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Executives

Craig A. Dynes – Senior Vice President and Chief Financial Officer

Alan Trefler - Chief Executive Officer and Chairman

Analysts

Geoff Hulme - Porter Orlin

Edward Hemmelgarn - Shaker Investments

Gregg Speicher - Moss Creek

[Hal Barry – Graham Partners]

Unidentified Analyst – [Inaudible] River Partners

Pegasystems Inc. (PEGA) Q1 2008 Earnings Call May 9, 2008 9:00 AM ET

Operator

Welcome to the Pegasystems first quarter 2008 earnings call. (Operator Instructions) At this time, for opening remarks, I would like to turn the call over to Craig Dynes.

Craig A. Dynes

Welcome to the Pegasystems 2008 Q1 earnings conference call. With me here in Cambridge is Alan Trefler, Pegasystems’s Chairman and CEO. Before I introduce Alan, I will start with our Safe Harbor statement and 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, intend, belief, estimates, targets, forecasting, could and other similar expressions identify forward-looking statements, which speak only of the date that statement is made.

Because such statements deal with future events, they are subject to various risks and uncertainties. Actual results for the 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 other factors affecting the timing of our license revenue recognition, the level of term license renewals, our ability to release new products and evolve existing ones, the impact on our business of 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 and 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 its report on Form 10-K for the year ended December 31, 2007, and 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.

Given the challenge of the economy, Q1 was a great start to 2008. Our revenue of $48.5 million was a new quarterly record for the company and represents 29% growth in Q1 2007. In the quarter, we increased net income to almost $3 million, generating a strong $13.9 million in cash flow from operations, and ended the quarter with $161 million of cash and short-term investments.

Q1 results were driven by dramatic increase in license revenue. License revenue was up $5.4 million or 45% from Q1 2007. Most of the increase was in term license revenue, which was up 162%. The mix of term versus the perpetual license bookings can fluctuate from quarter to quarter, which causes our backlog of term licenses to move up and down. In Q3 and Q4 2007, we booked many more term deals than we were able to recognize.

This quarter our revenue is catching up, so as a result of the increase in term license revenue the total of our outstanding term license decreased by about $4.5 million from $71.4 million at December 31 to $66.9 million. These are non-cancelable term licenses where we fulfilled all of the requirements to recognize revenue.

While this $66.9 million is not yet recorded in our financial statements, they will hit our P&L as payments become due. It is worth noting that at the end of the license term, which is typically in the range of three to five years customers must either renew their license or stop using the software.

As I said, the mix of perpetual and term licenses varies, so in contrast to the slight decrease in our backlog of term licenses, there was a $4.4 million offsetting increase in the license component of deferred revenue which shot up by $8.7 million to $41.9 million from $33.2 million at December 31.

In a limited number of arrangements we granted a license to unspecified future software releases. In these circumstances the arrangement is recognized as a subscription. And this quarter we recognized subscription license revenue, which was approximately $500,000 for the quarter.

License signings were down from Q4. This is an expected trend and consistent with prior years as bookings on our industry are historically greater in the third and fourth quarter than they are in the first two quarters. This quarter we expanded our financial statement presentation to show maintenance revenue on the face of the income statement.

Often companies group maintenance and professional services together into one category, usually just called services. However, professional services comprised of consulting and education is a lot different from maintenance revenue. Maintenance is a function of the strength of our growing user base, which renew maintenance contracts on an annual basis because of the value that they place on their Pega applications.

Maintenance revenue is almost $9 million per quarter and is up 27% from Q1 2007. This is a strong and predictable source of revenue, which will now be highlighted in the income statement. Other software companies use this approach, which we felt was the most transparent and informative presentation.

Revenue from professional services, now compromised only of training and consulting services, was $22 million, an increase of 20% from Q1. Consulting revenue was up $3.3 million or 19% from last Q1, while training revenue was up about $0.5 million or 41%.

It is common in the industry to have consultants work on site based on verbal agreements that get replaced with signed work orders at quarter end. However, inevitably, each quarter some consulting revenue slips into the next quarter as work orders are not signed or completed in time for the quarter end. This quarter the slippage into Q2 was greater than normal, as some signatures were not received here by March 31.

