Pegasystems Inc. Q4 2008 Earnings Call Transcript

| About: Pegasystems Inc. (PEGA)

Pegasystems Inc. (NASDAQ:PEGA)

Q4 2008 Earnings Call

March 10, 2009; 9:00 am ET

Executives

Alan Trefler - Chairman & Chief Executive Officer

Craig Dynes - Chief Financial Officer

Analysts

Edward Hemmelgarn - Shaker Investments

Brian Murphy - Sidoti & Company

Gregg Speicher - Moss Creek

Geoff Hulme - Porter Orlin

Operator

Good day everyone and welcome to today’s Pegasystems Incorporated year end and fourth quarter earnings conference call. Today’s call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Craig Dynes. Please go ahead, sir.

Craig Dynes

Thank you. Good morning and welcome to the Pegasystems 2008 annual earnings conference call. With me here in Cambridge is Alan Trefler, Pegasystems Chairman and CEO. Before we introduce Alan, I’ll start with our Safe Harbor statement and then provide my financial commentary.

Certain statements contained in this presentation may be construed as forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. The words anticipates, projects, expects, plans, intends, believes, estimates, targets, forecasts, could, and other similar expressions identify forward-looking statements which speak only as of 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 2009 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 include without limitation variation demand and the difficulty in predicting the completion of product acceptance and other factors affecting the timing of our license revenue recognition; the level of term license renewals; our ability to develop require new products and evolve the existing ones, the impact of our business of the recent financial crisis in the global capital markets and the negative global economic trends and the ongoing consolidation in the financial services and healthcare markets; our ability to attract and retain key personnel; reliance on key third-party relationships; management of the company’s growth; and other risks and uncertainties.

Further information concerning factors that could cause actual results to differ materially from those projected is contained in the company’s filings with the Securities and Exchange Commission, including its report on Form 10-K for year ended December 31, 2008 and other recent filings with the SEC. The company undertakes no obligation to revise or update forward-looking statements as a result of new information since these statements may no longer be accurate or timely.

The overwhelming weight of the economic news can make it difficult to comprehend the financial success that we’ve seen this year. Not only did we achieve record revenues for the year, we set new quarterly revenue records in all four quarters. New license signings for Q4 were the highest in our history, and we finished 2008 with a record backlog. We believe our success is due to the way we work with our customers to find business solutions that can help them during these painful economic times.

During Q4, we closed a meaningful licensing arrangement with a big three auto maker during one of the worst quarters for car sales in recent history. This was not Q4 budgets spend; this deal closed because of the value proportion of saving millions by automating a complex business process with the Pega application that will incrementally rollout starting in six months.

The value proposition generated by automated business processes in months rather than years drove our revenue to $212 million in 2008, an increase of $50 million or 31% from 2007. The largest component of this increase is term license revenues, which increased by 94% during the year.

The total of our outstanding term licenses now stands at $88.5 million, these are non-cancelable term licenses were we filed all the requirements to recognize revenue, other than received payment of the term license fees. This $88.5 million does not yet record in our financial statements, but will be recognized as revenue in the future as payments become due.

The details of when these licenses will become revenue are summarized on page 32 of our 10-K. This summary shows that as of the year end we expect that $31 million of this balance will be recognized as revenue in 2009. This is an increase of 45% over the comparable number at the end of 2007 which was $21.3 million.

As I said, new license signings in Q4 were the largest in our history. During 2008, license signings were almost equally split between our four verticals; financial services, insurance, health care payers, and other large institutions such as governments. Historically our license signings follow a pattern of much higher booking in the second half of the year compared to the first. These second half booking build backlog and AR.

Maintenance revenue was $40.1 million for 2008, an increase of $8.9 million or 29% from 2007. As noted in our 10-K, the increase in maintenance revenue is the function of the continued growth in the installed based of our software. Almost every customer renews maintenance each year.

Revenue from professional services, comprised only of training and consulting services was $95 million for 2008, an increase of 19% from 2007. While we’ve seen a significant increase in demand for professional services in Europe, the dramatic drop in the Euro and the British pound against the dollar offset this growth when we translate into US dollars.

This currency movement along with the Q4 holidays in the US resulted in a decrease in services revenue in Q4 as compared to Q3. However, driven by our Q3 and Q4 license signings, we expect services revenue to increase in 2009, but at a rate less than license revenue as more of our services work is being done by our partners and by our customers as they both become enabled to create applications.

