Pegasystems Inc.
Q2 2013 Earnings Call Transcript

Published: 9 Aug 2013

[Operator:]

Good day, ladies and gentlemen, and welcome to your Pegasystems' Inc. Second Quarter Earnings 2013. [Operator Instructions] And as a reminder, today's conference is being recorded. And now, I would like to turn it over to your host, Max Mayer, Senior Vice President, Corporate Development.

[Max Mayer:]

Good evening, and welcome to the Pegasystems' 2013 Q2 earnings conference call. With me here in Cambridge is Alan Trefler, Pegasystems' Founder and CEO. Before I turn the call over to Alan, I'll 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, forecasts and could and other similar expressions identify forward-looking statements, which speak only as of the date the statement was made. Because such statements deal with future events, they're subject to various risks and uncertainties. Actual results for the fiscal year 2013 and beyond could differ materially from the company's current expectations. Factors that could cause the company's results to differ material from those expressed in forward-looking statements are contained in the company's press release announcing its Q2 2013 earnings and in the company's filings with the Securities and Exchange Commission, including its report on Form 10-K for the year ended December 31, 2012, and other recent filings with the SEC. The company undertakes no obligation to revise or update forward-looking statements as a result of new information, since these statements may no longer be accurate or timely. After a strong Q1, Q2 was another great quarter for both bookings and license revenue. License revenue in Q2 2013 increased to $40 million, a 30% increase compared to the same period last year. This trend continues to validate the significant value proposition our software provides to our customers in solving their business process and customer engagement challenges. License signings increased significantly when compared to Q1 2013 and to Q2 2012 due to a higher number of deals and a higher average-deal size. Our international business contributed a significant portion to this quarter's license signings, a positive change from Q1. As we regularly mention, our business tends to be back-end loaded in the year, and the value of our license signings and, consequently, our revenues can be lumpy and fluctuate depending on our customers' needs, the timing of their budgets and their overall confidence level in the economic conditions affecting their business. License backlog, computed by adding the license backlog in our Liquidity section on Page 22 of our 10-Q and the deferred license revenue Note 8 of our 10-Q, totaled $272 million as of the end of this quarter, an increase of $40 million from the end of the second quarter of 2012 and only a slight decrease of $3 million when compared to the first quarter of 2013. It is typical for our business, as it is for many software companies, to consume backlog in the first half of the year and build backlog towards year end when license signings tend to be stronger due to customer buying patterns. Maintenance revenue in the first half was $74.3 million. This is a 14% jump from the $64.3 million in the first half of 2012. This increase is due to our client installed base that continues to grow while our maintenance renewal rates continue to be strong. Professional services revenue for the first 6 months of 2013 was $8 million lower or about 10% down from the first 6 months of 2012. As discussed in our Q1 2013 earnings call, this reduction is consistent with our strategy to grow the number of partner -- number of implementations performed by our partners and clients with Pega providing expert services. Despite the reduction in professional services revenue, the gross margin was 15% in the first half of 2013, about the same as the first half of 2012. This is primarily due to lower staff on-boarding time and expenses, as more of our customers become enabled and more of our implementation projects were led by our partners. The decline in our training revenue in the quarter in the first 6 months was mainly due to the introduction of Pega Academy, a much less expensive online training alternative, where we are seeing significant growth. This shift is consistent with our strategy of offering more accessible and more convenient training for our increasing partner ecosystem. Growth of online self-study is a trend we expect to continue. Operating expenses for the quarter increased by $7 million from Q1. This increase is almost entirely due to increased sales and marketing expense, including $4 million for marketing events, of which the biggest share was our record PegaWORLD 2013; $2 million from increased commission expense associated with the higher value of new license arrangements signed in Q2 2013; and higher employee compensation expense, driven by the 27 sales and marketing employee adds during the quarter. We anticipate our sales expense to increase in Q3, as we continue to hire additional sales personnel to increase coverage in our current geographies and industry verticals. R&D expenses increased slightly in Q2 2013 as compared to Q1. We continue to grow our R&D headcount with about 2/3 of the new staff being added in our centers in India. We intend to continue R&D investments throughout 2013 as we drive to extend our strong leadership position in BPM and CRM markets. G&A expense in Q2 2013 increased only slightly from Q1. This increase was primarily related to higher compensation expense and professional fees. As in prior quarters, we provided supplemental information in our press release to reconcile to a non-GAAP model, following the same format that was used when we provided guidance for 2013 as part of our Q4 2012 earnings release. There are 2 reconciling items