On these agreements, we delay only the revenue and not the cost, so Q1 consulting margin suffered. This situation will reverse in Q2 when we recognize the delayed revenue. In addition, we have one arrangement where the contract terms demand that we defer both revenue and cost. This project is expected to end in Q2, and the revenue will be recognized. As a result, we expect services revenue to be higher in Q2.

Overall, Q1 gross profit was $28.9 million, up $7 million or 32% from Q1 ‘07. The largest component of the increase is comprised of the $5.4 million increase in license revenue. The balance of the increase in gross profit is due to a $1.8 million increase in maintenance gross profits.

Total operating expenses for the year increased $4.6 million or 21% from Q1 ‘07 to $26.7 million, over almost flat from Q4 ‘07. The largest increase from Q1 ‘07 was in sales and marketing, which increased $2.9 million or 25% to $14.7 million. However, sales and marketing expenses were actually lower from Q4 of ‘07.

During Q1, we had lower commissions but this decrease was partially offset by greater headcount and the costs associated with our annual sales training and kickoff event. We will continue to grow sales and marketing, especially where it’s necessary to provide more account penetration where we have seen increased sales radiation in named account or if it involves increased account or geographic coverage.

On a combined basis, R&D and G&A expenses increased in Q1 from Q4 levels by about $600,000. We have recently incorporated in India, 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 G&A.

In 2008 we will be out of the start-up stage and there will be increased R&D expenses associated with this new facility. We believe that continued investment in R&D is necessary to maintain and expand our relationship position in the BPM space.

Our FAS 123R charge for stock-based compensation was a modest $603,000 on a before-tax basis. Page 8 of the Q details how those charges allocated to each department. During Q4 of last year we completed an equity incentive grant to certain employees. That grant, along with options that will be granted to new employees in 2008, should increase this charge as we progress through the year.

Our interest income was slightly down in the quarter. There are two components to our interest income. One is interest from our investment portfolio, where yields continue to fall. And the second 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 are decreasing.

Our overall effective tax rate for Q1 was 29.5%, compared to 34.4% for the first quarter of 2007. The decrease in our effective tax rate from quarter to quarter is due primarily to changes in the geographic mix of income. The main component of that change is that we received a letter of approval for SEZ or Special Economic Zone tax holiday status under the India tax laws for the next 15 years.

For 2008 we are still anticipating our overall tax rate to be approximately 32%. This is up slightly from the Q1 rate primarily to additional discrete items that we anticipate booking throughout the year. Our net income for the quarter was $2.9 million, an increase of almost $2 million from Q1 2007.

We generated a remarkable $15.9 million in cash flow from operations as we had a great quarter for collections. However, we do not expect to continue to be at this pace. As a result of these strong collections, accounts receivable days billed outstanding calculated on a quarterly basis decreased to 48 days from 63 days in December 31, and our AR balance decreased by about $10 million from December 31. We ended the quarter with over $161 million in cash and investments.

We are very conservative with our investment portfolio, with no auction rate securities and mortgage-backed securities. The only risk we have to the subprime crisis is indirect and limited to our investment in corporate bonds of financial institutions that could be hurt by this crisis. As of today, we are not aware of any downgrades.

Q1 business activity caused deferred revenues to increase by almost $8.7 million to $41.9 million on March 31, compared to $33.2 million at December 31. The increase was primarily due to an increase of $4.4 million in deferred license revenues and $3.2 million in deferred maintenance revenue. It is worth noting that deferred revenue not only increased from Q4, but it has increased by $20 million from Q1 ‘07.

On June 4, 2007, we announced that our Board of Directors approved a third $10 million stock repurchase program, beginning July 1, 2007 and ending June 30, 2008. On February 14, we announced an extension to the program, an additional $15 million that would extend until December 31, 2008.

