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Pegasystems Inc. (NASDAQ:PEGA)

Q1 2014 Earnings Conference Call

May 6, 2014 6:00 p.m. ET

Executives

Rafeal Brown – CFO, Chief Administrative Officer, and SVP

Alan Trefler – Founder, Chairman and CEO

Analysts

Operator

Good day, ladies and gentlemen, and welcome to the Pegasystems First Quarter 2014 Earnings Call.

[Operator Instructions] And as a reminder, today's conference is being recorded.

And now I would like to turn it over to your host Rafe Brown.

Rafeal Brown

Good evening, ladies and gentlemen.

Certain statements contained in this presentation including but not limited to statements related to future earnings, bookings, revenue and mix of license revenue 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 and 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 fiscal year 2014 and beyond could differ materially from the company's current expectations.

Factors that could cause the company's results to differ materially from those expressed in forward-looking statements are contained in the company's press release announcing its Q1 2014 earnings and the company's filings with the securities and exchange commission including its quarterly report on Form 10-Q for the quarter ended March 31, 2014 and its annual report on Form 10-K for the year ended December 31, 2013, and other recent filings with the SEC.

Although subsequent events may cause the company's view to change, the company undertakes no obligation to revise or update forward-looking statements whether as a result of new information, future events or otherwise since these statements may no longer be accurate or timely.

And with that, I will turn the call over to Alan Trefler, Founder and Chief Executive Officer of Pegasystems.

Alan Trefler

Hey. Thanks a lot. Really appreciate the great work you and your team have been doing Rafe. And I'm pleased to say that Q1 was a strong quarter and a great way to start the year.

We had total non-GAAP revenue up 22% to $142 million. Our non-GAAP license revenue was up 23% to $53 million. And we have strong GAAP earnings at $0.20 a share, up 18%. All this with excellent cash flow. Very, very nice quarter.

We had a fantastic set of wins of companies, like new companies like Walt Disney, where two divisions of Walt Disney have chosen Pega to manage the workflow for distribution of media and localization of products such as films and TV and toys.

And a top global manufacturing firm, which is another success in the emerging area of internet of things. We're helping a heavy vehicle manufacturer manage the health of their clients' machinery and improve overall quality of customer experience. We had quite an experience in this area. For example, GM OnStar, a longstanding client, is going to be presenting at PegaWORLD, how they used Pega to drive customer response that is the backbone of that system.

And we're also showing we can become part of a comprehensive backbone to smaller firms as well. Pega is helping HomeServe, a leading multinational residential service and maintenance provider embark on a transformation program, to help them become more customer focused across multiple product lines, partners and channels, achieving global standardization while taking account of the business imperatives across the different markets.

And our existing customers of course are very, very central to our business, and we had excellent results there. Strong follow-on business for example with Royal Bank of Canada where the wealth management division previously deployed Pega as their U.S. service management platform and have extended the scope throughout their client onboarding process and deploying the platform as well in Canadian operations.

And moving into new client areas and places like AIG where Pega is helping AIG institutionalize their global customer feedback initiative across 75 countries worldwide. And we saw strong results in Europe, companies like Deutsche Bank, an existing customer. We're really helping them streamline their onboarding and know-your-customer client processing globally, to help them stay ahead of the constant regulatory change that we're seeing.

And going all the way down to say Macquarie in Australia where Macquarie, a leading Asia Pacific financial firm, significantly extended their use of Pega into more processes and departments. It's terrific to see a nice mix across geographies, across industries, and it makes us feel very, very positive about how the year has started.

I'll tell you that the Pega 7 release that we released last year is taking on just accolades, there's a great reception. We're hearing from clients that they're experiencing in some cases well over a 20% improvement in the speed and the capabilities that they're able to implement in the system, which is exactly why we like investing in this technology. The Pega customer service and Pega marketing technologies are proving to be a little winner in the CRM space.

And we have lots of new advancements in the area of the digital enterprise. Our cloud business is growing nicely. The mobile pipeline is advancing. And it's the combination we think of multichannel CRM and case management coupled with the new technology and the skills we got with the Antenna acquisition last October that we think is going to continue to make us a force in this area.

And today we announced the acquisition of MeshLabs, a very advanced social analytics and natural language processing specialist, which have capabilities that we are already combining with our Pega 7 case management and CRM, to give clients the ability for actionable insight and much more personalized customer service and we see increased offer acceptance.

