Pegasystems Q1 2023 Earnings Call Transcript

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Provided by Quartr
April 26, 2023

Key Takeaways

  • Q1 ACV growth of 15% year-over-year, driven by Pega Cloud ACV growth of 24% and representing ~67% of net new ACV, underscoring execution of strategy and progress toward a Rule of 40 model.
  • Generated $68M in operating cash flow and $75M in free cash flow, expanded Pega Cloud gross margin to 72%, and expect further margin leverage toward the mid-to-high 70s.
  • Unveiled a generative AI solution that integrates customers’ preferred AI APIs (e.g., AWS Bedrock) with built-in enterprise governance, auditing, and human approval on Pega’s model-driven decisioning and workflow automation platform.
  • Focused sales and marketing efforts on deepening engagements with existing marquee clients by driving digital transformation and automation via Pega Cloud enhancements and the LaunchPad low-code SaaS app platform with select early adopters.
  • Backlog increased 14% to $1.34B, and while Q1 revenue dipped due to the shift from upfront term-license revenue to ratable cloud recognition, management maintains full-year guidance, prioritizing ACV, cash flow, and backlog amid macro uncertainty.
AI Generated. May Contain Errors.
Earnings Conference Call
Pegasystems Q1 2023
00:00 / 00:00

There are 9 speakers on the call.

Operator

Greetings, and welcome to the Pegasystems First Quarter 2023 Earnings Results. At this time, all participants are in a listen only mode. A brief question and answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Kent Stillwell, please go ahead.

Speaker 1

Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems Q1 2020 3 Earnings Call. Before we begin, I would like to read our Safe Harbor statement. Certain statements contained in this presentation may be construed as Forward looking statements as defined in the Private Securities Litigation Reform Act of 1995. The words expects, Anticipates, intends, plans, believes, will, could, should, estimates, may, targets, strategies, 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 the statement was made that are based on current expectations and assumptions.

Speaker 1

Because such statements deal with future events, they are subject to various risks and uncertainties. Actual results for fiscal year 2020 And beyond may differ materially from the company's current expectations. Factors that could cause the company's results to differ materially from those expressed The forward looking statements are contained in the company's press release announcing its Q1 2023 earnings and in the company's filings with the Securities and James Commission, including its annual report on Form 10 ks for the year ended December 31, 2022, 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 publicly update or revise these forward looking statements, whether as a result of new information, future events or otherwise.

Speaker 1

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

Speaker 2

Thank you, Ken, And to everyone who is joining today's call, we had a terrific start in 2023. Our team executed our strategy well, leveraging our strengths And remaining resilient in an environment that we expect will remain uncertain for some time. In Q1, we achieved ACV growth of 15%, driven primarily by increasing our footprint in our existing clients And through strength in Pega Cloud. This is exactly what we said we had tremendous opportunity and where we would focus our sales and marketing efforts. We also saw select new logos, though that's not our focus for this year.

Speaker 2

Clients are responding positively to our architecture, our model, our focus on deep engagement. Hega Cloud is driving growth and cloud margins continue to scale. It's great to see us continuing to make solid progress towards becoming a rule of 40 company, balancing growth with fiscal discipline and generating significant cash Overall, our results reinforce the effectiveness of our strategy and we see tremendous opportunity for growth. Ken will discuss our financial results in more detail in a moment. Now, I'm spending a lot of time with our clients, Both at our Cambridge based executive briefing center, which continues to be solidly booked and on the road, including a trip to Europe I've just returned from.

Speaker 2

I continue to hear the same themes. Last week, I was in Germany, Italy and Sweden visiting clients. And despite the anxieties in Europe, The conversations I had were optimistic and clients continue to be deeply interested in building relationships with Pega. Digital transformation remains a driving force as organizations are looking for solutions to better deliver personalized engagement and optimize business processes. Citi just published a spending survey that noted the digital transformation It was one of the top investment priorities for CIOs in 2023.

Speaker 2

Pega has a long history of helping clients improve efficiency and effectiveness as well as to improve their customers' experience. Clients are also very interested in and in some ways concerned about the use of AI, Especially with the newest generative technologies, they want to know how to leverage AI in responsible ways to drive automation Without compromising enterprise governance or losing control of outcomes, our approach to digital transformation and to AI is perfectly aligned to both address these concerns and meet these needs. Now to talk about our approach, Our viewpoint in developing software has always been about building technologies and service business people. We provide the most powerful and scalable low code platform for AI powered decisioning and workflow automation. We make it simpler for enterprises to work smarter, unify experiences and adapt quickly.