During the quarter, we repurchased 229,000 shares for a total of $2.2 million, which left a balance of $13.9 million available for repurchases in 2008. Q1 is an unusual quarter in that due to the later filing date for the 10-K the company is in a quiet period for most of the quarter and can only purchase pursuant to its 10b5-1 plan.

In summary, this was a great quarter in light of difficult financial times. With more detail on Q1 achievements, I would like now to turn the call over to Pega’s Chairman and CEO, Alan Trefler.

Alan Trefler

It was obviously a strong quarter financially, and I’m also pleased to say that we’ve moved forward in a number of different areas that we think will bode well for us as we go into future quarters.

Talk about a couple of things here. First, we introduced a major new release of our Business Process Management platform, what we call PRPC, PegaRULES Process Commander Version 5.4, and we introduced it to analyst and customer accolades. Some new capabilities are in this release that were especially exciting include the ability to directly capture business objectives into the technology.

One of the messages and one of the missions of Business Process Management is to really make it so that organizations can be far more agile, far more effective. The traditional model by which business users go off and write 600-page requirement documents and hand them over a wall to be designed in IT and specified and signed off in blood and then converted into a program code, that’s a very 1970s way of doing things.

And BPM lets you completely change that process. With this technology we’re able to foster an entirely new mode of collaboration where business and technologists can work together and very quickly see, understand and capture right into the technology how they want it to work. It’s really very exciting, and the new advances in our release 5.4 have really captured the imagination of both clients and analysts.

Automated globalization, one of the things we’re finding increasingly is that organizations want to be able to define a set of processes, a set of rules, deploy them in an initial language and then be able to move across Europe, into Asia, and only have to define as little as they can to cause the systems to be translated into those languages.

We have build very, very rich capabilities into PegaRULES Process Commander to make that possible, and we have examples now of clients implementing and rolling out systems into new geographies to new constituencies that otherwise would have required enormous amounts of manual programming and maintenance.

Another great facility in 5.4 is what we call the Internet Application Composer, which actually allows people to deploy right inside their existing Internet portals PegaRULES Process Commander application. So you can be in somebody’s website and without actually having any perception of leaving it or even any perception of dealing with the Pegasystems, can suddenly have our process and rules control pieces of that user interaction.

And the great part about it is that if business users or IP staff change the way the system works, all of a sudden that change will now be deployed instantly to all jurisdictions. That change right down to the user interface will occur on the Web, will occur in the call center, and will occur in the back office, in all the different channels where the software might want to be used.

And finally, in an effort to try to make not just the front end of the development and definition process better but to make the entire process better, we have added facilities for smart automated testing to make it possible for people to make it just easier for them to get their software into production, to record test suites and be able to replay tests, to, well, make it just as built-for-change philosophy of ours can actually be done reliably and effectively.

The capabilities in previous releases actually allowed 17 of our customers, 17 new systems, to go live in the first quarter, among the highest in our history, and a strong indication of how our build-for-change technology is being broadly adopted. The go-lives were across financial services, healthcare, business process outsourcers who take processes from other companies and automate them, and were across the U.S., Canada, Europe and Asia.

Examples included insurance underwriting automation, healthcare member enrollment, know-your-customer solutions in banking to make sure that customers were properly identified and on boarded, and the exceptions management automation in financial services.

This whole ability of ours to handle not just the exceptions but also the front-end on boarding and client acquisition processes is I think part of what gives Pegasystems a lot of resiliency as we go forward, able to really match the needs of lots of customers in lot of settings. Customers have cited benefits in excess of 30% of new business growth and 40% reduction in operational costs as a result of these types of solutions.

Third, we are seeing very much an accentuated interest in other organizations building Pega practices. We said at the beginning of this year that we really wanted to target deepening relationships with strategic consulting firms, and we are really pleased to see our relationship with major firms, IBM Global Services, PricewaterhouseCoopers, Capgemini and Accenture.

Building, growing, with them making investments to both train staff and also, frankly, understand the PRPC message well enough to help us get involved and get into organizations where we ourselves might not have had the reach or the influence.

