Over the past two months, it's been no surprise that the market has been "revolting" against the most expensive corners of the tech sector. Growth is out, value is in. Some of last year's hottest stocks and most recent IPOs, such as Palantir (PLTR) and Snowflake (SNOW), have fallen dramatically from their all-time highs. Even the profitable tech mega-caps have taken a beating, though not as dramatic.
It's my view, however, that investors still need to maintain overweight exposure to the tech sector in spite of increased volatility. The trick, however, is to hone down on stock selection and pick cheaper names whose valuations are less prone to continued rate rises and further multiples re-rating.
Pegasystems (NASDAQ:PEGA) is a great option in this category. Though not a well-known brand among the average consumer, Pegasystems has become quite a tech powerhouse in its own right, having very recently crossed the >$1 billion in annual revenue mark (a milestone reached by very few technology companies). Pegasystems has years of operating history, strong leadership, a compelling product addressing two broad markets (BPM and CRM), and is undergoing a successful conversion into the cloud. Shares are off 20% off highs (suffering alongside its peers in the software sector in the indiscriminate selloff, but its losses haven't been as steep thanks to its more modest valuation) and down 10% for the year, marking a very good entry point for new investors:
In the CRM space, Pegasystems is up against heavyweights like Salesforce (CRM), Microsoft Dynamics CRM (MSFT), and Oracle CX CRM (ORCL). In the BPM space (a less familiar category within software that helps to automate tedious business processes and increase information workers' efficiency), Pegasystems competes against Appian (APPN). The latter, in my view, is Pegasystems' most meaningful growth opportunity, as the pandemic has forced companies not only to rely more on their technology stack but also to re-examine inefficient processes and building tech solutions around it - which is where Pega BPM comes in.
In my view, here are the top bullish drivers for Pegasystems:
- Continued cloud conversion. Pegasystems is now nearly three years into a cloud transition that began in early 2018, a move that the company says typically takes around 4-5 years. The company expects to be fully transitioned by early 2023. Continued buildup of ACV, especially on the Pega Cloud product, can help to shift sentiment in this stock.
- Buildup of cloud gross margins. As Pegasystems' scale in the cloud has increased, so have its gross margins. Improved profitability and cash flow can help to drive a re-rating in the stock.
- Becoming much more predictable thanks to recurring revenue. Pega has reached >$1 billion in revenue, but it's also close to reaching $1 billion in ACV (annual contract value; $835 million to be exact as of the end of its most recent quarter). The high degree of its contractually locked-in revenue makes the company's business much more predictable going forward.
- Continued consolidation in the software sector. Many older and slower-growing software companies have found themselves the target of private equity firms, especially if they have built up large recurring revenue bases. Talend (TLND) is a good example of a recent takeout of a cheaply valued, recurring-revenue software company in whose mold Pegasystems could follow (though being much larger, the pool of potential buyers for Pegasystems is admittedly more limited).
At current share prices near $119, Pegasystems trades at a market cap of $9.65 billion. After we net off the $465.2 million of cash and $518.2 million of debt on Pegasystems' most recent balance sheet, its enterprise value is $9.70 billion.
For the current fiscal year FY21, Pegasystems has guided to $1.25 billion in revenue, representing 22% y/y growth and above the $1.21 billion (+19% y/y) that consensus was expecting. Versus that revenue guidance (which still, in my view, has room for upside given the recent strong growth in ACV and the fact that Pegasystems has a relatively easy comp versus 2020 due to pandemic-related bookings softness), Pegasystems trades at 7.7x EV/FY21 revenue.
For a company that is managing to grow ACV at >20% y/y (and subscription/cloud revenue much faster than that), while sitting on top of huge end-markets, I think Pegasystems has a strong value proposition going for it. I'd use the recent dip as an opportune buying moment.
Q4 download
Let's now cover Pegasystems' latest fourth-quarter results in greater detail. The Q4 earnings summary is shown below:
Figure 1. Pegasystems Q4 results
Source: Pegasystems Q4 earnings release
Pegasystems' revenue in Q4 grew 8% y/y in Q4 to $298.6 million, accelerating four points over Q3's 4% y/y growth rate. As a reminder, Pegasystems' reported revenue growth right now is being weighed down by the company's transition toward recurring subscription revenue. The impact of this is to remove a chunk of upfront license sales, while at the same time improving overall customer lifetime revenue. As such, different metrics must be used to judge Pegasystems' progress.
ACV, or annual contract value, is the best measure to track. Pegasystems' ACV in Q4 grew at a 21% y/y pace to $835 million, on track to Q3's y/y growth pace. The company also added $58 million in net-new ACV in the quarter - far more than $39 million in Q3 and $27 million in Q2; reflecting a typical software buying pattern in which many new deals are signed just before year-end (before IT budgets are reset).
Figure 2. Pegasystems Q4 ACV trends
Source: Pegasystems Q4 earnings deck
We note as well that Pega Cloud itself (Pegasystems products hosted in Pegasystems' cloud) saw 57% y/y growth in ACV, on top of 56% y/y growth in revenue. This is a strong indicator that Pegasystems customers are responding well to the cloud shift and it'll continue to be a driver of optimism for Pegasystems in 2021. We note that other "legacy" software companies that have completed similar business model transitions to recurring revenue, such as Adobe (ADBE), Autodesk (ADSK) and Splunk (SPLK) have all rewarded by booming share prices.
Pegasystems' continued growth, especially in cloud, is helping the company to unlock profitability gains. Per CFO Ken Stilwell's prepared remarks on the Q4 earnings call (key points highlighted):
However, there are some inherent benefits of scale on our journey to be a Rule of 40 firm. First is its operating leverage. You could see Pega realizing the benefits of scale in our expanding Pega Cloud gross margin increasing from 51% in 2019 to 63% in 2020. As we grow in scale, we can clearly perform activities more efficiently, which we expect to positively contribute to our goal of achieving the Rule of 40 as we exit our cloud transition. Things like virtualization and automation can be leveraged more effectively at our increased size. Another benefit is scale has increased brand awareness. We anticipate investing in some incremental initiatives to ensure the market is aware on how Pega helps our clients to manage their digital transformation initiatives. This increased brand awareness will help us reduce sales cycles, decrease our customer acquisition costs, and improve sales efficiency; all big potential value levers for Pega."
As the company continues to make progress in its cloud transition, Pegasystems is guiding to pro forma profitability ($0.25 in positive pro forma EPS next year), versus -$0.37 this year.
Key takeaways
Pegasystems isn't necessarily the most exciting software company in the market, but that seems to be what the market is favoring these days. This is a company addressing two large software end-markets, growing ACV and backlog in the double digits, and making progress toward hitting the "Rule of 40". Sitting at under an 8x forward revenue multiple, I think investors have an opportunity to buy Pegasystems while it's still trading cheaply.
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