Pegasystems Management Discusses Q3 2013 Results - Earnings Call Transcript

Nov.12.13 | About: Pegasystems Inc. (PEGA)

Pegasystems (NASDAQ:PEGA)

Q3 2013 Earnings Call

November 12, 2013 6:00 pm ET

Executives

Beth Kurth

Alan Trefler - Founder, Chairman and Chief Executive Officer

Rafeal E. Brown - Chief Financial Officer, Chief Administrative Officer and Senior Vice President

Analysts

Richard H. Davis - Canaccord Genuity, Research Division

Raghavan Sarathy - Dougherty & Company LLC, Research Division

Kevin Ikeda - Wedbush Securities Inc., Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Pegasystems third quarter earnings call. [Operator Instructions]

I would like to turn the call over to your host, Beth Kurth. Please go ahead.

Beth Kurth

Thank you. 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, incurred 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 that are subject to various risks and uncertainties. Actual results for the fiscal year 2013 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 the forward-looking statements are contained in the company's press release announcing its Q3 2013 earnings and in the company's filings with the SEC, 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.

And with that, I will turn the floor over to Alan Trefler.

Alan Trefler

Yes. Thank you, and good evening. Q3 was a terrific quarter for Pega. Year-to-date, we've grown license revenue materially, are quite an achievement in these challenging times. For much of the last several weeks, I've spent considerable time visiting customers, prospects and partners in North America, Europe and India. There is tremendous excitement about our Pega 7 release. This is the latest major version upgrade of our unified model-driven platform and a significant step in our goals of both improving power and ease-of-use.

One recent example of the excitement was from the attendance and reaction to our first Pega developer conference held October 27 and 28 in Hyderabad, India. Responding to demand by our customers and partners in India, we decided to hold this conference with only 8 weeks advance notice. Yet, the conference was way oversold, with over 1,700 attendees from 52 organizations all there to learn about the powerful market-leading Pega 7 software.

Here are 2 telling quotes from conference attendees. The head of a partner's global BPM practice said, "everyone here, their eyes are lighting up when they see what they're able to do with the new technology." And from a customer Vice President, he said, "Pega 7 is going beyond boundaries. It's giving a different perspective to the development and building of applications." These are representative of the comments we now hear about Pega 7, which brings speed and simplicity to the building of serious build business apps.

Key among new capabilities in Pega 7 are a so-called responsive UI, a user interface, which allows you to have your business application respond automatically to whatever device you run it on. For example, shrinking from a desktop to an iPad or resizing itself for a smartphone, this dramatically reduces the time and skills needed to build world-class case management user interfaces, while dramatically improving the user experience.

Something really novel that we call Case Lifecycle Management, which allows businesspeople to graphically lay out their reusable business processes in context without having to awkwardly glue them together. Then the Pega 7 engine automates the software creation, so that's the way the application will work in practice. This really enables reuse and speeds of change.

And finally, simplified data transformation, which we call live data, which makes it significantly simpler for business applications to access enterprise data where it resides in whatever format it is in. This is one of the most challenging aspects in building SL applications, and putting this in really will significantly speed time-to-market and business responsiveness. These are just some of the very powerful capabilities that are generating excitement and buzz among customers, prospects and partners about our new release.

Also, however, very exciting are some of the changes we see occurring in the enterprise software market. For some time now, we've been explaining the Pega 7 and our solution frameworks address about a $30 billion market and the combination of Business Process Management, case management and various vertical application segments. We're seeing these merge into a new category. And as I talked to customers, partner executives and industry analysts, there's increasing evidence and momentum that this evolution is speeding up as it takes place. Organizations increasingly realize the traditional approaches to case management and customer centricity simply do not provide the agility and the responsiveness required to effectively compete in a continuously changing environment.

Both business and IT organizations know they need something different. But until now the enterprise software market definitions have not given them a name for this new requirement. Now we're seeing industry analysts, pundits, systems integration firms and customers asking aggressively for this new approach. Some call it "systems of differentiation." Some call it smart process applications. We can sometimes hear it referred to as dynamic case management through systems of agility. But regardless of the label, this confluence of market segments for a new type of business application is upon us. And increasingly, customers, partners and analysts are recognizing Pegasystems as the market leader and the best solution to this new emerging set of needs.

