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Pegasystems Inc. (NASDAQ:PEGA)

Q3 2010 Earnings Call

November 10, 2010 9:00 AM EST

Executives

Craig Dynes – CFO

Alan Trefler – Chairman and CEO

Analysts

Richard Davis – Canaccord Genuity

Laura Lederman – William Blair

Nathan Schneiderman – Roth Capital

Brian Murphy – Sidoti & Company

Raghavan Sarathy – Dougherty & Company

Steve Koenig – Longbow Research

Martin [ph] – HIIG [ph]

Edward Hemmelgarn – Shaker Investments

Brees Sparker [ph] – 451 Group

Operator

Good day, ladies and gentlemen, and welcome to Pegasystems Inc. third quarter 2010 earnings call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session with instructions following at that time. (Operator Instructions).

And as a reminder, this call is being recorded.

And now your host for today’s conference, Craig Dynes, Chief Financial Officer. Please begin, sir.

Craig Dynes

Thank you. Good morning and welcome to Pegasystems 2010 Q3 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 is made.

Because such statements deal with future events, they are subject to various risks and uncertainties. The 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 are contained in the company’s press release announcing its Q3 2010 earnings and in the company’s filings with the SEC, including its reports 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 another history-making quarter for Pegasystems. For the first time, the company exceeded $90 million in GAAP revenue in a single quarter. I say GAAP revenue, because due to the complications of purchase accounting, we provided non-GAAP financial information in our press release.

Like other software companies, we’ve excluded acquisition charges, amortization of intangible assets created as a result of purchase accounting as well as equity compensation charges. This allows easier comparison to other software companies as well as to analyst models to use these non-GAAP business measures.

GAAP or non-GAAP, Q3 was our 13th consecutive quarter of record revenue. Non-GAAP revenue of $95.4 million was up $30.6 million or 47% from Q3 2009. Our business is typically much stronger in the second half of the year. And as expected, 2010 is proving to be a very backend loaded year.

As an example, license revenue on a non-GAAP basis was $36.5 million, up $7.2 million or 25% from just last quarter. Q3 license revenue was driven by a significant increase in new license signings and an increase in average deal size compared to the first half of the year.

In addition to higher bookings, there was a slight swing to perpetual license bookings in Q3. For the first half of the year, new license signs or bookings were mostly evenly split between term and perpetual licenses. While in Q3, perpetual licenses accounted for mostly two-thirds of new license signings. The mix between perpetual and term licenses is driven by customer circumstances and can cause quarterly license revenue to be lumpy and somewhat unpredictable. Both term and perpetual new license signings were much higher in Q3 than they were in Q2.

Similar to last quarter, on a year-to-date basis, new license signings are higher this year as compared to last year in every vertical other than US healthcare. Our healthcare vertical was slower in the first half of the year due to the temporary uncertainty related to the Federal Healthcare Reform Act. However, there is now very strong activity in this vertical. The value of healthcare license signings was up significantly in Q3 and there is a very good pipeline for Q4.

While we concentrate our sales efforts on target or named accounts, we are also growing our customer base. Through the first three quarters, we have closed more than five times the number of license arrangements with new customers as compared to the first three quarters of last year. With the additional sales people we have brought onboard, we’re covering more accounts, more geographies and more partners.

Partners continue to be an important part of our revenue growth. Partners are associated with about 38% of all active opportunities in the pipeline. Partners are not just inducting in the market by sending consultants to take up training, just subsequent to the quarter, Accenture one of our platinum level partners acquired a smaller partner whose business was built entirely on Pegasystems. This demonstrates how serious an investment partners like Accenture are making in our business.

Our integration work with Chordiant is sufficiently complete that is impossible to talk about Chordiant versus Pegasystems deals. With one marketing organization, one management team, and a sales force that is integrated in the vast majority of our geographies, a pipeline deal flow on license signings are largely due to the combined team. So other than maintenance revenue, very little license revenue can be directly attributed to the Chordiant organization that we acquired back in April. Lastly, we had no 10% customers in the quarter.

Maintenance revenue was $26.1 million on a non-GAAP basis in Q3, more than double what it was in Q3 last year. $6.7 million of the $13.6 million increase is due to the amortization of the deferred maintenance agreements acquired from Chordiant, while the balance of the increase almost $7 million is due to the continued growth in our customer install base just about all of our customers subscribe to every new annual maintenance agreements.

Purchase accounting rules get a haircut to maintenance arrangements that are in deferred revenues at the time of acquisition, so we have provided supplementary information on non-GAAP revenues in order to follow maintenance revenue run rates.

Professional services revenues of $32.8 million on a non-GAAP basis are down by about $1 million from Q2. Q3 is historically a down revenue quarter for our professional services, due to lower utilization rates in the summer. This is a well established trend. Service revenue was down from Q2 to Q3 in 2009, as well as in 2008. Professional service revenues tend to trail in license signings and are therefore expected to increase in Q4, in spite of the fact that a growing portion of instrumentation work is being done by partners.

Demand from customers and partners for training is especially high. Training revenues are up 79% for the first nine months of the year in comparison to last year. Two or three quarters gross margins are about the same they were last year other than the much larger cost of license in our GAAP financial statements. This is due to the amortization of the software intangible asset created as part of purchase accounting. This charge is added back as part of the GAAP to non-GAAP reconciliation.

Page 24 of our 10-Q details the amortization of intangible assets. As I noted, professional service revenues tend to be lower in Q3 than in Q2. The revenue falloff on Q3, depresses gross margins in the quarter to the lowest point in the year before the revenue and gross margin improves in Q4. On a non-GAAP basis, total operating expenses for the quarter other than the acquisition restructuring charges was $50.2 million, an increase of only $2.2 million from Q2. This is the smallest quarterly increase this year.

