Pegasystems Inc. Q2 2010 Earnings Call Transcript

Aug.10.10 | About: Pegasystems Inc. (PEGA)

Pegasystems Inc. (NASDAQ:PEGA)

Q2 2010 Earnings Call Transcript

August 10, 2010 9:00 am ET

Executives

Craig Dynes – SVP and CFO

Alan Trefler – Chairman and CEO

Analysts

Nathan Schneiderman – Roth Capital

Laura Lederman – William Blair

Raghavan Sarathy – Dougherty & Company

Steve Koenig – Longbow Research

Brian Murphy – Sidoti & Company

Derrick Wood – Wedbush Securities

Operator

Good day ladies and gentlemen, and welcome to your Pegasystems Inc. Q2 2010 earnings conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator instructions) As a reminder, today’s conference call is being recorded.

I would now like to introduce your host for today’s conference call, Mr. Craig Dynes. You may begin, sir.

Craig Dynes

Good morning and welcome to the Pegasystems 2010 Q2 earnings conference call. With me here in Cambridge is Alan Trefler, Pegasystems’ Chairman and CEO. Before introducing Alan, I will 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, 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 fiscal year 2010 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 among others variation and demand and the difficulty in predicting the completion of product acceptance and other factors affecting the timing of our license revenue recognition, the mix of perpetual and term licenses, and the level of term license renewals, our ability to develop or acquire new products and evolve existing ones, 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, the potential loss of vendor-specific objective evidence for our professional services, management of the company’s growth, our ability to successfully integrate our acquisition of Chordiant Software, 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 the year ended December 31, 2009 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.

Q2 was a history-making quarter for Pegasystems. We worked hard on the largest acquisition in our history and at the same time reached a new milestone. For the first time, the company exceeded $80 million in revenue in a single quarter. A lot of work went into the integration of Chordiant, so let me give you an update.

We moved very quickly on integrating the two companies. The cash tender offer on April 21st, four days later, on April 25th, PegaWORLD our Annual User Conference started and we had Chordiant employees, customers and partners in attendance where we are already beginning with customers presenting initial product roadmap and demonstrating production integration. As of today, all of your organizations and systems are pretty much integrated. As an example, there is not a separate Chordiant sales organization. We have one sales team selling into their assigned accounts. It is a norm to see the sales team comprise of Pega and ex-Chordiant staff working together on opportunities we already seen deals with the customers’ life and mix of products. While this level of integration makes it very difficult to separate the deals and products, approximately $7.8 million of Q2 GAAP revenue can be directly attributed to Chordiant.

Most of the integration costs is reflected in the Q2 restructuring charge of $6 million. This charge is primarily for severance payments. We expect that there will be additional restructuring charges of approximately $1.7 million in Q3 as there are additional severance payments scheduled at the facility worked we have done. The restructuring charge is not a catch-off for our costs. There is still many Chordiant employees who are in transitional roles and whose salary costs are not in the restructuring charge.

So, in our Q2 financial statements, there is approximately $1 million of personnel costs in operating expense lines for staff who are employed on a temporary basis. During Q3, these transitional roles will wind down, and so we expect these OpEx costs to drop to about $400,000 in Q3 and be gone in Q4. In addition to the restructuring costs, during Q2, we recorded $3.4 million of acquisition-related expenses such as banker and legal fees, which are directly related to the transaction. This is in addition to $1.5 million of acquisition-related expenses that we recorded in Q1. In total, through the first six months, we recorded over $10 million in restructuring and acquisition expense.

Just to size the numbers and the impact they have on our GAAP bottom line, we have provided a non-GAAP financial information in our press release. Like other software companies, we have excluded these large acquisition costs, amortization of intangible assets created as a result of purchase accounting as well as FAS 123R charges. This allows us an easier comparison to other software companies as well as to analyst models who use these non-GAAP measures.

Lastly, we have provided guidance on a non-GAAP basis for easier comparisons. GAAP or non-GAAP, Q2 was our 12th consecutive quarter of record revenue. As I said, it’s also the first time in history that quarterly revenue has ever exceeded $80 million. License revenue on a GAAP basis was up $2.5 million, of $25.7 million in Q2 2009 to $28.2 million in Q2 of this year. Very little license revenues directly attributed to Chordiant. License revenue is slightly down from Q1 2010. This is a common trend for us. In fact, Q2 license revenue has been less than Q1 license revenue every year since 2004 as new license signings for bookings are typically much lower in Q1 and Q2.

New license signings were higher in Q2 this year as compared to last year’s Q2 in both Europe and Asia. They were also higher in every vertical other than US healthcare, which I suspect may be caused by the temporary uncertainty related to federal cost care reform. As a result, new license signings which are slightly lower in Q2 2010 compared to Q2 2009. However, 2009 is a tough comparison as it is far less backend loaded than normal. In fact, 2009 was the only year in the last five years that at the halfway point, bookings were more than 30% of the annual total. Our customers buy software from annual not quarterly budgets, and so they tend to save their budgets and evaluate products through Q1 and Q2 before spending on Q3 and Q4.

Maintenance revenue was $20.4 million in Q2, an increase of $8.2 million over Q2 ’09. About half of this increase is directly attributed to Chordiant. The acquisition-related increase in maintenance revenues is calculated only from April 21. So, there will be a further pickup in Q3. Purchase accounting rules gives a haircut to maintenance arrangements that are in deferred revenues at the time of acquisition. So, on a non-GAAP basis, maintenance revenues were $22.8 million for the quarter.

