Good day, everyone, and welcome to Pegasystems' 2007 annual earnings conference. Today's conference is being recorded. At this time, I'd turn the call over to Mr. Craig Dynes, Chief Financial Officer. Please go ahead, sir.
Good morning and welcome to the Pegasystems 2007 annual conference call. With me here in Cambridge is Alan Trefler, Pegasystems’ Chairman and CEO.
Before I introduce 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, forecast, 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're subject to various risks and uncertainties, actual results for fiscal year 2008 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, without limitation, variation in demand and the difficulty in predicting the completion of product acceptance and consequently, the timing of our license revenue recognition; the level of term license renewals; our ability to develop new products and evolve existing ones; the impacts of our business on the recent credit market turmoil 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; management of the company's growth; 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 it's report on Form 10-Q for the quarter ended September 30, 2007. 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.
2007 was another record year for the company. Our revenue of $162 million represents our second year of solid growth, an increase of 29% over 2006 and an increase of 62% over 2005. In addition to increasing revenue, we improved net income by a factor of three to $6.6 million, generated $25.3 million of cash from operations and ended the year with $150 million in cash and investments.
License revenue increased by 44% to $51.1 million for the year. Perpetual license revenue was $37.9 million, an increase of 39% from last year. Term license revenue was $13.2 million, an increase of 61% from 2006. Not only is term license revenue up dramatically, but we continue to build an inventory of non-cancelable term licenses, which are not yet recorded in this financial statements.
We now hold $71.4 million of term license arrangements, which will be recognized as revenue in future periods. This is more than double of $33.9 million that we had on our hand at the end of Q3 and more than five times the $14.2 million that we had on hand at the end of 2006. This is a major contributor to revenue.
The details of how this inventory of term licenses will hit at our P&L, the revenue and future periods is provided on page 33 of the 10-K, which we expect to file on Monday. This analysis shows that we already have on hand term licenses to support $21.3 million of term license revenue in 2008. This is already an increase of 61% over our 2007 term license revenue, up $13.2 million even before we had any new 2008 bookings.
Despite the unstable economy, for us Q4 was a strong finish for the year. Q4 bookings were higher than Q3 and you can see the impact of the bookings in the financial statement. Q4 license revenue was almost 9% higher than Q3. Deferred revenue increased by almost $15 million in the quarter and accounts receivable increased by $12.5 million.
Service revenue was $110.8 million for the year, up 22% or $20.2 million from 2006. Of this, professional services and training were $79.7 million, up $14.3 million or 22% from last year. Maintenance revenue grew 23% in 2007 to $31.1 million from $25.2 million in 2006. Q3 gross profit was $96.7 million, up $24.4 million or 34% from 2006.
The largest component of the increase is comprised of a $15.7 million increase in license revenue. The balance of this increase in gross profits is due to our success in increasing services revenue by 22% and holding the professional services gross margin constant at 41% even while incurring the high cost of recruiting, hiring and training 42% more professional services employees in a single year. We anticipate that the strong demand for services will continue into 2008.
Total operating expenses for the year increased $15.4 million or 19% from 2006 to $94.8 million. The largest increase was in sales and marketing, which increased $7.8 million or 18% to $51.7 million. We will continue to grow sales and marketing, especially where it's necessary to provide more account coverage, where we are seeing increased sales radiation in named accounts or if it involves increased accounts by geographic coverage.
R&D expenses increased $3.5 or 15% from last year. During the year, we increased both headcounts and use of offshore contractors. We are in the process of establishing an R&D center in India. We've recently incorporated and we are about to sign a lease for office space. At the present time, the Indian R&D operation is considered in a start-up stage and as such costs are included in the G&A line.
In 2008 however, we expect to incur higher R&D expenses associated with this new center. We believe that continued investment in R&D is necessary to maintain and expand our leadership position in the BPM space.
G&A expenses increased by $4.1 million to $16.9 million in 2007. Increased accounting fees of $1.3 million in Q1 and Q2 that were associated with our restatement are the primary reasons for this increase. The start-up costs associated with India as well as an increase in headcounts contributed to the rest of the increase.
Our FAS 123R charge for stock-based compensation was a modest $1.2 million in the year. On page 26 of the K, we detailed how this charge is allocated to each department. During Q4, we completed an equity incentive grant to certain employees. That grant along with the option that will be granted to new employees in 2008 should increase this charge to approximately $4.5 million in 2008.
Our interest income was slightly down in the year. There are two components to our interest income. One is interest from our investment portfolio, while the other is interest from the installment receivables on our balance sheet where the company has historically recorded the revenue on a net present value basis. We no longer recognize revenue in this manner and as a result, both the installments and the interest on those receivables are decreasing rapidly every year.
Our overall effective tax rate for 2007 is 34% which is the below the statutory rate primarily due to the generation of federal, state research credits of approximately $700,000 and a domestic production activity deduction of $300, 000 offset by some small discrete items.
