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Pegasystems (NASDAQ:PEGA)

Q1 2013 Earnings Call

May 06, 2013 6:00 pm ET

Executives

Max Mayer - Senior Vice President of Corporate Development

Alan Trefler - Founder, Chairman and Chief Executive Officer

Analysts

Richard H. Davis - Canaccord Genuity, Research Division

Steven R. Koenig - Wedbush Securities Inc., Research Division

Raghavan Sarathy - Dougherty & Company LLC, Research Division

Brian Murphy - Sidoti & Company, LLC

Operator

Good day, ladies and gentlemen, and welcome to the Pegasystems Inc. First Quarter Earnings Conference Call. [Operator Instructions] Today's conference is being recorded. I would now like to turn the call over to Max Mayer, Senior VP, Corporate Development. Please go ahead, sir.

Max Mayer

Good evening and welcome to Pegasystems' 2013 Q1 earnings conference call. Before I provide my commentary and then turn the program over to Pegasystems' Founder and CEO, Alan Trefler, I will start with our Safe Harbor statement. Certain statements contained in this presentation may be construed as forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. The words anticipate, projects, expects, plans, intends, believes, estimates, targets, forecasting, could, 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 2013 and beyond could differ materially from the company's current expectation. 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 2013 earnings and in the company's filings with the Securities and Exchange Commission, including its report on Form 10-K for the year ended December 31, 2012, and other recent filings with the SEC. The company undertakes no obligation to revise or update forward-looking statements as a result of new information, since these statements may no longer be accurate or timely.

Q1 represented a solid start for the year. Our $116 million revenue marks the second highest quarterly revenue attainment in our history. And this was achieved in a Q1 which has traditionally been a weak quarter, given the back-end loaded pattern of our year. License signings were solid, when compared to Q1 of 2012, the number of deals were higher, but the average deal size was lower. We had a somewhat difficult compare against Q1 2012 as a year-ago we had 2 extremely large pieces of add-on business from existing clients.

As we have mentioned in previous quarters, the value of our bookings and, consequently, our revenues can be lumpy, and fluctuate depending on customer needs, timing of budget and the overall confidence level in the economic conditions affecting their business. Licensed backlog as seen in the liquidity section of the Q, totaled $243 million as of the end of the first quarter, an increase of $33 million from the end of the first quarter 2012. This increase in backlog was achieved despite a persisting weak global economy. It is typical that our business cycle, as it is with many software companies, to consume backlog in the first half of the year and to build backlog towards year end when license signings tend to be stronger.

Our maintenance business continues to be very strong as seen by our record $36.3 million for the first quarter of 2013. We expect maintenance renewal rates to continue at strong levels. For the past several quarters, we've been discussing our strategy to grow our partner ecosystem and to move to a more expert services model within Pega.

The decline in our current -- consulting services revenue this quarter is in part related to this strategic direction. We've also discussed our target account strategy, which is to land and expand in named accounts. While many of our follow-on sales into target accounts are for new applications, we also saw a number of sales to expand the usage of existing customer applications, which did not lead to significant incremental consulting service revenue since the service work was already in progress. Thus, our strategy is to have an increasing percentage of implementation work done by our expanding partner ecosystem, and by the clients themselves, we do want to continue having a strong expert services function and anticipate having services revenue grow modestly in the remainder of 2013 from the Q1 numbers.

Our Professional Services margin in Q1 declined to 12%, which is primarily attributed to this decline in consulting revenue. In addition, there were a few large service projects in Q1 where expenses were recognized in the quarter, but where revenue will be recognized in future quarters.

We have also continued to invest and build in our Pega Academy online education. While this is expected to reduce our training revenue over time, we see the strategic potential of this low-cost self-study approach is having a meaningful positive effect on our business. Indeed, we are finding that our partners prefer Pega Academy model for technical training, while our customers tend to prefer the more traditional classroom-based training. The decline in our training revenues is a result of our partners' adoption of the lower cost online method, partially offset by increased demand of classroom training by our customers.

Gross profit in Q1 2013 increased 13% from Q1 2012, as a result of our higher overall revenue and an increased mix of higher-margin license in maintenance business versus our lower margin services business.

Operating expenses for the quarter decreased from the Q4 run rate by $12.2 million. This decrease is almost entirely due to a decrease in sales and marketing expenses, primarily associated with significantly reduced commission expense, resulting from lower license signings in Q1 2013 versus the dramatic sales in Q4 2012.