Evidence that the market's needs and acceptance of this emerging categorization is the excellent performance of Pega in Q3. We had 3 different international telecommunications companies choose Pega for order management and Next-Best-Action marketing to improve efficiency and increased cross-sell for customers. The combination of business responsiveness at the moment of truth for the customer, with analytics for improved outcomes and our vertical frameworks for rapid development to and deployment, really shows how we're pulling together these different markets into the new approach that I mentioned above.

We also won significant business in the health care segment in Q3, as health care organizations are dealing with the need to save money through personalized health care and clinical programs, and they have to be able to readily and easily change their business practices based on new products, new processes and all of the regulation that's hitting that business.

We also did well in the financial services sector in Q3, and we're seeing financial services companies under cost pressure and needing to really streamline the way they do business. And true to form, that's something that Pega's combination of technology is uniquely positioned to be able to address.

I was also pleased with the public sector segment in Q3. We actually have the highest number of quarterly orders in public sector segment in our history, with wins in both federal and state governments. Public sector organizations are beginning to acknowledge that their traditional approaches to business apps cannot get them through the tough challenges they are now experiencing with lower budgets and higher demand by stakeholders. So they're turning to the newer model that Pega represents. So in Q3, we saw major wins in the public sector for licensing applications, citizen service delivery and exceptions management.

So you can see across the segments the combination of business process automation, cross-channel customer experience, dynamic case management and verticals solutions really helps organizations improve agility and responsiveness, and these are all the things that Pega software is at its core.

Let me close by discussing our acquisition of Antenna Software in October. We see mobility as a critical element of what clients want and need in business software, and it's a fast-moving and rapidly changing market. And our philosophy is it for organizations to be agile and efficient, mobility has to become a core capability of their business applications, and core to their processes. It's not a separate thing that is distinct from the way they want to run the business. It's interesting because a recent analyst study showed that 75% of mobile applications either do not reach expected return or have any return at all. We think that this is because they've been overly simplistic, have not been fully and properly integrated with the core elements of the business and, of course, that is a tremendous strength that Pega has and Pega brings, and we see the introduction of the 250 very skilled resources from Antenna and being able to fit in their approach with our model-driven architecture as making it possible for us to both improve capabilities to the existing excellent Antenna customer base and also make mobility a key and core differentiator for Pega as we move forward. The clients and partners we've talked with are very excited about this combination, and they see it as really taking mobility applications to where they need to go.

So in closing, it has been a strong 2013 for Pega. And with that, let me welcome Rafe Brown, Pega's new Chief Administrative Officer and CFO, to his first earnings call. Welcome, Rafe.

Rafeal E. Brown

Thank you, Alan. I'm thrilled to become part of the Pegasystems team, given the company's best-in-class technology, leading customers and track record of growth. This is truly a fantastic opportunity. With a little more than a month behind me, I want to thank the entire Pega team for the warm welcome and for their hard work these past few months. I especially want to acknowledge Max Mayer for his leadership and dedication these last few months, in particular, for covering our most recent earnings calls.

Q3 was another great quarter for Pegasystems in terms of license revenue growth, bookings, earnings and cash flow. Our pipeline is robust. And though we have a tremendous amount of work to do to close 2013, we are looking forward to a strong finish to the year.

Let me begin by taking you through our third quarter results, starting with revenue. Q3 revenue was $122 million, up 20% from the year prior. Within that number, Q3 license revenue was $45 million. That's up 57% over Q3 of last year. On a year-to-date basis, which normalizes quarter-to-quarter volatility in our business, license revenue was up an impressive 34% over the prior year with total revenue up 12% over the same period last year.

Year-to-date, we continue to see a higher mix of license and maintenance revenue relative to Professional Services revenue versus the same period last year. This change in our mix of revenue is consistent with the company's strategy to focus on growing the number of implementations performed by our partners and clients, with Pega providing expert services.

