statements and there are no assurances that the matters contained in such statements will be achieved. Although subsequent events may cause our view to change, except as required by applicable law, we do not undertake and specifically disclaim any obligation to publicly update or revise the forward-looking statements, whether as a result of new information, future events, or otherwise. And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Thank you, Ken. Let me say that I'm pleased with our results for the first half, especially given the global pandemic. We are operating at a time of uncertainty and anxiety. I'm deeply respectful of how our team and our clients are engaging constructively and optimistically, despite the many tensions. All results reaffirm what we said last quarter, about how we thought the pandemic would likely to affect us and our clients in the near term. Our expectation that digital transformation would remain front and center, even during COVID has held true in Q2. Our business remains robust and we're helped by several major factors. An increasing percentage of our revenue is predictable and recurring. In the first half, our total ACV annual contract value, which we consider the best indicator of our improving cash flows and underlying business growth increased by 21% year-over-year and over 90% of our new clients [indiscernible]. Our Pega Cloud business continues to grow above 50% year-over-year. We are fortunate the digital transformation is more important than ever. And our strategy is resonating with our clients' prospects. Most of our clients are in industries that are less adversely affected by the pandemic. Ones like financial services insurance, health care, government, telecom, instead of more heavily in areas like hospitality, travel and consumer products. Our clients tend to be large organizations that can withstand the short-term financial pressures of today's market. We have little exposure comparatively to smaller organizations that are unfortunately struggling the worst right now. And we have a very strong cash position with more than $0.5 billion in the liquidity to help us weather this storm and continue to invest, where it makes sense for long-term growth. We have a strong and resilient team that is committed to the success of our clients…

Thanks, Alan. I want to express my best wishes for everyone's safety and well being during this unprecedented time. I'm going to start my remarks today by sharing some insights on Kevin's response to COVID-19 and a few observations on the impact of the pandemic on our clients, our employees and our industry. Starting with our customers. To-date, the overwhelming majority of our clients and prospects digital transformation buying behavior has been largely unaffected by the pandemic, while our business has not been negatively impacted in a significant way. We did see a couple projects delayed or cancelled due to shifting priorities of some client organization. We also saw a small number of our clients request additional flexibility with extended payment terms to help them work their way through this downturn. Most of our clients and prospects are acting with a new sense of urgency and rethinking what they should do differently in the short-term and in the long-term to build a robust modern business architecture. As a result, in many cases, our sales teams are getting more access to senior level executives than they ever have in the past. And they are having very effective discussions with dozens and dozens of executives, frankly very difficult to coordinate those meetings with travel schedules and the historical bias towards face-to-face in office meeting with senior executives. The good news for us is that the increased level of executive engagement and solid execution by our sales and marketing teams resulted and it's been a strong Q2, especially given the environment that we're in, these results are exciting to see. Clearly, many leaders are prioritizing digital transformation projects in a new way, given the structural changes in the way that people are working remotely from home, interacting through digital channels. We continue to…

Thank you. [Operator Instructions] We'll take our first question from Rishi Jaluria with D.A. Davidson. Please go ahead.

Hi, guys. Thanks so much for taking my questions and [indiscernible] continued strengthen the business. What are the start out with -- maybe you had an update on some of the hiring plans especially when it comes to new sales reps and alongside that the sales rep side, you have been hiring them over the past two years. Just how are you feeling now in terms of sales coverage and generally those [indiscernible]?

Well, I can answer that you blanked out a little bit. But if I understand your correctly, you're asking how we're feeling about the sales reps and tenure and what we're hiring. I think that the increased sales force has been able to do two things. One, I think it's given us greater liability, which proved really to be extremely helpful during this pandemic, because you have a lot more what I would describe as sort of a counter engagement, then sort of trying to bounce off, customers if you don't have enough reps to fully cover them. And on top of that, I think we've demonstrated that we've been able to grow as a result of hiring new sales reps. So the thing I'm pleased about is that I believe our onboarding and our education have really moved extremely effectively to this remote environment, but for our sales teams, and for the other folks that we're hiring. So I think we're going to continue to be able to develop productivity effectiveness as we grow the sales force and also looking to make the sales force we have more effective to be.

That's helpful. And I wanted to get a sense of -- as we look at strong ACB growth that you have pulling off so far this year, probably there are some -- anything from customers that indicates that there's been some going forward of projects or IT project in the back half of this year and then the first half, or is there just been kind of [indiscernible] plan and the pipeline growth in the back half of the year looked fairly strong so far this year?