As the fourth quarter of our fiscal year is always the strongest quarter for license signings, it is common to see this type of drop in commission expense in the first quarter of our new fiscal year. We anticipate an increase in sales and marketing expense in Q2 as we will hold Pega's user conference, PegaWORLD 2013, our largest marketing event of the year.

R&D headcount and cost increased slightly in Q1 2013 from Q4 2012. Headcount increased by 27 employees, primarily in India. We intend to increase R&D throughout 2013 in order to extend our strong leadership position in the BPM market.

G&A expense in Q1 2013 decreased slightly from Q4 2012. The decrease was primarily related to a reduction in the user professional fees and a slight reduction in headcount. In order to provide normalized run rate financial information and to allow comparisons to those building or publishing financial models, we have provided supplemental information in our press release to reconcile to a non-GAAP model. Following the same format that was used when we're providing guidance as part of our Q4 earnings release, there are 2 reconciling items: FAS 123R charges for stock-based compensation for Q1 were about $2.1 million; and the amortization expense of the intangible assets created by purchase accounting for our Chordiant acquisition was approximately $1.7 million. These non-GAAP adjustment reconciliations produced a $0.10 per share adjustment, resulting in non-GAAP EPS of $0.33 per share for Q1. We ended the quarter with $181 million in cash, up from $123 million at the end of 2012, and more than double the level of a year-ago. This increase was primarily due to the record collections of our larger receivables generated by tremendous Q4 2012 signings. A $66 million of Q1 cash flow provided from operations was net of payment for our annual company-wide bonus plan, 401(k) contribution match and a large Q4 2012 sales commissions.

As detailed in Note 5 of our 10-Q, trade account receivables decreased from $112.1 million at December 31 to $58.3 million in March 31. The average age of our receivables dropped from 60 to 37 days. Additionally, our unbilled accounts receivable decreased 42% to $13.4 million, primarily due to the timing of the billing for a large customer.

Deferred revenue, as detailed in Note 8 of our 10-Q, totaled $121 million at the end of Q1, a $7 million increase from the balance of $114 million at the end of 2012. The increase is a result of sizable increases in deferred maintenance and Professional Services, partially offset by a decrease in deferred license revenue.

During the year, we purchased 131,845 shares for $3.5 million in an average price of $27.56. At quarter end, we had a balance remaining of approximately $11.2 million available for future purchases.

On our 2012 year-end earnings call, we provided 2013 annual guidance for revenue and earnings per share on a GAAP and non-GAAP basis. Our revenue guidance included an explanation for the first half of 2013 in order to provide visibility into the timing of our annual results. In general, we do not comment on guidance throughout the year and do not provide quarterly guidance, given the volatility and lumpiness of our business. As previously stated, we sell both term and perpetual licenses and the mix between the 2 can cause quarters to be lumpy within the year. The swing to higher term licenses mix in Q1 -- Q4 2012 then back again to higher perpetual license mix in Q1 2013 illustrates this fact. In another example from last year, we followed a slow bookings and revenue Q3 with a bookings blowout in Q4.

In summary, Q1 was a solid start to the year. Our profitability was very good and our sales pipeline is strong. With this start and with PegaWORLD in Q2, we will continue to build growth momentum for the rest of the year. With that, I now turn the call over to Pegasystems' Founder and CEO, Alan Trefler.

Alan Trefler

Thanks, Max. We appreciate you and your finance team stepping up and doing a tremendous job. We're being very selective in our CFO search, and it's gratifying to know that the confidence of our team gives us the time to be selective in filling this key role.

Regarding the business results and environment, Q1 was a good quarter for Pegasystems, and I'm very excited about how I see the year beginning. It was gratifying to see the strong earnings performance, despite over a $1 million negative FX impact primarily due to issues in European currencies.

We're quite -- also quite pleased that we've complemented the 18% rise in license revenue we showed in 2012, with Q1 2013 where license revenue grew by 20% compared to a year ago.

Our business in Q1 was particularly strong in financial services, communication and manufacturing, with commitments to Pega by customers and other verticals also being encouraging. Bookings in North America was strong as with those in Asia-Pacific. And while Europe continues to be problematic, we're seeing some signs of strengthening there. While the dollar value of our overall signings was a little lighter than we wanted, the number of sales was up considerably, and we've had an influx of important new names who we expect will be successful in the initial roll outs and be in a position to buy more as the year progresses.