So we're seeing excellent results across the board, from case management to our analytics-based marketing. And I think it's really just a very exciting time.

Together, these technology-based offerings are often referred to, among the buzzword crowd, as SMAC, which stands for social, mobile, analytics and cloud. And we see Pega as having now one of the best combinations of these capabilities of any software vendor in the market. And we're the only firm to offer these in a single coherent architecture.

We think this is of critical importance in providing agility for both Pega and our clients. We reject the flank-and-stack [ph] philosophy of firms that stitch together software from companies they buy into what inevitably becomes a mess.

It's good that our product leadership was once again recognized by industry-leading analysts. In Q1 we were named the number one in dynamic case management by Forrester. Clear -- enterprise -- clear number one in enterprise CRM, mentioned as the technology designed for sophisticated enterprises. And a leader, by Gartner, in the customer engagement center quadrant. Many of these recent accolades, with our longstanding leadership in BPM, we think we have a powerful platform to engage customers broadly.

And as I've talked about on the last call, the positioning that Pega is taking about how we want to help our customers engage their customers is in the context of this new idea of the new digital enterprise. It's interesting because while digital enterprises have been talked about, I think it's only recently that people have come to realize that central to the concept of the digital enterprise is the notion of every company becoming a software company. The digital enterprise can be a strategy but execution requires software.

And that is our mission: to be the leader in better business software for the digital enterprise. And we have the best combination of capabilities to accomplish this. We've come to realize that clients want more than the alphabet soup of technology. As I said before, the flank-and-stack [ph] approach of gluing together bits and pieces from so-called segments misses what clients really need.

Now we love being a great CM, case management technology, BPM, business process management technology, DM, decision management, NBAM, next best action marketing, KM, knowledge management, MAM, mobile application management, and dozens of other so-called submarkets. But this alphabet soup is disastrous for agility and creating a coherent approach for clients and operations. It’s the antithesis of being customer-focused.

And by having an architecture that encompasses a broad swathe of these technologies in a way that makes sense to business people, it's what we think organizations are looking for and is highly, highly distinguished. And I think our approach is a great fit for companies that are looking to become digital but do it in a series of more agile steps, starting small, showing fast results in businesses, areas, with an architecture that they can have confidence will grow with their business, and increasing the teamwork between business and IT for faster time to market, and higher quality, which we do to our directly captured objectives technology, specializing for markets and personalizing for customers, while maintaining organizational-wide policies and [indiscernible] this concept of a layer cake, and obtain knowledge in the software, to make it easier for staffs to become effective, especially important given the need to improve productivity of knowledge workers.

So these elements all together provide the chance for businesses to rethink how they want to use software. And we think of that as absolutely critical. And our fantastic go-lives in Q1 shows how clients are using Pega software to be better.

Just a couple of quick examples, AIG is already using in production that Pega software they just bought this quarter, to automate and manage customer feedback across their global business, becoming more digital in the way they serve their customers. Telstra, who I visited recently down in Australia, is using Pega to automate customer service for clients to more dramatically improve service and ease-of-use for their customers, while improving the cash flow for the organization. And we have ING Insurance implementing multiple front-office customer journey [ph] initiatives using the software.

It's highly appealing to us to be able to engage with clients not at the alphabet soup level but in the area of business outcomes. And one thing that I think is very positive is we're seeing considerable interest in relationships with some of the world's leading management consulting firms such as Accenture, McKinsey and Boston Consulting Group. And these firms are being engaged at very high levels within their clients, being asked for advice on how to become a digital enterprise. And as I mentioned, you need a strategy, but we see all these firms as green, that execution requires software and a better approach to software.

And we think that they're realizing that Pega software is an ideal solution for the execution of a digital strategy. In fact, if you want more detail, come to PegaWORLD 2014, where one of our keynote speakers, Vik Sohoni from McKinsey, is co-leader of McKinsey's digital practice, and will be talking about their philosophy and how Pega software relates.

I'm also pleased to say that I've just completed my first full book. It's going to be published by Wiley on June 9. It's "Build for Change." And it's about revolutionizing customer engagement and continuous digital innovation. It's available for preorder now on Amazon if you're interested.

Let me say a few words about the operations of the business, because what we expect going forward is over the next few quarters we'll continue to invest, to take advantage of what we see as a significant growth opportunity in front of us. We plan to continue to increase our distribution capacity both direct and with partners. Our partner community continues to grow and it's growing with both traditional partners and a number of new well-regarded organizations that are signing up on a more regional basis.