Lastly, we have no 10% revenue customers in the year or the quarter. Our overall gross profit for the year was $129.9 million, up $33.1 million or 34% from 2007. The largest component of the increase is the $25.4 million or 50% increase in license revenue, coupled with an $8.3 million increase in maintenance gross profits.

Our professional services margin decrease to 20% in 2008 from 24% in 2007. The slowdown in the US economy resulted in lower demand and a rate pressure which lowered margins. We are not overly concerned with the slight decrease in margins as the primary goals of our professional service organization are not high margins, but successful implementations to drive follow on license sales, as well as enablement of our customers and our partners.

Adding to the decrease in services margin caused by rate pressure was our decision to continue to increase professional services headcount and infrastructure in spite of slowdown in the U.S. We anticipate that the significant Q3 and Q4 license bookings will increase demand for professional services in 2009.

Total operating expenses for the year were $115.4 million, an increase of about 22% for 2007. 58% or $12 million increase came from selling and marketing organization, which grew by 37 people in the year. $2.4 million of this increase was due to sales commissions, which is a result of the record level bookings achieved in the year. You should note that we will continue to grow in our sales and marketing organization. There’s a significant on-boarding time with new sales hires, that we will hire through 2009 in order to drive 2010 revenue growth.

During the year, our new R&D office in India became operational. As a result, future costs associated with the facility will be classified as R&D rather than G&A. We increased R&D spending by $5.3 million or 20% in the year. We believe that continued investment in R&D is necessary to maintain and expand our leadership position in the BPM.

Lastly, G&A expenses increased by $3.3 million or 19% during the year, primarily as a result of increased headcount and the costs associated with the Indian R&D facility, which were charged to G&A while the new center was in start up stage. Our FAS 123(NYSE:R) charge for stock-based compensation was $3.5 million for the year, up from $1.6 million from 2007. Note 14 to the financial statement details how those charges are allocated to which department.

Interest income was down in the year. Not only are rates lower, but we moved our cash investments into pre-refunded municipal bonds. These bonds which are secured by escrowed investments and treasury builds are very secure, and while they provide a lower pretax yield, they provide a decent after tax yield.

In addition, we have a smaller balance of installment receivables and therefore less interest income associated with the outstanding balance. This trend will continue in 2009 as installment receivables decline again. We’ve been investing in our European operation through 2007 and 2008. The results have been very favorable. EU bookings in 2008 were up substantially and the services revenue is setting new quarterly records.

Europe accounted for 32% of 2008 revenues, an increase ever 6 percentage points from 2007. This increase in European business has resulted in greater foreign cash and receivable balance. In the last half of the year, the rapid decline in the Euro and sterling resulted in a $4.5 million foreign exchange loss in the year as compared to a gain in 2007 and 2006.

Our overall effective tax rate for 2008 was 30%, down from 34% in 2007. Our effective tax rate increased in Q4 due to a one-time charge for uncertain tax provisions of approximately $850,000 that was booked as a result of the tax that we completed in the quarter. Despite this one-time tax entry, our net income was almost $11 million, an increase of $4.4 million or 66% for 2007.

Our strong Q4 bookings increased our AR balance by $9.5 million from $33.3 million at the end of Q3 to $42.8 million at the end of the year. Accounts receivable days billed outstanding calculated on a quarterly basis is at 56 days, down from 63 days December 31, 2007.

For the year, we generated $38.4 million in cash flow from operations. We ended the quarter with over $157.2 million in cash and investments, up from $150 million at the end of 2007 and down slightly from $171 million at September 30. The decrease from the end of Q3 was primarily due to repurchase of our stock.

During the quarter, we purchased 554,977 shares for $6.4 million, and an average price of 11.46. During 2008, we purchased a total of 1,535,927 shares for a total of $18.3 million which represents an average price of 11.94. There is a balance remaining of approximately $12.9 million available for repurchases in 2009.

Deferred revenue at $32.2 million was relatively unchanged from December 31, 2007, but increased by about $3.4 million in the quarter from $28.8 million at September 30. $2.4 million of the increase is deferred maintenance which will become revenue in 2009.

Now with regard to 2009, I am one of the few CFOs who is able to provide guidance for growth in 2009 on top of a 31% revenue growth in 2008. There is no escaping the news about current economic conditions.

The continual news coverage of layoffs, stock market results and doom and gloom is overwhelming. However, even with the current economic conditions inline and an expectation that business conditions should show some signs of life by Q4, our current pipeline, deferred revenue and back log, leads us to estimate that 2009 revenues should surpass $250 million and at this revenue level, GAAP net income should surpass $17 million.