Speaker 2

And we ensure that organizations can empower their employees Without compromising enterprise IT integrity, we're combining AI and automation to enable organizations to become autonomous enterprises It's self optimized towards business goals without sacrificing control. Now, as you've now There's an elevated interest in AI and lots of excitement and hype. And just as a reminder, since our founding 4 decades ago, Pega has helped enterprise clients use our AI powered solutions To automate complex business processes, improve customer experience and drive operational efficiency. We've been evolving our capabilities as the technology And our clients' needs have evolved and we're in a unique position to lean on this heritage of harnessing, understanding and leveraging AI to be able to provide unique capabilities to our clients. When we announced our generative AI plans last month, we stayed true to our approach with an offering that will allow clients to use the generative AI technology of their choice with enterprise governance to make generative AI truly enterprise ready.

Speaker 2

We focus on building out use cases that maximize value and minimize risk. For example, We use generative AI to create better performing marketing copy or to generate prototype applications from just a simple sentence. Our approach incorporates auditing and human approval that are the hallmarks of Pega's platform. This managed architectural foundation Reminds organizations with safety, security and reliability suitable for the enterprise. IT managers will be able to integrate Their own specific generative AI APIs use to peg Infinity and centrally manage licenses and controls To give clients flexibility to add existing or emerging generative AI APIs.

Speaker 2

A great example of our generative AI strategy coming to life is our recent inclusion in Amazon's announcement of Bedrock, A new AWS cloud service that allows developers to build and scale generative AI applications in the cloud. Because of our approach, we can easily integrate Bedrock into our platform and have use cases that can make it available to clients. At the same time, we can continue to support other cloud providers and other generative AI solutions based on our clients' preferences. We've been at the forefront of providing responsible AI for years and are committed to putting the controls Straight into our software to make sure that the fairness and transparency and robustness all exist. We believe the rapid generation generative AI developments will make lower end low code providers a commodity.

Speaker 2

But on the other hand, the higher end enterprise grade solutions like Pega are going to benefit. So we're excited about the opportunity to create additional value by augmenting our solutions for organizations. Now we've also rolled out new Pega Cloud enhancements supported by an enhanced global operations center That improves speed, scalability, agility, reliability and security. These improvements help organizations maximize the technology investments and deliver better experiences for staff and clients. And we're continuing to make progress with Pega LaunchPad, which we announced last year as our new cloud based low code application development platform That empowers software providers to build and commercialize workflow centric business to business SaaS apps.

Speaker 2

We're excited to be working with a select group of amazing early adopters whose Pega Launchpad powered apps are being built To address the needs of new markets that they will be pursuing. Now we're coming up on PegaWorld Inspire, Our annual trade show and it's going to be fabulous. We'll be showcasing our new AI capabilities, announcing several new offerings And demonstrating solutions at more than 40 partner booths and featuring over 200 demos 100,000 square feet of pure ingenuity, we'll also be highlighting the success stories for more than 40 clients, Including outstanding keynote presentations from Aflac, we'll talk about how they are using Pega to reduce roadblocks and bottlenecks And manage staffing punctuations and market pressures to continually deliver transformational outcomes. Citibank, One of our very first Pega clients who went live originally, obviously on a very different technology, in 1984 is using Pega to deliver on its mission of being a trusted financial services partner, levering decision science to drive omni channel customer centric experiences. Rabobank from the Netherlands, who will demonstrate how they are revolutionizing customer Using our low code and AI capabilities and Virgin Media, who will describe their journey to become a fully digital business, Leveraging Pega's customer service, case management and AI based decisioning.

Speaker 2

If you haven't yet, please check out the PegaWorld website, Register and join us to hear and see all of this in person, and especially feel free to join us for the investor session On Monday, June 12. So in summary, I'm pleased with our strong start to 2023 and our ongoing progress To be a rule of 40 based company, our results continue to be driven by ongoing demand from large global enterprises And for digital transformation solutions that drive automation and leverage AI, our strategy to focus our effort Our meaningful clients is proving effective and candidly is making us feel really good about how we're doing in the market as well as obviously winning business. We expect to face macroeconomic challenges in 2023, but think we are well prepared and with executing in challenging times. I feel confident that we are in the right space with the right capabilities and the right team. And our strategy is absolutely the right one to leverage the significant opportunity in front of us.

Speaker 2

To provide more color on our financial results, Let me now turn it over to our COO and CFO, Ken Stilwell.

Speaker 1

Thanks, Alan. Given an uncertain economic environment, it is great to see our team deliver such a strong start to 2023. The 3 most important metrics to measure the success of our business are annual contract value, ACV, Cash flow and backlog. So I'm going to focus my initial comments today on how we're progressing against these 3 critically important metrics. ACV grew 15% in constant currency year over year in Q1.

Speaker 1

Annual contract value growth has been and continues to be the most important metric for us. This strong result was powered by Pega Cloud ACV growth, which increased 24% in constant currency year over year. Pega Cloud represented approximately 67% of the $45,000,000 of net new ACV added in the quarter in constant currency. Pega Cloud ACV continues to be the largest ACV component and the fastest growing. Our ACV growth was bolstered by our to realign our go to market strategy and focus our resources on deepening our relationships with our marquee customers.