Looking at year-over-year growth on a regional basis, year-to-date revenue in the United States grew 9% to $189 million. Revenue from the European continent has improved nicely, growing at 47% to $66 million on a year-to-date basis, reflecting our sales team's growing traction on the content and early signs of business recovery in the sectors we serve.

In the third quarter, license signings increased significantly in total value terms when compared to the third quarter of 2012. Notably, our Q3 2013 results were achieved without reliance on a small number of very large transactions or wells as we often call them. This said, our fourth quarter pipeline does contain a few very large transactions that are important to our achieving our bookings target for the year.

In terms of the mix of license deals signed year-to-date, the percentage of perpetual licenses, wherein revenue is recognized in the quarter the deal is signed, has ticked up. The mix between perpetual and term licenses is, to a great extent, dictated by the needs for our customers, though the company does somewhat prefer term license deals. And remember, due to the disparate short-term accounting results for perpetual versus term license deals, small changes in relative license mix can have a significant effect on both revenue and margin in a given quarter.

Turning to the income statement. The company posted a GAAP gross margin of 69% in the third quarter, up from 63% in the third quarter of last year. This improvement is largely the result of the relative decrease in Professional Service revenues versus license and maintenance revenue, as discussed earlier. Operating expense dropped over $2 million in Q3 compared to Q2 of this year. The overall reduction in expense is a result of the fact that our annual user conference, PegaWORLD, occurred in the second quarter. Overall, we saw both sequential and year-on-year improvement in our operating margins.

You can expect that we will continue to focus on building operational efficiencies, but we'll be investing in areas that propel our growth, principally our sales and product development departments.

For example, the acquisition of Antenna will require additional investment. However, much like the Chordiant acquisition in 2010, which ultimately accelerated our call center business and development of our Next-Best-Action product, we believe the antenna acquisition accelerates our mobile strategy.

Turning to earnings. We posted third quarter non-GAAP earnings of $0.33 per share. On a year-to-date basis, our non-GAAP earnings total $0.88 per share compared to year-to-date earnings of $0.45 per share in 2012. Our GAAP earnings were $0.22 per fully diluted share for the third quarter, $0.58 per share on a year-to-date basis.

License backlog, computing by adding deferred license revenue as detailed on Page 11 of our third quarter 10-Q filed earlier today, and future cash receipts from license arrangements, as detailed on Page 22, totaled $268 million as of the end of the quarter, up $42 million or 19% from Q3 of last year.

As the company has discussed in prior quarters, our business tends to be back-end loaded in the year in terms of both the number and value of our license signings. As such, the company tends to consume backlog in the early part of the year. Consistent with last year, backlog is down year-to-date as of the third quarter.

In support of our land and expand sales strategy, year-to-date, more than 2/3 of the value of our licenses have been executed with existing customers. The conclusion here is that our software works. Our clients like their results, and they're willing to continue their investment in our technology.

Turning to cash flow. Operating cash flow for Q3 was $19 million. Year-to-date, operating cash flow was $83 million, up 187% over the same period last year, and in part the result of strong collections year-to-date. We ended the quarter with $188 million of cash on hand.

Our days build outstanding now stands at 50 days. Year-to-date, the company has repurchased 313,000 shares for $9.2 million. At quarter end, we had a balance of $5.6 million available for repurchase this year. We finished the quarter with a total headcount of approximately 2,300 employees, up 7% from the same point last year. Of course, this figure jumped significantly shortly after quarter end with the acquisition of Antenna, adding an additional 250 employees to our headcount figures.

Turning to the impact of the acquisition on our Q4 results. We expect that Antenna's operations will have no material impact on our 2013 revenue. We do expect Antenna's operations will reduce non-GAAP earnings in the fourth quarter by $0.03 to $0.05 per share.

As a reminder, a complete GAAP to non-GAAP reconciliation can be found in our earnings press release we issued earlier today.

In summary, Q3 was a great quarter, and we are looking forward to a strong finish to the year. I feel privileged, not only to report these results, but to be part of such a great management team.

With that, operator, we will open the call to questions.