In estimating net income, we are forecasting a FAS 123(R) charge of about $4.5 million for the year. Cash flow from operations should be approximately $25 million. You should note that in 2009, collections from installment receivables will be down from 2008 by about $13 million.

This is annual guidance and due to our business model, we did not provide quarterly guidance. However, I would like to point out something important with regard to quarterly revenue trends. 2008 was unusual and that we grew revenue in every quarter. This is not our norm. In 2005, 2006 and 2007, we exhibited a consistent pattern, where Q2 revenue was slightly down from a strong Q1.

After the decrease in Q2, revenue then rose to the second half of the year. This is due to the quarterly pattern of our bookings, which are lower in the first half of the year and higher in Q3 and Q4. The pattern of lower bookings in the first half of the year can result in lower Q2 revenue, so take notice in building your model, as this was the case for 2005, ‘06 and ‘07.

In summary, we are all pleased with our 2008 results. We know that the economy is difficult and that all software companies have reported how sales cycles are longer and more approvals are required for purchases. Accordingly, we are working hard on solid pipeline to grow further in 2009.

With more detail on Q4 achievements, I would now like to turn the call over to Pega’s Chairman and CEO, Alan Trefler.

Alan Trefler

Thank you so much, Craig. Despite the broad economic turmoil, Pega’s strong business growth continued in Q4 and we see positive indicators in our momentum as we enter the New Year.

The numbers tell a lot of the story. Over $212 million in revenue, 31% year-over-year growth on back of a 29% growth from 2007 on top of 2006, and frankly phenomenal license revenue growth of 50%. We ended the year with $167 million of cash and we feel we’re in a terrific position to continue to build our leadership position in this wonderful BPM market, despite a lot of what we’re seeing out there.

The reason we’re able to do this is Pegasystems Build for Change technology is very, very practically enabling customers to simultaneously reduce operating costs and improve customer service and loyalty. This value proposition resonates extremely well in today’s difficult pragmatic environment and we find that organizations can make decisions to buy our software, even if it’s not in the budget, because our software can get them benefits, in a quick enough payback period for them to decide to go forward.

Our customers love the concept. They can use technology to connect customer interactions in the front office to the back office, being able to provide seamless fulfillment and an excellent client experience.

Customers can make either a platform decision, as some have, to use our technology very broadly or they can say they want to start with a small point solution, obtaining that immediate return on investment and because of the architecture, we make it easy for them to expand and build on their initial decisions to select Pega software.

Consistent with this value proposition, we’re seeing an increasing use in contact centers, customer call centers, who are buying our process oriented technology as a preferred alternative to sort of the outdated data driven approach. We’re able to weave into the call centers to provide highly pragmatic and focused solutions or in some cases do wholesale replacements as organizations look to improve their service level and their efficiency.

As Craig mentioned, we had good results across the different verticals we do business with. Despite the turmoil of financial services, we actually had significant wins during the course of the year within Q4 around case management, creating wholesale banking service back bones that let an organization really tie parts of the company together, and using our new internet application composer to let us mash up into organizations existing web presence and portals.

In healthcare, we had great wins across the board, ranging from contact centers, to processing claims, to some of the new frameworks we’ve introduced around what’s called care and disease management that really help organizations not just save money, but also improve the way they care for people.

In insurance, we had everything from first notice of loss to the traditional work we do, around helping them process claims in the back office. We had a win in telecom around new product introduction. In the public sector, we had corporate enforcement, as well as case management solutions.

In automotive and other areas, we’ve been finding that warranty claims are an area that’s growing and an area that people are increasingly interested in. We did work in pharmaceuticals around regulatory compliance and in airport operations we were selected as the platform for some major rework being done in the U.K. airport system.

So, it was a pretty broad, pretty broad set of wins that powered this growth and it makes us encouraged that our technology is very, very compelling and applicable in lots of different areas. I think the reason that we were able to achieve this is entirely around our commitment to client success.

We were involved in 18 customer implementations that lodge in Q4, which caps a historic high of over 60 for the year. Even more satisfying, we know that there were many, many more implementations than we were involved in, that were driven by increasing ranks of partners, which are more and more critical to us and also our enabled customers who are able to take the Pega technology, use it and expand it without necessarily having to call on the key part of our strategy and our philosophy of growth.

So, why have we been able to do this, what’s different about the Pega technology in this particular market segment? Well, there are a couple of things that I think are key. Our customers are able to get very, very rapid returns on investment and get benefits in precise areas, while at the same time feeling they’re doing something that has strategic import.