We continue to increase headcount in the quarter rather than much lower rate than in Q1 or Q2. In addition to greater headcount costs, we have higher commissions associated with higher bookings. These increases were partially offset by cost reduction from the conclusion of many transitional roles associated with the Chordiant acquisition.

Sales and marketing expenses made up most of the quarterly increase and operating expenses. In Q3, sales and marketing headcount increased by 11, all of which were in the sales organization. The increased headcount commission expenses were partially offset by quarterly decrease in marketing expense. Q2 marketing expenses were higher than Q3 as they included the cost of PegaWORLD, our annual user conference.

As I said in last quarter’s call, we will continue to expand our sales organization, but at a reduced rate. Our plan was to do more hiring in the first half of the year and less during the second half of the year and we want our sales force focused on closing deals with less time for hiring, on-boarding, and training.

During Q3, we added 21 people to our R&D organization, the majority of which were located in India. We will continue to invest in R&D to lengthen our lead over possible competitors and make improvements in the products that will drive license revenue growth.

G&A expenses decreased from Q2, primarily as a result of reduced headcount. During Q3, all of the transitional roles from the Chordiant acquisition ended. Our FAS 123(NYSE:R) charge for stock-based compensation was about $1.6 million on a pretax basis in the quarter. Note 11 of the financial statements details how this charges allocated to cost of revenue and operating expenses. This charge is also shown as an adjustment on our GAAP to non-GAAP reconciliation that can be found in our earnings press release.

This quarter, foreign exchange rates reversed themselves and we recorded an FX gain of $1.5 million. On a year-to-date basis, we still have a loss of $4.1 million. At a normal tax rate, this loss represents about $0.07 per share to our EPS. Translational gains and losses do not reflect any fundamental change in our business condition and they are beyond our ability to control or forecast. We are however making legal, tax, and operational changes to move FX gains and losses from the P&L to comprehensive income, so as not to impact EPS.

Other income includes $572,000 of gains on warrants that we held in a private company that was acquired.

Our GAAP income tax provision looks a little strange. On a GAAP basis, we show a loss for the first three quarters, but we have a tax provision that increases the loss. This is yet another anomaly of new purchase accounting rules where certain items are now expensed for GAAP purposes, but are not deductible for tax purposes. Our non-GAAP provision of approximately 33% looks more normal and is a good rate to use for non-GAAP model.

During the quarter, we refined our calculation of the net operating losses of Chordiant that we can use in the future to offset taxable income. We’ve calculated that a $146 million of Chordiant losses can be used, but with annual usage limitations. This refinement resulted in us reporting $51.1 million of deferred tax assets in Q3.

On a non-GAAP basis, our net income of $9.8 million is a 46% improvement over Q3 2009. Basic EPS on a non-GAAP basis was $0.27 for Q3, representing half of our year-to-date basic non-GAAP EPS of $0.54. Another indicator of how backend loaded 2010.

Our accounts receivable balance increased by $10 million from $65.9 million at the end of Q2 to $75.9 million at the end of Q3. This increase is primarily due to greater new license signings in Q3. Our DSOs increased to about 60 days and some large payments landed in October. In fact, in the first four weeks of October, we collected approximately $40 million in cash, representing about 60% of the September AR balance.

During the quarter, we purchased 115,610 shares for $2.7 million at an average price of $23.28. At September 30th, with the balance remaining of approximately $9.8 million available for future repurchases, however subsequent to the quarter-end, at our November Board meeting, the Directors voted to increase the balance available to repurchase our common stock to $15 million and extended the buyback period to December 2011.

Deferred revenue of $48.8 million was down by about $5 million from $53.8 million at the end of Q2. The largest reduction was in deferred maintenance revenue, which normally decreases during the year as the balance is amortized in maintenance revenue.

Q3 proved to be another record quarter for the company. We ended the quarter with a very strong pipeline which we believe will allow us to continue to grow market share. As a result, we expect more revenue records in Q4 and continued growth in 2011.

With more detail on Q3 achievement, I would now like to turn the call over to Pegasys’ Chairman and CEO, Alan Trefler.

Alan Trefler

Thank you, Craig. Good morning, everyone. The third quarter 2010 was remarkable for a number of reasons. We achieved our highest quarterly revenue in history. We posted our 13th consecutive quarter revenue growth and we climbed to number 8 on Fortunes 2010 List of Fastest Growing Companies. But what we’re most proud of is the successes with clients and the wins we’ve achieved as we expanded presence and brought on new customers.

Since our last earnings release, Forrester has shown us as the leader in the BPM Wave report and Gartner has shown us the pretty clear leader in their BPMS magic quadrant. To actually see these beautiful pictures, come to our website and download the reports. Very exciting and I think reflects the strength and the investment that Pega has as we continue to push the envelope in this market.

Before I go to some highlights of our wins in go live, I want to talk a little bit about BPM leadership, how it’s attained and recap a bit of our strategy for this year. As we’ve grown our company from the $100 million total revenue in 2005 to $95 million in non-GAAP for just this quarter, we’ve seen a lot of the things change including the definition of what BPM is and how the competitive situation of landscape evolves.

Large stack vendors have in many cases latched on the BPM in some cases buying, and other smaller vendors have faded, frankly because I think that they have not had the right combination of innovation and customer success to really build a sustainable business, which has been our focus all along.

What I’ll tell you is that even if you see the large stack vendors continue to push in this space, they’re sort of stack up middleware orientation is very, very different in how they attack the problem, how they describe what they’re doing and well how they get results for customers. And we expect that we’re going to be able to be continue to be highly innovative and continue to differential ourselves even the minds of our clients.

