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Pegasystems Inc  (NASDAQ:PEGA)
Q3 2018 Earnings Conference Call
Nov. 07, 2018, 5:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, and welcome to the Pegasystems Third Quarter 2018 Earnings Results Call. Today's conference is being recorded.

At this time, I'd like to turn the conference over to Ken Stillwell, Chief Financial Officer. Please go ahead.

Ken Stillwell -- Chief Financial Officer, Chief Administrative Officer and Senior Vice President

Thank you. Good evening ladies and gentlemen and welcome to Pegasystems Q3 2018 earnings call.

Before we begin, I'd like to read our safe harbor statement. Certain statements contained in this presentation may be considered as forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. The words expects, anticipates, intends, plans, believes, could, should, estimates, may, targets, strategies, intends to, projects, forecasts, guidance, likely and usually or variations of such words or other similar expressions identify forward-looking statements, which speak only as of the date of the statement was made and are based on current expectations and assumptions.

Because such statements deal with future events, they are subject to various risks and uncertainties. Actual results for fiscal year 2018 and beyond could differ materially from the company's current expectations. Factors that could cause the company's results to differ materially from those expressed in forward-looking statements are contained in the company's press release announcing its Q3 2018 earnings and in the company's filings with the Securities and Exchange Commission, including its annual report on Form 10-K for the year ended December 31, 2017 and other recent filings with the SEC. Investors are cautioned not to place undue reliance on such forward-looking statements and there are no assurances that the matters contained in such statements will be achieved. Although, subsequent events may cause our view to change except as required by applicable law, we do not undertake and specifically disclaim any obligation to publicly update or revise these forward-looking statements whether as the result of new information, future events or otherwise.

And with that, I'll turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Alan Trefler -- Founder and Chief Executive Officer

Thank you, Ken. Right now, I'm in the midst of a busy week with clients. I'm actually in London, dialed in remotely. But if the connection does that, I'm sure Ken will step in until I can reconnect. In terms of some highlights, I'm pleased, really pleased with our year-to-date results. They reflect our strong business momentum. And I continue to be encouraged with the progress we make -- we're making as we focus on delivering the best solutions for digital transformation.

As I said, one of our key goals is to accelerate growth and the cloud. Our performance to-date is a good example of the progress we're making. We continue to see acceleration in our move to the cloud and recurring arrangements. Year-to-date, cloud represented 51% of all new deals, about double the rate from a year ago. This faster than anticipated move to cloud arrangement is really good for our business long time and our strong underlying business trends are also reflective in license and cloud ACV, which grew 36% from a year ago. Total ACV, which includes maintenance on former types of licenses grew a healthy 20% from a year ago as well to $537 million. As you know, it can be a lumpy business. So I'm particularly pleased to see a strong Q3, following on a strong Q2. And in a moment, Ken will provide additional financial details.

I'd like to touch on some of our strategy and differentiators. We continue to focus our efforts on delivering the best solutions for digital transformation, and we believe that requires both effective customer engagement capabilities and the capability to do serious digital process automation. Now, the strategy is driven by our six core differentiators. Our real-time omni-channel AI, our end-to-end automation in robotics; our journey-centric rapid delivery; the Situational Layer Cake technology that promotes reuse; the having of ability to actually have software that writes your software and Cloud Choice.

This unique combination allows us to do several things better than any of our competitors. We help our clients make better decisions by delivering one-to-one customer engagement, powered by that real-time AI. We help our clients get work done by making customer and employee-facing processes more efficient, see that end-to-end automation and very often we do both. For example in customer service, when customer interactions involve both dealing with clients effectively and processing work to resolve request on the spot.

Now, our results this quarter reflect the value of these differentiated solutions. And what we're able to offer to market, we saw a good mix of business across new and existing clients in our core verticals, our platform, our applications and across geographies. And we are pleased to see that we continue to win and expand our business into accounts that are already working with competitors like Salesforce.com and ServiceNow. We believe this demonstrates the recognition of our differentiated value proposition in a whole set of settings.