This complements our traditional use of systems integrators, great companies like Satyam, Cognizant, and Virtusa that have historically been able to give us breadth and depth and muscle. We’re now working also with these additional systems integrators to try to make sure we can deal with the strategic agendas of our clients as they go forward.

I am also pleased to say that in Q1, we acquired the staff and intellectual property of a fraud solutions company to allow us to really increase our depth and help us build our initial strong position in the area of fraud investigations case management and anti-money-laundering work.

We think that these sorts of areas will continue to be important institutions even as the economic headwinds are tough because frankly they need to do it for regulatory reasons, and reputational and financial risk is so great. So we’re adding very material facilities to our products to be able to make it so that we can do an excellent job going after these types of compliance-related opportunities.

And finally, just after Q1 closed, we were named by Forrester, which is one of the two leading technology evaluation firms and analysts, as a leader. And if you take a look at the picture, I would say that a really extremely strong leader, in what’s called the business rules wave.

Which basically enables our clients to know that not only are we the clear leader in Business Process Management, looking at the picture from Forrester and Gartner, but that our rules capability judged by itself gives clients that ability to be agile, to be able to change their rules and handle a wide variety of applications for capturing business intent and business intelligence in their technology.

One of the things that I am really proud of is as we’ve taken this new approach to Business Process Management that’s embodied in our PegaRULES Process Commander technology, that the team here has understood the importance to not just have the best product from a combined perspective, but to make sure that the rules and process capabilities looked at on their own were world class.

I think that focusing on this allows our customers to have the assurance that as they hit new types of application requirements, as they move forward to use the technology more broadly, it will always be world class, and of course we get the extraordinary benefit of having rules and processes work together, like they do in people’s heads, when folks want to deploy both technologies in conjunction.

So to wrap up and before we open in a moment the line for any questions that there might be, we all know that the current macroeconomic climate is on everyone’s mind. We’ve seen clients become more conservative in their spending and frankly much more demanding about the cost effectiveness of what they choose to do.

However, we are fortunate to have a product and a value proposition that can be very cost effective, and we’re continuing to see interest and buying activity. It’s exciting. This is Pega’s 25th anniversary. We’ve been in business now 25 years, and we’ve seen good times and bad times.

I think that we’ve finally put together an extremely strong value proposition that will have the ability to resonate with buyers and clients in both good economic times and bad economic times. And so we’re excited about our performance in the first quarter and are looking forward to continue to perform strongly the rest of the year.

With that, let me open it up to any questions that might exist.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Geoff Hulme - Porter Orlin.

Geoff Hulme - Porter Orlin

How do you think about, now that you’re getting to some critical mass and traction in this hot, as Forrester defines it, sector that a lot of people are making claim to making progress in, from consulting firms to systems integration, to big application software companies?

We’ve grown nicely here. We’re still a $200 million software company that some people probably haven’t heard of yet. But how do you think about having this position that you have in this functional area with all of these other companies surrounding you, and getting from this point to the next point?

Alan Trefler

Well, I think a couple of thoughts. First, we understand that for us to take true leadership in this area as this market becomes less fragmented we need to grow very, very rapidly. And as we think about how to do that, we understand that that’s probably going to be through a mix of things.

That very much we believe is going to involve a different relationship with strategic consultancies so that we can leverage that we are less responsible for delivering all the services. And we’ve made that a key corporate objective, and we’re working very diligently to pursue that.

We also believe that the market is still in many ways nascent and frankly in some ways competition is getting easier, not harder. The acquisition of other companies that were in the magic quadrant a year, 18 months ago by the acquisition, for example, of FileNet or the just-announced acquisition of BEA, I think actually serves to weaken innovation in this sector. And our clients have told us and we have seen that we’re not just in a leadership position, but we’re actually able to increase that leadership.

I believe that as our product improves and as our network increases, that we have a tremendous opportunity here. Particularly if at some point in time this market turns from being a push market where we’re selling directly, to a pull market where in fact there is clients who really understand what BPM can do and can apply it.

Right now that’s still very early, I think, as you point out, and there’s still confusion. Our job is to over the next year get our brand out there, get the true message of BPM out there, and then see if we can have the channels and other support to support rapid growth.