Professional service revenues were up 31% on a year-to-date basis over last year. The Chordiant acquisition contributed $3.9 million to professional services revenue in the quarter. If I take out the acquisition pickup, service revenues would still be up by 23%. Demand from customers and partners for training is especially high. Training revenues are 67% for the first six months of the year in comparison to last year. At the halfway point of the year, gross margins were about the same as they were last year. Professional services were at 18% versus 19% and maintenance is at 87% versus 88%. You should note that we have a much larger cost of license in our GAAP financial statements. This is due to the amortization of the software intangible assets created as part of the purchase accounting. This charge is added back as part of the GAAP to non-GAAP reconciliation.

Page 20 of our 10-Q details amortization on intangible assets. Total operating expenses for the quarter other than the acquisition and restructuring charges were $50.6 million [ph], an increase of about $20.2 million or 66% from Q2 2009. Approximately 6.5 of the increase is due to increased staff and costs from Chordiant employees. The balance represents the strategy of investment that we have been following from 2006 with a goal of growing the company to become a billion dollar a year player.

Sales and marketing expenses are up substantially as this is the major area of investment for us. On a year-to-date basis, sales and marketing expenses were up $19.7 million, from $32.1 million in 2009 to $51.8 million in 2010. While marketing programs such as PegaWORLD accounted for $2.1 million in increase, the vast majority is due to increased headcount.

In the first six months, we have added 112 people to sales and marketing group, of which 89 are in the sales organization. We have been investing heavily in the sales organization, partly because investments last year was tempered by concerns on the economy. At June 30th, 2010, we have 58% more account executives on board than we did at June 30th, 2009. However, we estimate that on average, it takes about nine months for a sales rep to become productive, as it takes time to onboard training, sign accounts and starting building pipeline. So, while we had 58% more reps onboard at June 30th this year than last, the number of reps that have been onboard for more than nine months is up only 15%. This means that more than 40% of the sales reps may not be fully productive until late this year or early next year. So, this clearly an investment’s drive revenue growth in 2011, even though we bear the costs in 2010.

We plan to continue to add more people to the sales organization during the rest of 2010, but at a reduced pace. In addition to the investment in sales and marketing, during the quarter, we added 99 people to our R&D organization. Approximately 61 were added as a result of the Chordiant acquisition. Of the remaining 38, 30 were added in India. The headcount for G&A is up by 32 from last quarter, 20 of these people are Chordiant employees in transitional roles which will end by the end of June 3.

Our FAS 123R charge for stock-based compensation was about $2.2 million in the quarter, up from $900,000 in Q2 ’09. Note 11 to the financial statements details all those charges allocated to profit revenue and operating expense. This quarter, we recorded another foreign exchange translation loss of $2.5 million due to changes in the value of Pound stronger than Euro. Pega’s current operating structure is not very foreign currency content, as most of the changes in foreign currency hit our P&L as opposed to comprehensive income, which is in equity accounting. However, with the acquisition of Chordiant, we were able to balance our foreign cash and it resulted in a partial hedge on currency movements. This should moderate the impact of the P&L for the rest of the year.

On a year-to-date basis, we recorded foreign exchange loss of $5.6 million. This represents a charge of $0.13 of EPS. Because translation gains or losses do not reflect any change in our business condition, they are beyond our ability to control or forecast. In February, when we gave guidance, we ignored the potential and under predictable foreign exchange gains or losses by stating that we assumed the constant US dollar. Our business is nowhere still in liquidity and currency situation in Europe.

Even after adding back the purchase accounting charges as part of the reconciliation to get to non-GAAP measures of our business, our non-GAAP earnings of $0.10 per share are down slightly from non-GAAP EPS of $0.17 for Q1. Q2 is usually our toughest quarter in the year, and since last year, it was an anomaly, it’s difficult compared to 2009. The comparison is even tougher when you consider that in Q2 last year, we had a foreign exchange gain of $2.9 million or about $0.06 a share. While in Q2 this year, we reported a foreign exchange loss of $2.5 million or about $0.05 a share. That’s a quarter-to-quarter swing of $0.11 on something that has no significant impact on our business.

On April 21st, we picked up $14.2 million of Chordiant accounts receivable. Our ending accounts receivable balance of $65.9 million is an increase of $23.6 million from March 31, 2010 or $26.5 million from December 31, 2009. Adding in Chordiant accounts receivable which resulted from sales on pre-acquisition period causes the DSO calculation to generate a higher but still respectable days sales outstanding of 49 days. During the first six months, we purchased 99,603 shares for $3.3 million at an average price of $33.08 [ph]. Our Board replenished the buyback program in Q4 last year and so we still have a balance remaining of approximately $12.5 million available for future purchases.

Deferred revenue of $53.8 million was up by about $20.9 million from December 31. The increase is due to deferred maintenance revenue as a result from our Chordiant acquisition. In addition to providing non-GAAP financial statements, we have provided an update to guidance on both the GAAP and non-GAAP basis. We expect revenue to be $348 million on a GAAP basis and $360 million on a non-GAAP basis. The largest difference between the $12 million reduction or haircut that we take on maintenance for the next year. In addition to this revenue, we have added back the acquisition-related expenses, restructuring charges, amortization of the intangible assets created as a result of the purchase accounting and equity compensation charges estimate a non-GAAP earnings per share of approximately $1.02.

As a reminder, our guidance is always annual guidance. We don’t give quarterly guidance for two reasons. Our customers not us determine whether they will buy a term of perpetual license and a change in the mix or timing can make our quarters extremely lumpy. In addition, we don’t get crazy discounts at the end of the quarter to make guidance assumptions because our business is built on follow-on sales through existing accounts. Big end-of-quarter discounts would ruin our business model. Consistent with the guidance that we gave in February, this is going to be a backend loaded year where we have a very strong and large pipeline, which we think will continue to drive record revenues for the rest of the year.

With more detail on Q2 achievements, I would now like to turn the call over to Pega’s Chairman and CEO, Alan Trefler.