Our financial services continues to be a core strength for us. For example, Bank of Nova Scotia extended our partnership as part of a global one bank digital transformation strategy. They've been a customer for this goal and Pega is helping Scotia give its customers true omni-channel experiences. Customer journey is able to start and complete on any channel, seamlessly and intelligently. And Lloyds Banking Group, the largest retail bank here in the UK continues to extend its work with Pega. Most recently with the new Pega Cloud solution that's helping Lloyds comply with new regulations, increased productivity and importantly increased customer satisfaction.

We also see good momentum in government businesses. In the US, we continue to expand our work within the Federal Government with both new and existing organizations. Similar to our private sector clients, government agencies are pursuing digital transformation, looking to focus on both increasing efficiency and responsiveness, while improving citizen engagement. We're interestingly seeing similar interests globally in governments in EMEA and Asia Pacific as well.

For example, in Japan, our new client, the Ministry of Economy, Trade and Industry chose Pega as part of a digital transformation initiative to optimize and digitize the processes they used to monitor the safety of companies working with potentially dangerous materials. These are the sorts of systems that improve employee productivity and satisfaction, while ensuring that the right processes are followed to comply with appropriate regulations. We continue to see continue -- we continue to see real momentum in the government sector. I'll tell you from just having been in a variety of industries in the field over the last three weeks, there is a lot of enthusiasm and I'm very excited about how things are going.

From the technology point of view, the customer response is enthusiastic regarding our biggest product launch when we introduced Pega Infinity at PegaWorld in June. Now, we continue to enhance our product suite. And last month for the first time, released the newest versions about our platform and applications as a single way. And this release includes substantial capabilities in the real-time omni-channel AI, the end-to-end robotics and automation and will really help our marketing sales, service and platform clients to like their customers. We've made our software easier to adopt with redesigned user-focused studios. And we've made the software increasingly frictionless to deploy, with advanced testing, DevOps capabilities to improve deployment and, of course, Pega Cloud.

From an industry recognition point of view, we also have continued to receive awards and recognition from the leading industry analysts, like Gartner, Forrester and Ovum. Just this quarter, Forrester named Pega as the Leader in Digital Decisioning Platforms. That picture is just wonderful and available on our website. Pega has the highest aggregate critical capability score in Gartner's just published Critical Capabilities for the CRM Engagement Center report. Gartner named Pega Visionary in their Magic Quadrant for mobile app development. And Chartis Research named Pega a category leader with the highest scores among 21 solutions in the Know Your Customer space for the second year in a row. This continued recognition I think is just a demonstration that Pega is relentlessly focused and committed to building our technology and making sure that we're able to attract and retain our talent, able to make Pega a great place to work and able to turn that into tangible, technical and business goals.

And in closing, you may recall that last February, I filed a shareholder letter describing interest in gathering feedback on potentially creating a second class of equity. Since then, we've had a number of interesting discussions. And tonight, just filed the supplemental second letter that outlined some updated thinking and questions. To ensure that as we discussed responsibilities with shareholders, there isn't risk that we accidentally create a possible Reg FD issue. As I said in February, there are specific plans and I expect to continue to learn through further conversations. That supplemented letter was filed tonight as an 8-K. And if you have questions, feel free to reach out to me or Ken.

So in summary, I'm really pleased with our performance in Q3 -- through Q3. We've seen good acceleration quarter-to-quarter in license and cloud ACV. We continue to invest appropriately in marketing sales to reach our ambitious goals and targets. And we're very positive about how our software is being adopted by our -- and our long-term growth opportunities.

To provide more color on the financial results, I will now turn it over to Pega's CFO, Ken Stillwell.