[Alan Trefler:]

Thanks, Max, and thank you to all the listeners who have joined us this evening. I'd like to just briefly elaborate on some of Pega's Q2 and first half performance, some of the key wins that we've been focusing on, some of the markets that we've been targeting and how we can value in those markets and wrap up with a little bit of a discussion of some of the upcoming engineering work that's going to be seen, which is what we think is very exciting. Our business performed quite well in Q2 and for the first half of 2013. Signings were up significantly over Q1 as Max spoke about, and at the same time, the pipeline size and quality increased as well over Q1. We accomplished this without any whale deals in the first half, whereas by comparison last year, there were 2 in the bookings numbers. We closed over 75 deals in Q2, a record number for our company; and consistent with our business over the last few years, about 70% of our bookings were from existing accounts and the remainder were from by some pretty exciting new names. Now it's terrific to have such additional buys from existing accounts, because now it says a couple of things

[Operator:]

[Operator Instructions] Our first question is coming from Steve Koenig from Wedbush Securities.

[Steven R. Koenig:]

If I can ask maybe one and one follow-up. First question is you've been seeing some pretty good margin improvement here. Just kind of wondering what's behind this. Is this sustainable? Is it somewhat of a function of just quarterly choppiness? Or are we seeing the beginnings of, Alan, like you've talked about as wanting to see the marketing move more from push to kind of a demand pull sort of scenario with prospects? Just any comments on that margin and then one quick follow-up, if you don't mind. [Audio Gap]

[Alan Trefler:]

Business in favor of really trying to do a good job for our clients. Can you hear me? We having an odd thing on the phone.

[Steven R. Koenig:]

Yes, now I can hear you.

[Alan Trefler:]

Right. So you didn't hear the beginning of that, I guess, so I will start. So I think the difference in margins is primarily caused by the shift in the mix of revenue from what are intrinsically lower margins in service to the higher margins in software. So I think that's really very positive. We are seeing evidence of more transition to a bit of, what I'm describing, a bit of a pull. I'm not ready to say that there's a sound of this sucking the software into our customers out of our doors, but there's still a lot of work to close this business. But there's a lot more enthusiasm, particularly for our products. One of the things that I think has been an issue in the market, to tell you the truth, that's impeded that transition from push to pull, is there's a very, very significant number of software projects implemented or attempted to be implemented by competing products that just haven't delivered well. One of the interesting things, if you take a look at the Gartner numbers, is that if you go back to their 2010 Quadrant, they have, I believe, 9 companies in the leader category, right, 9 companies in the leader category; and if you take a look at that Quadrant now, 2.5 years later, they have 3 in the leader category. I think a lot of those were earned by, frankly, not being able to have the sort of record of client success that we don't take for granted. We're very appreciative of our customers working with us and our partners working hard to do it. But the software that can get customers all the way to where they want to go, we think, is going to have an important advantage in getting this market to understand how powerful this technology can be. So really part of getting that switch is in our hands, by being able to make -- create more visibility to client success and gets customers excited.

[Steven R. Koenig:]

Okay, that's helpful. And now, if I may then, somewhat of a related question here, which is -- you're competing for attention and there's a lot of important trends that are going on, including cloud computing, big data, et cetera, and you've got competitors, for example, with the SaaS message with the focus at the low end of the customer service market, but they have a real simple message that business users have now been educated on SaaS in a way that they really haven't been educated maybe on DPM. How do you get attention in this kind of [indiscernible] and in the midst of the important things going on in the environment?