We’ve been building and increasing our partner ecosystem. We focused, as we mentioned earlier in the year on trying to build great relationships, not just with some of our traditional Indian partners, but also with the tier one partners, Ascential, IBM Global Services and Capgemini, that can actually work with organizations to change the way they think about how they want to evolve their businesses.

Business Process Management or as I prefer to think about it or Business Process Automation is very much on the minds of executives, who are trying to think about how they can save money and take better control of the business.

I also think that customers are looking for a stable supplier, who is committed to this industry and this area and this is where Pegasystems, having more than 25 years of experience, having a powerful balance sheet and a real commitment to the space allows organizations to buy with a very, very high level of confidence.

As a result of this, we have been able to materially gain share in this wonderful area. Data quest forecasted that this BPM space is one of the best areas of software right now and they think that it’s growing at a 15% to 16% compound annual growth rate, but when you look at our 29% revenue growth in 2007 and our 31% revenue growth in 2008, you’ll see that we actually are in a position where we’re doing far better than the average.

We are excited, because though software is a tricky, lumpy, challenging business, we think that the strong end to the year means that even in what was a miserable fourth quarter, customers saw the value and we’re optimistic as we go into this year that they will continue to do so.

Thus as Craig said, we are continuing to invest, to ensure we are well positioned to leverage our technology and frankly work to build what we hope will be a great company. We’re continuing to hire at all levels and I’ll tell you this is a wonderful time to be hiring. We are investing and strengthening our technology to make it easier to use, easier to support and support the increased scale of our customers.

One of the major things that we are introducing is something we call the federated frameworks. These enable an organization to think of having a number of Pegasystems put together, using things such as that internet application composer to make as though a variety of Pegasystems can appear as a seamless experience. Some of these organizations are so large and so diverse that we know that we need to be able to handle lots of business problems for them and we’re seeing customers responding very, very much to this.

We are increasing the internal use of our technology both to improve our operational efficiencies and make sure that we are exercising what this technology is capable of and we think that in the future, that should allow us to have greater efficiencies and be a real show place for this.

We are continuing to build deep relationships and invest in those relationships with our tier one partners. We think that BPM represents a new way of viewing the whole prospect of business change and that will require transformational thinking as companies come out of this sort of highly pragmatic sort of state of mind that they’re in.

So, even though we are selling to pragmatic buyers, I’m pleased also to tell you that some of them really see the disruptive potential of this. The fact is that client success and existing customers were responsible for over 75% of the business that we signed up last year and it’s because we work hard with those customers, work to incorporate their needs in our technology that we’ve been able to evolve it and grow it to frankly grow with them.

We’re really working to change the way that we sell to these organizations. Years ago you could sell at the entire spectrum of how customers would buy. Now we find that companies are in one of two buckets; agonizingly pragmatic and practical or transformational, really looking to steal a margin on competitors.

That practical side, where we’re really good at that, was being able to deliver technology in just a couple of months and the transformational side, well it’s really a pleasure to know that a number of our customers have used this to seriously gain market share and enter entirely into new business lines.

At the beginning of this year, Gartner, which is the sort of predominant industry analyst firm, came out with their Magic Quadrant and once again we were very gratified and pleased with what is our excellent positioning in the leader quadrant. I think what is interesting is if you take a look at the picture, you’ll see that on the two axis of that quadrant, Pegasystems is clearing standing out.

The first axis is completing this vision and that really talks to the ability of the product, to meet the needs of clients and whether or not the direction we’re heading is one that resonates with customers; but the other one that I’m even more pleased at being able to show that we are clearly, clearly in the lead on, is what’s called ability to execute.

Our ability to execute is not measured by something we tell Gartner, it’s measured by the fact that when they talk to our clients, our clients are saying that they’re getting pragmatic business value, that they see that the software adds value to their day-to-day business is and supports their strategy and frankly, that is the only reason why in these miserable times we’ve been able to put up some of the numbers and that is the reason why we are going forward with such enthusiasm about what BPM can do for industries and businesses.

I’ll tell you that this is a great time for the Build-for-Change message we talk about and that we are working hard to deliver on this promise to our clients and our shareholders. With that operator, are there any questions?

Question-and-Answer session

(Operator Instructions) Your first question comes from Brian Murphy - Sidoti & Company.

Brian Murphy - Sidoti & Company

I don’t know if this is for you Alan or for you Craig, but could you give us an idea of what kind of currency translation loss is embedded in your EPS guidance for ‘09?