Operator

Your next question comes from Edward Hemmelgarn - Shaker Investments.

Edward Hemmelgarn - Shaker Investments

You commented that in the 10-Q and on the call, I think, is that you said that orders were down from the fourth quarter. How did orders during the quarter compare to the prior year’s first quarter?

Craig A. Dynes

You make a very good point that orders are always down in Q1 compared to Q4. We were right around where we expected to be in our budget. The geographic mix was a little bit different. I think we were just a little bit up from where we were in last Q1, but we definitely came off a very strong Q3 and Q4. And so Q1 concentration was in building pipeline and building deals that we can close throughout the rest of the year.

Edward Hemmelgarn - Shaker Investments

So you are now getting a more of a what one would describe as a pattern that you would expect.

Craig A. Dynes

It’s a pretty consistent pattern in the industry. Whenever you’re selling a product to someone on the customer side as a capital expenditure, they get their CapEx budgets in Q1 and they have to decide what made it and what didn’t, and then they start evaluating what they are going to do. And they spend very frugally for the first two quarters, and by mid-Q3 they wake up and they go, wow, we’ve got this budget; we better choose it or lose it. And you see a much higher level of activity in those quarters.

Edward Hemmelgarn - Shaker Investments

Are you seeing any overall warming at corporations in terms of their interest? A number of people have commented that at the beginning of the year there was the shock and there was a bit of a reluctance on the part of corporations to engage. Are you finding that changing now that we’re in the fifth month of the year?

Alan Trefler

Well, I think we’ve not really seen a problem getting our clients to engage, particularly since a lot of our strategy is to radiate or to continue to evolve in existing customers where they understand what we can do. What I will say is that there is an increasing, throughout the year and actually in the fourth quarter clients are less likely to believe the hype. There tends to be just a really pragmatic interest. I think there tends to be an interest to do things in phases or waves as opposed to go out and buy what might end up being lots of shelfware.

So the conservatism from the newspapers we’re seeing is manifested in the buying behavior. But it’s not a lack of interest, and we’re wildly busy. So we’re not at all in a situation where our sales force and our services teams are being shut out of clients; it’s very much to the contrary. I just want to make sure that as they do something they’ll get a financial benefit in three to six months.

Edward Hemmelgarn - Shaker Investments

Subscription revenue, there was a new curve that you threw at us. Was that something that was also present but not material in ‘06 and ‘07, or this was something new in the first quarter?

Craig A. Dynes

It’s something new in the first quarter. It’s a way to solve certain problems that customers have where they need certain features. Perhaps they plan to start with a domestic rollout of an application but then want to move to a worldwide application and they need new features in the future. And so it becomes more of a subscription when the arrangement includes unspecified future features.

Edward Hemmelgarn - Shaker Investments

You expect, though, this is a feature of your offerings that will likely continue in the future.

Craig A. Dynes

I think the offering makes sense in a lot of cases, especially in some of our accounts. We have some of the largest corporations in the world, and most of them operate very internationally, and this makes sense for them.

Alan Trefler

And my view has always been that what was classified here as a subscription is in many ways really quite analogous to what you would have thought of as term licenses. Clients paying a more modest amount sometimes over periods of time, or regardless of when they pay, the revenue gets spread out over a period of time as opposed to the alternative, which is the big upfront perpetual model.

Edward Hemmelgarn - Shaker Investments

Well, but the difference is with your term license, they have to in the future, the client has to continue to renew, and so as long as they are using it, it’s in effect a perpetual payment at some. Obviously if you have to renew the term at whatever the term terms are at that point in time. But with a subscription, I am assuming that it’s just a longer period to pay for a perpetual license.

Craig A. Dynes

No; actually it’s not. It is a set period of time of which they can get these new benefits, and after that point in time, if they end the subscription, they no longer get the benefits of these new features.

Craig A. Dynes

As Alan said, it’s more analogous to a term.

Alan Trefler

And it obviously varies. It can vary by deal. But in principle, I think you can think of it as being in many ways a similar to term and the maintenance that goes along with terms.