Ken Stillwell -- Chief Financial Officer, Chief Administrative Officer and Senior Vice President

Thanks, Alan. Year-to-date, 2018 has highlighted the very positive momentum we're seeing in the business. Not only do we have the strongest Q3 in Pega's history, we also experienced significant growth sequentially over Q2 of 2018, which by the way was a very solid quarter as well. We experienced the continued acceleration of our ACV growth and consistent shift toward cloud commitments. As we've discussed in the past, our strategy has been to accelerate growth with a much higher mix of term and cloud commitments.

Year-to-date, cloud commitments were 51% of total commitments. The associated short-term revenue trade-off that occurs with a significant movement to the cloud is, well, today pretty well understood by the market. Over time, we can leverage the movement to recurring contracts by expanding our margin as we gain operating leverage correct. That said, I want to reiterate that if one just looks at our reported year-to-date revenue, it would lead to an incorrect conclusion about the growth of the business.

Our year-over-year term and cloud subscription ACV growth of 36% is more indicative of our overall business momentum. Year-to-date 2018, our mix of new commitments with 90% term and cloud subscription, conversely perpetual deals dropped to only to 10% year-to-date 2018. This confirms our belief that customers are increasingly comfortable with contracting under recurring arrangements and aided by cloud -- by Pega's Cloud Choice differentiation. We had anticipated the cloud portion of new commitments would increased to 30% for the full year 2018 versus the actual 51% we're experiencing year-to-date. As I have said throughout the past few quarters, it's a pretty significant shift, but really welcomed. The short-term revenue impact to the shift is obvious, if you look at the top-line revenue, impacting our year-to-date revenue by at least $40 million.

Let me talk a little more about the details. I'll also remind everyone that we had a very large term renewal of $35 million that occurred in the first quarter of 2017. If you normalize our revenue for these two elements, those elements being the $35 million renewal in the first quarter of 2017 and the significant movement to cloud, total revenue growth would look very different. Our maintenance revenue growth came in at 9%, which is slowing a bit, but reflects our big acceleration away from perpetual to cloud. Consulting revenue grew 5% year-over-year, consistent with our strategy to increase the share of implementation work that our partners lead. Cloud revenue grew by an amazing 60% year-over-year. So when you look at the individual revenue elements, you can clearly see our movement to recurring and specifically cloud playing out favorably, so our strategy is working well.

As I've mentioned, we model the full year with an estimate for cloud at 30% of new commitments versus the 51% that I mentioned previously. Cloud momentum has been accelerated through the year and it's driving -- is driven by market demand as well as improvements to our go-to-market. As we have said in the past, each 1% shift toward cloud has the potential to reduce full year 2018 revenue by over $3 million. As the economic value is reflected in ACV, but the revenue is taken over the length of the arrangement under a cloud agreement. Hence, the short-term reduction in reported revenue and EPS is exchanged for more favorable higher long-term cash flows.

We began disclosing annual contract value or ACV a couple of years ago. With the impact of implementing the new revenue standard, we believe ACV is highly correlated to recurring and predictable cash flows. Our term and cloud subscription ACV grew by 36% year-over-year, which highlights the growth in predictable future cash flows from license and increasingly cloud. Including maintenance, we entered the third quarter with $537 million of total ACV, which is up 20% from a year ago and 40% over the past eight quarters. Total ACV now equals 60% of our trailing 12-month revenue, which is up from approximately 50% of our trailing 12 months revenue just a couple years back.

We have consciously continued our strategic investments in go-to-market capacity. And in fact, we're looking to continue investing in our capacity to capture a larger share of the growth opportunity. We finished the period with approximately 4,500 employees, up 9% from September 30, 2017. We're confident in the market, our product leadership, Cloud Choice and our ability to capture share and that the ACV acceleration we're seeing supports the long-term value stream that we're creating at Pega.