I was seeing a lot of evidence that people are going sacrifice their second half for the first half. I actually see more people cancelled things that they didn't think were critical just throughout the year so that they could maintain their focus on things that aren't critical. Thankfully, the digital transformations that we do, I think tends to fall more in the critical bucket of both the immediate stuff that we can do to get something off the ground, but also the fact that we can offer people a path to a well architected long-term effective solution. So I have no basis to evaluate this part of Pega, the second half problem like you might [indiscernible].

And last one from me, and I will jump off. Can you [indiscernible] mention there were some services part that can't be done remotely. Can you give us a little bit more color on -- what is preventing that from happening, and then maybe some color around that? What does that mean, right? Does that mean that this four deals that were already closed? I'm adding to say, the time until the customer goes live, shipped out and doesn't reflect all the closed deals. Waiting for more color around that [indiscernible]?

Sure, Rishi. So I would say that just to clarify, it is very rare that we will see a client not be able to support a remote professional services work. I mean, it does happen. I mentioned that because in full disclosure, it will happen, now and again, but it is not something that is common and it certainly is not happening in any big way. But I would even tell you that I actually am surprised how well people are able to work remotely. So I would say in general, I think the environment is quite frankly, better in terms of effectiveness than I would have anticipated back in March. But that said, some clients are not as comfortable don't have the technical infrastructure, culturally may not be as effective at working remotely. And quite frankly, those are many times the clients that actually are the most in need for digital transformation. So I do think it does happen. And I feel like -- just in the interest of full disclosure, we should mention that it can happen, but it's certainly not something that's happening often.

I think that's a good question. I mean, it's not just us to be to be able to work remotely, which I think we've demonstrated that we could do at scale. The client participants in those projects also need to be able to or need to be comfortable working remotely. But as Ken said, this is not a material part of it.

We'll take our next question from Chris Merwin with Goldman Sachs. Please go ahead.

I wanted to ask a bit about the use cases for the product, the deals you're winning or even those that are in the pipeline. Are you starting to see some different use cases for the low code platform and particularly in light of how many customers seemingly are looking to digitally transform key systems where in terms of impetus might not have been in place before? So just curious if there's been any evolution there that you've seen more recently?

Well, I think the evolution has been that which I view as encouraging is that a number of organizations have realized that even the things that they didn't think were problems actually are problems. And so you're able to have more engaged conversations with senior people about how they actually create a digital transformation strategy. Whereas a lot of times, I think, before, there was a little less of a strategic focus, but being able to do the low code, your high speed deliveries, but also have those strategic conversations, I think puts us in a pretty advantage position. Just think about how we describe what we do. We do basically customer engagement, work involving, expert systems and artificial intelligence, generally to help make good decisions. We provide process automation to drive that work done. And then we provide an environment that makes that work across channels and across different back end systems. That is a recipe that is strongly beneficial for any organization trying to do a transformation.

Okay, that's great. And just one other question, if I could, Ken, it looks like the backlog actually accelerated from 20% growth last quarter I think 30% growth this quarter. Can you talk a bit about what caused that big step up and any other color you could share but the cadence and bookings as you move through the second quarter and [indiscernible]?

Yes. So Chris, couple things that are interesting. The first thing that's interesting is that as we hire more account executives and actually get into a stronger cadence with our clients around faster yield cycles and really getting started with Pega Cloud and accelerating off of that, kind of that minimum lovable product, as you might call it, to be able to -- and reduce the kind of the deployment cycle of our clients out there in cloud. What you see is, as you see more business activity moving throughout the year, meaning everything is the Q4 deal that's really large as a whale. It's kind of log jam at the end of the year. So that's one promising thing around this Q2. This was by far the strongest Q2 that we've ever had. Now, you would expect that as we're growing, it was a very solid Q2 especially given COVID. Second thing is, it's a demonstration of our duration of contract length holding up, which is really a sign that clients are continuing to think about their investments in Pega on a very long-term basis. Now we're not -- we see actually are not encouraging our sales teams to extend the life of contracts. But I think there was some, there's always some focus around when you sell fast, when you sell cloud, the duration can compress, and therefore, cause a less efficient selling cycle if you're selling one-year versus a three-year. And I think what you're seeing is that not only is the business activity up, but the durations are holding, very steady and specifically around Pega Cloud. So it's just a really great sign of our retention rate, the continued investment and the momentum of Pega. Cloud.

We'll take our next question from Steve Enders with KeyBanc.

I'm going to check on the last quarter that pipeline was up really strong year-over-year, just wondering where pipeline stands today and how the top of funnel performed as you as you moved through the quarter?

