Pegasystems Looks Good, but Not Great

Pegasystems is a small fish in a big pond; will it be snuffed out by powerful competitors or continue making a home for itself?

Mar 6, 2014 at 2:00AM

The enterprise software landscape is dominated by giants like SAP (NYSE:SAP), IBM (NYSE:IBM), and Oracle (NYSE:ORCL) with annual revenues of $22 billion, $99 billion, and $37 billion, respectively . Pegasystems (NASDAQ:PEGA) is surprisingly competitive despite its annual revenue of only $508 million. It wins business with major government agencies as well as top tier clients like Bank of America, Cisco, and American Express.

Pegasystems' advantage is the customizability and ease of use its software provides. It enables easier business process integration due to its unique approach to client application development. Other solutions usually require the client to restructure at least some business processes prior to or during implementation. Pegasystems allows the client to create enterprise applications directly from their existing business process designs, which is a major short-term cost advantage for clients.

Performance snapshot
Pegasystems' revenue has grown at an average rate of 18% over the last four years . Software license agreement revenue increased 17% from last year, and maintenance revenue is up 18% year over year , which should continue to increase along with new licensing. However, service revenue is down 3%, mostly from a decrease in demand for consulting services due to an increase in partnerships with consulting firms who act as integrators.

There are also significant increases in expected revenue in the pipeline. Term license contracts on average are scheduled to bring in 44% more per year over the next five years compared to the five-year outlook last year . This could be due to Pegasystems' effectiveness at retaining clients since 80% of the value of new license agreements in 2013 came from existing customers. In 2012, that ratio was 74% .

Competitive challenges
The main challenge Pegasystems faces is its size relative to major competitors. The resources available to other companies offering similar products are much greater, which leaves Pegasystems at a considerable disadvantage in sales and marketing, research and development, and service/consulting.

SAP, IBM, and Oracle each spend more on research and development in one quarter than Pegasystems' total revenue from 2013 . With those R&D budgets, larger companies are developing technologies that are revolutionizing the industry such as SAP's HANA, IBM's PureData, and Oracle's Exadata products. As these new technologies gain momentum, and market share, Pegasystems will have to rely on its unique approach to application development, and its established footholds with major clients. 

Investing bottom line
Pegasystems will probably never compete at the same level as its bigger rivals, but it is growing and maintains some advantages over others in its field. In the next year it will be good to keep an eye on the percentage of growth from new customers. If that increases, be prepared to act on good entry points.

If revenue from new customers becomes a smaller and smaller portion of overall revenue growth, it will signal that the resource gap between Pegasystems and its larger competitors is too great to be effectively countered by the narrow advantages Pegasystems provides. In this scenario it would most likely be a good time to exit some or all positions in the stock.

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Charlie Roe owns shares of Pegasystems. The Motley Fool recommends American Express, Bank of America, Cisco Systems, and Pegasystems. The Motley Fool owns shares of Bank of America, International Business Machines, and Oracle.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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