Alan Trefler

Thank you Craig and good morning all. Overall, the second quarter was very successful for Pegasystems. Despite a difficult economy, we had our 12th consecutive quarter of revenue growth. Very different from other firms who have claimed 2010 successes on easy compares after having retrenched in 2008 and 2009. We achieved licensed wins across a broad spectrum of our targeted verticals, we crushed our prior attendance record for PegaWORLD, our user conference, and we had over 25 systems go live in leading organizations around the world, because the largest acquisition in the company’s history and continue to deepen relationships with key partners, contributing to a record level of pipeline and sales activity with the world’s leading organizations.

But before I talk more about some of that good stuff, let me acknowledge that there challenges, and we have chosen to make significant investments at a time when conservativism is the norm when economies are in distress. We have said many times before that we don’t manage the business on a quarterly business, but instead focus on the huge market opportunity in front of us and on the long-term business value growth of the firm. Despite a stressful economy and despite the fact that software is our lumpy business at best, the returns we see from our clients in the adoption of our technology is so significant that we are convinced that the right action was and is to continue to invest for long-term profitable growth.

Let me give some color on our thinking about the business. First, the use of the BPM technology is a very big market opportunity, and we have a very excited highly differentiated product line. We have a leading technology that’s clearly pretty revolutionary in providing a level of agility to our clients that has kept them buying. When we looked at the last year or so, large portions of even our target markets were uncovered. Let me remind folks that we have a target account strategy. What that means is unlike some of the companies that sort of do a lot of general purpose marketing and hope that leads come in that they can respond to, we actually pick companies that we think would be appropriate users of our technology and we assign sales reps to them, and it’s up to sort of lead generation fulfillment model, it’s really getting, understand the organization, focus, collaborate and deck. So, we are in fact tied to the number of sales reps we have in making the decision to increase the sales reps we think was very, very critical to allowing us to increase capacity.

Now, there are ways we can augment them, and I will talk about partners and other things that we can do as well, but at the end of the day, we took a look at it and we decided we had not meaningfully increased the sales force in the 2008 post-crash environment and 2009. The reason for that is we have been terrified like everybody else at what has been going on in the market and sort of the drumbeat of bad news. So, we were pretty modest. But if you take a look at the license revenue for the two years from the end of 2007 to 2009, we had a staggering increase on license revenue. License revenue grew 127% from $51 million in ’07 to $116 million last year. But total sales and marketing staff increased at only 65% across those two years, only about half that rate.

We significantly increased hiring in Chordiant acquisition this year, thus bringing sales capacity more in line with our actual historical growth and facilitating future growth. Fourth, Chordiant has consumed a lot of our energy that will clearly be worth it. Craig points out that it was our largest, actually more than 10 times larger than what we have done before, and I think we appropriately focused a lot of management attention to the integration. It was as hard as we expected, but with even more potential. We have not only spent time internally on integration alignment, but have had dozens of meetings with senior executives of Chordiant clients understanding what they were seeking so we could incorporate their needs into our plans. And we have seen favorable responses, I will touch more on it a little bit.

Fifth, we are confident that we will achieve a significant return on the significant investments we are making. They give us the capacity we need to grow the business to take advantage of the opportunity. But investment involves upfront expense and comes with all the attended upfront costs and challenges that rapid growth entails. However, I will say it’s been a good time to be looking to hire, and we are very pleased with the talent we found, not just in sales, but in building out our solutions and development capabilities to attack complementary verticals that need our technology and making it so that we could reach out areas like public sector, life sciences and communication with stronger teams.

We are also fortunate to have a well-structured and highly regarded onboarding program for our staff as well as experienced cadre of first-level of managers. That made it sensible for us to front-load these investments early in ’10 to make sure that we would build the capacity particularly as we went into next year. One advantage we have is that we are doing things that are familiar. We are extending and deepening our target account model rather than contemplating any sort of massive change in approach. We are entering the verticals with the problems we are trying to solve or similar to the problems we solved so well in our existing verticals.

New business acquisition processes, customer service processes, fulfillment processes, things we call the servicing backbone, these sorts of things we find highly, highly applicable in areas like communications or for example, in life sciences with adverse event reporting and case management. We also see with great enthusiasm a lot of energy in our systems integration partners. We have invested significantly to make sure we have a capacity to work with these partners, to make them both want to, but able to build Pega practices and allow them to really create their own differentiated solutions using our technology. The fact of that level of enthusiasm from world-class organizations like Accenture, Capgemini, Infosys, Cognizant, IBM, Tata, these all demonstrate that there is a lot of enthusiasm in the market for building on an increasing a Pega ecosystem that ultimately I think is what we need to do to get to that next plateau, that next level of growth. Obviously the proof of these investments we are making in sales staff solutions frameworks, partner support will only be shown as we see our end-of-year performance and put forward our plan for 2011.

Nonetheless, we are confident enough about our prospects to target our being a $360 million company this year, something that would have appeared inconceivable just three years ago. So, let’s understand a little bit more about what we did achieve in the quarter. We had named accounts across a lot of verticals, life sciences, government, telecom, energy, financial services, healthcare, insurance, choose to deploy new product or increase their product years. We added names across the world, North America, Europe, and in Asia, and we continue to expand the benefits of our business with just demonstrated agility time and time again shown by our clients as we deploy the products.

Our product advances have been recognized as well. With the release of SmartBPM 6, we have taken a dramatic step forward in meeting the needs of the pragmatic business buyer. In April, we hosted a record over 1,200 attendees at our PegaWORLD conference, and we had dozens of clients choose to speak and share how they were using this technology. The level of enthusiasm and the level of pipeline that we saw come out of this was unprecedented. They were able to present successes in achieving rapid returns on investment through the technology, how they automated the programming and how they now automate work, enabling them to quickly open new revenue opportunities and control costs.