We think that the key factors that have set us apart is this commitment to highly innovative technology, the ability to deliver it and our dedication to customer success. We have continued to push in both directions relentlessly. Pega clients are furthering their efforts to become more customer centric and are really using our technology as the way that they deliver best service to their customers, whether it’s in a contact center, a claims management operation, transaction processing, or even a collections.

The way that customers have [inaudible] manifest itself is actually pretty interesting. Our customers are able to accelerate the requirements gathering process by doing what we call DCO, Directly Capturing Objectives, right into our software, dramatically reducing time to market and the cost and errors often associated with the lengthy stage of the software development process called Requirements Gathering.

By using our technology right upfront, by being able to generate the documentation out of our technology, we’re able to really make up, so that clients can see what they’re going to get, and that’s been responsible for the numerous 90-day implementation cycles that our customers talk about when they come to our PegaWORLD Conference.

Then we leverage our rules based process management platform to be able to execute situationally, to be able to make sure that what the customers have captured, handled the unique needs, the product needs, the geographical needs, the multichannel needs of their clients. This situational execution has been a very, very important part. We often talk about what we call the Layer Cake that allows customers to define what they want to be different for their customers without having to make laborious changes like our implementations.

And then finally, ultimately, at the end of the day, we think that this is really about automating work, making what this system does both more personal and more efficient, getting rid of unnecessary steps, eliminating expensive resources and that’s enabled us to be successful both in difficult economies and when economies are growing in the last five years.

So by giving our clients a chance to distinguish themselves in their markets, by making ourselves really the hub of their customer centric, we have a message that we see resonating with clients and that we can continue to build on, both in terms of our core product and by adding on top of it with some of the framework assets that makes the realization of these capabilities just way more accessible and easy to use for our customers.

We’ve been recapping the strategy for the year. In 2009, we like everybody else were very, very concerned about the economy, and despite the fact that, obviously for us it was a year of consecutive record quarters, we were pretty cautious in hiring particularly in sales and that coupled with massive over performance in 2009 which had a really, really terrific results has made for some pretty tough compares.

To make sure that we were setting ourselves up to do well in 2010 but also really have strong growth in 2011 and beyond, we decided and we spoke about openly on the conference calls going into 2010 to really build up particularly in the first half the sales force and some of the other related areas.

We wanted to deepen the penetration in our established accounts going deeper into the Fortune 100, Fortune 200. We wanted to add new sales and frameworks teams to target markets, things like telecom and life sciences and manufacturing with our warranty framework and horizontal frameworks like collection that could be applicable in a variety of industries.

We wanted to support new deployment models like the Cloud being able to make it so that we could actually offer Pega in conjunction with Amazon in the Elastic Compute Cloud environment in that sort of environment, because we’re actually very well suited to it, and our development environment actually runs out of a browser which is one of the things you really need to be Cloud competent.

We also wanted to go into new geographies. We wanted to broaden our reach across Europe, for example, moving into Italy and beginning to cover other countries more deeply, deepening our presence in Asia, and we have actually continue to increase in Singapore and Hong Kong and across Australia, and opening up Japan, where we’ve actually launched a set of efforts and have our Managing Director actually starting to do our first paid engagements there which for us is very exciting.

But I’ll tell you that I think we’ve executed well across all of these strategies and we think it’s a good harbinger for what we see going forward. We’ve been able to hire a tremendous amount of talent, we’ve been able to integrate it well, and we’re seeing as I’ll talk about the wins, the new frameworks and some of the new capabilities in some of the new sales people beginning to post returns.

So let me highlight some of the wins and customer successes in the third quarter. In Europe, we were able to extend the use of our case management capabilities, with a large UK Government division wanting to leverage BPM to manage cases within its own compliance department. This customer has now over 25,000 users across the organization in Pega technology. And I’ll tell you that closing this sort of business after the austerity program was put in recently is exactly a good example of our customers, our existing customers see tremendous value, and one which will extend their footprint even when times are difficult then tough.

One of the world’s largest banks based here in the US signed another major deal to upgrade their treasury investigations and customer service, upgrading from some of our older technologies they we’ve been using for years. One of the things we’re very, very proud of is how we’ve been able to bring our customers along across four complete generations of our technologies since we started the business.

We also won another major deal in a large US bank that’s going to use our decision management technology to drive better customer service and outcomes across multiple channels across the retail bank. Customer service reps, ATMs, branches, the bank’s website and mobile devices, and even email will all benefit from this in reduction of advanced decisioning.

In Australia, a leading bank selected us to help in financial crime management, leveraging our case management framework that we offer to support anti-money laundering activities.

In government, we achieved our first ever state government win in the area of grants management, helping to fulfill and manage the lifecycle of grants including the application process, contracting, payments, et cetera. We’re actually very excited that as austerity becomes important in a lot of the state and local governments that this area will prove to be good, because the fact that our technology is good at saving money.

In healthcare, we won a major new name account, is one of the largest healthcare payer organizations plans to use our technology across a broad set of departments, including the contact center claims processing and provide a contracting, which is another example of giving business users the ability to take more control of their processes and manage rules that drives their business.

In telecom, we won a new name account in Europe for the customer that will be using our decisioning solutions to present offers in the sales channel, taking an account of real-time context of a conversation. We’re also going to go support other customer facing channels of personal service tailored to each situation.

We also had another telecom customer, sold our first framework in the area of collection. This is a newly developed framework that leverages both the decisioning technology that we’ve got from Chordiant and also the BPM PRPC technology. And this combination really can bring both accuracy responsiveness and control to complicated processes such as this.

And I say this across the board, across the industries into the Cloud where we now have more than a dozen of our clients using our technology, we really saw excellent, excellent results across the first nine months of the year.

Go live are to my mind though the ultimate test of customers not just buying but being able to get results. And the success is there with numerous – we’re expect that when we have our PegaWORLD in the second quarter of next, then we’re going to have a record number of customers clamoring to come and speak.