We have been investing in R&D and will continue to grow R&D. We're seeing this pay off in bookings, we're adults [ph] the marketplace, product leadership, and as I said, getting tangible feedback from our clients that our products are getting better in ways that matter to them.

And you're going to be able to have the chance in early June to see the great new offerings and announcements at PegaWORLD. We're going to be showing new capabilities in customer service, next best action marketing, as well as vertical solutions, mobility and social.

We'll continue to invest in maximizing the use of our technology. We have an enablement program at Pega and their customers and partners are showing great interest in our online Pega academy when in Q1 alone we had over 7600 partner class enrollment, of which nearly 2000 were from partner staff totally new to the ecosystem.

You're going to see us reinvesting in a stronger digital community and really trying to build relationships between our customers and between our customers and ourselves more digitally as a company ourselves. And we're going to continue to invest in Pega's expert services to make sure that we've got the depths and the sophistication of staff to deal with clients as they address some of the most sophisticated business problems in the world.

I am also pleased that we recently hired our new CMO, Robert Tas and have charged him with building out a significant digital community. And we think that this will really help the positioning we have as better business software for the digital enterprise.

As I turn the call over to Rafe, I'm also very proud that in Q1 Pegasystems was named by Forbes Magazine to be one of America's 100 Must Trustworthy Companies. We aspire to be a firm that is trustworthy to all of our stakeholders, and it was terrific to have that recognized as one of only two technology firms on that list.

And now I turn the call over to our CFO, Rafe Brown.

Rafeal Brown

Thank you, Alan. For the first quarter of 2014, we're reporting both GAAP and non-GAAP results. A full reconciliation of all GAAP to non-GAAP measures is provided in the financial tables of the press release issued earlier today and is available on our website.

For the first quarter of 2014, non-GAAP revenue was $142 million, up 22% year over year. This includes a contribution of approximately $6 million from Antenna which we acquired in the fourth quarter of last year. Non-GAAP license revenue was $53 million, up 23% year over year. This includes a contribution of approximately $2 million from Antenna.

In an effort to provide better visibility on our growing cloud business, we've begun breaking out detail of our services revenue in the footnotes for the financial statements, which can be found in our Form 10-Q filed earlier today. In addition, we will be including cloud backlog in our overall backlog measures. Given that an increasing number of our clients are evaluating both our on-premise and cloud offerings, we felt it important to include the small but growing element in our overall revenue and backlog measures. For the first quarter, our non-GAAP cloud revenue stood at $4 million, up 129% over the prior year.

As we've previously stated, it is our objective to over time increase the contribution of license cloud and maintenance revenue relative to other services revenue as we endeavor to increase the number of implementations performed by our partners and clients. As a percentage of first quarter 2014 non-GAAP revenue, license cloud and maintenance revenue stood at 72% of total revenue, up from 70% in the first quarter of 2013. In dollar terms, non-GAAP professional services and training revenue were $40 million in the first quarter, up approximately $5 million from the first quarter of 2013. We do expect professional services revenue will grow in 2014, albeit at a slower pace than license, maintenance and cloud revenue.

Looking at our results on a geographic basis, non-GAAP revenue in North America grew 22% to $88 million for the first quarter of 2014 and stands at 62% of total revenue. Our European business had a strong start to the year. Overall revenue from EMEA was approximately $45 million on a non-GAAP basis, up 27% on the year-over-year basis. Our Asia Pacific business was up 7% year over year.

While large transactions remain an important part of our business, our efforts to build a consistent flow of somewhat modest transactions is bearing fruit. Our Q1 results were achieved without booking any transactions over $10 million. The overall number of deals was up during the quarter. In addition, the average deal size was also somewhat higher when compared to the first quarter of 2013.

In terms of the dollar mix of license revenue recognized during the quarter, 56% of our revenue was recognized from term or subscription arrangements, up from 39% in the first quarter of 2013. As we've previously discussed, the mix between perpetual and ratable license or cloud arrangement is to a great extent dictated by the needs of our clients. This said, the company does prefer the visibility provided by term license for cloud transactions.

Keep in mind that while we are continuing our efforts to smooth bookings throughout the year, this will be a process that takes time. As such, we continue to expect bookings revenue to be largely backend-loaded in 2014. Furthermore, the success of our efforts to increase the dollar value of deals being ratably recognized will likely only be measurable on a full-year basis.