We were able to demonstrate also firsthand how the Chordiant and Pega integration would work. Some highlights, we were selected by a very large insurance company based in the UK to support new business transformation, starting with quotes and driving it in to the entire revenue system. Another UK win was with a large global banking organization, that’s using us to support their global service request backbone, a group-wide servicing backbone to manage service requests over hundreds of thousands of employees in 70 countries.

In Australia, we continue to radiate at a large bank has, has multiple uses of our SmartBPM technology to drive their lending processes across multiple channels and multiple lines of business. We actually achieved the win with our new decision management technology resulting in the Chordiant acquisition at a large new named North American telecom that will be using the technology to enable intelligent cross-sell and up-sell to help manage churn. This marks a milestone in enabling Pega to extend into the telecom vertical here in the US. And we continued our radiation in the North American insurance vertical with wins at two very large insurance companies, one using Pega to enable the customer to deploy web-sell service using our Internet application composite framework that brings matchup technology to the Web.

So, I would say, all in all, it was pretty exciting from a sales perspective. From a go live perspective, it was unprecedented, over 25 systems going live with – well one of the largest credit companies in the world launched a card member case management system in the disputes management system, and we have become their standard for case management as they deal with customer service going forward. We had another major insurer launch in new workers’ compensation system leveraging their existing back-end technology, but making it so they could be far more effective and competitive and both save money and write more new business, and we launched a new more mortgage application management system that enabled a leading bank to triple the volume of mortgage origination without adding any headcount, and allowing them to do a much better job of reviewing the loans to ensure greater reliability.

The list goes on and on. It’s actually really very, very exciting from a go-live perspective, and one of the things we like is that we had a very strong mix of new name customers as well as existing, in fact we have far more new name customers in the first half of this year than we did last year when frankly people were really depicting the economy. This is a good sign given that so much of our business is follow-on sales and we think that’s a real good indication of client success. To touch back on Chordiant, in late April, we announced its closing and since then, we have made significant progress in integrating the organization as Craig discussed. In addition, we visited with numerous customers in the past month and see general excitement with regard to the combination. Most customers understood that Chordiant was likely to acquire and I think Pega scene is one of the best alternatives that they could envision here.

We have also begun communicating a unified product roadmap to customers to provide them with guidance and visibility and how we plan to meet their needs by bringing the offerings together. It’s really pretty exciting to think about bringing the Chordiant decision management technology to Pega clients and then bringing some of our advanced BPM technology to the Chordiant client family and it’s being well received by the organizations we are talking to. In the Q2, our partner relationships continue to rapidly advance and partner source pipeline continues to grow at a record case and ahead of plan. Partner enablement is a key indicator of partner confidence and also continues to grow at a rate well above our 2010 targets, with both the delivery and sales organizations within our partners spending a lot of time to become enabled.

Through the Chordiant acquisition, we gained several additional key executive sponsors at a number of our partnered partners as the advent of our decisioning and analytics capabilities represents a good strategic initiative for them to talk to their clients about. And several of our partners have begun to develop their own frameworks on our PRPC SmartBPM technology, and we will be announcing products throughout the year in varying verticals.

In Q2, we also a significant uptick of our new Pega Cloud BPM offering, which we offer in conjunction with Amazon on their Elastic Compute Cloud and we have now got over a dozen customers who are making material use of the cloud environment and the fact that we have got a nice thin client development environment that’s uniquely suited for running on the cloud to be able to make the development and deployment faster. We think this is very, very positive and are looking forward to continue to have many, many more client customers as we go forward.

So, all in all, I would say Q2 was a success. Significant wins across target verticals, major go-lives, blockbuster PegaWORLD, closing of our largest acquisition, and significant traction and a record level of pipeline, both independently and with our key partners. We think that this investment we have made in the first half is appropriate. It’s adds needed capacity and frankly is the right thing for us to do and see no reason to believe that we won’t get the returns we expect from it.

With that, let me thank you and turn it, open over to questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from Nathan Schneiderman with Roth Capital.

Nathan Schneiderman – Roth Capital

Hi Alan and Craig, thanks very much for taking my questions. First one for you, as far as the Chordiant contribution goes, do you still comfortable that Chordiant is going to contribute $45 million to your pro forma revenue this year?

Craig Dynes

Yes, part of the increase in Chordiant revenue are directly attributed to Chordiant is on a GAAP basis in the Q. So, the non-GAAP basis is significantly higher. We gave guidance about $348 million in the GAAP basis and $360 million. So, we are confident that they will contribute. And you know, that’s just this year. Once we get going and we start really capitalizing on synergies, we expect better things for next year.

Nathan Schneiderman – Roth Capital

Given that you are still thinking $45 million would be the Chordiant contribution, that would imply $33 million of Chordiant contribution in the second half, how back-end loaded do you envision that for Q4?

Alan Trefler

I don’t think the Chordiant contribution is terribly back-end loaded. Frankly, I think that as Craig said in his presentation, we worked very, very hard to try to make it, so the Chordiant contribution and the Pega contribution have both sort of come into the same stream. I assume you are getting the $45 million number from the fact that we originally were at $315 million and we now are at $360 million, if that’s correct. So, I don’t know that we are going to be in a position to tell you exactly how much of that at the end of the year was Chordiant or not, but obviously as I said, we feel comfortable, the $360 million continues to the right target for us.

Nathan Schneiderman – Roth Capital

I have a couple of questions related to the guidance, Craig. I wanted to clarify, is your guidance for the $1.02 based on fully diluted share count, or is it basic share count?

Craig Dynes

Fully diluted.

Nathan Schneiderman – Roth Capital

And does it include the negative impact of this $0.13 penalty for FX that you experienced during the first half?

Craig Dynes

Yes, it does. Originally, we didn’t want to forecast that. I mean, who can’t forecast that right. But it is what it is, we have taken that hit for Q1 and Q2 and we think that we have some measures in place to greatly reduce the fluctuations in that for the rest of the year.