Edward Hemmelgarn - Shaker Investments

The key difference is that you’re already delivering some products in there, but you don’t know preciously the exact terms, final terms of what you’re going to be delivering to them.

Craig A. Dynes

Yes, unspecified new features over the term.

Edward Hemmelgarn - Shaker Investments

What, in terms of service cost to sales, do you have a target that when you look at service and training what you would like to be able to get that to on a normal run rate that you’re modeling to at some point in the future.

Craig A. Dynes

Well, to be quite honest we’re not too concerned about the margin on the enablement. Our objective is to enable customers. By enabling customers they can do more of the work when it comes to implementing applications. They can do that work faster. They can do a better job of it, which means that they will enjoy the benefits of that application faster, and they’ll be ready to buy the next license in a shorter period of time. So that’s the objective of the enablement.

As far as the service margin goes, as I said the service margin is down this quarter. You’ll see a more normalized version of that margin next quarter and through the year. Now that we peeled off maintenance, you’ll see that normalize.

Operator

Your next question comes from Gregg Speicher - Moss Creek.

Gregg Speicher - Moss Creek

How does the service department feel right now? Is it really bulging up against capacity? All the other fast-growing companies I follow, that’s one of the harder things to manage. Is it just tough to manage that right now due to demand?

Alan Trefler

It’s very busy, and different geographies have different rates. But we are seeing an extremely high demand for services. Our strategy, though, is very explicit. Our strategy is we are really trying to bring up three classes of additional resource into the mix.

The first class is the client themselves, where we have a very specific client enablement strategy and have been successful with many of our clients, that tend to be very effective at implementing Pegasystems and both helping on implementations and even doing new implementations themselves.

The second is our, what I would describe as our muscle partners, organizations that can bring Indian or onshore resources to try to bulk up teams if they want to make a big push to get something done quickly. And the third is these emerging strategic partners where we see them as not just building teams that can do work but also being able to engage with a strategic agenda around customers transforming their business, etc.

So our strategy very much is to not grow the services organization at the rates we expect the overall service ecosystem to grow and to very, very radically focus on enablement, focus on frankly working with some of these, both clients and partners to do a little handholding as they come up the curve; and all of that frankly reduces services margins.

I have told the services organization point blank that this year and, frankly, as long as we think that the growth possibilities are there, enablement and spreading the word is more important than what happens in any given quarter or what happens to the services business as a standalone business. Its not, it’s really there as part of this vision of how to get BPM understood in the industry.

Craig A. Dynes

We are ultimately a software company, not a service company. I just had one more thing to your comment, Gregg, is that we provide professional services with two sets of resources, our own employees and subcontractors. And when you add your own employees, your capacity goes up in a step function. And to smooth that out, and if we have a sudden surge or a sudden decrease, in a month or a quarter or whatever, we ramp up and down the contractors. They are the buffer.

Gregg Speicher - Moss Creek

Would you want to have any further comments on either the revenue or the cash flow guidance for ‘08 with the strong results from Q1?

Craig A. Dynes

Well, we only give annual guidance.

Gregg Speicher - Moss Creek

Could you give us an update on the named account/affinity model you’ve been building out? Are you happy with each salesman’s progress? Do you need keep hiring rapidly to keep that working? Any thoughts there?

Alan Trefler

Well, we are hiring and we are evaluating. We did a number of re-evaluations and some actions as we ended the year. We’re very much trying to look at the effectiveness of the overall sale force, to try to make sure that it’s not just making numbers in aggregate, but that every sales person has the right support and that we have the right expectations of the sales people, so that we can in effect get, I would describe as more reliable results in the future.

We have made a number of changes in that regard, and I will tell you it is a wonderful time to be the hot company in a hot sector. When so many enterprise software companies, the mid-tiers, business objects, from BEA to FileNet, when all of those have been acquired, we’re finding that we’ve really got a good chance to hire top-notch sales people. We’re continuing to hire with an 80% focus on the affinity model or 80% of our sales force is in fact dedicated to specific named accounts and really get a chance to build these relationships.

