Pegasystems Takes Wing

It's been a long time since anyone had good news to share about Pegasystems (Nasdaq: PEGA). That changed yesterday -- or did it?

Pegasystems was one of two inaugural picks for the Motley Fool Hidden Gems portfolio in July 2003. But the rules-based business software maker soon went lame, reporting quarter after quarter of disappointing results, culminating in its ouster from our recommended list in March 2005. Yet over the last 52 weeks, the stock price has soared 25%, trouncing the S&P's 7% rise.

The stock notched a sizeable portion of its gain just yesterday, in response to an announcement that the firm had finally decided to do something useful with its enormous pile o' cash. With $117 million in the bank, cold hard cash composes 45% of Pegasystems' market capitalization. What's more, the firm is again cash flow positive; it claims it can produce $20 million from operations per annum, and spends only about $2 million of that on capital expenditures.

Yesterday, we learned that management had figured out what to do with about $14 million worth of the coming year's excess cash: Give it away. Pegasystems announced a $10 million stock-buyback program through June 2007, and a $0.03-per-share quarterly dividend -- its first ever. Over the course of the year, at today's share count, the new dividend program would cost the company approximately $4.3 million. So long as free cash keeps flowing at the rate of $18 million per annum, therefore, Pegasystems should easily be able to return $14 million to shareholders every year, indefinitely. But is that reason enough to let the stock back in the corral?

Management's announcement addresses one of the four key reasons Tom Gardner cited in dismissing the company from our stable: It hoarded way more cash than it needed, "much of which should have been returned to shareholders years ago." Let's look at Tom's other three reasons for letting Pegasystems go, and see whether they still stand. Said Tom:

• "[Pegasystems has] failed to attract and retain customers ." In last month's earnings report, CEO Alan Trefler stated that the company is "increasing [its] sales to new customers and extending relationships with existing customers," signing 17 new customers in Q1 2006 alone. Score a second point for Pegasystems.
  
  
• "Sales are slowing ." Year over year, sales grew 12% last quarter, 3% the quarter before that, 25% the quarter before that, and declined 1% four quarters ago -- evincing no obvious trend. Part of the reason is that the firm has changed how it recognizes revenue, stretching it out over the life of a contract. That dampens upfront revenue upon contract signing, but should generate more recurring revenue over time. Until we see concrete results, though, I can't give Pegasystems points for this one.
  
  
• "CEO and founder Alan Trefler continues to sell, even after a steep decline in the share price." Trefler continued to unload huge numbers of shares after our March 2005 sell recommendation, but hasn't sold any shares this year. That job was taken over by now-ex-Chief Financial Officer Chris Sullivan, who sold off his entire stake after announcing he was leaving the company in May. Score one for Trefler, but subtract one for Sullivan, making this issue a wash.

All told, my Take is that Pegasystems has begun to address three of our four concerns about the company. It added a new concern when its CFO jumped ship, however; at best, this is a job half done. The company is on the right track, but it doesn't deserve a renewed place in the Hidden Gems portfolio just yet.

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Fool contributor Rich Smith does not own shares of any company named above.