Turning to profitability on a year-to-date basis, our non-GAAP fully diluted net income and earnings per share have been materially impacted by the sharp shift to cloud and the lack of near-term revenue associated with a shift like what we're experiencing. Although, the results could look confusing during such a transition, we are fully committed to continuing to drive to recurring and specifically cloud. Our cloud margin continues to expand as we scale our cloud business, contributing to confidence that our overall margins will improve over time. The outcome over the next few years will result in our ability to generate a significant amount of recurring cash flow and expand our free cash flow margins.

We're disclosing $522 million of commitments from customers that have not been taken to revenue, as of September 30, 2018, including perpetual, term, cloud, maintenance and consulting. You'll note that 60% of these commitments are projected to convert to revenue in the next 12 months. This is commonly referred to as remaining performance obligation or RPO. The absolute number will fluctuate over time based on the growth of the underlying business and also the average duration of the contracts that are in backlog. However, this number is helpful to illustrate the scale of commitments made from our customers. And I hope this helps to provide additional visibility to total commitments.

From a cash flow perspective year-to-date, we produced $67 million of operating cash flow and finished the period with total cash and marketable securities of over $200 million. As we transition to cloud and create long-term recurring cash flow from our clients, during this transition, there will be lower free cash flow compared to under our perpetual model, which has a large upfront payment, but lesser recurring payments. Once we're through the transition, operating cash flow will normalize and align very close to our operating margins over the long-term. Year-to-date 2018, we returned over $71 million to shareholders through dividends, net settlements of equity and share buybacks. In summary, we're very pleased with our year-to-date execution against our strategy and are focused on finishing what has been so far an incredible 2018.

And with that, operator, we open the call to questions.

Questions and Answers:

Operator

Thank you. (Operator Instructions) And we'll take our first question today from Rishi Jaluria with D.A. Davidson.

Rishi Jaluria -- D.A. Davidson -- Analyst

Hey, Alan and Ken, thanks for taking my questions and nice to see some continued cloud momentum. Alan, let me start with you. I believe in your prepared remarks, you talked about ServiceNow as your competitor and any -- I missed in the past, I -- this is the first time I've heard you talk about ServiceNow as a competitor on a conference call. So maybe, if you could square a little bit into -- on what angles you're competing against ServiceNow? And then since its a company a lot of us know well, what -- how are you thinking about your differentiation versus them?

Alan Trefler -- Founder and Chief Executive Officer

Well, we see ServiceNow as a company that's also seeking to be a platform company, seeking to be a CRM firm and talking about digital transformation. And we're routinely asked by clients how we should see ourselves or how they should see us compared to Salesforce or ServiceNow because to some degree we run into those folks all the time. And we've recently scored some pretty major wins in organizations that had large deployments of both of those firms. And so as they grow, we are of course going to see the more. And we do want to make sure we are alert in the market to all possible competitors. And they have been mentioned as well.

Rishi Jaluria -- D.A. Davidson -- Analyst

Got it. Okay. That's helpful. And Ken, as we look at your remaining performance obligations, and by the way thank you for coming up with a catchier name and committed not yet recognized revenue. But since this is a new metric for us, how should we be thinking about the sequential changes at least from Q2 to Q3 here? I mean, I think it looks like we saw about a $50 million increase in cloud performance obligations sequentially, but just want to get some context around that number?

Ken Stillwell -- Chief Financial Officer, Chief Administrative Officer and Senior Vice President

So good question, Rishi. So there are some things in the remaining performance obligation that are probably less relevant to look at quarter-to-quarter. For instance, the amount of perpetual revenue that hasn't been taken to revenue. That will move -- that will have different seasonality changes and depending on contracts, et cetera. So I would say that's probably less helpful. But certainly, the Cloud One, if you look at the next 12 months, that is really a leading indicator to the amount of commitments that are already under contracts for cloud. And so as our cloud business grows, you would expect the next 12 months of cloud commitments to grow. Not always in a linear fashion to our actual underlying growth because timing of renewals can be slightly less linear, but that's a helpful one. And in additional -- additionally, term is an interesting one because as you know, under 606, term commitments when booked largely come into revenue upfront, but there are some situations when they don't. Like if use -- if there's usage tranches or there's things that cause that revenue to be earned over time, so it's helpful that you can actually use that coupled with our revenue to be able to understand the total amount of commitments that were made to Pega in a specific time period, similar to the way that we used backlog under the old accounting standard.