The pipeline is still strong. The pipeline we have doesn't wiggle around that much during the quarter, if you think about it, but we still see plenty of opportunities primarily with customers we've had some contact with, they're large customers or small customers, because this environment here makes it much harder to go slamming into lots of small businesses. But we have lots and lots of runway at our top 10 customers have enormous amount of additional ACB opportunity as we continue to perform well for them. So the pipeline is not concerned at all.

Okay. Got you. That's helpful. Just want to check, have been hearing from some other vendors reporting so far about income to pay being a real differentiator in the quarter in the ability to get deals, just wondering how you're seeing the environment today to either capture new customers or to take incremental opportunities within your current customer base.

So I think incumbency is helpful. And incumbency in very large organizations that are well suited to what we do is doubly helpful. I think if you're selling a product, if you're selling an HR system or something where they can only buy one, obviously incumbency can be a limitation. There's so many ways that these organizations can continue to apply what we do that we're having and I would have to say the strategic compensation accelerated in the last four or five months in terms of where we want to go together in terms of partnership. So incumbency definitely helped. I'm asked sometimes when we worried that we're going to sell out the world's biggest companies that we're in. And the answer to that is not remotely, so much upside, because we've never been a company to sell these stupid enterprise licenses which a lot of clients -- without it being reasonable. That's just never been in our DNA. So we have real upside as we continue to perform, it's really come with us to do that.

I would add another piece of color on that. Steve. If you think about Pega's business traditionally, about two-thirds to 75% of our bookings each and every year, come from our existing clients. So certainly incumbency has led to lots of Pega growth over time, but it's really important to have a balanced view, you have to really cover those incumbent organizations. So Pega can continue to further penetrate to Alan's point. But that said, we've generated a lot of new logo growth as well in the first half. And so I don't think that then all of the businesses just going to be incumbent. So I do think that is certainly would view incumbency in a time of any economic pressure or stress. But I do think our opportunity to both continue to enrich the relationships that we have with our existing clients. But also gather very large and significant logos as we actually build kind of new fertile ground to continue to expand. I think the opportunity for digital transformation really provides that. So we've always been dependent on continuing to sell to our clients, but I think that we've also generated lots of new relationships in the first half as well.

We'll take our next question from Mohit Gogia with Barclays. Please go ahead.

And I'll offer my congratulations on the solid quarter, despite the pandemic. My first question is for Alan. I wanted to dig more into this federal vertical. See you guys have previously discussed that being your fastest vertical last year and obviously some interesting things you have outlined through the first half. So wanted to see what is working well, there is essentially a competitive landscape not just in the [indiscernible], but also in the border enterprise softwares with a lot of activity. So I just want to begin with what is working there and whether you can use the table maybe sort of like increase your ventilation and increase the growth rates in some of the other tables? And then I have a follow-up question.

Let me make sure, I understood which vertical you were asking about this sort of cut out, if you just --

The federal vertical.

Federal vertical. Yes, so look, we were not very deep in federal if you go back five years, and it's been absolutely terrific and it's to my mind only getting better. It's not just the recently announced big IRS, you could imagine the sort of competitive environment around some of that is key. But if you think about all the other parts of the government that we're working with, from defense to being the systems at, the U.S. Marshals chose to modernize, the desire to try to create efficiency. That's huge. And we're seeing that not just in the government of the U.S., but we're also seeing it in places like Australia as I mentioned, when we talked earlier about the U.K. So that is an excellent vertical for us. And we are doubling down on it, great place to be able to put additional selling resources and also to build the right partnerships because those are so important when selling to government. So I was thrilled. And even in places I mentioned, the German government, for example, another example of a new logo for us, and also work with the government in France. So we're seeing a lot of stuff in lot of places.

Thank you. So the follow up question to Ken. You alluded to that obviously 21 percentage [indiscernible] despite the pandemic is pretty strong when some of the other vendors are feeling some of the heat from COVID-19. But you also alluded to that there is an opportunity going forward maybe accelerate the ACB growth rate. So I was wondering if you can dig into some of these vectors that you think or maybe in the near to mid-term or more important when it comes to opportunity to accelerate that. I think you mentioned that two-third of the ACB growth or other new bookings come from existing clients. So obviously expansion rates, an upward trajectory for expansion rates, maybe as one vectors. But was wondering, if you can drill into the business aspect. Thanks guys.