Alan Trefler

We have made some calculations and built that into our net income number for 2009; however I will tell you that it’s very difficult to predict the currency movements and to hedge against all of them. So it is a point where it’s not as accurate a forecast as we would like; certainly not as accurate as other aspects of the business, which we have under our control.

Brian Murphy - Sidoti & Company

Okay and just looking at it, it looks like your revenue from continental Europe, almost tripled in 2008. Can you just give us an idea of what’s happening there? I mean did you take down some big deals this year or anything would be helpful?

Alan Trefler

Well, we’ve made a decision; we were going to expand in the UK and Europe and I think that that has paid off. We’ve actually opened offices in Amsterdam, we’ve incorporated in Germany and Switzerland and so we’ve broadened our footprint, hired some additional staff and frankly paid some more attention to that area and are seeing some returns from that.

We had a good mix of business. We did have a very large piece of business, but we also had a number of smaller ones, so I would say that it wasn’t one big thing, but we’re actually seeing good activity in Germany and Switzerland, in France, in Holland and some of that is actually percolating through other parts of Europe as well. So it’s really I think a response to some of the investment and additional attention.

Relative to the question on exchange rates, we took a real beating. I think it was disclosed in the K that our total foreign exchange loss last year was over $4 million. At some point this has got to stop I would imagine. So, I don’t think we can predict exactly what’s going to happen, but I think we’re certainly hoping that the foreign exchange in 2009 will be less damaging than it was in 2008.

Brian Murphy - Sidoti & Company

Craig, I think last year your guidance for cash flow from operations for 2008 was $25 million, you guys put up $38 million. When I look at guidance for 2009 it’s again $25 million; how should we interpret that? Is that just sort of your typical conservatism here?

Craig Dynes

No. Actually, if you look on our balance sheet, we’re starting 2009 with $13 million less of installment receivables and those installment receivables are from a long, long time ago when the company used to do MPV accounting and those things are dwindling down. So there’s $13 million less and that means $13 million less of cash to collect.

Brian Murphy - Sidoti & Company

Okay and Alan, you mentioned that you were taking share in your space here. Just broadly, would you say that share take is coming at the expense of the stack vendors or some of the smaller guys in the pure place?

Alan Trefler

Well, I think some of the smaller and mid-sized guys are suffering because, frankly customers are wondering who is going to survive some of the shakeout and some of them haven’t had the depth of resource to really invest like we have.

Figuring out the share of some of the stack vendors is frankly as individual vendors pretty confusing, because let’s just say stack vendors have been known to periodically reclassify what they’re selling, to sort of try to look the best in every market that they allegedly play in.

So it’s a little hard sometimes to know whether Oracle, for example, thinks it’s BPM versus 75 other things that they might be selling there, but we are very comfortable that in the business that we are in. We are winning the sales that we’re in; we’re winning a very, very significant number of engagements that are closing. We’re of course seeing fewer things actually close as organizations are sometimes deferring things, but obviously we were able to overcome that to post the results that we were at that year.

So, I think we’re actually gaining share against both. I can prove it a little more empirically against the smaller guys than we are kind of against some of the bigger ones.

Operator

Your next question comes from Edward Hemmelgarn - Shaker Investments.

Edward Hemmelgarn - Shaker Investments

Can you talk a little bit about two things; one is, are you finding any changes in the mix of your new orders coming from either your percentage from existing customers versus new customers; has that changed at all?

Alan Trefler

I think it’s been fairly consistent. As I mentioned, more than three quarters of our business came from organizations that we had a relationship with and part of what we’re seeing is that in this world of mergers and acquisitions, sometimes these companies are finding that they are, actually becoming much larger, in some cases spinning-off pieces.

So, I think the existing relationships were really quite important in last year and the fact that we’re careful enough of trying to get clients to be successful, I think it was key. My prediction is that will be true for this year as well, although of course who knows what they’re looking forward.

Edward Hemmelgarn - Shaker Investments

In terms of the software, you keep making improvements to it, but do you have anything, any larger changes that you’re anticipating or improvements to your basic software, say over the next few years versus where it’s at right now?

Alan Trefler

Sure, I mean some of the changes are actually pretty material in terms of what they take to implement and what they do. So for example, this, what we call Internet Application Composer, allows us to really snap in to client’s existing infrastructure, either at their externally facing web portals or into some of their internal other types of applications.

Being able to match the brand and the look and the feel of a client’s existing website or existing application environment actually was a pretty big addition and we’re seeing quite a bit of interest from organizations who see this as a way to sort of refresh and renew their legacy architectures, as opposed to trying to pull them out and rip them out.