Question-and-Answer Session

Operator

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

Richard H. Davis - Canaccord Genuity, Research Division

Quick question. Do you -- I mean, you kind of talked about it at high level, but each of the last couple of years, Q4, you guys have made like retailers look like pikers [ph] because you do 50% to 60% of your bookings in 1 quarter. Does that feel like it'll be similarly back-end loaded or just order of magnitude or were just trying to kind of triangulate around that? And then the second kind of tactical question is, is on Antenna. The purchase price looked pretty darn low. I mean, it's was great buy because I remember, they were trying to go public at one point. But is there any earnouts at all in that figure, at all? Or is it the straight-up, kind of a mid-20s purchase price?

Alan Trefler

So on the Antenna, it was a straight-up purchase. I think we're pretty careful acquirers, and we really liked some of the work they had been done -- doing in the last particularly, I would say, 12 to 18 months. But the business has struggled for a little bit, but we were very, very impressed, and we think it's both an excellent team. And obviously, really, really important for us to be investing in. So we feel pretty good about that. In terms of the back-end loading, yes, I think we did get some nice business closed in Q3, that in past years might have drifted off to Q4. But we're still expecting and looking to do a strong Q4. And as Rafe said, you got a couple of whales in there, We've had sort of a whale for a year which -- it's not a bad thing, to tell you the truth. But we are working, and we think we might be able to get a couple of big deals in the quarter as well.

Richard H. Davis - Canaccord Genuity, Research Division

And then lastly, with regard to Antenna, expectations' wise, should we just figure, 50-50 license service split or is that roughly about right? You know, when we're trying to model it out?

Alan Trefler

I think there might be a touch more in service than in license, it's service and maintenance there. So I think it will be a little more heavily weighted towards that.

Operator

Our next question comes from Raghavan Sarathy with Dougherty & Company.

Raghavan Sarathy - Dougherty & Company LLC, Research Division

Sorry, if you already talked about this. Can you give us some sense for the revenue run rate of Antenna Software? I know you've talked about expenses. Can you give us some sense about the revenue run rate of this business? And then, are you going to be continuing to sell the development platform or is it going to be assumed in your platform?

Rafeal E. Brown

Yes, the revenue run rate for antenna is around $5 million on a quarterly basis. So we don't think it's going to have a big impact on Q4 as noted.

Alan Trefler

And in terms of what we're doing, so if they've got a pretty, pretty interesting set of mobile first development platform capabilities, they call AMPchroma, and we are continuing to sell that, and we are in the process of also integrating their capabilities in what we are already did in mobile, which I think is going to make our mobile offerings even stronger. So it's a combination of continuing to let them to what they've been doing. And also, as we look, probably towards the PegaWORLD's timeframe. Middle of next year, we think we could do have some really very great exciting things to be able to put forward.

Raghavan Sarathy - Dougherty & Company LLC, Research Division

Okay. And then my second question is around bookings. If you look at the fourth quarter, I think, you know Alan, you just talked about couple of big deals, but when I look at the license comparison, you do have tough comparison for the fourth quarter, how should we think about the license revenue growth of the quarter? Because I think the perpetual license is a big swing factor.

Alan Trefler

Yes, it is. And as you well know, we live in a world of high adventure. When It comes to figuring out exactly what's going to come in term and what's going to come in perpetual. I will tell you that what we call the working set, which is the collection of deals that have either closed or that we're working looks quite good. However, there's still a lot of work to do between now and the end of the -- between now and the end of the year, and I guarantee you, we're all highly focused on it. I wish I could give you some better guidance, but in reality, you know what we know.

Raghavan Sarathy - Dougherty & Company LLC, Research Division

And so this is my one final question, whether -- I mean, you talked about center[ph] across the board. Are you -- was it driven by sort of -- I mean, is it Pega 7 product you talked about? Or is it too early for customers to migrate to Pega 7? How does the upgrade work? Do they -- is the product get covered by the maintenance? And what would that mean in terms of revenue for you going forward?

Alan Trefler

Sure. So Pega 7 would be available to existing maintenance paying customers under the arrangement. And so it's just not the movement to Pega 7, it's not going to lead to massive springs of new revenue. But we see having Pega 7 available, and being able to really get customers excited about the product as being a very, very good harbinger, especially for next year. Anything we did in Q3 though, was not materially driven by Pega 7, maybe a little.