We've also been implementing improvements to our sales processes that are intended to help us ameliorate some of our traditional quarter-to-quarter lumpiness. And the increased numbers of sales and results in breaking into new accounts are consistent with our goals in this area. We've also taken steps to specifically link sales activity to the opportunities in the pipeline, giving us unprecedented ability to prune the pipe and optimize the activity of the selling team. Our pipeline remains very strong, with an excellent collection of new client add-on sales and many of those large transformational deals in the mix. Partners, especially on our key brands, are generating and supporting an unprecedented amount of activity. As we've discussed, establishing a capable part in the ecosystem is central to our strategy. The growth in partner practices, as measured by the number of trained and certified staff, continues to accelerate.

Our Pega Academy online education has been profoundly embraced by partners, and we have tens of thousands of lessons a quarter being taken. We think that partner enablement is a leading indicator since partners build staff based on customer demand.

As you know, I spent considerable time in the field with clients and prospects in all of our verticals and all of our regions. Since I'm often asked about the kind of dynamics I see with these clients and how the economy is impacting their thinking and willingness to buy, I'd like to talk a little bit about what we see happening.

We've discussed that Pega has shown the ability to grow in both good economic times and challenging times. However, the positioning of our offering and the expectations of how clients buy is affected by both your strategic needs and the macro environment. Let me share with you key points that I'm hearing and how we are responding. In talking to business in IT executives in leading organization, there are actually 3 themes that we believe will be part of the software landscape for the next several years. First, organizations are dealing in an environment of great change and uncertainty. And they believe this environment will persist for some time. In the short-term, this increases risk aversion, which typically means longer sales cycles, multiple proof points in the sales process and buying in tranches or segments into a business return is amply demonstrated.

And let's find out by more broadly. In an environment of uncertainty, organizations want software that will help them be agile, be fast to market and help them differentiate themselves from competitors. Thus, organizations are shifting from buying software to solve a specific problem, to buying software for the business results more generally.

This is positive for Pega since we approach the problems we're solving from the business perspective, down to the technology. And we really only focus on selling in those places where our solution has a clear return for the client.

Second, we have seen changes in the profile of software providers. Certainly in leading organizations, we're talking to business people who are technology savvy and to tech people who are business savvy. It's not uncommon to see business users who used to be leaders -- used to leaders in IT and IT leaders who used to be leaders on the business side. These leaders find the historical separation between business and IT to be a model from the past. And they're looking for software that helps them dramatically improve the collaboration, the working relationship and the speed between these functions.

We agree in the importance of this and have the unique concept called Directly Capture Objectives, or DCO for short, where business and IT collaborate directly in the software, to design and configure their enterprise class applications. DCO enables agility and collaboration that is frequently a key element in our wins, while also maintaining the enterprise status of our technology where it can expand to deal with the full problems customers will have to address.

The third theme I'm hearing is the challenge organizations are having in contemplating and providing a seamless omni-channel experience for clients, while also improving efficiency across our operating units. It's a complex problem that historical software practice have typically mostly overbuilt or persisted too much technology in each individual channel silo and didn't really enable companies to go across their businesses and deal with their customers the way they needed to.

Solving the cross-silo and multichannel problems is a strength of Pega technology with our layered cake and 6-hour cakes automation, organizations are finding that we have important capabilities -- are key-buying factors in their software selection, a real positive for us.

So despite the economy, I'm feeling very good that Pega's technology differentiation matches well with the business themes I hear from clients. And the criteria that people are using to buy, are well aligned with what we're doing. Indeed it's clearer than ever that the market potential we see in front of us is huge.

I'd also like to talk about marketing the product. Pega continues to give good visibility and kudos for the power of our offerings. For example, we were clearly positioned as the leader in BPM by Forrester, our key industry analyst firm. We believe that our upcoming generations of software can take the promise of what we do and make it much more accessible to the markets. And we are setting the stage for a much broader adoption of our technology. We've identified major capabilities that will be in our version 7 release planned for the summer, and we'll continue to invest, especially significantly in R&D, in and sales and marketing, with the goal of bringing together both a level of powered simplicity in our software, and giving us the positioning to lead this market and open the potential of what we do to an ever more extended audience of buyers.