Rishi Jaluria -- D.A. Davidson -- Analyst

Okay. Got it. That's helpful. And then last one from me and I'll jump off. But as we think about the numbers, and I don't want to read too much into this, but if I know it's correct, you've done 51% of new sales being cloud year-to-date. Last quarter was 54%, Q1 was 48%. Does that mean that it declined sequentially from Q2 to Q3 or am I thinking about this wrong?

Ken Stillwell -- Chief Financial Officer, Chief Administrative Officer and Senior Vice President

It may have declined a couple percentage points. But I would say, it's still been in a fairly narrow range through the first three quarters of about 50%. So I certainly wouldn't suggest that a slight movement like that would indicate any market trend change. What I would say is we're seeing about 50%. And the conclusion I would draw from that is it's been largely consistent for each of the first three quarters.

Rishi Jaluria -- D.A. Davidson -- Analyst

Okay, great. Thanks a lot guys.

Ken Stillwell -- Chief Financial Officer, Chief Administrative Officer and Senior Vice President

Thanks, Rishi.

Operator

(Operator Instructions) We'll now hear from Mark Schappel with Benchmark.

Mark Schappel -- Benchmark -- Analyst

Hi. Thank you for taking my questions. Alan, starting with you, public sector has been a big focus of the company. And obviously, 3Q is a big public sector quarter. And you referenced a couple of good deals this quarter. With respect to the delivery mechanism in the government and the shift to cloud, what are your government customers? What's their approach to cloud versus licenses? Are they still hang on to licenses or are you starting to see them adopt -- or starting to adopt cloud deals?

Alan Trefler -- Founder and Chief Executive Officer

We're seeing them adopt cloud deals. The interesting thing that's an option for us is the entire -- the whole question of Cloud Choice because we give them a lot of options as to whether a government customer might choose to use the cloud from Pega or whether a government customer might choose, for example, to move it to one of the AWS or Azure type instances that they might use externally or some of them actually are still focusing on having some level of private cloud. We deal with a number of agencies actually in several countries that have an extreme security expectation. And frankly, some of those agencies would never buy from an American cloud company to run on the American cloud because of some of the laws that have been passed, which could make them subject to US subpoenas. So in those cases, I think we're seeing the move to cloud, if they want to be a cloud that they choose to run. I think that's great for us from a positioning point of view. It really enforces the value of that Cloud Choice proposition.

Mark Schappel -- Benchmark -- Analyst

Great. Thanks. And then Ken in your prepared remarks, I believe you noted that the company plans to increase investments in the sales and marketing area. I was wondering, if you could just expand on that a little bit, such as where you plan to focus those investments in terms of say geography, sector, customer size?

Ken Stillwell -- Chief Financial Officer, Chief Administrative Officer and Senior Vice President

So we have some primary markets geography and also verticals, where we've been very successful over the years. And as you can imagine, at our size, we have a lot of runway to improve our coverage of some of these very, very viable and interesting enterprise organizations. So I think I would be less focused on Denver versus Boston versus the UK and more just highlighting the fact that we have a lot of runway to really grow the business to a much bigger size than what we are right now and naturally having customer-facing capacity is important to be able to drive that.