Speaker 1

Our first quarter results provide clear evidence this strategy is working. Our ACV growth was broad based and in addition, we are attracting new logos, Although that is not our primary focus for 2023. Moving to cash flow. In Q1, We generated $68,000,000 in operating cash flow and produced $75,000,000 in our free cash flow metric, which is a great start to 2023. We still have a lot of work to do for the year though.

Speaker 1

When we started our subscription transition in late 2017, our vision was to transform Pega's economic model And build a successful business for the long term while delivering tremendous value for our clients. Our strong ACV growth coupled with our strong free cash flow Generation is the result of many years of hard work by our team to sharpen our growth strategy and efficiency. We're now running the business as a subscription business. We're really happy with the success we've had anchoring the concept of efficient growth. And as you can see, some of the results are starting to show as we progress through the Q1 numbers.

Speaker 1

We expanded Pega Cloud gross margin to 72% and we're increasing our operating leverage and we believe there's more up to our paid gross margin in the future. Moving on to backlog. Total backlog increased by 14% year over year currency to $1,340,000,000 driven by growth in Pega Cloud backlog. Revenue had 2 thirds of our net new ACV add from Pega Cloud in Q1 and that drive that combined With a lower number of term license renewals, we obviously would recognize less revenue in the quarter than we did last year in the Q1. That's because the majority of revenue from term license deals is recognized upfront and upon renewal.

Speaker 1

In contrast, Pega Cloud revenue is recognized ratably over time. Given these dynamics, revenue and non GAAP EPS in an individual quarter can be highly variable And sometimes it's not representative of the underlying fundamentals of what's happening in the business. For example, Total revenue in Q1 was down 14% year over year, driven by this 39% drop in term license revenue. We discussed this back in February. Our term license backlog was unusually high at $172,000,000 In the Q4 of 2021 and you saw that backlog significantly impact revenue In the Q1 of 2022, given that our term license backlog balance at the end of 2022 Was significantly less than the prior year, we expected term license revenue in Q1 of 'twenty three to decline We also repurchased $33,000,000 of our $600,000,000 convertible notes, Approximately a 10% discount.

Speaker 1

This transaction was not part of a formal repurchase policy. Rather, as we generate cash, We will look to opportunistically retire our convertible debt. Similarly to last quarter, Given an uncertain economic environment, we thought it would be helpful to provide some thoughts on modeling our business. Our practice is to provide annual guidance at the start of the year And not to update guidance unless we've done a material acquisition or something else materially happens in the business Like we mentioned last year, we do not provide quarterly guidance. Given our focus on increasing cash flow, we added a new metric this year, free cash flow.

Speaker 1

Our commitment to generating free cash flow is strong. As a company, we understand the value, especially in an uncertain growth environment of delivering both free cash flow generation and free cash flow improvement as we scale. That way, when we actually see these periods That are less certain in the growth environment when the economic climate is not as welcoming, we established a solid free cash flow base business. As we expect our sales and marketing expenses to be higher in the first half of twenty twenty three compared to the second half, That's driven by our PegaWorld conference being live in 2023 and as we've mentioned, as Alan mentioned After a 4 year virtual sessions, Monday, June 12, At PegaWorld, we will host investors to discuss our long term model and our long term strategy. If you're interested in registering for the investor session, please e mail pegainvestorrelationspega.com.

Speaker 1

The agenda will include updates on our go to market strategy, our product innovation and also our financial model. We will also include time on the agenda as usual for questions and discussion. In closing, our team executed very well in the first Quarter of 2023, of course, we're still facing with all of our other participants in the software market an uncertain economic environment. So We're going to continue focusing on those 3 most important metrics as I mentioned, ACV, cash flow and backlog. Operator, please open the line for questions.

Operator

Thank you. We will now be conducting a question and answer session. Your first question comes from Kevin Kumar with Goldman Sachs. Please go ahead.

Speaker 3

Thanks for taking my question. Ken, the guidance you provided last quarter for 2023, I believe, factored in some softness in the macro environment. Have you seen anything materialize in terms of lengthening of deal sales cycles or changes to close rates or have those held up relatively well?

Speaker 1

Yes. Great question, Kevin. So there's a couple aspects of that. So the first one is, in terms of our Team executing against our sales campaigns and our pipeline. I think we've I wouldn't say there was any that we saw in Q1.

Speaker 1

I think we executed well. I think our clients are still engaging. They're very committed to their digital transformation initiatives. That said, you can definitely sense that there's some level of economic concern out there as there was last But I think our execution against our pipeline was solid. So I think there's 2 pieces of that.

Speaker 1

Our execution was good, but You can feel the uncertainty or the kind of the timidity that's out there in the marketplace. But we haven't seen that translate into actually like statistical deterioration of our close metrics.

Speaker 3

Yes, that's helpful. And then curious on the comment on logo ads. I know the focus has been more on in existing customers and there's been some changes in the sales organization to focus on that. So was that kind of through the natural course of The sales process, I'm just curious if those were meaningful contributors to ACV. Thanks.