Nathan Schneiderman – Roth Capital

Okay. And a final question for you. On the $360 million of guidance for the year, what approximately do you see as license, your license, software licenses as a percent of total revenue, just pretty approximately there?

Craig Dynes

I don’t believe we gave that indication right now.

Nathan Schneiderman – Roth Capital

Okay. Thank you very much.

Operator

Our next question comes from Laura Lederman with William Blair.

Laura Lederman – William Blair

Yes, hi. Several things can cause a slowdown in the market. Obviously, you mentioned not adding sales capacity. You mentioned the difficult comparisons with last year, but other things that could impact a company's results obviously would be competition or market penetration. So, can you talk a little bit about those and why you think the slowdown in new customer billings doesn't relate to those two factors? Thank you.

Alan Trefler

Sure, Laura. So, a couple of things. In terms of market penetration, even in our traditional markets like financial services, we are far from having – penetrate to that market to the level where there is not a lot of opportunity and in fact we are adding staff in those existing markets to both better cover and cover additional accounts. So, I would say that even in our oldest market financial services, I don’t think we are more than 20% penetrated of where we could be as we take a look at just a very, very large organizations that are out there. Well, as a competition, I actually think the competitive environment is better than it was a year ago from our perspective. We have had a number of our competitors so to get sucked up by other companies, and customers have a pretty cynical view of what ends up happening particularly since inevitably the management turns over, you know, sort of aggressive entrepreneurial culture tends to become a little more staid and a little more corporate.

So, it was a very competitive environment, it continues to be competitive environment, but I haven’t seen any meaningful change in the competitive dynamic.

Laura Lederman – William Blair

Any major losses to the competitors this quarter that surprised you or –?

Alan Trefler

I think our win rates have continued to be around the same. We do have tough competitors. The biggest challenge I would say we have with our competitors is inevitably they will go in and having perhaps lost of the business, we will offer to let clients try it for free. One of the really cool things that happened this quarter is a customer that had made a decision with one of a very, very large competitors, actually back to us this quarter, having discovered that it was a reasonable spree. So, I am not seeing anything that’s particularly difficult, but it’s been a tough and a challenging market all along. I am actually quite pleased however that some of these smaller companies were acquired, I think that’s actually long term helpful for us.

Laura Lederman – William Blair

If you look at how you did in the quarter, it sounds like it was below what you thought. What was different? Did deals slip? The pipeline wasn't as mature as you thought, in other words, why was it less in terms of a bookings quarter than you would have expected? Because you knew what your sales headcount was, etcetera.

Alan Trefler

Yes, you know, it’s interesting, because once again, we still, until we get to be, I would say even double the current size that we are, you still get a level of statistical anomaly to a something of a small sample size. We had a lot more new clients come onboard, which is great, new name customers, but they tended to come on for somewhat smaller purchases, which average deal size was down because some of the huge, huge purchases that some customers have come onboard with, they actually wanted to sort of do a $1 million purchase instead of a $3 million or $4 million purchase, which we had a couple of those happen in the first half of last year. I am not all unhappy about that, because as we do that, we are actually preserving what’s ultimately going to be a good, and I think a lucrative relationship, because generally when clients spend a lot more upfront, they sometimes have unduly lofty expectations about discounts and things of that type. So, I think what I would describe is sort of the lack of whales, would be the one thing that was – I can’t say was surprising, because we can’t statistically expect whales, but it is the thing that made the comparison also a little difficult.

Laura Lederman – William Blair

Final question for me and then I will pass it on. If you look at the pipeline, can you give us a sense of how much bigger it is year-over-year, how mature versus immature the pipeline is, coverage to revenue, in other words, something to give us comfort in the $360 million in revenues?

Alan Trefler

Yes, it’s up very significantly I would say year-over-year. Craig is looking for the numbers, but off the top of my head, I would say that the pipeline is up 40%, 50% over, Craig just checked, it’s in about the 50% range of increase. Obviously, when the pipeline increases that much, more of it early-stage than late stage, but we think that the pipeline is generally of extremely high quality.

Laura Lederman – William Blair

Actually – I am sorry, go ahead.

Craig Dynes

The vertical bookings were less which would be healthcare, we have a very strong pipeline for the remainder of the year.

Laura Lederman – William Blair

Thank you.

Operator

Our next question comes from Raghavan Sarathy with Dougherty.

Raghavan Sarathy – Dougherty & Company

Good morning. Thanks for taking my questions. Start out with a clarification question, Craig. So, your full-year guidance of $1.02 includes about $0.10 or so FX loss. So, you did $0.27 in non-GAAP EPS in the first half. So, you are implying that your full-year guidance implies $0.75 non-GAAP for the second half. Did I understand that correctly?

Craig Dynes

As I said in February and as I said today that this was always going to be a backend loaded quarter when it came to profitability.

Raghavan Sarathy – Dougherty & Company

So, the backend loaded year, not the quarter. So the number we are looking at, $0.75 for the second half, as implied by your guidance, that's all I wanted to make sure.

Craig Dynes

Yes.

Raghavan Sarathy – Dougherty & Company

Okay, all right. So in terms of, I think, Alan, you kind of talked about the new customer wins are up year-over-year. The ASPs are down. Can you give us some color on why customers are buying in small chunks this year versus last year, when it seems like macro economy is improving and there seems to be more spending on IT?

Alan Trefler

I think remember, we sell more to the business people than we sell to IT. So, most of our projects are justified in the business. I am hearing a bit of an echo on the line, I am not sure if the –

Operator

It seems like you are echoing off of the current questioner’s line.

