Pegasystems' Shift to the Cloud Hurts Sales Figure

Pegasystems (PEGA 0.95%) this week announced first-quarter earnings results that, under normal circumstances, might be concerning for investors. The enterprise software specialist posted a double-digit revenue decline and generated a net loss for the period, after all. However, Pegasystems is still transitioning to a cloud-based subscription sales model, and that shift is pressuring the headline numbers. After accounting for the change, contract growth was healthy to start off fiscal 2019.

Let's take a closer look at the latest quarterly numbers.

Data source: Pegasystems' financial filings.

What happened with Pegasystems this quarter?

Pegasystems saw its clients continue to eagerly take up subscription-based contracts, which pressured revenue and earnings since those sales are booked over time rather than in one large transaction.

Image source: Getty Images.

Here are a few highlights from the quarter:

• Reported revenue fell 10% as steep declines in term and perpetual license contracts more than offset surging growth in the cloud business. That cloud segment saw sales growth accelerate to 78% from 66% last quarter.
• Annual contract value (ACV) is management's preferred growth metric since it better captures demand shifts during the business model change. ACV rose 20% to $591 million, to stay roughly even with the growth rate over the last several quarters.
• Gross profit margin fell to 65% of sales from 68% a year ago. Rising expenses, meanwhile, generated an operating loss of $34 million compared to a gain of $8 million in early 2018.
• Backlog, or reserved contracts that have yet to be booked, increased 38% year over year to $633 million.

What management had to say

Executives described healthy operating trends for the industry and for the company over the last few months. "We're off to a solid start for 2019," CEO Alan Trefler said in a press release. "We continue to see strong demand from companies engaging in digital transformation to improve customer experience and automate business processes."

Management was especially pleased to see a larger portion of its client base choose subscription services rather than short-term licenses. "It's really exciting to see Pega becoming a much larger recurring business," CFO Ken Stillwell said. "Pega Cloud reached 70% of new client commitments," he explained, "above our Q1 2018 mix of 50%." Stillwell continued, "While this is terrific for our business, it resulted in a reduction of nearly $20 million of revenue with a commensurate increase to backlog."

Looking forward

Trefler and his team are calling for a return to modest revenue growth this year, although profitability might remain negative. Those earnings, and the top-line pace, won't reflect the underlying demand improvement because Pegasystems' move toward subscription services replaces large up-front cash inflows with revenue that accrues over several years.

As it did in 2018, that shift will pressure reported operating metrics this year. Yet growth in ACV and backlog demonstrate that demand is still healthy for Pegasystems' enterprise management software offerings.