We also believe we can do much more to give visibility for our clients' successes in the power of our products. In about 5 weeks, we will hold our PegaWORLD user conference and those who come can hear for themselves the type of proven and staggering business results that are being achieved from leading organizations. Among others, KC Wu from Cisco will be talking about the Cisco value chain. And Annette Barnes will be talking about driving business transformation at Lloyd's Banking Group. Gavin Munroe will be talking about revamping the whole London remediation challenges at BofA. And Eric Martinez will be talking about claim separations at AIG and the establishment of a claims processing background -- backbone. And very many more customers will bringing -- will be bringing real life stories that show the application of Pega technology for real business benefits.

At PegaWORLD you'll also be able to see numerous BPM-based business solutions that we've released in recent months and are preparing for the future. Examples include: major capabilities to improve productivity and speed of implementations; user enhancement for all users, whether they're in the web channel, the browser channel or the back office, or on mobile; a new release of our unified decisioning and analytic solutions; a significant new release of our industry-leading multiple customer service offerings into a cross channel and drive intent-led service; and our vertical releases in insurance, health care, government, financial services and really making it possible to drive benefits that businesspeople can more readily internalize.

So, again, come and join us and see why we, our partners and our customers, are so excited about Pega. We're expecting by far, a record attendance and it's going to be a tremendous show. But best of all, because of the key and differentiated customer stories of people being successful and the many prospects who get to talk to real clients and see what this technology can do now and for them in the future. And with that, operator, we can open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Richard Davis from Canaccord.

Richard H. Davis - Canaccord Genuity, Research Division

So when we run the numbers, we're trying on a kind of rolling 4-quarter basis if you add up, kind of, all your software licenses change and license backlog and changed in deferred, it's probably down 10%, which is -- in a tough economy is not horrific. Do you think, Alan, about any kind of modulation on that? Or is there a point, in which you would say, hey look, we're going to -- not pull back but just not hire as aggressively, in other words. And those kind of things, or is it just like, look, you look at the business there's so much opportunity, let's run with this thing and exploit while we can.

Alan Trefler

Well we're a little more modest in Q1, and I think that contributed a bit to earnings. But I look at it a little bit differently, which is, I haven't run the 4 quarters, but if I look year-over-year, which I would think would be consistent with what the 4 quarters would get you, our count of deals was up by about 33% or more. And the average deals side was a little lower, but part of it was we had actually have 2 whales in Q1 of 2012, compared to 0 whales this quarter. And there's nothing wrong with getting a higher volume of transactions and not being as whale dependent, though we're not there yet. So I feel pretty good about the business and I'm really happy about a lot of the, sort of, starter names we've developed, which are top-notch customers, folks like Cisco, for example, which I think if we do a good job we should see a lot of follow on business later in the year and years to come. So we're not pulling back. We're still being conservative about overhead, but we do expect to accelerate the hiring, if we are happy with what we see, particularly through a strong PegaWORLD.

Operator

[Operator Instructions] The next question comes from Steve Koenig from Wedbush Securities.

Steven R. Koenig - Wedbush Securities Inc., Research Division

I was curious to get your thoughts on, kind of, when we look at who's been doing better in Q1, which companies categorized have not been doing as well, it seems as if there is a bit of a shift towards the business buyer, away from IT, there's certainly a continuing shift to SaaS, it also seems as if applications may be doing a little better than infrastructure. Other people may be seeing different things in their coverage, but that's what I'm seeing. I'm just wondering if you could elaborate a little bit on how those trends could impact you or are impacting you.

Alan Trefler

So we've got a selling model that is geared towards the business buyer. And the way we think about it is to be geared to the business buyer, you need to invest in, as we have, what is a pretty expensive vertically oriented business. So folks may not know this, but our global sales force is suited to get into the regions, is organized every price we have any scale into financial services, which is separate for banking and insurance, telecommunications, health care. We've verticalized this quickly and as much as we can because, well, we think that, that's how the business buyers are engaged. And from that, we feel very connected with the business. And that actually is the primary way that we enter organizations. So while we still see IT having an influence and we think we've got a story that can work reasonably well with IT, we've been business buyer oriented, I'd say, for the last 5 or 7 years and that's true globally. So I would agree with your assessment and I think we're well-positioned to do that. We've also had some good uptake on our platform-as-a-service, or our SaaS offering, we call Pega Cloud. And I think that's very positive, though to be frank, the types of things people were using us for are tending to be what I would describe as sort of pretty serious applications that require often a lot of integration and where there's still some anxiety, even in the most forward-looking companies, about putting it all out on the cloud. So the ability to actually offer cloud, particularly for development but also in some cases, for production, but to be able to say, "Hey we understand that you want to run this inside your firewall. You want to connect this up to a couple dozen systems." We think that's one of the things we do extremely well. And some of the offerings, some of the things we released press releases on in Q1, represented partnerships, in particularly a partnership with SAP and a partnership with salesforce.com. Where in both of those cases, we're bringing a sort of traditional Pega mission capable facilities into the cloud environment via [indiscernible] and to complement the big SAP customers, which represent probably about 60%, 65% of our install base and are pretty important. So I think that those trends are there. I think the cloud trend is mitigated based on just the folks we happen to be selling to, but it's also there. And I think we're well positioned with our vertically oriented sales force to talk to the business. That's what we do, and that's what we've invested in. Does that makes sense?