So, some of these, though under the umbrella from our perspective of BPM, really do represent pretty significant, new opportunities for us to broaden the product line and get greater customer applications.

The other thing that we are going to be rolling out this year is our platform as a service offering, where we’ve actually implemented the ability for our technology to be used on a platform as a service basis and we think that this is going to be of interest to both large customers who want to create their own, what we call ‘my cloud,’ their own sort of private cloud for the organization to be able to facilitate them rolling out process management or in some cases being willing to do that over the web.

Though, I’ll tell you, a lot of my customers are a little bit quirky about having data outside their fire wall. So, I think that the ‘my cloud’ piece is going to be pretty key. Getting our product to be able to work in that environment did take a fair amount of work for us and we’re looking forward to rolling out that set of technologies this year.

Edward Hemmelgarn - Shaker Investments

Is that something you expect in the first half or the second half of the year?

Alan Trefler

We’re already experimenting with it, with a number of sort of what I would describe as select early adopter sites and I would hope that we’ll be able to roll that out sometime in the second quarter.

Edward Hemmelgarn - Shaker Investments

As far as new industries, I mean obviously you talked about the deal or contract you had with, I’m assuming Ford Motor, but are there any industries that you’re seeing now that are becoming interested or that you didn’t see a year ago?

Alan Trefler

Well, Teleco which we knew a year ago I think has actually shown increased promise and we’re actually winning business and frankly looking to invest in improving our domain knowledge in the telecommunications area. I think that the travel business, Expedia recently went live with a contact center that was talked about by their CEO in one of their conference calls, and being able to work with state-of-the-art companies like that has been pretty exciting for us over the last year.

This airport opportunity, it’s a whole world around actually facilitating the mechanics of travel and saving those organizations a lot of money in helping them for example to run airports and that’s just another place where we think we can take examples of success and move them forward.

So yes, we’re seeing some of these very, very interesting pockets and actually we’re hopeful that our increased focus on partners will bring us into more deals of this type and give us some more leverage.

Operator

Your next question comes from the line of Gregg Speicher - Moss Creek.

Gregg Speicher - Moss Creek

This maybe somewhat similar to the previous question, I’m not sure, but in looking at these pipelines versus last year for each vertical, you said each vertical was approximately the same. Would you say that is still true or have some moved ahead and some lagged?

Craig Dynes

That number represented the new license bookings for 2008 in the year. It’s an annual number. That number bounces around from quarter-to-quarter. Certain industries buy at different times of the year, so we sort of look at it on an annual basis.

Gregg Speicher - Moss Creek

Okay, but do you see any of them really just coming to you wanting more and more or some starting to suffer a little bit or not?

Alan Trefler

Well, I think the tenor of the business is pretty balanced between those verticals. Years ago we used to be almost exclusively in banking and given what’s been going on in banking, we’re actually quite glad that a couple of years ago we very consciously sort of broadened our footprint and broadened our focus there.

Though, we are still seeing business coming from the banking industry here as well, I would say that if the crisis had not occurred, we would have seen a meaningfully more growth in both banking and insurance. Both of those pipelines were clearly impacted by what went on, but we were able to grow through it and even in those industries we were able to get customers to sign up.

Gregg Speicher - Moss Creek

Okay and what was interesting in talking with customers at your user conference and kind of what you just highlighted here is just sort of the growing waves in different processes that customers are using this. I mean how much of a factor in your growth is that? It gets in there in one section and they go, ‘hey, we can do it for this, we can do it for that,’ I mean does that just keep going until they, basically have a new platform or what do you think about that?

Alan Trefler

Well, I don’t want to make you think that the sales guys don’t have to do a lot of work, but the customers are realizing the breadth and the applicability of the technology and frankly as we are doing our technology investments and we’re now in the position and we’re able to I think pretty wisely invest quite a bit of money, we’re listening very carefully to the types of things that would facilitate them doing exactly what you’re talking about and really broaden the footprint. Some of that is subtle, but it is very central to what our strategy is; we call it sort of a radiation strategy in our clients.

Gregg Speicher - Moss Creek

Okay and last question, tell me if I’m doing this right, but when I adjust the final ‘08 cash flow and then the ‘09 guidance cash flow and I take out the installment payments, it does look like that net cash flow may actually be guided down just slightly for ‘09. Is that fair or is that the right way to look at it?

Craig Dynes

It should be pretty consistent once you take those installment payments out.

Gregg Speicher - Moss Creek

Okay, somewhere in the same area?

Craig Dynes

Yes, it should be pretty close to $25 million.

