Pegasystems (NASDAQ:PEGA) is growing its business at a robust pace, even if those gains aren't immediately evident from a glance at its reported revenue. That's because the business software specialist is transitioning from a term license model to subscriptions, which tends to reduce revenue and earnings in the short term while boosting long-term cash flow.

That trade-off was the key theme in Pegasystems' latest earnings report, that showed strong demand for its cloud-based licenses.

Let's take a closer look at the numbers:

 Metric

Q3 2018

Q3 2017

Year-Over-Year Change

Revenue

$203 million

$191 million

6%

Net income

($8 million)

$3 million

N/A

Earnings per share

($0.10)

$0.01

N/A

Data source: Pegasystems' financial filings.

What happened this quarter?

Pegasystems posted faster growth in its core cloud sales segment, and a minor slowdown in its maintenance contracts. Overall, the results pointed to accelerating demand momentum in the context of operating losses.

A customer service representative at work in front of a computer.

Image source: Getty Images.

Here are a few highlights from the quarter

  • Revenue growth ticked up to 6% from 5% in the prior quarter as growth in subscription sales modestly outpaced losses from Pegasystems' legacy term licenses business.
  • Annual contract value (ACV), the metric executives believe best expresses Pegasystems' underlying growth pace, expanded at 20% to hold steady compared to last quarter's gains. That boost was supported by a deeper suite of software products and customers' shifting preferences toward cloud-based delivery.
  • Gross profit was $129 million, or 64% of sales, compared to $121 million, or 63% of sales a year ago.
  • Operating expenses outgrew the pace of reported revenue gains, and so operating losses expanded to $17 million from $2 million. Pegasystems booked a lower tax rate, though, which pushed reported losses to just under $8 million.
  • Backlog, representing orders that have yet to be billed, improved to $522 million from $477 million last quarter.

What management had to say

Executives were encouraged by the healthy sales demand this quarter, and through the last nine months. "I'm pleased with our year to date results," CEO Alan Trefler said in a press release. "which demonstrate our strong business momentum." In a conference call with Wall Street analysts, Trefler added context to those general comments, saying "We continue to see acceleration in our move to the cloud and recurring arrangements."

He continued, "this faster than anticipated move ... is really good for the business long term, and our strong underlying business trends are also reflected in license and cloud ACV, which grew 36%."

Looking forward

The shift toward subscription sales pressures sales and profit results, and that impact is clear from the fact that revenue is unchanged over the past nine months while non-GAAP earnings have declined by 65%. However, Pegasystems' accelerating ACV growth reflects a growing base of customers who have committed to paying for its subscription services. That's a valuable asset for any business.

Executives believe that these gains will yield strong cash flow rates in the coming years, along with improving profitability. It's not clear yet where the company's margins will land once it completes its shift away from term-based licenses, but there's no ambiguity about Pegasystems' healthy sales pace.

Demitrios Kalogeropoulos has no position in any of the stocks mentioned. The Motley Fool recommends Pegasystems. The Motley Fool has a disclosure policy.