A large global insurance company completed their first notice of law system using our customer process management technology and our insurance framework. That’s going to unable them to more rapidly handle clients as well as enable straight do processing in some cases and do a better job of tracking fraud.

The retirement division of a global bank began building out a servicing backbone that will eventually provide the division with a one-stop service management shop for all matters related to servicing for 401(k) customers.

Another go live happened with IBM Global Services, who work with us to build a new Claims Adjudication System for a large US federal government regulatory group. And also the Federal Reserve themselves went live with the new Case Management Exception Processing system, given the volume of cases managed by this customer, PRPC was uniquely suited to meet both the robust management requirements and ensure proper agility, accuracy, efficiency and scale.

So we’re happy across the board with the way this is going. I’ll also tell you that the Chordiant acquisition that closed in April of this year, has continued to progress extremely well. We are very pleased with the talent. The engagement with the Chordiant customers has been excellent. We’ve found numerous situations where the synergies between the traditional Chordiant products and the Pega technology makes a lot of sense for those clients and has really helped deepened us in a number of key industries such as telecommunications. And we continue to believe that this is going to be unified into Pega that well is a best of both worlds for our customers and for our investors.

Growth partners which we also just talked about early in the year is being extremely strategic. We’re very, very satisfied. We were able in Q3 2010 to surpass our partner pipeline and enablement targets for the years. We now have over 3,500 partners staff in the partner ecosystem over a 1,000 has been certified just so far this year. In addition to SIBOS, a major international financial service trade show with well over 7,000 or 8,000 bankers, it was held this year in Amsterdam.

We had both Accenture and Capgemini announcing products built on Pega technology. Accenture announced a corporate banking portal and Capgemini announced a Know Your Customer, KYC framework for the financial services industry. This compliments some of the successes we had in Q2. We’re a major provider of insurance services to the German speaking market actually has built and we’ve already sold a framework that really leverages their historical expertise with our process management and rules.

So we continue to believe that this partner ecosystem is going to be a very, very important way for us to get leverage as we grow the business going into next year. And the fact that companies such as Accenture are willing to invest in building and buying Pega expertise. I think also is an exciting affirmation of the potential to partners, the larger partners see in doing work with Pegasystems.

So in conclusions, our Q3 was outstanding. We are continuing to push very, very hard in both the dimensions of product sales, customer success and making sure that we’re living up and working diligently to achieve the potential that we think is possible in this market. We continue to take a customer centered approach as our customers do and the world’s leading organizations are continuing to trust us, now though in new industries and new geographies, I think creating a path for good future success.

With that let me open it up for any questions that there might be.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question is from Richard Davis of Canaccord Genuity. Your line is open.

Richard Davis – Canaccord Genuity

Thanks very much. So it sounds like Chordiant under your help and guidance has started to maybe not sprint but at least gallop or trot forward. Is that a fair assessment? And then the second more derivative question would be look, I mean they had a long standing customer base, but it seemed to me that you guys can up-sell and cross-sell additional either features or functionality and/or expand within their customer base that they have, because that’s why I’m just trying to – and I know what’s now part of the whole team but I’m just trying to kind of notionally think about the growth opportunities that you get out of that acquisition?

Alan Trefler

Yes, I think you are correct in both dimensions. In particularly decisioning products and decisioning expertise, has already complimented what Pega additionally offered, as I mentioned we’ve actually closed business in a whole new area of collections that brings together both process and decisioning in a really good way.

I also will tell you having met now with several dozen of major Chordiant clients. There is a lot of energy and excitement about being able to use the Pega BPM technology to really help in everything from the call center to improving the way that marketing works, which is another area that Chordiant have a lot of expertise.

So we had thought that they would be really, really good client related synergies that there’ll be a change to up-sell and we vitalized some of those relationships. And we’re seeing that that’s definitely going to be true.

Richard Davis – Canaccord Genuity

Got it and then, I understand on a quarterly basis, services margins move around. But on a full-year basis, how do you think about that business, should that be a – is that 10% margin business, is it a 30%, is it somewhere between, how do you – everyone has their own opinion on how you should run those things. And so I was just curios what’s your thoughts are in terms of how you think about that side of the equation?

Craig Dynes

It’s definitely not a 30% business. We look at – the primarily function of professional services is to make customer implementations successful, because successful customer implementations lead to radiation in the account. Historically 75% of our revenue comes from the existing accounts.

So we are willing to have a lower professional services margin in order to make customers successful, to enable customers and often times on engagements, we’re working with partners. And we take the time to enable the partners that they are better able to go often on their own and be successful as well.

So worrying about whether professional services is 15% or 12% doesn’t mean a lot if you drive more license revenue which is essentially 100% margin and that’s really how we’re thinking about the business.

Historically, it’s always been down in Q3, as I say in the summer, utilization rates go way down especially in Europe. So in 2008, 2009 and this year, revenue went down from Q2 to Q3, but you still got the same number of guys, a lot of them are on vacation in Europe. So that does hurt margins in Q3 and it’s always been the case.

Richard Davis – Canaccord Genuity

Got it, that’s helpful. Thanks very much.

Operator

Thank you. Our next question is from Laura Lederman of William Blair. Your line is open.

Laura Lederman – William Blair

Yes, good morning. Thank you for taking my questions. A few, one, can you talk about this year there have been no whales, which is interesting. Some thoughts as to, are there now ones in the pipeline for Q4 and also for next year and also separately competitive update obviously with Savvion being bought and Lombardi being bought and Oracle making noises in the market. Well, can you talk a little bit about any changes you’re seeing in the competitive environment, and then I have one final one. Thank you.