[Alan Trefler:]

I think that's a great question, and one of the things that we've been working on very diligently, especially over the last couple of weeks, was putting together what our thoughts are about how to really dial up our marketing and our messaging. And I'm not going to leak anything, but I think we've got some really, really good stuff that we're going to be starting to roll out in the second half of this year. And I think it's incumbent on us to, frankly, do a top-notch job of telling our story. And to some degree, I believe we've been talking more to a smaller community and not giving proper attention to the importance of establishing a more significant brand. So you should expect that we're going to come out with some new messaging aimed specifically at the problem you mentioned, and we'll get to see how that works. I've been told that I did a bit of a serious error in my presentation when I was talking about Lloyds. It -- somebody said that I may have said that they're working to save GBP 1 million a year. In fact, the actual number that they're saving is in excess of GBP 1 billion a year on a run rate basis, and they are well along their way on that journey. So if I got it wrong, I apologize.

[Operator:]

Our next question is coming from Raghavan Sarathy from Dougherty & Company.

[Raghavan Sarathy:]

Two questions. First question has 2 parts. So at the last quarter, you talked about a number of transactions so that's 30% [ph] [indiscernible] lower. I know you mentioned that you closed 75 deals in the current quarter, so how does that compare to last quarter and same quarter a year ago? And how did the ASP turn? It looks like the timing have include [indiscernible] even though you didn't have bigger deals. And I have a follow-up.

[Alan Trefler:]

So I'm doublechecking the numbers. But from memory, I think the ASPs between first quarter and second quarter were in a similar range, no material real shift. Compared to a year ago, if you look -- the problem with ASPs is they get really influenced by a whale. So I'm actually not at all unhappy to have -- as long as the customers eventually become whales, I'm not at all unhappy to have things broken up into some of the smaller pieces. I think that it's consistent with us over time, perhaps, becoming a somewhat more predictable company quarter-to-quarter. Year-to-year, we do pretty well, but quarter-to-quarter, it can be pretty lumpy. This is actually from my point of view. It's too early to say that it's a trend, but I view it's sort of a positive development.

[Raghavan Sarathy:]

Okay. And then like you said, it's kind of difficult to look at your company quarter-to-quarter. If I look at the first half signings. This is first half of last year, the license signings were flat. So can you talk about the pipeline you have? It looks like there's no whales deal. There's no significant upside. But can you talk about the pipeline of opportunities you have? And I guess, at the end of the day, how should we think about licensing signings growth for the year?

[Alan Trefler:]

So I think that -- so a couple different things. One, I actually don't think it was flat 6 months to 6 months, and we're going to doublecheck, but I think it was up somewhat, so I'm not sure how you're calculating that. In fact, I'm quite certain that it was. Relative to the pipeline, so the pipeline is up in aggregate, but we talked, as we -- end of the last year, about looking to implement some new practices and processes in the way we do our selling that we have implemented, and I think we're starting to see some positive results. One is as opposed to looking at just the sort of aggregate pipeline, we actually have really called out a significant number of deals that we consider to be what we call the working set, which are really the things that we expect are both high probability, but also things where we can influence the outcome very significantly. And the reality is that, that actually has a very [indiscernible] effect on improving the conversations between the sales managers and the sales reps and bring everybody right up to me, visibility as to what's going to happen. So what I'll tell you is I don't have a working set a year ago to compare this to because it's a new practice, but the working set is stronger than I could imagine. So we're seeing just lots of good stuff in the pipe. True to form, the predictability of what closes in Q3 versus what closes in Q4 is always one of those interesting challenges. But boy, the level of activity was unprecedented in Q2 and going into Q3 is at an unprecedented sort of working set level.

[Operator:]

And our next question comes from Brian Murphy from Sidoti & Company.

[Brian Murphy:]

Alan, do you expect this year to be less back-end loaded from a bookings perspective than it was last year or perhaps over the past few years?

[Alan Trefler:]

I think this is also going to be a back-end loaded year. I mean it's just the nature of it, and that it will be important to us because that's how we want to build backlog for going in and once again, having a strong year in 2014, 2015. Because some of our deals are multi-year deals, as you know. So we still expect it to be heavily back-end loaded. I'm a little happier than I was in prior years, where year-to-date, the back-end loadings had not covered much of the expense of the earlier parts of the year. But no, this is still -- we haven't yet changed the nature of this business. It's still being very Q4 heavy. As I said, we're implementing some new management practices but, of course, it's going to take some period of time for those to take root and perhaps help us bring more into the earlier quarters.

