Pega - What’s changed in a year
It has been about a year since I last wrote about Pegasystems (NASDAQ:PEGA) - and I doubt that many people have either noticed or pined for me to take up the keyboard and compose a screed on the subject. And in looking back on some metrics, I find it hard to take exception to the lack of interest regarding this name. In the last year, the shares have gone up and down and wound up about where they started - although that isn’t much worse than the software index as a whole which is up 8% since the start of last year. But unlike the average software company which has seen substantial growth in reported numbers over the past year, Pega looks set to report just mid-single digit top-line growth and a substantial profit decline over that same span. And so far as it goes, if one were to believe the First Call consensus - and I do not - this current year, i.e. 2019, is supposed to feature more of the same with further mid-single digit growth and no improvement in margins.
So why bother with the name? There are plenty of more exciting software companies when it comes to growth; as I commented to a fellow investor over the weekend, a few quarters of 70% growth can fix almost any valuation problem one can conjure. Pega is not a 70% growth vehicle, but neither is it doomed to single-digit growth. And I am not recommending the shares because the valuation is low - although that certainly helps. Pega shares are not going to be for some readers - they are the proverbial dusty corner with only 5 analysts covering the name. And so long as the current CEO remains, the company will not get sold - although should he choose to retire, Pega would be almost certainly sold at a premium valuation within months. And, as explained below, the headline numbers are still at levels that will not get the company to screen well - and that remains a significant component of the investment process, at least for institutions.
But the art of analysis, as opposed to the “science,” consists of trying to look behind numbers and discern trends and in the case of Pega, try to evaluate when the company’s operational performance will be reflected in headline numbers and a different valuation paradigm. At the start of last year, I had hoped that such an evolution would be at hand; that didn’t turn out to be the case - but despite that detour, the company actually has had a more than respectable performance in terms of the metrics that should interest investors - in particular the strong growth of its ACV (Annual Contract Value). In particular, the company has seen its total ACV grow by 20% this year and its product ACV grow by 36%. That latter metric is more like the results seen by a hyper-growth company, rather than an investment such as this stuck far away in a dusty corner. In addition, the company’s Remaining Performance Obligation (RPO), which is a new caption coming into use by many software vendors to illuminate future committed revenue streams, grew by 10% sequentially to greater than $500 million. Some of that growth is the timing of the remaining perpetual deals that Pega books, and part of it can be maintenance renewals. But it is still a decent leading indicator and represents the success of the company’s selling motion. Well, more than half of the RPO balance relates to future cloud revenue commitments and the cloud RPO for Pega actually grew by more than 23% in Q3 compared to Q2 levels.
Given the overall growth in ACV, the growth in cloud RPO and the absolute growth in recognized cloud revenues (67% in the quarter and 60% through 9 months), I think it is fair to categorize Q3 as a period of blow-out results, obscured by a transition to the cloud that is substantially greater than had been forecast by the company.
Over the course of years, many companies of this vintage (Pega was founded in 1983) have made the transition from on-premise revenue to subscriptions to cloud. Some of them such as PTC Inc. (PTC) and Aspen Tech (AZPN) have wound up being fabulous investments even when lacking massive top-line growth characteristics. (Neither PTC nor Aspen has shown material revenue or earnings growth in the past several years and in the case of PTC, much of its modest growth has been inorganic. Nonetheless, PTC shares appreciated 20% over the past year while Aspen, despite a substantial oil and gas vertical exposure, has seen its shares appreciate 15%. Other significant names that have gone through a similar transition such as Autodesk (ADSK) and of course Adobe (ADBE) really do have substantial growth opportunities, and their valuations have escalated meaningfully.
Pega is in the midst of a similar transition, but with the advantage that it has technology that is market leading in a strong business segment. Obviously, that hasn’t been enough to see the shares show any kind of appreciation. But hope, as the saying goes, or as Alexander Pope once put it, springs eternal. I feel reasonably confident that the First Call consensus numbers for the current year will be handily beaten both with regards to revenue growth and reported earnings.
A brief discussion of Pega’s technology
In addition to the somewhat opaque financials whose headlines can mislead investors, Pega has a rather unusual niche in its market space. Overall, Pega is often described as a CRM company, and depending on one’s definition that is the case. As readers are probably aware, there are a plethora of competitors in the space, starting with Salesforce (CRM), including all of the stack vendors with Microsoft (MSFT) showing some specific strength, and nowadays including hyper-growth contenders such as HubSpot (HUBS). A couple of years ago, integrated predictive analytics might have been a differentiator - and perhaps Pega still has a lead in this component of a CRM solution - but Salesforce has Einstein and everybody is going to have some form of integrated AI with not all that much differentiation.
Gartner even has a category called “cool vendors” which sounds a bit much. There isn’t all that much room left for independent vendors, and while the outlook for HUBS, CRM and MSFT remains strong, I would never recommend Pega shares because of the company’s participation in the space. Gartner describes the company as a leader in its CRM MQ analysis and to some extent, it does offer a very unique set of solutions.