Yes, sure. So I'll mention a couple things that I think are interesting. The first thing is, if you looked at our net retention rate, if you kind of reverse engineer our net retention rate at 21%, ACB growth, our net retention rates, somewhere in the 113% to 116% kind of range. So if you just think about that 113%, 116% net retention or net expansion year-over-year for our existing clients. If you take that percentage and you think about the impact of digital transformation and the fact that we even in our largest clients, we're not even 10% or 20% penetrated on what we could sell them that really ties to our strategy around density of hiring account executive and really further creating relationship kind of equity around the largest organizations, making sure that we're covering the different buyers, the different business units and further penetrate it. That's a tremendous opportunity. Another example of an opportunity is that you just asked about early, the federal state, even just looking at the U.S. federal state, that vertical is so relevant for Pega they're going through digital transformation, the government is looking at Cloud burst, which is that much more relevant and now with our strategy over the last few years of really pushing as cloud being our primary go-to-market, that vertical is one of the emerging and fastest growing but still not 10% of Pega's business yet. So if you think about that as an opportunity and ignore new logos and all of the other opportunities across the business, we can accelerate our ACB just on those two dimensions noticeably. So I think that's what's exciting as we have so much opportunity with our existing installed base or existing client base. And then we have these verticals like a federal vertical, that's just one country. It's just one buyer, really within that country. And I think there's just a tremendous amount of opportunity or wins [indiscernible] IRS, really just demonstrating how credible we are in that in that space, even with being relatively -- that being a relatively less mature vertical in terms of the growth rate. So I think that there's just opportunity like that in all the countries and other verticals, but I'm just giving you a sense of why we believe that we can accelerate our growth rate and we want to continue to invest in that.

We'll take our next question from Yun Kim with Rosenblatt. Please go ahead.

Obviously, Pega Cloud had a spectacular quarter, sequential ACB business actually was up record. And I just want to talk more about the trends that you're seeing in that particular business. What are the trends around the deal size? If our customers making bigger commitment, or what's the thinking by higher deal volume, any trend that you're seeing between new and existing customers for the Pega Cloud business? Thank you.

Ken, I will let you answer statistically but viscerally the businesses coming across the entire continuum. So it wasn't driven by a couple of monster deals. This was exactly like you wanted, Ken, give some more specifics.

Yes. Well, I can give you one measure that'll answer your question. It's the average deal size of take Pega Cloud versus the average deal size of client cloud was largely the same for the first half of the year. So that metric probably answers your question. We're not doing lots and lots of clients, but we're not doing just a small number of very large ones. It's really down the middle Pega Cloud.

Remember that Pega Cloud and client class that's over 90% of our revenue. So yes, that's really -- that's the business, that's over bits of perpetual of all contracts aren't -- as they shouldn't, aren't driving our business. You can see that in the percentage of revenue perpetual going down, which is frankly a delight and the recurring revenue and recurring commitments growing up.

And Alan, obviously, the digital transformation, secular trend is definitely resonating with your business. Can you update us on traction with the large global system innovators, obviously, [indiscernible] also embrace digital transformation initiatives out there.

Yes. I think, they're definitely extremely interested. We are engaging with them and show them the relationship that really deepened. I will point out that in just the last three, four months, we've actually brought in a new Head of Pega Ecosystem, very experienced woman, who brings tremendous background in terms of being able to build those relationships with those sorts of particularly the larger size and the new leader of our go-to-market, which we announced just started June 1. Haydon Stafford also has a tremendous background working with both Salesforce and Microsoft Dynamics CRM in building extremely material relationships with partner organizations. So we are committed to the partners, I think you're going to see that being an increasing area of emphasis. And I think a lot of leverage to that as well.

Okay, great. Good to hear. So you can in terms of the current model transition, we are seeing Pega Cloud accelerate versus decline, would that affect margin, at least in the near term? And also, how should we think about margin benefit coming from the total revenue now that line is going to start going faster given that the model transition has passed the midpoint.

As Pega Cloud continues to accelerate, you do have some variable costs with Pega Cloud, but you get a much bigger operating leverage or operating lever as Pega Cloud gets larger. So net-net of that change, the combination of those two factors, I think will not impact our margins, positively or negatively as Pega Cloud. A little bit more variable costs, but also better operating leverage and operating scale efficiency. To your second part of your question, which is, what should happen over the next couple years? Well, when you get through a cloud transition, you wash away all your perpetual revenue at the beginning and it takes you a series of years to build that back in the business. And so normally, when you start a cloud transition and you end the cloud transition, or start a recurring transition ended, your margin profiles look similar when you start a new, because once you end it, that's when the operating leverage can really be exhibited on the business model. And so we will exit this transition in 2022. So between now and 2022 and beyond, you'll see improvements in our operating margin each and every year, so we kind of get some more of that fine plus model, which will still be out in like, say the 2023 time period. So you should see operating margin improvement and operating cash flow improvements, it's just kind of better each year that you go through it now that we're past the hardest point.