Speaker 2

Well, this is Alan. We do get inbound customers, meaningful organizations that either have somebody who has worked with us somewhere else or See what leading companies are doing in the various industries and those are in the basis How we are and will in the future be adding new logos, because, well, that's Very consistent with our strategy. I will tell you that by giving ourselves the capacity to spend a lot more time With several hundred customers that are critical to us and we have significant relationships with, we have absolutely uncovered The opportunity types that we had expected working with those companies and see both the upside and candidly are really, I I think building and continuing to improve great relationships with very important organizations. So the strategy feels really good, Particularly in a year that may be a little tougher.

Speaker 1

I would also add one other point to that, which is the I wanted to be very clear because I think There are some people that heard the message of our strategy that we were not entertaining new logos or that Somehow new clients were not important to Pega. That is not true. It's just not where the majority of our focus is because we think And sometimes we find them and sometimes they find us. And I think that that's that will continue to happen. I just wanted to make sure that was that Nuance was clear.

Speaker 3

Great. Thank you both.

Speaker 4

Thank you.

Operator

Next question, Rishi Jaluria with RBC Capital Markets. Please go ahead.

Speaker 4

Hi, this is Richard Polin on for Rishi. Thanks for taking my question. So I guess the first one is just a 2 part question around generative AI and kind of what you're doing on that lane. So it sounds like a lot of the value proposition is the security and compliance that you're kind of wrapping around some of the AI technologies. It's really exciting opportunity, but just kind of if you could just elaborate a little bit on how you're differentiating against the other generative AI type Solutions out there.

Speaker 4

And then just a follow-up on that is just how you think about the monetization opportunity long term? Thanks.

Speaker 2

Sure. So I think we've got a structural advantage compared to lots of other companies Because Pega has always been a model driven company. What that means is you create a model of how you want your business to run. And from that model, our system actually writes the software. We're using the generative technology To basically inform the model.

Speaker 2

So for instance, you can say, hey, I want to define a process for home equity loan. And Generative AI will do a terrific job of identifying what are the stages you would go through, what would a schema, data schema look like that would capture the information that you would need. What would, for example, sample data look like That you might use to be able to test it. And all of those are components that go into our model. This gives you such an amazing opportunity To really jump start, but also simplify a lot of things about how you apply technology To your business.

Speaker 2

So those are the types of examples, things that really leverage an architecture that I think is extremely well suited. And candidly, a lot of the companies that have been talking about low code, I think are in enormous trouble, Because low code apps that don't fit a real enterprise standard and don't have the right structures I think in many cases, just going to be replaced by people using generative idea AI to write the code. There's a huge market for things that are a little more sophisticated, need to be updated with G Link. You don't just do it once and use it, but you want to be able to update it and update it again, update it 6 months later. And those are the types of things But I think we have a structural advantage for or towards when we do it.

Speaker 2

Monetizing it, I think this is Absolutely going to drive additional demand for Pega and a variety of use cases. And with our clients in general, When they use our software more, it gives us a chance to get paid more. And that's good for them and it's good for us. So I think that this has candidly a lot of appropriate excitement in addition to the hype we see, which is nonstop, but we're not affected by that. Yes.

Speaker 2

As part of it, I think having a pretty mature understanding of what AI is about. And we were on this technology Long before it brought to the mainstream media.

Speaker 4

Thank you, Alan. That's super insightful. And then maybe one for Ken. Just as we think about the pace of Pega Cloud gross margin expansion and it's been really solid in the past recent years, How should we think about that kind of going forward? I know one of the previous targets, I think, was in the mid to high 70s range by 2025.

Speaker 4

Is that kind of the track we should

Speaker 1

So, maybe it's maybe interesting to paint the picture. When we first started Pega Cloud, the 1st couple of years, our gross margin was 35%, then it was 45%, then it was 50%. And then when it was about 50%, we set a target of 70%. And now that we've surpassed 70, we moved the target to 75 a couple of years ago. And then we kind of said, well, maybe we could do high 70s.

Speaker 1

And Naturally, that can't go on forever, of course, right, because at some point you do hit a point where the efficiency has got to stabilize. But I think like best in class SaaS companies would strive to have gross margins that begin with an 8, Right. And so we want to be best in class and we're starting to get some good scale. So I think, 75% to high 70% is Maybe a mile marker on that journey to being a best in class SaaS company from gross margin standpoint. Maybe that's the way I'll frame it.

Speaker 2

Yes. I would just throw in that the way this Extensive automation into our cloud operations that both save money, but also make the system more reliable and more effective for our clients. Being able to rework, so you may have heard me talk about Project Phoenix, actually about 5 years ago We talked about that. We work the system to be a cloud oriented and microservices oriented architecture. There's a lot of what I would describe as non financially related improvements That go beyond just what we would get from scale.