So, what does Pega have that has led the company to a period of substantial growth recrudescence? Firstly, it has a strong quality mantra compared to some of its rivals. Its releases aren’t buggy, its SFA capabilities are probably more extensive than any of its rivals'. At the moment, the Decision Hub platform is considered the class of the industry. It does all of the things now, that AI is supposed to do including prescriptive, next step guidance. It has what is described as a forecasting widget that provides insights into forecasting accuracy - one of the banes of the existence of almost any sales executive. That lead may not likely persist indefinitely - but at the moment it is a benefit that Pega can offer.
But the real advantages the company has are two-fold. It is one of the few companies that provides its users with a common data model and single platform code base for options across on-premise, multiple clouds and hybrid deployments. I have commented about this advantage in writing about Cloudera (CLDR) in its niche and it is a palpable capability that is appreciated by most users who simply do not want to have to deal with vendor lock-in.
The other major advantage offered by Pega is that its solution, unique in the space, combines business process modeling, automation and typical sales force automation capabilities on a single platform. This allows the company to successfully compete for larger and more complex deployments. It has been very successful in the financial services vertical where customers are trying to help end-users decide on proper insurance coverage or on an appropriate mortgage. Most end-users are not quite ready for digital transformations that rely exclusively on a self-service paradigm, and are looking for customer service representatives to guide them through a process to a beneficial outcome.
Pega addresses a subset of the market for CRM although it addresses more than the market for BPM, but does so with a set of solutions that offer substantially greater benefits for users. Not all users want to go through the wrenching process of re-engineering their processes along with using those reformed processes to deploy a digital transformation strategy. It is not the easiest thing for an enterprise to undertake and choosing to go with a relatively smaller vendor such as Pega to accomplish a relatively substantial undertaking is a tough decision to make. But it is relatively clear at this point that most enterprises will have to go through their own digital epiphanies over the coming few years. Their own customers simply will not be willing to continue to consume services without having access to technology that allows them more choices and more self-service. And when those epiphanies arrive, Pega is there with the least painful set of solutions available and the best record of success. That is really why the company has been successful in significantly re-accelerating its growth.
Along with a few other software vendors, Pega, in its most recent release, offers low code and no-code versions of its product. At some point, the no-code paradigm, as it improves, is going to be a requirement for most software vendors. At the moment, however, it appears that Pega, and competitor Appian (APPN) are pioneers in offering this capability in their niche - and there appears to be a fair level of enthusiasm for using low-code capabilities in Pega’s Cloud Choice offering.
Pega’s Competition and its future direction
Rather than looking at Pega’s well-known CRM competitors, it is more relevant, I believe to consider the competitors it has in the Business Process Management (BPM) space which is really where the heart of the company’s technology. While Pega has a variety of CRM solutions, it is not going to compete for projects that are focused on simply automating the sales process by providing templates and analysis of sales activity. Potential clients for Pega are those who need to fix their workflows to deal with digital transformation requirements while they also implement a sophisticated CRM process. And potential clients are going to be those who accept that complexity is part of what a buyer signs up for in implementing Pega. I have linked here to the latest Gartner evaluation of the space. As has been the case for many years, Pega is considered to have the most effective set of tools in this space in every one of the use cases that were considered by Gartner. Appian and Software AG are basically tied for 2nd. Forrester has ranked Pega as the leader in what it calls the “digital decisioning space.” Most recently, a consultant called Ovum has named Pega as the leader in robotic process automation. I think it is fair to suggest that Pega has a lead in terms of its functional capabilities; that doesn’t always translate one for one into revenue growth leadership.
Pega has developed something called a Situational Layer Cake, which is designed so that users can reuse common policies and procedures in multiple applications. This is considered by some to be a substantial capability that distinguishes the company offering.
In the BPM space, Pega's major competitors these days are IBM (IBM), Software AG (OTCQX:STWRY), and Appian. There are many other competitors in the space who focus on the mid-market. At this point, most of Pega’s emphasis is on deepening its relationships with Fortune 500 clients - although it does have something called PegaExpress designed for smaller implementations and offering a "no-code" capability.
The company most investors will focus on as an analog to Pega is Appian, which has been valued highly because of its low-code development engine. These days, APPN has an EV/S that is about double that of Pega, although its headline growth is just 15%. Its product revenue growth was most recently reported at 42%, however. Appian is a company that is transitioning from a professional services revenue model to one based primarily on subscription. At this point, just a bit more than half of its revenues come from subscription, and that pushes its “real” valuation to extraordinary levels.
Pega’s other largest competitors have been around for a long time. They are multi-product companies and BPM is one of just many of their offerings. As the Garner evaluation suggests, Pega has functional advantages of different kinds compared to all of them. Earlier in the article, I linked to an article that evaluates the space, Pega and its leadership role. The article is well worth reading by any investor with an interest in the shares.
Pega’s future direction at this time is essentially more of the same. The crucial improvements the company needs to develop will be those that make the software easier to adopt. Pega has been a leader in embracing DevOps capabilities to improve deployment but still has a long way to go. It continues to release more AI features as well as robotics and automation functionality. Pega’s future success is unlikely to be limited by technology - its challenges are to find more implementation partners and to make it easier and quicker for its customers to implement its solutions.