Alan Trefler

Sure. So there are actually a whole bunch of whales in the pipeline. I’ve got a mixed feeling about whales. I think as a business we don’t want to depend on them though, certainly we got some in 2009 and we’d love them dearly. I am actually quite happy to do smaller sales that preserve the value equation between us and the client, and make it so that we have the potential for more of a long-term. And clients are making sure that they get value from what they are buying.

But the nature of this business and the nature of our size is a couple of whales can change the quarter which is frankly, why we don’t obsess that much about the quarter-to-quarter results, because it can be impacted either by a whale coming in or by decision with the client to do a term license as opposed to a perpetual license, and obviously we think the term model is just fine as well.

So I think you need of think of this in terms of a sort of a more global contacts there.

Laura Lederman – William Blair

And the second update was competition, and what changes you’ve seen since the acquisition of Lombardi and Savvion?

Alan Trefler

Yes, its actually pretty interesting, I don’t believe any of – or simply not very many of our large customers really believe that they’re going to get leading edge innovation and thought leadership out of what I sometimes refer to as the bone collectors, the companies that sort of scoop up damaged companies. And they have a lot of history of not really getting very innovative stuff. So if you actually take a look at some of the campaign, some of the campaigns to clients, take a look at some of what Oracle does, really base very much around fear.

Be scared of buying things, if you buy them all for us. I actually believe that given that most customers think that the sector that we’re in is a sector that innovation still matters in, and is a sector that’s extremely important to their customers. It’s about how they actually serve their customers and how they differentiate in the market, that overtime we will see that the stack vendors though always being in the mix are going to be seen by the clients as not being able to provide adequate innovation. And we actually are and do see that. So I was actually thrilled and these companies got by.

So the reality is that you see the stack vendors always – we’re just now not also seeing the sort of scrappy innovative vendors. We would have seen the stack vendors anyway, basically now, I think we’ve really consolidated in the market in the way that would be long-term favorable for us.

Laura Lederman – William Blair

And one for you Craig, which is sales headcount either where we stand today and where we stood a year ago or to be a percentage increase so we could get a sense of standing year-to-date versus a year ago how much the sales headcount has increased which helps obviously understand revenue opportunity?

Craig Dynes

The details on sales and marketing headcount is compared year-over-year in the Q, most of the increase throughout this year has been in the sales organization, as I said 11 addition heads came on board in Q3 and all of them were in the sales organization. Something I pointed out last quarter on the call was that the actual account execs and this was a June, June-over-June, we were up 58%.

But a very small proportion had actually been on board for extended period of time where they could be expected to be fully productive. There is a long ramp time to bring somebody on board, get them sufficiently trained, assign them to their accounts and have them start building pipeline.

Laura Lederman – William Blair

Thank you. I’ll follow-up later in the queue.

Operator

Thank you. Our next question is from Nathan Schneiderman of Roth Capital. Your line is open.

Nathan Schneiderman – Roth Capital

Hi Alan and Craig. Thanks for taking my questions. I wanted to begin just on your guidance view for the year, last quarter your guidance was $360 million of revenue and $1.02 of pro forma diluted EPS. How comfortable – is that still your guidance, and how comfortable are you with that at this point?

Craig Dynes

Well it’s the company’s policy to issue annual guidance and not quarterly guidance and to not comment on it throughout the year. This year was a bit of an exception because the Chordiant acquisition. Last quarter we had to give updated guidance primarily to have the people understand that the GAAP guidance was really going to non-GAAP guidance.

So our business as Alan said can be extreme – or maybe I said this time, can be extremely lumpy as clients make the decision to go from term to perpetual or perpetual to term, when they engage with us. So we tend not to give quarterly guidance, and we tend to take a much longer view of that.

Nathan Schneiderman – Roth Capital

I guess, I didn’t understand your answer to my question. Are you still comfortable with the $360 million and $1.02 or not necessarily?

Craig Dynes

Well as I said we tend not to comment on guidance throughout the year.

Nathan Schneiderman – Roth Capital

Okay, all right. Let me ask the question this way, is there anything one time in the expense structure for Q3 that will not recur in Q4 either in cost of revenues or in the operating expense, or would you expect all of those to have seasonal sequential increases?

Craig Dynes

No, the anomalies that we’re in the cost structure due to the Chordiant acquisition in terms of people in transitional roles, that has pretty much ended. So there shouldn’t be anything special in Q4, although Q4 is traditionally our highest bookings quarter in the year, and that therefore drives the highest commission expense in the quarter.

Nathan Schneiderman – Roth Capital

Okay. The 10-Q referenced a big deal in the year ago period. Could you share with us the dollar value of that deal, and what was the dollar value of the biggest deal this Q3 2010?

Alan Trefler

Last year we had – trying to remember the exact timing of it, but we had, some businesses was materially over $10 million in size and the deals this year have been more modest.

Craig Dynes

There is nothing over $10 million so far this year.

Operator

Thank you. Our next question is from Brian Murphy of Sidoti & Company. Your line is open.

Brian Murphy – Sidoti & Company

Hi, thanks for taking my question. Alan, you mentioned that the headcount in your partner ecosystem was in the vicinity of 3,500. Just curious where was that number last year?

Alan Trefler

So it’s interesting depending on how you’ve counted. So we’ve upped our expectations of our partners training etcetera. I would say that the overall partner ecosystem so far this year has grown very materially in our premier partners. It’s probably up good 30% I would say over the last year and is increasing its speed.

Brian Murphy – Sidoti & Company

And you mentioned –

Craig Dynes

There is a lot of good indicators. If you went to PegaWORLD, you saw the level of participation by partners. If you look at our training revenue, lot of out-script and partners coming to training and as we said Accenture just bought a smaller partner who was a 100% focused on Pega.