In 2007, we had utilized all of our NOLs and our federal tax credit carryforwards, which reduced current U.S. tax payables by approximately $10 million. For 2008, we are anticipating our overall tax rate to be approximately 32% due to the domestic production activities deduction.
Our net income for the year was $6.6 million, an increase of $4.8 million from 2006. Q4 net income was down from Q3 primarily due to the costs of our Q4 User Conference and larger sales commission associated with much higher bookings that gave rise to the $30 plus million increase in term licenses and the $15 million increase in deferred revenue. We are comfortable that during the year we struck the rate balance of profitability, investing in near 30% revenue growth and increasing our inventory of term licenses, which will become revenue and therefore income in future years. We are expecting increased profitability in 2008.
We generated $25 million in cash flow from operations and ended the year with $150 million in cash and investments. We are very conservative with our investment portfolio. At the end of the year, we did not hold any auction rate on mortgage-backed securities. Our risk related to the sub-prime crisis is therefore indirect and limited to our investments in corporate bonds of large financial institution that could possibly be hurt by this crises.
As of today, however, we are not aware of any downgrades on this portfolio.
We had an excellent quarter for collections and billing. As a result, our account receivable days billed outstanding at December 31 dropped to a remarkable 48 days compared to 66 days at September 30 and 70 days at December 31, 2006. Q4 business activity caused deferred revenue to increase almost $15 million to $33.2 million from $18.2 million at September 30th. Deferred revenue at December 31 in comparison was only $17.1 million.
On June 4th, we announced that our Board of Directors approved a third $10 million stock repurchase program beginning July 1, 2007 and ending June 30, 2008. During 2007, we repurchased 847,362 shares, which left a balance of only about $1.2 million available for repurchases in 2008. On February 14th, we announced that we've repurchased a total of 873,325 shares at an average price of $11.45, and so the third program was affectively complete.
As a result, we announced an additional $15 million repurchase program that would extend until December 31, 2008. This $15 million extension to the repurchase program will become effective next week. After such a great 2007 I am pleased with the opportunity to provide guidance on our 2008. But before I get into the detail (inaudible) frame it up with regard to the number one question I hear from investors, which is always about our exposure to the sub-prime crisis. First of all our business focus is targeted on four verticals financial services, healthcare payers, insurance and public sector.
During the year our growth rate in insurance, healthcare payers and public sector verticals has been greater than our growth in the financial services sector. Therefore our financial services vertical has been declining relative to the other three, given the current economy environment we expect our U.S. financial service vertical to be down in Q1 and Q2 from the levels we have experienced in Q4 and then to start increasing in the second half of the year.
Internationally we do expect growth in our financial services vertical in 2008. In fact during 2007, we added several new banks to this account list and we expect our strategy of filling incremental purpose based licenses to new accounts to drive this growth. In fact this year we have already closed new business with two international banks in Q1. We don’t think that we are overly optimistic with this forecast. Our financial customers tell us that we are perceived as an important part of cost reduction plans, fraud and compliance projects and business reengineering and that there is budget available for all these initiatives.
So our plans for slower growth in financial services led by cost reductions and fraud implementations in the U.S. and internationally, unless there is a major recession that impacts all business segments. We expect to grow through the current sub-prime crisis and are therefore forecasting revenue for 2008 to surpass $200 million.
As I said last year we saw both term and perpetual licenses (inaudible) cause our revenue forecast to vary. That variance as well as the general state of the uncertainty in economy could result in a potential range of plus or minus 10% on this revenue guidance. We have a market leadership position and according to the latest Gartner report has strengthened since last year. Our recently announced 5.4 release of PRPC will build on this lead and drive new license lines. It is for this reason that we'll continue to investment in R&D in 2008 by increasing the number of software engineers in both Cambridge and India.
As I said we also plan to invest in sales resources where we see continued growth and market demand in order to maintain our growth. As a result of these investments, along with a much larger, FAS 123R charge have approximately $4.5 million in 2008 we expect net income to be in the range of $9 million to $12 million depending on our revenue achievement. Lastly we ended 2007 with $150 million in cash and short-term investments and we expect cash flow from operations to approximate $25 million in 2008. So in summary we had a great 2007 and we expect an even better 2008. I would now like to turn the call over to the PEGA’s Chairman and CEO Alan Trefler.
Thanks very much Craig. Obviously there was, broad achievements across the board as you listened to Craig’s commentary about the financial results. We're obviously very pleased with the way that the year turned out on that front. In terms of other areas I can tell you the company has been performing well also. From our point of view of product, hiring new staff to meet our growth needs, expanding our footprint with partners and most importantly a relentless focus client extent and all in those dimensions.
I think the company has made meaningful advances in 2007. Starting for a moment with product you know PEGA has and in 2007 we were able to announce -- received many accolades from industry analysts and other sources that evaluate our product. In fact we are really quite pleased that when you take a look at the Forrester and the Gartner definitions of who were the leaders in this exciting Business Process Management space that PEGA has now got into the point where we really, I believe clearly stand out as being clear leader from a technology perspective.