Alan Trefler

If you could mute yourself, that would be good. So, I would say that the ASPs were the – what I would describe as kind of lack of whales, would do to sort of individual circumstances of the customers. There were customers that could have made much larger purchases, but wanted to sort of take it a bit slower, which I don’t think there is anything particularly wrong, in fact I would generally prefer working with our clients that way. So, there was nothing macro. The reality is we have three whales in the first half of last year and it was different this year.

Raghavan Sarathy – Dougherty & Company

All right. And then in terms of healthcare vertical, Craig, you kind of touched upon that. Do you see the reform actually holding up things and do you expect that to change in the second half of the year?

Craig Dynes

So, I think that what we are seeing is some temporary sort of uncertainty in that market. I think people are now getting over that. They are starting to think about purchase decisions and the pipeline is actually very strong for healthcare for the rest of the year. And by the way, we have always found historically that healthcare has been much of a backend loaded business. And again, we are looking at a tough compare where last year, it was last year we closed significant healthcare deals in Q2 and healthcare deals in Q3. So, last year was an anomaly.

Raghavan Sarathy – Dougherty & Company

All right. Then one final question and I will pass on. So, this question was asked before, so let me ask it a little differently. So, if I look at the license revenue growth for the first half, it was about 11%. I know you have not provided guidance on license revenue growth in the past. That said, when you look at again the revenue growth in the first half, you are looking at low teens from mid-40s that we saw recently. And also you have (inaudible) effect on EPS in the second half. So, things are a lot different now than in the past. We haven't seen this kind of backend loaded year. So, given this backdrop, can you give us some color on how to think about license revenue growth in the second half?

Alan Trefler

I think the right way to think about the license revenue throughout is to realize that we only had a little additional capacity of experienced sales reps in the first year and first half of the year. So, if you take a look at the first half of this year compared to previous years, our growth in the sales force, which is directly tied to license revenue was modest, very, very modest. I think Craig cited only 15% more than it was a year ago in terms of experienced reps. Now, we have brought on a lot of reps who have much shorter tenure, but will be hitting the sort of nine months that we look at in Q4 and going into 2011. So, we have a very material increase in the sales force, that it’s not a slam dunk, but it’s our job to get those guys productive and you can see it in the headcount numbers that we talked about and that we report in the Q, that we have actually jumped up the sales force and the support for that sales force. So, that’s why and I don’t think it’s actually very complicated, that’s why I would expect that it will be backend loaded.

Craig Dynes

And as I said, it’s very typical for us to license revenue till down from Q1 and Q2, in fact it’s done that virtually every year since 2004.

Operator

Sir, would you like us to move on to our next question?

Alan Trefler

Yes, pleasure.

Operator

Our next question comes from Steve Koenig with Longbow Research.

Steve Koenig – Longbow Research

Good morning. Thanks for taking my questions, guys. Let me start with some housekeeping questions and then move on. Craig, in going through your Q last night, what – we found commentary that we were looking at the contribution from Chordiant, and we found commentary that – this is on a GAAP basis, that Chordiant maintenance added $3.9 million, and ProServ from Chordiant added $3.9 million. So, that gives me $7.8 million contribution from – on a GAAP basis. And that is even – so assuming no license, is that number higher than the $7.2 million contribution you mentioned on a GAAP basis? So, I am wondering, can you help us with that calculation?

Craig Dynes

As I said, there was a very little contribution from Chordiant on license revenue. It was primarily in maintenance and in professional services.

Steve Koenig – Longbow Research

Okay. So, the Chordiant maintenance and professional services contribution was at $7.8 million, was it $7.8 million or was it $7.2 million?

Craig Dynes

It should be $7.8 million, I believe. I will look at the Q, I don’t have it in front of me, but it’s $7.8 million I believe.

Steve Koenig – Longbow Research

Okay, thanks. And then can you remind us, the licenses that Chordiant has typically generated, are those mostly perpetual, term or subscription, or are you accounting for them differently than Chordiant did?

Alan Trefler

Historically, I would say the licenses were very, very significantly standard traditional perpetual licenses, and actually if you look back on their history, they were also really quite lumpy in terms of when they would hit. We are planning to offer them in a variety of mechanisms more consistent with how Pega licenses.

Craig Dynes

And we will not be changing the accounting. The accounting is what the accounting is according to the terms of the license agreement.

Steve Koenig – Longbow Research

Okay, and the deferred revenue write-down haircut that you took on licenses, that would relate to the perpetuals then?

Craig Dynes

That refers to the maintenance. Part of the craziness of purchase accounting is that if somebody was to renew $1 million of maintenance agreement on April 19th, we would probably only be able to report something like $600,000 of that maintenance revenue as opposed to a very similar maintenance renewal on April 25th after the acquisition where we will get the full million. So, that’s why we add that back to give people the true run rate.

Steve Koenig – Longbow Research

Okay. But the thing that confuses me is in your reconciliation in your print, you also have a haircut on the license lines as well, in the ProServ line. So where do those come from?

Craig Dynes

There is a small amount of license revenue, a small amount of ProServ revenue that fits and deferred and we do take a small haircut on that, but for the most part, most of it is in maintenance.

Steve Koenig – Longbow Research

Okay. Great. And then move on to maybe last housecleaning questions here. So, when I look at what kind of – how you need to generate the EPS in the second half that you are targeting, assuming no big FX gain or losses and assuming no big change to the other income line, I come up with you need an operating margin around a 20% level. Am I thinking about that the wrong way or is there something very wrong with my calculation, or if not, what is going to get us to that kind of operating margin?

Craig Dynes

As we said, the bookings for this year are going to be very much backend loaded as our customers buy out of annual budgets and those bookings especially at the license piece are virtually 100% margin and fall right to the bottom line. So, we will be adding additional staff, but we will be additional staff at a reduced rate in Q3 and Q4, and there are some Chordiant staff that are onboard and they are in the OpEx line, their transitional roles will end and their costs will follow during Q3 and Q4.