Brian Murphy – Sidoti & Company

And Alan, you mentioned that you had a go live with IBM Global Services. I’m curious to know if your relationship with the services group is changing at all or whether you were expected to change as the product group makes more of a push into BPM?

Alan Trefler

I think our relationship with IBM has always been a little skitsofrantic [ph] and I was expecting that to continue. We actually are big users of the IBM stack that we actually own a mainframe of those things, and have been for a long time.

The software group there, again I think, sometimes do think that org [ph] actually in IBM’s long-term interest because when we actually sell a system, we often move a lot of IBM gear. The Global Services organization and individual sales people at IBM, we I think have overall a very good relationship with. But its episodic, it’s kind of sometimes its good and it’s sometimes its not.

The reality is though that some of the IBM initiatives fit beautifully both in the area of process automation and in the area of decision management. And we are continuing to invest in that relationship and spend time and we’ve gotten pay back and I think we’ll get pay back going forward as well.

Brian Murphy – Sidoti & Company

Thanks, I’ll get back in the queue.

Operator

Thank you. Our next question is from Raghavan Sarathy of Dougherty & Company. Your line is open.

Raghavan Sarathy – Dougherty & Company

Good morning, thanks for taking my questions. First on the new sales guys that you hired, you’ve been ramping up your account execs starting late last year. I was wondering if you could share with us the progress these guys are making in terms of closing deals, I know it takes them six to nine months. Can you give us any color on how do you feel about the progress and the productivity from these guys if you look out to next year?

Craig Dynes

One measure Ragh, is the pipeline and the pipeline at the end of Q3 is – I’m looking at the pipeline at the end of every quarter going back in 2009, it is by far the highest that it’s been.

Alan Trefler

We just want them to cater that they’re generating pipeline. We’ve also had a couple of actually folks from business in some cases and some pretty significant business. So I am encouraged by the talent that we’ve brought on. And we’ve invested a lot of just energy and time training them and cross training, some of the Chordiant people that came on as well, our staff from some of that technology. But we’re feeling good about the sales force and working at.

Raghavan Sarathy – Dougherty & Company

Okay, and then in terms of license signing, so it’s actually two questions. Craig, can you give us some color on the year-on-year growth on license signing? And also I noticed in your Q, when you discussed subscription revenue, it declined year-on-year due to change in customers selection of renewal option. And I was wondering, did the customer select perpetual or term, when it came for a renewal? Can you help us understand those?

Alan Trefler

Well I could actually, I think I can answer some of those as well. I think that this year suffered a bit from being a tough compare and the fact that if you go back and look at 2009, we really did increased the sales force very material in 2009. So that's something we took aggressive steps to remedy as we entered towards the very end of last year and as we entered into this year. That coupled with some of 2,000 whales leads to a tough compare but we’re still very optimistic about what we’re going to be able to get done when we announced the year as a whole even compared to 2009.

Relative to customer renewals, we have lots of deals that go all sorts of ways. We have customers that sometimes will flip and have a new piece of business be a term deal instead of a perpetual, and we do have customers who come to the conclusion of a term arrangement and want to change it. And depending on the circumstances we’ll do what makes sense in general. So you’ll see those sorts of things happen, fairly routinely and I don’t actually think its very material on individual clients.

Raghavan Sarathy – Dougherty & Company

All right, just one final question. There was $2.6 million adjustment to GAAP license revenues, I know this is related to the purchase accounting. Was it all applied to the perpetual license or split across the three license lines?

Craig Dynes

I believe it was perpetual. Chordiant didn’t do a lot in the way of term licenses. So I believe it was perpetual license that was in deferred revenue at the time of the acquisition. So the GAAP rules are we took a big hair cut on it.

Raghavan Sarathy – Dougherty & Company

Okay, thank you. I’ll jump back in the queue.

Operator

Thank you. Our next question is from Steve Koenig of Longbow Research. Your line is open.

Steve Koenig – Longbow Research

Hi Craig, hi Alan. Thanks for taking my questions. I’d like to just follow-up on the question about the licenses. I understand they do move around a lot by quarter-by-quarter as customers may select different renewal options. When I look at the subscription line though that the fall-off sequentially of about $3 million is the majority of your subscription revenue. On an annualizing basis that’s $12 million a year, and if for example that represented a customer moving to a perpetual license which was booked in the quarter that would be a very significant piece of revenue. So I am wondering if you can comment on specifically why subscriptions were down so hard sequentially and how should we expect subscriptions to trend going forward?

Craig Dynes

Subscriptions are hard to predict because people get confused, they think subscription is Software-as-a-Service. Its not, its just an accounting methodology. And one of the aspects of that methodology is that you take subscription revenue up until the customer payment.

And if there is staggered customer payment, often times what happens is that in a quarter your subscription revenue dries up on an account until they have a big schedule payment next quarter and it jumps back up. So they do bounce round a little bit its not a case that somebody switched from a subscription to a perpetual, and actual fact the subscription revenue is a perpetual license. Its just a methodology in terms of revenue recognition, its not Software-as-a-Service.

Steve Koenig – Longbow Research

Okay, so in this case, it wasn’t a case about subscription customer, you haven't booked that revenue as a one-time due to some kind of switch.

Craig Dynes

No.

Steve Koenig – Longbow Research

And accounting as more of a cash payment issue?

Craig Dynes

Yes, because you take subscription – you may have a customer that pays you make up some numbers $5 million every other quarter or something towards perpetual and that also in one quarter you can't take more subscription that what they paid. So it could run into a little dry fill for a couple of months and then a payment is due and then you have a catch-up.

Steve Koenig – Longbow Research

Okay so in that case Craig, how should we think on a normalized basis about kind of the level of subscription revenue or the mix of subscription revenue for Pega on a more normalized basis?