Operator

Your next question comes from Geoff Hulme - Porter Orlin.

Geoff Hulme - Porter Orlin

Alan, I was curious what your two or three organizational goals are, top goals for ‘09, kind of away from the numbers, just what you would like to see Pega accomplish this year?

Alan Trefler

Well, I think we need to do a much better job at marketing. We actually have a search opened for somebody to run our marketing function. The Elmen work is being done by a fellow who is standing in on a temporary basis. So, if anybody knows anybody, we’re always glad to get resumes and I think that part of what our mission needs to be is to get the message out better and make sure that we are working to build a brand. So I would put that very, very significantly on the list of organizational goals.

I think that client success is so central; we’re making major, major changes to the way we think of enablement and training. We spent a lot of money training our new staff that we hire and we’re putting a lot of work into training customers and partners. We believe that that can be more efficiently done and we’ll try both in a product perspective and our educational perspective to improve that.

I would say that the sort of third sort of organizational thing is we’re going to be implementing a lot of certification programs to be able to get both our organization, our services people, certified at multiple levels of expertise and then opening those up to our partners and our customers to see if we can broaden the ecosystem of folks who really are expert in and promote Pegasystems. So, I’d have to say that those were three of probably seven or eight pretty significant things we’re trying to do.

Operator

(Operator Instructions) Your next question comes from Brian Murphy - Sidoti & Company.

Brian Murphy - Sidoti & Company

Craig, not to harp on this cash flow from operations guidance, but you guys are guiding for net income up 50% next year and it looks like adjusting for installment receivables, cash flow is going to be flat. Is there a working capital investment or what’s happening there?

Craig Dynes

Well, there may be a working capital investment as we go through the year. Certainly some of our accounts are hurting, budgets are restricted and oftentimes we can solve some of their problems by taking licenses and instead of allowing them to have the one big time buy to sort of trench that out during the year, so that they can take the license in smaller bites and that will impact our cash flow as well.

Brian Murphy - Sidoti & Company

It looks like last year you got sort of a good bump in cash flow from the increase in the deferred revenue balance and it looks like this year that’s flat. Is that part of the difference there?

Craig Dynes

It’s a little bit of a difference. The primary increase between Q3 and Q4 deferred revenue was in maintenance and that maintenance piece will turnover into revenue into 2009.

Alan Trefler

One insight of our cash flow can be found by taking a look at the liquidity section, where we show these pretty much hell or high water contracts, where customers are going to pay us on a subscription basis. Subscription is very fashionable these days, that’s what the whole software’s and service movement is about.

We’re allowing customers to take subscriptions as well, even when they install the software internally. The affect of that though, is that we take all of the expense around the sale. The pre-sales work, the selling work, the commissions to the sales people, we take that meaningfully up front even if the cash flow and revenue comes in over two, three, four, five years.

So, one of the things I tend to look at when I try to judge how the company is doing is the delta in that balance as well, which frankly in some ways could have been cash, but reflects an asset, logically an asset. It’s not on the balance sheet as an asset.

Alan Trefler

Yes, I mean if you use the $88.5 million worth of term licenses we built up, we received no cash back, yet we’ve spent all the marketing cost to get those customers informed, we spent the sales closing costs then we spent the commissions and we have yet to collect the license revenue and the cash.

Brian Murphy - Sidoti & Company

Got it and sort of kind of staying on that thread. Alan, your subscription revenue is growing from pretty much nothing, sequentially now at sort of a $6 million run rate. I mean, should we continue to expect that to grow sequentially in ‘09?

Alan Trefler

When you say subscriptions, do you mean the term licenses or the one line item says subscriptions?

Brian Murphy - Sidoti & Company

Yes, the line item that you’re breaking out under license revenue.

Alan Trefler

Yes, subscriptions are pretty unusual. All it takes is one minor little change to the terms of the contract that drives the disclosure into subscription. They’re rather unusual, but we do like that model because it’s very, very similar to a term license. To us there’s no difference, it’s just a disclosure on the P&L, but I just do want to point out that a subscription doesn’t mean hosted. We don’t host the software even though it’s a subscription.

Brian Murphy - Sidoti & Company

Could you guys talk about just what you’re seeing in terms of trends with deal sizes?

Craig Dynes

So, what was interesting is our deal size floated up a little in 2008, not necessarily that every deal was up a little higher, but the deal size actually rose to be a little closer to $1 million up from about, I would have said 700 K. So it drifted up a touch.