Steve Koenig – Longbow Research

Okay. And Craig, did you say earlier those are more G&A-weighted than in the other OpEx lines?

Craig Dynes

It’s about 20 of them in the G&A line. You could imagine that once the acquisition closes, they have to help us take off their stub year, and then they have to help us pick up ending balances into our accounting systems and do a lot of work. So, yes, there are a lot of G&A people that are going to fall off by the end of Q3.

Steve Koenig – Longbow Research

Okay. And then just two last questions, on the 89 addition to the sales organization, can you guys talk about what kinds of roles were those hired into? I assume heavily weighted towards quota carriers.

Alan Trefler

Yes, absolutely. We hired quota-carrying sales reps, they also need what we call sales engineers or sales consultants that needs to be able to work with them, and so you are kind of buying these guys almost in pairs, as it were.

Steve Koenig – Longbow Research

Okay. Got you, great. And then last question, Alan, as you are going out and talking to the Chordiant customers, especially you mentioned over the last month or two, and you talk to them about the roadmap, the kind of a two-part question there is can you give us a flavor for some of the highlights on the integrated product roadmap that you are talking about with them? And secondly, how are they responding to that?

Alan Trefler

I think the response is really overall quite favorable. We have come up with ways that we can preserve the clients’ investments I think quite well. That was one of the things that they were worried about. I think we are also going to increase the investment in, for example, well just pragmatic things that the customer ends up getting in both the decisioning and in some parts of the foundation products, which are the predominant products that customers were. We are worried about, and frankly, the customers had seen – Chordiant’s revenue had declined pretty precipitously over the last two years as they went through the top 2008 and 2009 period. They went down from sort of mid-120s to in the 70 something sort of range. And so, I think most clients anticipate that Chordiant was going to be acquired as did a lot the staff frankly, too. Having Pega acquire them was viewed as like wonderful compared to alternatives like Oracle or other sorts of firms. And I think we have lived up to that expectation with both the customers and the staff as we work hard to really bring them together. So, I would say that overall it’s been quite positive.

Steve Koenig – Longbow Research

Terrific. Thanks so much for your answers.

Alan Trefler

Operator, are there more people in queue or are we just –?

Operator

One moment. Our next question comes from Brian Murphy. Brian Murphy with Sidoti & Company.

Brian Murphy – Sidoti & Company

Hi, thanks for taking my question. I just have another question on the guidance. I am just trying to par some of your comments with the guidance. I am hearing sort of lack of whales in the pipeline, lower ASPs, deals in the pipeline are in the earlier stages and license bookings in the first half of the year were down year-over-year, but yet to get to that sort of 20% operating margin range that the guidance implies for the back half of the year, that would seem to imply a pretty significant acceleration in license revenue growth. So, the question is what gives you the confidence or sort of increased visibility given the lower level of deferred license revenue backlog that you can sort of hit that guidance?

Alan Trefler

Well, one thing just to be clear. There is not a lack of whales at all in the pipeline, in fact we have some lovely whales swimming along in the pipeline right now. The reality is that some of the deals in the first half just weren’t the whales that sometimes occur. I don’t think we are unduly counting on the whales to make our guidance number, however to be blunt, we like the whales when they happen, but sometimes you end up paying for the whale and what you are able to do long term with the client. So, we try to take a pretty balanced approach. We look long and hard at the numbers and the reality is we have a lot of work to do in the second half, but we have onboarded a very significant number of really terrific sales people. Some of them have actually closed business in six months, which is not what we expect and was actually unusual in the level of quality of staff and the effectiveness of the onboarding makes me feel really good that these hires were the right thing to do. So, some of that I know is perhaps more subjective. Objectively, the pipeline is well up. But it’s not really at all surprising that it would be somewhat earlier stage given that the sales reps who generated it are all earlier stage as well. So, I am not seeing anything in that, that causes me concern, but yes, we do have a lot of work to do.

Brian Murphy – Sidoti & Company

Okay. And Alan, you know, you mentioned that you are getting more deals from new clients. Can you just remind us sort of historically what percentage of license bookings come from new clients, maybe where it is today, and where you expect that to be in any year from now?

Alan Trefler

Historically, for the last couple of years, we have seen about 70% of the revenue be follow-on revenue from existing customers. So, quite a bit, and that’s why we think it’s a good thing when we hit more new clients, particularly when these are clients who have a capacity to buy a lot more.

Brian Murphy – Sidoti & Company

Okay. And where is that today, or where has it been in the first half?

Alan Trefler

I think it was similar. We got a lot more new clients, but as I said, they weren’t whales. We got about twice as many deals in the first half of 2010 as in the first half of 2009. It wasn’t a minor increase, it was actually just an enormous amount of activity.

Brian Murphy – Sidoti & Company

And what kind of sort of uptick are you seeing from your emerging verticals and life sciences manufacturing and telco I guess?

Alan Trefler

I think that in the life sciences area, we are very, very excited. That’s a market that also continues to consolidate. Oracle just gives up phase forward, and a lot of clients hate that. They don’t think they are looking for new and more agile ways to do things and don’t necessarily trust that Oracle is always doing what’s in their interest. The telco vertical is going to be spectacular for us. We can see that Chordiant actually brought a lot of telco customers and expertise. We signed some of our first significant business in the retail vertical in the past quarter, and one thing, even though it’s not a new vertical, one thing I would say is that I had complained as you may recall in the past that we just hadn’t gotten government rights. We have actually really increased the team associated with the government, and I am pleased to say that they are scoring and that their pipeline is looking excellent as well. So, I think I am prepared to actually declare that problems having been fixed and then we have to go and move forward cashing on it, but there is a lot of opportunity there, too.

Brian Murphy – Sidoti & Company

Great. And maybe one more quick housekeeping question, just your geographic breakdown. The other bucket, there was a big jump in revenue in that other bucket, could you just remind us what’s in there and what accounts for that’s like in the June quarter?