Speaker 2

And that's what makes me excited and think that Yes, we can't raise the bar forever, but we do have a little more we can go.

Speaker 4

Thank you. Very helpful, guys.

Operator

Next question, Steve Enders with Citi. Please go ahead.

Speaker 5

All right, great. Thanks for taking the question here. I guess maybe just following up on the AI discussion. I guess how do you think about where you have like a right to win And we'll be kind of focusing on your AI initiatives and embedding that in the product versus maybe looking at the rest of Technology ecosystem and partnering with other technology vendors or third parties to embed some of that functionality into your product set?

Speaker 2

Well, we're definitely building our generative capabilities to be able to partner. We talked about the partnership with AWS, Partnership with the other major AI providers also is central to how we're going to go to market. So we see being able to use the super rapidly emerging large language model capabilities that are going to continue to evolve As something that needs to be part of our open architecture there. We of course also have some of our own AI capabilities When it comes to what we call the customer decision hub and what we call process AI, which is the ability to use AI in processes To be able to make them learning and self optimizing, which is not really a generative technology, but is also very powerful Both a benefit and a cost savings and a customer service perspective. So I feel really well equipped To be able to be a significant player, not that we're going to come up with something super general, Right.

Speaker 2

Because I think that's going to be an insanely competitive space. But for the types of customers that we know we can serve, But have enterprise needs that actually fit perfectly with the types of things we're considering and doing. We're getting great feedback The early clients we've shown this to that we're absolutely on the right track and they're going to be delivering things this year that they would be excited to use.

Speaker 5

Okay, understood and appreciate the thoughts there. I guess maybe for Ken, really good Cash flow in the quarter, I mean, I think it kind of accounted for half of the initial guide that you put out for the year there. Was there anything one time in nature that maybe stopped holding into the end of the quarter? Or Anything that we should be thinking about as we think about cash, the pace of cash flow throughout the rest of the year here going forward?

Speaker 1

Yes, sure. Steve, just a reminder that typically our billings are higher in Q4 and Q1, which would mean that our collections would be typically higher in Q4 and Q1. Now that said, we do have a lot of cash outlays in Q1 because like, for example, we have our annual CICP payment that goes out. We have so we have a higher It's a higher payment of a commission quarter typically because Q4s are typically higher in bookings. So there were some offsets to that.

Speaker 1

But I would say Q4 and Q1 are Typically stronger free cash flow quarters in Q2 and Q3 are typically less strong just because of the nature of our bookings and billings. But that said, Q1 was very strong in terms of free cash flow.

Speaker 5

Okay. Appreciate the answer there. Thanks again for taking the questions.

Speaker 1

Sure.

Operator

Next question, Jake Roberge with William Blair. Please go ahead.

Speaker 6

Hey, thanks for taking my questions. Alan, just Wanted to dig deeper into your comment that generative AI could commoditize lower end low code use cases. Could you just talk a little bit more about why Pega's history in the AI world and It's positioning in more mission critical workflows help you really take advantage of the opportunities from the AI theme moving forward?

Speaker 2

Well, sure. And I also can just explain why I think our positioning in our technology provides a moat That is consistent with our enterprise approach. When Pega goes into a customer, the types of things we talk about with a low code customer If we talk about building a low code app factory, what does that mean? Well, that means they're able to build apps quickly, But it also means the asset of a structure that lets them be hoped together that doesn't have them be really isolated And then also let them leverage the other enterprise assets like the interfaces, like some of the controls, the other types of things That are going to be either consistent or related across apps. This ability to have what we call a layer cake, Where certain things go across the entire customer enterprise and other things might vary with, Say different divisions of a bank or of an insurance company or that might vary with types of work or applications, Those all fit into a cake.

Speaker 2

They run-in a way that really is complementary to each other. I think that really lends itself To being super distinguished from companies that have just a bunch of little apps running around. And any company that's been betting their future On generating low code apps that do kind of simple things or that run on a mobile device, We've experimented with generating little mobile apps that are actually really quite remarkable in some ways That look exactly like the demos from some of our competitors. I think that you're going to find the market is really going It's going to end up really shaking out the market because I think the low end is just going to go away.

Speaker 6

Very helpful. Thanks for that color. And then, Ken, how do you feel about the pace of your subscription transition at the start of this year? Have you seen any impact The migration as a result of the macro and you feel like Pega is still on track to complete the transition this year and be a Roll of 40 business as you exit 2024?

Speaker 1

So the subscription those are good questions. I'm going to tease a couple of them out. First, The subscription transition pace, I think is I'm very happy with. There has been some Maybe it took a little longer to get through the kind of financial transformation of the subscription, probably by 6 months So a year than what I had originally kind of envisioned in my mind. I thought it would take 4 to 5 years.

Speaker 1

It took more like 5 to 6 years. But In general, close enough. But it so I think that went well. Not every client is going to want Pega Cloud. That's an important way.