Operator

[Operator Instructions] The next question comes from Raghavan Sarathy from Dougherty & Company.

Raghavan Sarathy - Dougherty & Company LLC, Research Division

I wanted to ask you about the U.K. and Europe. I guess, if I did my math right, was down some into 30% in those 2 regions. Just wondering, Alan, if you could comment on what you're seeing in those 2. And I know you talked about a couple of whale deals from a bookings perspective, can you talk a bit from a revenue perspective?

Alan Trefler

Sure. Because I didn't think they were down quite that much year-over-year. On a percentage basis, it's 'cause the number was bigger, they went down a little bit. But the U.K. and Europe have been disappointing and there's no question about that. But I'm just looking at Page 14 in the document, the U.K. went down from about $18 million to $15.5 million, but Europe went up from $17.2 million to basically $20 million. So I look at them as being kind of mediocrely flattish year-on-year, and we're seeing some signs of life, which I view as encouraging, though we're not getting -- I'm not getting carried away. Yes, check those numbers and I'm glad to take a follow-up question later if I've got it wrong.

Operator

The next question comes from Brian Murphy from Sidoti & Company.

Brian Murphy - Sidoti & Company, LLC

Alan, with the lower ASPs in the quarter and sort of the trend toward tranche buying, I was wondering if you were surprised by the swing toward perpetual revenue in the quarter.

Alan Trefler

I can't say that I'm surprised. Customer preferences vary a lot, and we end up -- one of the things I've said, and I think is true, is on a year-on-year basis, the company performance is actually really quite stable. When you look at any individual quarter, there's just enough going on that you've got some variations there. So I would tell you that it's not really a surprise. And I wouldn't actually say that I would view it as a long-term trend. We actually prefer the term ratable deals, I just find it easier to manage and it's actually the way when the company started, God forbid, close to 3 decades ago, we were doing ratable. That was the way that we did our selling. But in this environment where one of the things that, frankly, scares clients is the thought that a company like ours might end up selling out to IBM or Oracle. Some of these guys want perpetual licenses largely for self-defense, and I think some of it depends on whether they've been burned recently. It can be a little emotional. But I don't think there's any secular trend there that you can point to, it wouldn't shock me at all if it swung back the other way next quarter.

Brian Murphy - Sidoti & Company, LLC

Okay. And I think you threw out a couple of metrics there. I'm not sure if you said the deal count was up 33%. But could you just give a little bit more color in terms of sort of how many new logos you guys are signing now?

Alan Trefler

Yes. It was actually great in terms of new deals. The actual aggregate deal count was up north of 33%, which tells me that we're really doing a good job of your penetrating and percolating in more accounts. And I think that's pretty consistent with what our strategy is. It's a terrific thing. Relative to the new names, they were a series of just awesome independent names, which in some cases, I'm not allowed to mention them, but if you show up at PegaWORLD, you can check out the badges and it's going to be very impressive and that is a terrific opportunity for people to actually see what's going on. We're expecting well over 2,000 people there and it's going to be the largest BPM conference by far. And I can tell you, based on the registrations, and based on the speakers, I think it's going to be a terrific relationship and selling event for us, so we're pretty excited.

Operator

[Operator Instructions] And I'm showing no further questions. I would now like to turn the call back over to Alan Trefler.

Alan Trefler

Well I'd like to thank everybody. And I think as a lot of you know, I'm presenting at the Jefferies conference tomorrow and we have a pretty full dance card of one-on-ones, so it's pretty deep. I look forward to talking to a number of the folks who I see on this call, then. And I'd like to thank everybody for their support and let you guys know we're working hard. I think we're going to have a great PegaWORLD with a terrific new release to talk about. Thank you very much, everyone.

Operator

Ladies and gentlemen, that does conclude the conference for today. Again, thank you for your participation, you may all disconnect. Have a good day.

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