Alan Trefler

You know, I was actually a little surprised about that as well when I went down to Craig, and I actually hadn’t thought it had been that much in other, but it turns out that when we say US, we literally mean US instead of North America, which I think is actually, I actually think of North America as being sold together.

Craig Dynes

But the SEC doesn’t.

Alan Trefler

The SEC doesn’t. So, a big chunk of that was we had a very, very good quarter in Canada.

Brian Murphy – Sidoti & Company

I see. Thanks very much.

Operator

Our next question comes from Derrick Wood with Wedbush Securities.

Derrick Wood – Wedbush Securities

Good morning, thank you. So, how much did Chordiant contribute to the backlog, could you give us a stat and the Chordiant telco win, was that recognized in the quarter, or is that going to be recognized over future quarters?

Alan Trefler

Yes, I think some of the telco win was recognized in the quarter. It wasn’t a whale or anything. So, it’s just more of a new entrée. And I don’t know that we actually give backlog contributions for Chordiant versus Pega, but the Chordiant as you would expect was not enormous when we acquired the company, and it’s not actually the major part of what contributed to our end of Q2 pipeline, because frankly, we are still, we have just rolled out the training for Chordiant to the broader sales force as we have gone into Q3. So, the broadening of the people who can sell Chordiant technology is really just, and it just happened. So, it was not meaningfully contributing to that pipeline increase that I talked about.

Derrick Wood – Wedbush Securities

So, would you say that Chordiant, maybe with the training going on with Chordiant, maybe the pipeline has come down a little bit since that was acquired?

Alan Trefler

No, I think it was about flat. It might be a little bit higher, because we just have more people there, but as I said, the training didn’t really happen until Q3, if you can think about it, we really did an awful lot of the training in July.

Derrick Wood – Wedbush Securities

Thank you very much.

Alan Trefler

On the pipeline number, the pipeline increase I cited was as of the end of Q2.

Derrick Wood – Wedbush Securities

Okay. What are you doing with the foundation talks, just maybe proactively sold to new customers or are you (inaudible) focus on maintaining the installed base there?

Alan Trefler

In certain markets, we are continuing to sell foundation to new clients, though most clients are selecting and have opted for the Pega version of customer relationship management which is quite a bit different, but we have actually been pretty pleased with what we think is going to be about the stickiness and the ongoing interest in foundation and part of our roadmap was to make two meaningful improvements to the foundation product that I think were very well received by the clients.

Derrick Wood – Wedbush Securities

Okay. Craig, I think the Q2 is –

Craig Dynes

Derrick, you broke off, could you repeat that?

Derrick Wood – Wedbush Securities

Yes, can you hear me now?

Craig Dynes

Yes.

Derrick Wood – Wedbush Securities

Craig, so I was saying, I think you said Q2 was the toughest quarter of the year and I was hoping if you could give a little bit more color on, and I would imagine and revenue recognition as well as bookings, but why is Q2 a tough quarter for you? Lot of other software companies have did the rebounds from Q1, why do you see Q2 as being a really tough quarter?

Craig Dynes

We see for a variety of reasons. First of all, when we look at new license signs or bookings, there is a substantial difference between bookings in Q1 and Q2, and Q3 and Q4. That’s no mystery in this business. Most of the bookings come in, as I said, it’s very unusual for us to have even as much as 30% of the bookings in by the end of Q2. So, Q1, we get a lot of fall over from deals that we closed in Q4. A lot of times we don’t have complete arrangement, we have revenue recognition issues, and those comp fall into Q1. So, by the time you hit Q2, you have got slower bookings in Q1, slower bookings in Q2. So, it’s always been a little bit of a struggle, and as I say, historically, Q2 license revenues have always been lesser than Q1 for, I think I look to the day as back as 2004.

Derrick Wood – Wedbush Securities

Okay. Well, is there any color you can give, since you guys don’t give annual guidance, it’s been real tough for some of us to model quarterly, how it’s been tracking so far in Q3?

Alan Trefler

I think once again, I think you could pick up that our tone is actually pretty positive, we have affirmed the $360 million number, and we have work to do, but we are feeling good about what’s going on in the business in terms of the Chordiant acquisition as well, which I think is going to be very exciting. The thing I will tell you is that given when we hire the sales folks, we expect that the preponderance of them will be at the nine-month plus level in the fourth quarter. We started hard in the beginning of the year, pushing, hiring, we are pleased with the way that hiring has gone. I will also say one more thing, we don’t actually manage the sales force particularly to quarters either. The sales people have annual quotas and one of the things I really like is that given this target account model, they are really interested in making sure that they do the right deal for the client, the right deal this year and the right deal next year, so that – I actually sort of an interesting thing to see a sales guy step back and say, you know, maybe we are better off selling something a little smaller now, because I will get something in Q4, I will get something next year, we actually have that behavior which I think shows a real maturity on their part, and past year has paid off. So, those are the things that I would say should give positive color to the fact that we think we can get the job done on the second half.

Craig Dynes

I think just to add one point to it, and that is that I said that in Q2, we were up in Asia, we were up in Europe, we were up in every vertical with the exception of healthcare and I think a lot of healthcare was caused by uncertainty due to the federal government changing some of the rules, but I think that’s temporary. We have a great healthcare team, and I look at their pipeline, and I look at where in the pipeline their deals are, and I think they are going to have a very strong Q3, Q4, and as I see, that’s the only area where we were down.

Operator

Those in line have actually left the queue, and there are no further questions at this time.

Craig Dynes

All right. Well, thank you very much, and we will look forward to next quarter’s call and in between meeting with investors on individual business.

Alan Trefler

Thank you.

Operator

Ladies and gentlemen, that concludes today’s presentation.

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