Craig Dynes

It’s actually pretty minimal. We don’t enter into those agreements very often. They’re fairly unique, and its not – we prefer to keep people on a straight perpetual or straight term license. Its very rare that we get into the subscription accounting.

Steve Koenig – Longbow Research

Okay, and then lastly just probably another one of you Craig. We had modeled and help perhaps DSOs would be down little bit more following, after a quarter of Chordiant being in there. And I remember you mentioned you had some good collections in the start of Q4 here. How should we think about DSOs trending and then more generally, how should we think about operating cash flow – when should it turn positive? Should it be positive in Q4, should it be positive for the year? Any thoughts on how we can think about cash flow, it would be helpful too?

Craig Dynes

Sure. So first of all DSOs were up because we had quite a few very strong bookings at the very end of the quarter, so they go directly into accounts receivable. And a lot of times that would rise up the number.

It just seemed and I don’t know why, that we had a lot of payments just missed the quarter and fall into October, as I pointed out, in the first few weeks of October, we collected $40 million which is a vast majority of the receivable balance. So to take a snapshot of anyone time is a little big misleading.

With regard to cash flow, the cash flow from operations this quarter was hurt because we booked a lot of deals and they’re sitting in receivables. You can see that on statements of changes. During the first half of the year of course cash flow [inaudible].

Operator

Thank you. Our next question comes from Arnold Schultz [ph] of [inaudible]. Your line is open.

Martin – HIIG

Well this is Martin [ph] with HIIG [ph]. Prior to its acquisition Chordiant about $40 million of contractual backlog, how much of that is factored into the aggregate term license value that you reported, I know you said not much of their business is termed but how much of that is in your off balance sheet numbers? Thank you.

Craig Dynes

Most of their backlog was maintenance agreements that they held kind of practice defining multiyear maintenance agreements which is something that we don’t do and that caused to do to lot of their backlog. When you do purchase accounting of course, you take a hair cut on that and that’s what you’ll see in the GAAP to non-GAAP reconciliation.

Martin – HIIG

Okay.

Alan Trefler

But I don’t think any – I don’t think there were any Chordiant term deal. I used to see – if the question is specifically about term that wasn’t a model that they?

Craig Dynes

No, they didn’t do many term deals at all.

Martin – HIIG

Okay. So the acquired contractual backlog doesn’t roll into your reported metrics essentially in anyway?

Craig Dynes

No.

Martin – HIIG

Okay.

Craig Dynes

No, those are all our deals.

Martin – HIIG

Thank you.

Operator

Thank you. Our next question is from Edward Hemmelgarn of Shaker Investments. Your line is open.

Edward Hemmelgarn – Shaker Investments

Questions, you had the one Chordiant software deal that you had $2.6 million, that if you – under normal circumstances your revenue would have been higher by that amount. How much of that was in, was actually recognized and was in deferred revenues as license revenues because of the acquisition purchase price allocation?

Craig Dynes

I’m sorry Edward, could you repeat the question?

Edward Hemmelgarn – Shaker Investments

Well in other words I mean, is if you – you had a deal that was in deferred revenue, okay, in effect, I mean that’s when you bought Chordiant, I mean it was under ordinary circumstances it was – which is kind to be recognized this quarter but when you calculate – or when you accounted for it in the purchase price allocation, it took a hair cut of $2.6 million. Obviously some of it was still in license revenue or deferred license revenue, I mean to account for some of that I’m assuming and of the $17 million plus that you – of the purchase price allocation that you put into deferred revenue, how much of that was deferred license revenues as opposed to deferred maintenance or deferred service?

Craig Dynes

Most of it was deferred maintenance. There was a couple of license deals and you’re right, you’re picking up the $2.6 million on the GAAP to non-GAAP adjustment. So there was a perpetual license deal in there. There was little deferred service, I think it was probably only about couple of million dollars and as you can look on the GAAP to non-GAAP, you see there is a very little add back there.

Edward Hemmelgarn – Shaker Investments

But I think the majority of that was maintenance, right?

Craig Dynes

Yes, most of –

Edward Hemmelgarn – Shaker Investments

Well I understand – I’m just trying to get an idea, was it a million dollars in deferred license revenue or was it $500,000, or was it $2.5 million, I mean what are we talking about?

Craig Dynes

You could probably think but I don’t know the exact details of that deal because you had value each deal. But generally you take a hair cut of almost 50% on some of these things.

Edward Hemmelgarn – Shaker Investments

Okay, then can Alan, can you talk a little bit about new customers in terms of you’ve got, you’ve added dramatically the sales force obviously. What percentage of orders that you’re getting in now are coming from new customers relative to existing customers, not in terms of dollar route but just in terms of new customers. Can you talk a little bit more about that?

Alan Trefler

Yes, trying to see if I can find the actual numbers here but this really I would say that it’s gone up which is unsurprising and it’s definitely well over a third of the bookings I would say are related within – the relationships are related to new clients this year. It’s up quite significantly from last year.

Craig Dynes

Yes, the number of accounts is up almost five fold. Typically though with new accounts, and I say typically because there are exceptions. Lot of times with new accounts, the deals are smaller to start with people, we tend to try and sell them the smaller something that could be delivered quickly and successfully and that gets fee-to-value on that initial transaction which helps us establish ourselves with that account. But that’s – the number of new customers is a function of a – a lot of it is a function of new sales people covering new accounts and new geographies and new partners as well. Partners tend to bring us new customers.

Edward Hemmelgarn – Shaker Investments

Well, I guess I’m just trying to get at somewhat obviously with the new customers, but in terms of all these new sales people you’ve added, is it your – if there is always a lag and someone just getting the first order but as you’ve described it, they tend to be at least your experience says they tend to be smaller at first. So when you would really expect to see impact of the new sales force hires in 2011, 2012 as opposed to this year?