We'll take our next question from Mark Schappel with Benchmark. Please go ahead.

Nice job in the quarter. Very Nice job. So I was starting with you -- in your prepared remarks, you touched on your new messaging solution and the RPA X-ray Vision solution, I believe. I was wondering if you could just go into a little more details on those two products and how they differ from other solution in the marketplace?

Sure. I didn't hear the first one, once again, my line is little [dropppy] [ph], what was the first one?

So in your prepared remarks, you touched on your new solution, one was a new messaging solution, another one called I think X-ray vision. I was wondering if you could just go into a little bit more detail.

I got it. Thanks. I just wanted to make sure I heard properly. So we selectively acquire a company and bring them into the mix and weave them in to what would be a cogent solution for our clients. And both -- so last year, we bought a company called In The Chat, which brought very, very sophisticated messaging technology and also actually brought a great leader, who's the GM, General Manager of our customer service business, into the company. And this represents the rolling out of that technology is part of the platform. And it really is a perfect example of where communications technology and process automation technology really go hand in hand together, and it demos beautifully. And there's a lovely augmentation system. You may remember several years ago, we bought a robotics player, something called OpenSpan. And we integrated robotics into what Pega offers, frankly, completely different ways of the robot first time people who I think -- it was interesting Gartner put robotics into the truck, disillusioned it a couple of months ago, because robotics projects are not incredibly fragile, particularly when people start putting lots of business logic in the robots. But we're able to do with our solution is to be able to make the way less bracket by keeping the business logic work along the product channel and in an omni-channel sort of position in the center of their business. And then just using the robot, when you have to go the last bit if there's not an automated [indiscernible]. And this X-ray capability actually takes that architecture that was already established and makes it tremendously less fragile, tremendously more able to self heal even if the backend systems change, doesn't break the robots. Robots actually understand how to find the right data and do the right thing. And I just think it's another example of bringing great technology to the outside, but making it even better by weaving it in to a service background and AI back then. Does that make sense?

It does. Great. Thank you. Helpful.

We'll take our final question from Steve Koenig with SMBC Nikko.

Just want to answer question and one follow-up, Ken, can you just help connect the dots on how the numbers, I'm looking at the cloud percentage of new commitments was 50% for the first half in total, I think it ran maybe a little high in Q1, maybe a little lower in Q2, but cloud ACB accelerated sharply. So just maybe help me understand that. And then I got one more specific question for you guys.

Yes. So the cloud ACB did not accelerate because of a mix shift, which is your -- I see where you're going with the question. So you're right. It is just the bookings more strong in Q2, which actually and the percentage of Pega Cloud was high enough such that it led to an acceleration.

Okay, that's helpful thing, Ken. And then just my last question, I'm curious, maybe just on, your initiative that you embarked on a couple of years ago now to [good deal] [ph] velocity. And now you made a reference to some of the code deals earlier shows that coming, I heard you that duration is steady and that's a good thing. But wondering about deal velocity? And then, I'll just add as well, any color on any major competitor take-off in the quarter as well. And that's it for me.

Sure. So we work in a highly competitive world. So every piece of business, we're winning somebody else's losing, that's just the way it goes. We show very well competitively particularly in the sweet spots, which I think our view on low-code deals all the way back to our original vision of being a model driven platform. So places where we, I just think pretty solidly win is when the company does not want to adopt low-code as a series of little standalone islands, department things that they'd like to give those department and the business users the power to be able to drive chain, while at the same time having something that can scale for the enterprise and really support the right of the standards, security and other sorts of things. You might remember years ago, lotus notes the kind of the low-code system of its day, all of those systems are either long dead or considered just dreadful technical debt. That's what -- somebody remembers those stories, or knows about those stories. That's when we consistently I think, are highly, highly successful. So the idea of the low-code app factory for business, there's not a bunch of tiny little systems hanging around. But it's really a way to think about the enterprise. That's when we are enormously advantaged. And frankly, I think more and more enterprises [indiscernible]. So I understand the question.

With that I know, we're down the hour. Let me just wrap up by saying thank you to all the investors that have been interested in us and stood by us as we've gone through these incredibly hard times. The Pega team is working extremely diligently. I think we're working well with our clients. I think we all need to have a level of care and patience to make sure we're getting through all this. And I'm thrilled that this is, I think, tested our team and made and shown it to be extremely strong. And whatever happens in the future, we need to continue to build out that strength and we'll be working hard on your behalf. So with that, let me say thank you and have a great evening.

Ladies and gentlemen, this concludes today's conference. We appreciate your participation. You may now disconnect.