A review of Pega’s Financials and reiterating the case for the shares
One of the problems in evaluating Pega is that the headline numbers that are typically used to analyze a company are in a state of flux and really do not accurately depict what is going on in terms of the operational performance. That has limited the upside Pega shares have been able to deliver - or better said - the shares have been stuck in neutral for 18 months while many investors have seen far better performance from hyper-growth holdings with much higher valuation. The company hasn’t provided a specific guide as to when the build-up in cloud commitments it has sold will start to overtake the negative influences of the transition to ratable revenue sources.
Just for the record, so far through 9 months, Pega has seen a decline in term licenses as well as a decline in perpetual licenses. Cloud revenues, as reported, have risen by 60% and their percentage and dollar growth rate are accelerating - but they are still just 9% of total revenues. Maintenance revenues are still rising - Pega’s applications are sticky and even modest increases in the base will keep maintenance revenues growing. Consulting revenues have been flat - Pega is attempting, with some degree of urgency, to attempt to recruit more SI partners and is throwing assignments their way. Overall, this is an economy that has seen a shortage of high-skill SI consultants and it is difficult to find new partners. It is one of the risks of the company strategy.
The overall mix of these revenue streams has meant that reported revenues have been essentially flat on a year-to-date basis, although they were up last quarter. Pega does not really provide short-term revenue guidance. At the moment, the First Call consensus calls for revenue growth of 5.5% in the quarter to be reported in late February. I would not be surprised to see the company grow at a faster cadence than the consensus forecast - mainly because I expect there was a significant end of year budget flush which is likely to have brought along a large perpetual deal or three for Pega.
Last quarter, the company missed the consensus EPS target by a moderate amount - again, the company does not really provide anything like quarterly earnings guidance which typically winds up being a guess. The company has ramped sales and marketing head-count noticeably and the success of the company’s selling motion is increasing commission expenses as well. GAAP sales and marketing expense rose by 40%, mainly reflecting new hires and higher commissions. Research and development expense is also rising, but just by 13% last quarter on a GAAP basis. The strong growth in sales and marketing expense drove reported GAAP earnings to a loss and led to a minimal level of reported non-GAAP EPS.
Overall, Pega’s reported performance show trends that do not accord with the reality of its business. The CFO said that the switch to cloud had penalized the top line by more than $40 million year to date, compared to the initial expectation for a cloud bookings percentage of 30%. That mix switch has had the impact of reducing reported revenue by about 7% of reported revenues. Presumably, most of this revenue would have been profit, and the EPS impact of the mix swing is probably in the range of at least $.50. In addition, Pega had a large maintenance renewal - $35 million - that was recognized last year. That alone would have contributed another 500 bps to reported revenue growth.
Overall, the cloud now represents 51% of bookings but just 11% of revenues last quarter, which suggests that magnitude of the impact of the transition. I would expect that over time, Pega will do away with perpetual licenses which have now declined to just 10% of revenues, and simply offer subscription and cloud consumption models.
Unfortunately, Pega has not really provided a completely transparent set of assumptions that investors and analysts might use to specifically equate the company’s growth to expectations on an apples-to-apples basis. Overall, absent this transition, and absent the impact of the one-time maintenance renewal anomaly, I think Pega would be seeing mid-high teens growth this year. Based on the company’s business momentum, my guess is that growth percentages will rise, but exactly how much revenue growth might be reported in this current year is difficult to project at this point and will be strongly dependent on the ratio of cloud to other bookings - a metric that is simply impossible to forecast.
Pega is still generating cash, paying dividends and buying back stock. But free cash flow has been constrained by the transition as well. The $50+ million increase in remaining performance obligations that the company reported on a sequential basis this past quarter will be generating cash flow over several years, although about half of it is contracted to be paid by users over the coming year.
The CFO, at least thus far, hasn’t chosen to provide all of the tools that an analyst might need to either project cash flow or to recast earnings on a steady state basis. I imagine that the company will show more than 5% growth on a reported basis next year (the current First Call consensus estimate), simply the level of 1-year cloud RPO has reached $88 million which compares to reported cloud revenue of $58 million through the 1st nine months of this year. The cloud RPO actually doubled in the quarter, another indicator of just how strong cloud bookings actually were.
I haven’t discussed Pega valuation metrics in any detail, simply because they do not present an accurate picture of the company’s business momentum, The EV/S is, as mentioned quite a bit below the average for a mid-teens growth rate, at about 3.7X. On the other hand, the company has a constrained free cash flow margin that results in a relation to growth a bit less than the average based on reported numbers.
I am not able to suggest with any certainty that the company management will provide sufficient visibility into bookings strength so that investors become convinced of the business momentum I have deduced from the numbers. And until that happens, I don’t imagine that Pega shares will dramatically outperform the IGV. But for investors willing to look into a dusty corner, evaluate technology and look behind headlines, the upside of Pega shares is substantial. I like this kind of a bet, although it may well require more patience than might be the case for some of the hyper-growth names in my coverage universe.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PEGA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.