[Brian Murphy:]

Obviously, a lot of look at first half perpetual license sales that I think are up more than 50% versus last year, I shouldn't look at that as a conscious effort or a way to smooth out the quarterly volatility. Is that -- or is there something happening in the environment?

[Alan Trefler:]

Honestly, a lot of that is just the sort of vagaries and lumpiness that you see. We try to sell the best deal to the customer that the customer is prepared to buy. I personally have a bias towards term deals, so would rather do that. Then -- and then we actually compensate, I'd say, at a higher level for term deals, so there's a little bit bias in our system for us to sell terms. But customers, I think, are just sometimes wanting perpetuals. And frankly, I think one of the motivations for that is with so many software companies being acquired and once the companies are acquired, companies typically experience -- there's a couple of typical bad experiences. One is that there are certain acquisitive vendors who were known to be pretty brutal in terms of renegotiating contracts that they thought they had. And the other experience is that the talent almost inevitably leaves, sometimes pretty quickly, and the energy and the rhythm of change and the focus of business is obviously not the same in extremely large sort of multiproduct firms as opposed to firms who really have a common architecture. I think those 2 things are causing certain companies to want to make sure they're in better control of their destiny. Because they perceive, and I've been told this by a number of buyers, that they perceive that they have more control should something happen like an acquisition, if they're in a position where they have a perpetual license as opposed to having the license in doubt as well as having to argue about maintenance. So we're not creating any sense that they should worry. I'm not getting any sense that the customer are worried that we're going to be acquired, but this is a direction that I've seen them giving to their purchasing people. And it obviously is going to affect people who only sell on a term basis or on a subscription basis, plus companies like us, which have the choice. I think that may have had some influence over the last year.

[Operator:]

[Operator Instructions] Okay, and it appears there are no following questions. I'd like to turn the call back to Alan Trefler for any concluding remarks. Actually, before we close, I do show one last question coming from Raghavan Sarathy from Dougherty & Company.

[Raghavan Sarathy:]

Just a couple of follow-ups. And so Alan, you talked about Europe, you're happy that sort of rebounded. That seems somewhat counter to what we are hearing about Europe. So can we talk about, is that from a revenue perspective or license signings perspective or both? And how you're seeing kind of different trend? And then I have a follow-up for Max on sales and marketing expenses.

[Alan Trefler:]

Sure. So the -- Europe was up from both the signings and the revenue point of view. To be honest, it was a bit of an easy compare, because Europe has been under some pressure historically. But we actually had both in England and on the continent, significant business with actually multiple customers. So we were very, very pleased. And I think one of the reasons things are a little different for us is those are examples where clients have had some success. It's easy for them to make the decision to buy more when they have a lot more fund [ph], when they have a level of confidence. And you had a question for Max?

[Raghavan Sarathy:]

Yes. And so historically, Max, when we looked at the sales and marketing expenses, it has declined sequentially because you're coming off of a user [ph] conference. You talked about the hiring, maybe Alan, you can chime in. So what -- how many people are you going to hire? How should we think about these expenses sequentially? And then, Alan, what is your focus of -- in terms of hiring? Are you trying to go to new geographies or verticals? So give us some color.

[Alan Trefler:]

So I think that some of that is still to be determined based on how we feel 2014 is going to go. All the hiring we really do, from this point forward, from a sales perspective, is really about populating 2014. So I would expect that -- obviously, Q2 was more expensive like it always is because of PegaWORLD, which adds a couple of million to it. But I do expect that we will be hiring at a good pace in Q3 and Q4 in anticipation of 2014.

[Max Mayer:]

Yes, we've ramped up the number of recruiters going at the sales headcount, because we want to dramatically ramp 2014. We know we need more salespeople that will [ph] cover our existing accounts and cover accounts that we're not covering today. So we would expect to ramp up sales headcount throughout the second half.

[Operator:]

And our next question is from Brian Murphy from Sidoti & Company.

[Brian Murphy:]

Alan, just a follow-up on the hiring question, how should we think about the CFO vacancy here?