Speaker 1

It really ties to our Now we want every client to have Pega Cloud, but the reality is not everyone has the use case or may choose to want to manage it themselves Depending on lots of things that might be decided within their environment. So that's but that's okay. But I think such a significant amount of our clients will. In terms of clients who chose to move workloads on to Pega Cloud, I mean, we have not pushed clients or in some cases forced clients Like other companies have done to say you have no choice, you must move, because we understand that our clients and our relationship is different than typical software company and we need to be respectful of how much how mission critical the Pega applications are and how hard it might be to just shift over to another environment. That said, we do have clients every kind of year, every quarter having those conversations and some Have begun to move and some have moved new workloads.

Speaker 1

The most important thing for us I think though is that 2 thirds of our clients Have seen Pega Cloud, meaning they may not have all of their estate on Pega Cloud, but they have something there. And I think that they know the value and over That migration, as you mentioned, will happen to the extent that the clients kind of want to. In terms of the economic Kind of maybe if you have headwind in the economy, does that mean people move Or not move to Pega Cloud. I think it's kind of like maybe the punch line of your question. And I would say that really depends On whether the client views a movement to a vendor cloud like Pega Cloud is going to solve some other Financial inefficiency that they may have or some optimization that they may have inside their organization.

Speaker 1

That is absolutely true for some of our clients. For other clients, they may not be ready to move because they may not have they may not want to use some of those resources in the short term So I would say that last part, it really depends. I would say overall, the economic environment Probably is a little bit helpful to have clients think about Pega Cloud when it's a tougher environment, but that's not a

Speaker 2

universal Yes, it's also beneficial. Customers are under pressure in terms of retaining some of the right skilled staff. Listen, once again, obviously, it's super easy when we're operating and running it. But just to make it a little intangible for folks, We've got some customers, very large customers where we have systems that literally do tens of millions of cases a month That are so woven into their business that they're actually connected to Dozens of their systems with sometimes hundreds of interfaces that are used that really are doing a lot of heavy duty, a Combination of automation and driving decisions. If a customer like that has made the strategic decision that they want to move To an Amazon or Google Cloud and they want to basically pick up their data center And move their data center in total, including apps that may not run on the cloud that might be billing and accounting systems That would have to run-in a non vendor cloud.

Speaker 2

We think that's an entirely reasonable thing for them to do And that is very empowering to our customers to give them that sort of cloud choice. But a lot of times it has to do with whether their strategy is to cloudify If they want to, as it were, by sort of doing the best of breed, we're going to go out to the vendors who know how to do it best Or whether they want to do it by picking up their data center and or data centers and moving them on mass. And there's some of each.

Speaker 6

Sounds great. Thanks for taking my questions.

Speaker 7

Thank you.

Operator

Next question, Pinjalambhora with JPMorgan. Please go ahead.

Speaker 8

Hey, thanks for taking the questions. Ken, I'll try one more time on the SCF Performance seems pretty strong. It seems like the change in working capital was positive after a long time in Q1. And then it seems like the SBC jumped a little bit. I want to just make sure there's not one time thing that's driving this.

Speaker 8

Just Thinking through what should we expect for the year on free cash flow.

Speaker 1

Sorry, Mitchell. I Heard the free cash flow point, but did you say SBC for the second point?

Speaker 8

The stock based comp seems jumped a little bit And seems like Okay. Yes. Go ahead.

Speaker 1

Yes. I'll explain. I thought I just you were a little bit faint on the volume. That's why I asked. Okay.

Speaker 1

So, Yes. So free cash flow, if you think about maybe the way to think about free cash flow is to think about Billings and billings connected a little bit to the revenue cycle. If you think about the revenue cycle Our largest quarters for revenue are typically Q1 and Q4. Our softest quarters for revenue are Q2 and Q3. Our buildings are not Materially different than that across the year, which means our billings would be higher in Q1 and Q4 And a little bit lesser in Q2 and Q3, but our costs are relatively consistent across the year.

Speaker 1

And so if you now take billings and cost and you translate that into cash flow, our cash flow would typically be stronger in Q1 In Q4 and less strong in Q2 and Q3. So I'm going to so hopefully that's helpful to give a little bit of color on the cash flow. On stock based comp, One of the biggest there is a adjustment I should say adjustment. There is a Higher stock based comp in the beginning and through 2023, because of 2 factors. Primarily one, we actually adjusted our vesting period from 5 to 4 years For stock based compensation, which will play in a little bit into the kind of near term acceleration, but not so I would And then the second one is that we actually did an equity grant that was out of cycle In the second half of twenty twenty two and that is in the calculation for 2023 that Certainly would not be something that would repeat.

Speaker 1

So there is a little bit there is some one time pressure up on that, that is not a Structural change to our stock based compensation strategy.

Speaker 8

Yes, understood. Very clear. One for Alan, obviously, we have heard a lot of AI in this call and you're doing a lot of things around AI. I want to ask you about How do you think about kind of the potential to capture incremental value from the efficiency that customers will gain from using AI capabilities Versus kind of the potential pressure on seats that those efficiencies might actually drive?