Alan Trefler

We still target deals in the 500,000 to $1 million range, but occasionally one of our well known partners will invite us to a party that we normally wouldn’t even know about and when they do that, typically those transactions are larger than what we would target.

Brian Murphy - Sidoti & Company

That was actually my next question. I mean so as you gain traction with these tier one service partners, not only are they helping you with the service business and you get a nice sort of mix shift there, but they’re also bringing you into larger deals right?

Alan Trefler

Yes, their deals are typically larger than what we would target on our own and they have the clout to get those deals done.

Craig Dynes

The trade off for that is frankly there’s less predictability about when those big lumpy deals actually close, because the tradeoff you get for working with one of those service partners is generally where we have a little less control over the mechanics of the transaction than when we’re driving the bus ourselves.

Brian Murphy - Sidoti & Company

Would you say that they’re adding head count to their practices, their Pega practices?

Craig Dynes

Absolutely; we’ve gotten meaningful commitments from partners to add head count.

Alan Trefler

One of our partners was at our sales kickoff and he gave a speech to the sales organization. He was definitely pumped up about growth in the year.

Operator

Your next question comes from Edward Hemmelgarn - Shaker Investments.

Edward Hemmelgarn - Shaker Investments

Yes, just a couple of more questions. One, Craig regarding the services, with the increased or rebound in business in the U.S. in the first half of the year, do you expect to see margins get back to more normalized levels?

Craig Dynes

They may increase, but as I said it’s not our primary objective. We’re spending more of our time, we’re willing to spend more of our hours in making sure that customer is extremely successful in five or six or seven months. On top of that, we want to spend the time to enable the customer and that’s the time that you often can’t get billed for.

So, doing that knowledge transfer to a customer and beyond that doing knowledge transfer to partners. When you work with partners, oftentimes they’re not as familiar with the product and we invest the time to enable those partners, so that they can do more work on their own.

Edward Hemmelgarn - Shaker Investments

Again I’d understand that it’s never going to be a big profit generator for you, but there was just I think a 7% increase in your or I guess it actually was 8% in your cost of sales in Q4 versus Q3. So I’m just trying to get some idea if that’s going to be the run rate or do you think that that’s going to at least improve a little bit?

Craig Dynes

I would say that we’re targeting 20 and slightly above margin on professional services. Now mind you, in our case though, professional services does not include maintenance, we break maintenance out.

Edward Hemmelgarn - Shaker Investments

Okay and Alan the other question I just had is, as you do these deals with partners do you get any more pressure or desire on the part of your customers to do broader site licenses as opposed to individual kind of like usage license?

Alan Trefler

Brain I think one of the reasons that we’re around and frankly a lot of the smaller or mid-sized competitors have either died or been driven into the arms of acquirers, which is a different way of dying frankly for most of them, is that we strongly resist the traditional irrational pricing model of software companies.

We think customers should pay a reasonable price for using some software and, if they use it more broadly and are getting value from it, that they should pay a reasonable price for that additional use and we have walked away from deals and pieces of business where the sort of site license insanity, I think would have been adopted by other customers.

So, there’s no new pressure. Customers have always asked for it, they’ve been trained to ask for it and I think frankly for customers where that’s a prime goal, they will probably find that they need to buy something else.

Craig Dynes

Site licenses are hard to get done these days. I mean, it’s much easier to sell series $1 million licenses that are purpose based in solving particular problems than it is to go in there and try to sign a $20 million.

Edward Hemmelgarn - Shaker Investments

Software deal?

Craig Dynes

Yes or IT and that’s typically who could buy those.

Operator

Your next question comes from Gregg Speicher - Moss Creek.

Gregg Speicher - Moss Creek

One last question, you mentioned some of the newer products that you introduced around last year’s conference; would you say the new product uptake has been ahead of plan or about on target or you just want to put them out there and see how it went?

Alan Trefler

I think that there’s been a lot of interest in particularly some of the new products. When we do something that we think is a little bit sort of radical, we tend to roll it out to a select number of customers first and make sure that we’re comfortable and frankly get that client feedback and we’ve been doing that and that’s our plan for the first half of this year on some of those new products.

So, I think that was always our intent and we’re seeing interest that supports that. So, I guess I would have to say that was pretty much as we would have expected.

Operator

There are no further questions at this time. I’d like to turn things back to our speakers for any closing remarks.

Craig Dynes

Thank you very much everyone. We look forward to talking to you again at the end of Q1, which is not that far away.

Alan Trefler

Bye-bye.

Operator

Thank you everyone. That does conclude today’s conference. You may now disconnect.

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