[Alan Trefler:]

You should think that we're a pretty appealing company to work for, and we're very picky. That's the right way to think about it, and we have complete confidence in our finance staff and its ability to keep the business running. And everything, I think it's just going spectacularly. So we're going to be appropriately prudent. We've been talking, especially recently with -- some great candidates, and so I'm actually pretty excited that we should be able to bring this to a close fairly soon.

[Operator:]

And our next question is from Jim Thropp [ph] from Discovery Investment [ph].

[Unknown Analyst:]

Alan, I want to know -- I heard you say -- comment about Europe rebounding, that you had an easy compare. I just wondered what the back half of 2012 looked like, and if you could comment a little bit more about the specific areas in Europe and just what the second half you think will look like.

[Alan Trefler:]

I think the second half is going to be pretty good as well. It's going to be much more about Q4 in Europe than Q3, because as you know, much of Europe is often very [indiscernible] until -- for some time there at the end of August or early September. So that just -- it doesn't give a lot of runway to get certain things done in that quarter. But the -- that working set that I talked about has a lot of strength in Europe. I have no reason to believe that our good first half is an anomaly. That's true for APAC as well, though APAC is obviously smaller.

[Unknown Analyst:]

Okay. And then the other question I have was on just verticals. I didn't hear a whole lot of color. I know you talked a little about it, but I just wondered if something was really stronger in the quarter and then what you expected in the backlog, what was in the backlog maybe that -- may jump out [indiscernible] as far as verticals going forward?

[Alan Trefler:]

Yes, so in the verticals, we're actually seeing some really pretty interesting things in certain industries, where we've come out with these 2 process extenders is what we call them, one for SAP and one for salesforce.com, where we're actually partners now with both of those organizations. And it makes it really easy for companies who have those systems, but who want to really put world-class sort of process automation, that's analytics-driven into those environments. And so I think in the industries in which those guys have a good footprint, we're seeing just a whole new opportunity for business that we haven't seen before, which I think is actually pretty exciting. So it's really around those sets of capabilities. Those areas would typically be some areas around financial services have been good. In varieties of telcos and insurance, we're seeing some pretty interesting things in that space.

[Max Mayer:]

Yes, I would add that we saw a lot of strength in life sciences in the quarter and see that continuing and which is really good for us. We see strength in the public sector, and our pipeline of the public sector is quite strong over a year ago and even over Q1. And as Alan said, we see a lot of increasing strength in the insurance sector, so just to highlight a few.

[Unknown Analyst:]

And then the last question I have is that the accounts receivable kind of jumped back up in Q2 and after obviously a very strong collection period in Q1. I just wondered if you could comment a little bit about the rest of the year and if this is concentrated very much in a couple of customers and just, in general, a more normalized cash flow environment the rest of the year. Or -- well, what do you expect, I guess?

[Alan Trefler:]

Yes, so I think what happened in Q1 is that the finance team were showing off, did such a spectacular job of collection that we fell to like -- I think a bizarrely low number like our DSOs are something in the mid-30s. 37% is -- let me recall the number, so which is a record. So that shows that in the absence of a CFO on duty, they really dug in and delivered an exceptional, exceptional level. That's not a sustainable number. The numbers that we're at is the right sort of number, sort of business of our type, I think, on an ongoing basis. So I don't expect any continued change, particularly in that number, one way or the other.

[Unknown Analyst:]

The 61 days is pretty normal -- are pretty normal then?

[Alan Trefler:]

Yes. I think if you look around the industry, yes, it goes up and down a little, but it's 20% up or down. But 37% was just not a sustainable number. I'm sorry to say, though. If they want to prove me wrong, I'm glad to see if that can change my view.

[Operator:]

This does conclude our Q&A session. I'd like to turn it back to Max Mayer or Alan Trefler for closing remarks.

[Alan Trefler:]

Well, you can turn it back to both of us. Let me just thank you for taking the time to listen. You should know that we're working hard for you, and we're very committed to building a great business. Thank you very much.

[Max Mayer:]

Thank you very much.

[Operator:]

Okay. Ladies and gentlemen, this does conclude your conference. You may now disconnect and have a great day.