Speaker 2

So, I think for a lot of folks, the automation that occurs It's going to put pressure on seats because candidly, if you can do things in automated channels or Self-service becomes better or the chatbots become better. That obviously affects, for example, the number of contact centers that you have. However, to the extent that it's being run through us And we are the tooling that I think companies find is best to use to manage those Client interactions, including the automated ones, we've really moved away from user based pricing To basically work based pricing. So from our point of view, we don't see a revenue bleed from a customer who's got a couple of seats I think I'm automating those because candidly, it's better for the customer, and it's fine for us. So I think we're pretty Insulated based on the outcome based pricing that we've really tended to do for the last 5 years.

Speaker 8

Got it. Thank you.

Speaker 2

Thanks, Mitchell.

Operator

Next question, Steve Koenig with SMBC Nikko. Please go ahead.

Speaker 7

Hi, gentlemen. Thanks for taking my questions. Congratulations on a great start to the year. Just maybe a housekeeping question or 2 for Ken and then a question for Alan. Ken, you mentioned that 67%, I think it was of net new ACV is cloud.

Speaker 7

Just so I'm clear, You guide based on an assumption on cloud percentage of new client commitments and that guide I think 60% to 70% for the year. Is that the same definition that you're using as this net new ACV being cloud or what like what was the percent of new

Speaker 1

client commitments? Was it the I'm to be very consistent with that metric to what our reported metric is because it can sometimes get confusing when we Use a metric that may be across 1 or 2 quarters versus 1 quarter. So that was the reason. But yes, it's essentially the same measure. We just felt like it would be much easier to talk about that metric Because that will translate into revenue, that will translate into billings, into backlog, etcetera.

Speaker 7

Got it. That makes sense. We can calculate From the financials, so that's great. Okay. So you're on track with your guide so far in terms of your cloud assumption This is my takeaway there.

Speaker 7

And then I we also noticed The cloud ACV and RPO was very good in the quarter, better than we expected and cloud was especially good. The cloud ACV was a bit higher than we would have Predicted based on the revenue results, cloud revenue. And so I'm wondering whether some back end loaded cloud deals that should help cloud revenue next quarter. And then on the same lines, you had an outlook that subscription licenses would be relatively level for Q1 through Q3. Is that still kind of your thinking here?

Speaker 7

And then one last one for Alex, if you don't mind.

Speaker 1

So revenue lags ACV for sure. So when we book deals, They typically don't have really any revenue impact in the quarter. I'm generalizing. But so there's definitely a lagging effect there. And yes, we think that for our term license revenue for 20 20 That would be more back end loaded because that's when the renewals are happening.

Speaker 1

That is a correct statement as well. Now if you want to hit Alan with his question.

Speaker 7

Got it. Great. Thanks. Super. So moving you had another question on generative AI, but very relevant here, I think.

Speaker 7

Alan, one of the kind of knocks on Pega, I guess, over the years is that there's not as many Pega developers as there are Java developers. So kind of hard, that's a hard one just to overcome that. But you got more and more Pega Train developers, a lot of partners who've grown Ecosystem very well. I'm really focused on that. The steroid AI capability, do you to build models even or to help build the model that We talked about earlier.

Speaker 7

Does that fundamentally make the current Pega Train Developers more productive or can that be used to democratize development of a model? And then along the same lines like, Does the model even need to be transparent to users if this AI gets good enough? Like why not have the AI From the language model build the process model and then have the whole thing turn that have Pega turn that into code, soup to nuts. So anyway, just some random questions for you. Hopefully, that's coherent.

Speaker 2

No, I think they're good questions and they're certainly top of mind. So, Pega historically, in addition to perhaps there being fewer developers than Java, which is Kindly a high bar to jump over. We've also at times been criticized for being a little hard to use or Requiring a learning curve, which we've been working to improve, but it's one of the things that takes work. I think that the advent of generative AI It takes a mass makes a massive change to both of those. It will make existing developers very much more productive, but it really opens up The use of the technology to a much more to use your word democratize Group of citizen developers, where we can leverage the structure we have, because a lot of the citizen developer stuff has the risk I'm not really providing the right guidance for an enterprise.

Speaker 2

So we can provide that guidance and control with like our layer cake, but still make it so that The instructions don't require, any sort of deep Pega knowledge, but can be interpreted from language. Now relative to your question of why go into the model at all, the real challenge when you look at demos and think about this stuff, It's not just how do you create a little app. Certainly for customers who have more than a, what I would describe as a single small app need, but if you need to create a system That does a number of things and talks to a number of back ends. You need some structure that captures how that system works. Because when you want to go make changes to that system, you need to be able to go to a structure to make the changes.