Alan --

Alan Trefler -- Founder and Chief Executive Officer

Yeah. I'm going to -- yeah, I can jump in. You're not going to see us running into sluice of new geographies because we have done actually quite a bit of analysis this year and we've decided that what we really want to do is increase our density in the number of organizations that we might be covering with a fraction of a person or that we might be covering with an individual when the scale of the company and the scale of the opportunity in it would mean that, to cover it effectively, you need to be several times just one person. And so by taking that as a strategy, I actually feel really good that we're going to be able to improve the reliability of our selling because we're not going into experimental new places. I mean, just talking about the government for a moment, to properly cover the opportunities we have with government, we could be several times our current size in that team and still frankly have what I would consider only partial coverage. So I feel good that we know where and how to increase that density and to increase that coverage, which should be more reliable that if we say we're running into a whole bunch of new geographies.

Mark Schappel -- Benchmark -- Analyst

Great. Thank you. And then finally Ken again for you, with respect to operating margins in the quarter, where do you estimate operating margins would have been if it wasn't for the aggressive shift to the cloud?

Ken Stillwell -- Chief Financial Officer, Chief Administrative Officer and Senior Vice President

So if you adjust -- if you think about the cloud -- the impact of moving to a much higher cloud percentage, and you really have to think Mark not just of the 30% to the 50%, but you have to think about what our cloud percentage was last year, which was in the low 20s to where we are, which is just, call it, 50%, 51%. If you compare that, that's a fairly significant amount of impact, which actually all hits the bottom-line to your -- which is where your question is coming from. We've looked at it kind of in a -- to get a directional estimate of where our margin would be, that our margin would be somewhere in the high-teens, right, which is slightly better than where we would have been last year. But once again, we're growing at a faster pace and we're actually increasing selling capacity to prepare for kind of the next year and the follow-on year growth and that helps to offset what would have otherwise been a greater margin expansion. The problem with it is the accounting because of the pushing the revenue out under cloud arrangements really obfuscates that natural inherent margin we have because you won't see that until you have a number of cloud years stacked in, which we're really only in about the first 18 months of that big shift to cloud.

Mark Schappel -- Benchmark -- Analyst

Got it. Thank you. That's helpful. That's all from me.

Ken Stillwell -- Chief Financial Officer, Chief Administrative Officer and Senior Vice President

Thanks Mark.

Operator

(Operator Instructions) We do have a question from Stephen Bersey with MUFG.

Stephen Bersey -- MUFG -- Analyst

Hey, guys. Nice quarter. Just wondering, if you're noticing any trends as far as industry vertical and acceptance or push-back to cloud adoption?

Alan Trefler -- Founder and Chief Executive Officer

No -- I -- this is Alan, I'll say that -- so cloud has become truly a mainstream capability and desire across, I would say, pretty much all the verticals. So there are specific applications, where customers are not as interested for a variety of special security or other sorts of reasons, but the cloud has been really subject to a huge transition. With hindsight, I wish we had accelerated our transition and I referenced to this three years ago. But since we've put the pedal down, we're seeing the results that we want. And so we think that's just going to continue. I am -- frankly, I was a little surprised that in some of the industries that folks have become so accepting, but at this point, we're all in.

Stephen Bersey -- MUFG -- Analyst

Okay.

Operator

(Operator Instructions)

Alan Trefler -- Founder and Chief Executive Officer

I'm sorry, is there another question?

Operator

There are no questions, sir.

Alan Trefler -- Founder and Chief Executive Officer

Well, on that take, I'm just going to wrap it up. It's a little bit late here in London and it's been a long week. But I want to thank everyone and let you know that we're working very diligently on your behalf and are really pleased with what's going on and how we think we can continue to drive success. Talk to you all soon.

Operator

That does conclude today's conference call. Thank you for your participation. You may now disconnect.

Duration: 31 minutes

Call participants:

Ken Stillwell -- Chief Financial Officer, Chief Administrative Officer and Senior Vice President

Alan Trefler -- Founder and Chief Executive Officer

Rishi Jaluria -- D.A. Davidson -- Analyst

Mark Schappel -- Benchmark -- Analyst

Stephen Bersey -- MUFG -- Analyst

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