Gregg Speicher - Moss Creek

Can you talk about the company you acquired, revenues, numbers of customers, etc?

Alan Trefler

Yes, the company that we acquired had some really great technology and some staff and modest revenues, but what we really liked was their staff and their technology, and they tended to operate in the middle tier of banks. And what we’re doing right now is we’re bringing their intellectual property into our high-end engine, so that we can deploy it at the world’s biggest banks and other financial institutions. They also have experience in insurance and some other key areas.

So we’re basically taking something we like and are bringing it up market. So there is no really revenue that we acquired at all from them. We really just acquired the IP assets and the staff, and we allowed them to continue with their existing revenue base and existing customers because frankly that was not our target market, the tier banks are not.

Craig A. Dynes

Nevertheless the addition of these people, their level of expertise, their contacts in the industry, are helping us right now to build pipeline.

Operator

Your next question comes from [Hal Barry – Graham Partners].

[Hal Barry – Graham Partners]

Craig, as you hit this $200 million run rate, you think you’re near a point where you can provide investors some target-operating model in terms of gross margin and operating margin level that you think the business should obtain, or not necessarily near term but at least mid-range to longer-term target?

Craig A. Dynes

Well, I think as we go through the year and we see that back and forth, we build these term license inventories. We draw them down a little bit. I think through the year we’ll see that level of inventory perhaps reach a more normalized level. And at that point in time we won’t be deferring revenue onto off-balance sheet inventory, and we can really look at our P&L and give a more normalized level. We did give guidance of increased profitability for the year.

[Hal Barry – Graham Partners]

But no comments on when you think you should achieve best-in-class software [inaudible] margin operating margin levels?

Alan Trefler

I think it’s hard. My personal opinion is that in situations where you are pursuing unusually rapid growth, and we are targeting to be a growth firm here, that that coupled with the inherent lumpiness of our business can make giving the more stable margin analysis that frankly larger firms or firms that are not growing as fast can give, I think that makes it difficult. Yes, my belief is as we grow and as the business becomes more mature, obviously that’s going to be much, much easier.

Craig A. Dynes

It’s a trade-off for us every quarter when we make decisions on hiring new sales people, investing more in R&D, or cutting back on those things and increasing our bottom line. And as Alan said, by investing in growth we are leaning towards that decision.

[Hal Barry – Graham Partners]

Alan, when you look at the PRPC implementations today versus one or two years ago, how big is the change in terms of having the business user educated today to the extent that they are the ones editing and adjusting these business objectives versus waiting for IT to do it and then just having it implemented on that end? How engaged in the process do you see the business user at this point?

Alan Trefler

Getting the business to be more hands-on in terms of their implementations as opposed to thinking that the responsibility ends with writing Word documents is something that requires not just technical change but in organizations there needs to be a cultural change.

So what we’ve seen in the last couple of years that’s extremely gratifying. Because we have a lot of customers now, not all of them but a lot of customers, where the people we call business architects, people from the business who’ve generally been through a week of training, are actually making pretty amazing ongoing changes either individually or as part of project teams during implementation.

And that has become I would say in the last two years very much a reality at maybe about half of the accounts that we do business with. I think that’s going to increase as the other organizations see what’s possible, and frankly as our software gets better. We still think we have work to do to continue to drive this vision, but pretty happy with where it is.

Operator

Your next question comes from Unidentified Analyst – [Inaudible] River Partners.

Unidentified Analyst – [Inaudible] River Partners

How much of the business right now is being driven by the system integrators, not a sales guy at Pega passing it along to them, but them driving it with their customers direct?

Alan Trefler

So I would say it’s much, much larger than it’s ever been before, and I think that’s partially because we have conscious strategy. And I will give you the answer, but in truth it’s not like the systems integrators will actually close the business for you. We need to continue to sell with them and work with them and sometimes convince them that we are the best solution for their customer.

But I would just say off the top of my head that a quarter or more of our selling is intimately tied to systems integrators, and I would say it may even be as high as a third, as I think about the last quarter or two.