Alan Trefler

Well, we knew we were going to see it primarily in 2011. If the sales guys that we’re hiring in 2010 aren’t nicely productive in 2011, shame on us. I think that should be more than adequate time I would say. So I’m actually just looking at some things that, Craig has pulled up.

And in fact the new customer deals are very meaningful percentage here of what we’re signing up, and we think that’s exactly as it should be, we’ve actually been very excited by being able to put these new names on, and given that we don’t sell out customers, but we have long-term mutually beneficial relationships with them. Getting into a new customer and doing good job for them is money in the bank and good service for them.

Operator

Thank you. (Operator Instructions) Our next question is from Brees Sparker [ph] of 451 Group. Your line is open.

Brees Sparker – 451 Group

Hi guys, good morning. So in this record setting pipeline you have, can you tell us, is it trending to license or term or can you give us some feelings there?

Alan Trefler

I think – I don’t think the proportions are particularly changing. Sometimes those decisions are not made actually into quite late in the decision process. It’ll go back and forth with the client. But this really – so when we put it in, we don’t obsess when we label the opportunity about where this is going to end up being a term or end up being a perpetual because as I said they’ll often slip back and forth. Sometimes our clients find that there capital budget approvals are much harder to achieve, then just ongoing operating expense, so that’s kind of a tradeoff between license and term. But I haven't sensed any particular change over the last 12 months.

Brees Sparker – 451 Group

So there is no theme among all these new customers you’re signing, they don’t tend to be a one way or the other for whatever the trend or a new thought might be?

Alan Trefler

No, it’s very much the same sort of mix that we’ve seen with the traditional customer.

Craig Dynes

And it’s extremely unpredictable. Last year when the economy was bad everybody was predicting we would swing towards more terms and it just didn’t happen. So I’ve given up trying to predict.

Brees Sparker – 451 Group

Okay, and my other question is related around call centers. What percentage of your newer bookings in pipeline are around either replacing old call center systems or augmenting or decisioning or that type of deal?

Alan Trefler

Yes, so it’s actually that’s way up.

Brees Sparker – 451 Group

Okay.

Alan Trefler

And we’re doing both a lot more call center work and a lot more what I will call multi-channel work where the customer actually uses us not just in the call center, but to be able to handle service in, for example the web or in the voice response unit or in a branch facility as well. So things that I would describe is being part of front office customer service, is very, very significantly up.

I would say that at this point, a good 50% or more of our business is either a call center replacement in some cases but much more often a place where we’ve been woven into an existing call center system to make it better, and by the way many of those that need to replacements down the road. It was going to hollow out their existing environments.

So call centers are going to be very significant for us I think going into next year.

Brees Sparker – 451 Group

Okay, perfect. Thank you.

Operator

Thank you. Our next question is from Raghavan Sarathy of Dougherty & Company. Your line is open.

Raghavan Sarathy – Dougherty & Company

Already answered. Thank you.

Operator

Thank you. Our next question is from Brian Murphy of Sidoti & Company. Your line is open.

Brian Murphy – Sidoti & Company

Hi, just had one quick follow-up. Alan, you mentioned the tough comps, the tough lessons booking comps in 2009 and sort of they out-performance that you guys had in 2009. Just looking back now at that bookings environment in 2009, I mean was there anything unusual about that environment or do you think that you can get back to that level of sales force productivity?

Alan Trefler

So with a little bit of high insight, the thing that I think was unusual was despite the fact that our license revenue increased about 50% in 2008. We chocked back on hiring in the first half of 2009, which I think had a pretty direct impact on our 2010 performance. That coupled with the couple of whales is the thing that’s unusual, as I said when went into this year, we decided we’ve going to work to rectify that and that’s been the basis for the – I think you said the 58% number of growth in terms of sales and marketing headcount.

So the thing that was perhaps unusual, the rational was we read the papers and decided that we’d slow the hiring down in the first half. With the full benefit of high insight, I wish we hadn’t done that, it would have actually made this year easier. And we are going to be very thoughtful as we go in – we’re right now in the middle of our 2011 planning.

We’re going fairly thoughtful about thinking what we want 2011 rollouts to be, but I believe if we continue to see really strong pipeline, if we’re able to show that the new sales people are coming online and being successful, then I do think we want to continue to grow sales and marketing because there are lot of really, really great uncovered accounts that could really profit from our stuff.

Brian Murphy – Sidoti & Company

Got it. That makes sense. So it sounds like there was a period where there was sort of a depletion in their early stages of the pipeline and maybe that manifested in the first half of the year here. Do you think we’ve lapped that sort of hiccup in the pipeline and we should get back to sort of robust license bookings growth?

Alan Trefler

Yes, certainly the pipeline from a year ago has grown in a way that’s consistent with the sort of sales and marketing growth that we’ve seen. We’ve seen a very significant increase in the pipeline in the year-to-year basis. And if you would go back a year before, obviously we worked on sales people at the same rate in the first half of 2009. So we haven't seen that. It was much flatter. So the numbers don’t lie, I think you look at sales and marketing expense over a couple of years. Take a look at license revenue and actually I think the story is pretty clear.

Brian Murphy – Sidoti & Company

Thanks very much.

Operator

Thank you. I’m showing no further questions or comments at this time. I would like to turn the conference over to the Chief Financial Officer, Mr. Craig Dynes, for any closing remarks.

Craig Dynes

Thank you very much everyone for attending our call. We’ll look forward to talking to you again at the, our end of year call which will probably be scheduled for February. And I will be out on the road and we’ll be talking to some of you very shortly. Thank you very much.

Alan Trefler

Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program. You may now disconnect and have a wonderful day.

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