Speaker 2

You don't want to go around regenerating things all the time. That would be super unreliable, Really easy to introduce Fox. And because we have this model that's the center of our architecture, I think we're uniquely qualified to not just be able to capture like a little process flow, but to be able to capture the really robust things you You need to build an app, how you edit and validate data, how you actually send it out to different back end systems, how you decide what the right controls are, If the thing is going to post the transaction, who needs to approve it? All of those types of things are in our model and they're visible. They Make sense to the business people and now our models will be able to be constructed in this really exciting and Staggeringly, I think, well, staggeringly powerful way.

Speaker 2

So that's why we're really excited about what this does for us. And it's not just going to be one turn of the crank. This is going to really influence, I think, the business that we're in quite a bit for years.

Speaker 7

Got it. Hey, thanks a lot. Congrats again. Thanks, Steve.

Operator

Next question, Joe Mears with Truett Securities. Please go ahead.

Speaker 5

Thanks so much, guys. Just have one question. Thinking about the white space within the current customer base, I think in the past you've spoken to it being quite large. I'm just curious if you could remind us of And then maybe just qualitatively how that fits into different buckets, whether it's different selling to different geographies or new product cases? And then maybe just how task mining with Everflow might help kind of even broaden that opportunity?

Speaker 5

Thanks so much.

Speaker 1

So I'll take the first part and then Alan you can take maybe the process of mining part. So we often think about this and we and actually Joe we can never you can We can use market data from 3rd party We know our spend is and we kind of have a directional idea of what we think would be a reasonable target. And when you look across our client base, we are well below 10% penetrated, single digits, kind of mid single digits penetration. And when you go out What would that look like after 3 to 4 years of growth with those clients? We maybe approach 10%.

Speaker 1

So I think even in our largest We've talked about maybe we're 25%, 30% penetrated in some of our largest clients in terms of what we might be able to get from them. So I think the number is Almost ridiculously high to talk about how much we can tackle that $100,000,000,000 market That we have out there. So I think it's we've been in business for a long time, our 40 year anniversary Actually, this month, as a company, but I don't think we should mistake that and the relationship we have for our clients to think that We are deeply penetrated in those clients in terms of the opportunity set. Alan, you want to

Speaker 2

maybe talk about EberFlow? Yes. So That's absolutely correct. And when I go talk to the government of Bavaria, like I did last week when I was in Germany, Yes. We have such a tiny fraction of what we're able to do for those the governments and same for the commercial enterprises as well, Where there's really in all but a few cases staggering upside.

Speaker 2

And candidly, the customers like the attention and they deserve the attention. So I think this is going to be win win for everybody. Everflow is just a wonderful tool to help people just get a better understanding of what's going on With their processes. And I think it's less that Everflow itself generates large amounts of ACV. I think it's more that the use of Everflow I was part of the discovery of how you can do better automation and how you can apply the Pega platform technology To be able to handle the things that Pega workflow is a good at.

Speaker 5

Awesome. Thank you so much, guys.

Operator

Next question, Vinod Srinivasarathavan with Barclays. Please go ahead.

Speaker 3

Hi. Thank you for taking my question. Just one for me. You've talked about usage based buying before and you talked about it a little bit earlier. Can you talk about how did usage patterns with customers purchasing the product in this way trend throughout the quarter?

Speaker 1

So just to be clear, when we think about the usage based contracts, What we're really talking about is the ability for our clients to bring on new use cases, new workloads to expand their footprint of Pega in a And as they do that, naturally the volume that they use where they see value from that, we get A small fraction of that value that is created by the client. In terms of usage across the year, Some clients have it very consistent because it's a very predictable and repeatable process. Some have peaks and troughs Through the year because of the nature of the business like loan originations might be bigger in the spring. It might be in other parts of the year, for example. But in terms of the quarter, there weren't I wouldn't say that there's trends that we're tracking on usage.

Speaker 1

What I would say is that The majority of our engagement with clients, we're engaging in this way so that we can actually help our clients have a frictionless way to adopt And not have to go back in kind of the traditional perpetual world, if you go back many years where they had to actually go through a Sizing it up in a purchasing process and trying to identify the need and go through a very rigorous and Overhead heavy internal process, we want our clients to be able to get value from Pega in a frictionless way and that's really

Speaker 2

a very important part of the Usage based model. And we'll often calculate the usage based on a trailing 12 month average. So that individual quarters won't bounce up and down, and usage won't vary month to month. Customers and Both customers and us, I think are happier when that's a little smoother. And so that's how we've tended to do this.

Speaker 3

Got it. Thank you. Appreciate it.

Speaker 2

So with that, let me thank everybody for attending. We're excited about where we are. We're working hard. And I want you guys to know, particularly the ones who want to see brilliant generative AI capabilities That PegaWorld is going to be, I think, enormously exciting this year. So the MGM brand, it's June 11 through 13th, Investor Day on 12th and look forward to seeing you on Vegas.

Speaker 2

Thank you very much.

Operator

This concludes today's teleconference. You may disconnect your lines at this time and thank you for your participation.

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