Unidentified Analyst – [Inaudible] River Partners

I assume that’s up substantially year-over-year?

Alan Trefler

Yes, it is. Two years ago, it was entirely episodic. We would occasionally get something that was done in conjunction with the systems integrator, but we did not have that maturity of relationship. I will tell you that a much larger percentage of deals that are not necessarily driven in by or in conjunction with systems integrators, there were systems integrators actually have a very material part of working with the clients during implementation. The significant majority of our deals have system integrator involvement in the implementations with the client.

Unidentified Analyst – [Inaudible] River Partners

Can you talk a little bit about the average deal size and where that’s been trending?

Alan Trefler

Yes, it’s actually been pretty stable between I’d say it very much goes between $400,000 and $650,000. Now we have numerous outlined events, million-dollar-plus deals. We have several of those this quarter here. I am not a great fan, frankly, of massive, massive deals because usually when a client overbuys, somewhere down the road either the client or the software vendor ends up regretting that.

And so we don’t actually push the team to go and try to do the bubblicious massive deals or, I know there are other companies that depend on those; those not our style. But we have several over a $1 million deals this quarter.

Unidentified Analyst – [Inaudible] River Partners

Can you just touch a little bit on how you price. How do you price the deal and what separates a big deal from a smaller deal, and you’re not pricing per seat necessarily.

Alan Trefler

Our model is a model where we think the client should pay a fair price relative to the usage of the technology. And the usage of the technology is often measured in terms of seats. For example, we in Q1 won a very nice highly competitive call center piece of business where you would license it by the number of call center seats.

Because the technology’s so broadly used in situations where it’s not used by people who can be seen in seats or even in some cases is not used by people at all, we have a metering module built into the system, where it actually can measure the number of times it’s invoked in a year, the number of times the system actually does a piece of work, meaningful work in a year.

And we will sell clients those, think of them as services-oriented architecture clients. We’ll sell them in effect an engine license that’s metered based on this indication usage there. It can in fact be very cost effective for clients, and if they use it more over the future years we’ll get paid more.

Unidentified Analyst – [Inaudible] River Partners

On the mix of customers in terms of, by vertical, what are you seeing there?

Alan Trefler

I think we’re seeing that our healthcare business is doing actually extremely well. That continues to be a real star. I think we have seen some conservatism in the financial services businesses, around the insurance business and the financial services banking businesses, where there is a lot of activity. But as I said, people are just being just very, very sure that they’re going to get a cost-effective return in a short three, six, nine-month timeframe as opposed to doing larger projects.

Craig A. Dynes

That being said, though, we did close business with the financial services sector in both the U.S. and international. It’s not like the business has been shut down. We’re still doing business with them.

Operator

Your last question is a follow-up from Gregg Speicher - Moss Creek.

Gregg Speicher - Moss Creek

You talked about the new major release. Is there anything particular to the functionality that you were talking about that’ll help you get over some of the conservative spending or hesitation by customers? Is there anything that really increases ROI or shortens the implementation cycle? Anything like that you can point to?

Alan Trefler

Yes, we’ve actually been now using this for a couple of months. We began using it actually before it was officially released and have been using the technology now for the last couple of months post-release. And the estimates of our services teams is that the use of this functionality can reduce the implementation duration and cost 20% to 30%, which is very material, obviously.

So we’re seeing clients intrigued about this, and I think that’s part of what, frankly, just makes it easier to generate interest. If you can take a project and take a six-month project down to four and a half months, suddenly the return on investment is much more tangible.

Craig A. Dynes

And that’s important right now, you hear a software company saying about it’s getting more difficult and there is more reviews. By lowering that cost, by decreasing the time that it takes to do an implementation, we dramatically improve the IRR, and that helps get things approved and through their purchasing system.

Alan Trefler

And I would like to thank everybody for joining us on this call. We are glad to have made it through 25 years. We are hoping that our next 25 years shows an accelerated growth rate. And we are working extremely hard for you to see if we can make that true. So once again, thank you.

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Source: Pegasystems Inc. Q1 2008 Earnings Call Transcript
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