However our product is great, product running in customers is what it is all about. And it is really exciting last year we expanded our footprint in 61 organizations and signed 23 new meaningful customers. Remember the clients we are going after are the top names, organizations that we think are going through clearly set the standard for how companies compete with agility, with effectiveness and being able to grow, expand their business and we are looking to do it in a way that really focuses on business enablement. So one of the things I am very, very pleased about is that we have very significant increases in the number of trained people.
We actually had 1,437 customers attend a training class last year. And we now end the year with close to 1,500 Certified System Architects, people who have not just been through training, but have been through some of the advanced course and had actually gone through a certification exam. So the population of people and our clients, partners, and also at PEGA who can help deliver the benefits of Business Process Management is increasing as an important part of how we gauge the ability of the company to grow. Let me talk for a moment about what BPM is about and why it's transformational and how I sort of see the current economic environment and competitive landscape right now.
Business process management as we think of it really helps our clients achieve four different things. First; it lets them achieve, well the raising of their top line. It lets them sell new business, do a better job of quoting or binding insurance, on boarding accounts, knowing their customers and going after new customer segments. It also allows them to do a better job of managing their customer relationships, working in call centers or other channels, enabling the organization to have a consistent and efficient vehicle by which they can treat their customers well. They can retain their customers and get the benefits that new business provides when you are able to actually retain.
The third area is in creating what we call sometimes a service backbone, the ability to automate the service processes, the [fulfillment] processes of an organization to drive out needless, wasteful work that ends up getting done by people. What we find in lots of organizations that a very significant amount of the work in fact, frankly, can and should be automated. And what the PegaRULES Process Commander technology does is that it lets business people capture the way they want to automate in the software themselves. So that, well they don’t have to go to engineering groups to actually get code written, they can actually change their processes and get these service efficiencies.
Which brings us to the fourth area, where we see business process management technology being applied, and that is in the area of fraud, risk management and other sorts of compliance related activities. What business process management technology lets you do, is it lets you actually build in to your processes many of the aspects of risk reduction, fraud control and compliance management. So in these four areas new business, CRM, servicing backbones and risk fraud compliance we think that our clients will continue to find enough benefit to continue to invest in the technology.
What's interesting is you know having been around these many years, when times get tough, organizations from our experience tend to shift a little more to productivity improvements and of course making sure that they are in compliance and a little more away from, for example trying to lift the top line. But there is so much opportunity in our organization that we do business with that we are encouraged and we believe we will be able to continue growing despite what happens. Selling enterprise software is an interesting business, it has to be lumpy by its nature, it has to be subject to a lot of variation and clients frankly can get skittish as well.
One of the things that we are actually quite pleased about is some of the market consolidation, that is causing some of our competitors to leave the market we acquired and I will tell you that's having very positive impacts in our relationships with our clients. Organizations that two years ago we viewed as strong competitors have now greatly weakened as a result of mergers that were completed or frankly are in the process that we think as a result of mergers that have been announced. This also has put pressure on our smaller less well funded competitors who clients look at and say realistically they no longer have the confidence that they can rely on the management team they are talking to, to be the sustaining management team.
I think that a rising tide sort of lifts all boats, but when the waves turn choppy and get a little tough that's the chance to see what are the really good boats and I think give good organizations a chance to pull away from their competitors. With that in mind, we are going to continue to invest in the coming years. As Craig mentioned, we're going to continue to invest in R&D. We do believe we have by far the best product, but at this stage we're not going to take that for granted and we think we owe it to our investors and our clients to ensure that we continue to push the envelope in this important area. Because that makes a big difference in terms of our clients ability to achieve the success they need.
We're going to invest in our business across the board working very, very diligently to make sure those investments are prudent, but to build our sales and marketing force to increase our services capability though not at the same rate that we intend to grow the rest of the business. As we are really going to focus on trying to build a very strong partner community this year and become increasingly involved with partners in terms of delivering. In fact, we're leveraging the business which is the central part of our strategy here.
And I'll tell you we're going to be hiring across the board. This is a wonderful time to actually be a growing and stable company, and we're seeing quite a bit of interest from extremely capable people who are interested in joining the PEGA team and it's our intent to take aggressive advantage of that (inaudible) during the year.
So to wrap up, and before I turn it open for questions, this notion we have (inaudible) Business Process Management sell for to empower business operations, to let organizations achieve greater vigility and as PEGA's grand promise as our tag line says to let organizations build for change. I believe we'll continue to resonate and is really a message that whose time has come.
With that, let me turn it over to the operator. Operator if there are any questions.
Thank you. (Operator Instructions).And it appears that at this time we have no questions.
Well I would like to thank everybody for listening. I would like to thank the investors who had confidence in us as we entered 2007 that we would do a responsible job. I would like the customers that have believed in our products and I would like to thank all the PEGA staff who worked so hard in 2007 and are getting us off to a great start in 2008. Thank you very much.
And that does include today’s conference. Again thank you for your participation.
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