Operator

[Operator Instructions] Our next question comes from Kevin Ikeda with Wedbush Securities.

Kevin Ikeda - Wedbush Securities Inc., Research Division

Just wanted to get a little more color on the Antenna acquisition. What's the initial target for cross-selling? Will you be selling Pega into the Antenna base or selling Antenna into the Pega base?

Alan Trefler

We think it can go both ways. And part of what's interesting is that I think one of the challenges that mobile apps have had historically is they've been great for like displaying a little bit of data. But in terms of actually doing real work, the great majority of them don't actually do that. And that's part of that industry analyst quote that I read that said, "boy, companies have been doing them, but they're not sure exactly, necessarily what they're getting". We obviously have an absolutely terrific, terrific platform for being able to sit behind a mobile app, and there's this is whole concept of what's called "mobile back-end as a service" where you actually put up a system on the cloud and use that as an intermediary for people to be able to build and deploy mobile apps. We see that system on the cloud being a Pega system as offering the Antenna customer base, and actually new clients, some Really, really terrific opportunities to have a model-driven architecture there where everybody else is writing code. So I think there's going to be some great opportunities into the Antenna customer base, and I think it's going to be really appealing as a next year sort of thing, across the board.

Kevin Ikeda - Wedbush Securities Inc., Research Division

Okay, and just one more. Given that many other software vendors are adopting a mixed model or transition into pay-as-you-go model, do you expect to see any sort of mixed shift towards term or perpetuals or away from the other?

Alan Trefler

Well, I think that Rafe pointed out that our perpetual mix had ticked up somewhat this quarter, obviously good for short-term revenue. The reality is, we like term. When the company was started actually, we only offered term licenses. That was it. And so the fact that there's been a push by some companies to really, really want to buy perpetuals, frankly driven in a material way, I think, by the acquisitive nature of companies like Oracle and IBM and them not wanting to be in a situation where they've got a term license with one of those firms. They feel better that they have a perpetual license though that's obviously not something that we're looking to happen to us. The predilection of the clients can be very strong. And you know we made the decision that a businesses is good business, we would be prepared to offer perpetual as well as a term. But you should be aware that we do favor terms and we really try to encourage the sale, when there's really a choice.

Operator

Our next question comes from Raghavan Sarathy from Dougherty & Company.

Raghavan Sarathy - Dougherty & Company LLC, Research Division

Quick follow-up on this expense that you talked about related to the Antenna software. So you said on a non-GAAP basis, it's going to be diluted $0.03 to $0.05. Do you -- will there be any -- you think that minimal revenue, but I want to make sure that's actually on a non-GAAP basis, you're not going to -- there's not going to be much revenue. And it seems to me that it if it's about $0.03 to $0.05. Is the expense rate is roughly $2.5 million for this business on a quarterly basis? I want to make sure I'm looking at this right there.

Rafeal E. Brown

No. So their expense run rate for the quarter is probably around $7.5 million a quarter. And keep in mind, so the revenue numbers, as I just mentioned, will be around $5 million. As they're just coming into the company, we're still getting our arms around the business and making sure we're investing to see them off to a good start. On a GAAP basis, it, of course, gets quite a bit more complicated because there's the haircut to GAAP revenue that will be determined as the valuation work is completed.

Raghavan Sarathy - Dougherty & Company LLC, Research Division

But you will recognize roughly 5 million on a non-GAAP basis?

Rafeal E. Brown

Correct.

Operator

[Operator Instructions] We don't show any other questions in queue. I'll turn it back to Alan Trefler for closing remarks.

Alan Trefler

Well, thank you to everyone who joined the call. We're obviously very pleased about how we've done year-to-date. 34% year-on-year license revenue, I think, has been quite an accomplishment for the team, and we feel quite excited, and we know we have a lot of work to do between now and the end of the year, and we're going to get back to it. So with that, thank you very much, everyone.

Operator

Ladies and gentlemen, thank you for participating in today's program. This concludes the program. You may all disconnect.

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