Our non-GAAP gross margin was 69.7% for the quarter, roughly flat with the first quarter of 2013. Turning to the rest of the income statement, for Q1 2014, we posted a non-GAAP operating margin of 16.6%, roughly flat when compared to our operating margin for the first quarter of 2013. This result is particularly positive in light of the ongoing integration of Antenna into the company.

First quarter non-GAAP operating expenses were approximately $76 million, up 22% from the first quarter of 2013. As we've discussed in the past, we intend to carefully balance investments and growth initiatives with the delivery of attractive profits to demonstrate the substance of our business.

In addition to the planned investment in sales and marketing that Alan mentioned, I do want to note that, consistent with 2013, PegaWORLD will generate meaningful expenditures in the second quarter. This said, last year's PegaWORLD conference confirmed that there's no better opportunity for prospective clients than meet with and hear success stories from our existing clients. For that reason, we are excited to host an even bigger PegaWORLD this year than ever before.

Turning to earnings. We posted non-GAAP earnings totaling $15.7 million in the first quarter, an increase of 22% over the prior year. On a fully diluted EPS basis, this totals $0.20 per share, up 18% from the first quarter of last year.

Now, to discuss license backlog. As mentioned, we are including cloud backlog in our overall backlog computations for the first time. We compute license and cloud backlog by adding deferred license and cloud revenue $63 million to our off-balance sheet license and cloud commitments of $270 million, which are signed license and cloud arrangements that are unbilled and not recorded on our balance sheet. As a reminder, you can find detail of both elements in our 10-Q filed earlier today.

We finished the quarter with $333 million of total license and cloud backlog. This ending number includes approximately $4 million of acquired Antenna backlog. For year-over-year comparison purposes, it should be noted that total backlog as of Q1 2013 of $285 million included $11 million of cloud backlog.

Consistent with the first quarter and prior years, we did consume backlog during the quarter. However, we were pleased that we consumed less backlog during Q1 of 2014 compared to Q1 or 2013 on both an absolute dollar and relative percentage basis. For the quarter, the company produced $73 million of operating cash flow, an increase of 10% over the prior year. Free cash flow, which we define as operating cash flow less CapEx, was $72 million, also up 10% over the prior year.

We finished the quarter with total cash and marketable securities of $221 million, up 22% over the prior year. Notably, our total cash position is now higher than before the acquisition of Antenna in Q4 of 2013.

During the first quarter, the company repurchased 211,000 shares for $4.5 million, and at the end of the quarter we had a balance of $10 million available for repurchases for the remainder of the year. We finished the quarter with a total headcount of approximately 2600 employees, up approximately 22% from the same point last year.

In summary, we are pleased with our Q1 results and we are hitting 2014 with solid momentum.

Before I conclude, I would like to remind our analysts, investors to save the dates for PegaWORLD, June 8th through June 10th, in Washington, D.C. This is a great opportunity for you to hear from our clients themselves how Pega's better business software is enabling the digital enterprise.

We are also having a special investor check on Monday, June 9th. If you would like to find out more, please contact us through our Investor Relations website.

And with that, operator, we will open the call to questions.

Question-and-Answer Session

Operator

[Operator Instructions]

Sir, at the moment I'm showing no questions, but I will give the instructions again. [Operator Instructions]

Alan Trefler

Well, I guess there are times when good results speak for themselves.

So I'll just close by repeating the invitation to join us at PegaWORLD 2014. You can find it on our website. It's June 8th to 10th at the Gaylord in New York -- I'm sorry, in Washington, D.C. And we've got an awesome collection of customers who agreed to come forward and speak to others about what they're doing, which is actually pretty remarkable.

We have the EVP and Head of Client Service Delivery from Bank of New York Mellon, the Head of Customer Base Management from the largest telco in the U.K., the CFO of the FBI, the CIO of Medicare and Retirement from UnitedHealth, the CTO of PayPal, and many, many more. It's a conference that really is geared around having customers hear real in-depth stories of digital experience and transformation. And even if somebody can come just for the Monday, which will be the 9th, I think you'd be sure to find it highly, highly worthwhile.

So, a great start to the year, an exciting time for Pegasystems and for our customers. And we're working hard for all of you. Thank you.

Operator

Okay. Ladies and gentlemen, this does conclude your conference. You may now disconnect. And have a great day.

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