Pegasystems Q2 2023 Earnings Call Transcript

Quartr
Provided by Quartr
July 27, 2023

There are 12 speakers on the call.

Operator

Greetings, and welcome to the Pegasystems Second Quarter 2023 Earnings Conference Call. 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, Peter Welburn, Vice President of Corporate Development and Investor Relations.

Operator

Thank you, sir. You may begin.

Speaker 1

Good morning, everyone, and welcome to Systems Q2 2023 Earnings Call. Before we begin, I would like to read our Safe Harbor statement. Certain statements contained in this Identify forward looking statements, which speak only as of the date 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 2023 and beyond could differ materially from the company's current expectations.

Speaker 1

Factors that could cause the company's results to differ materially from those expressed in forward looking statements are contained in the press release announcing its Q2 2023 earnings and in the company's filings with the Securities and Exchange Commission, including its annual report on Form 10 ks for the year ended December 31, 2022, and in 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 views 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 a result of new information, future events or otherwise. And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Speaker 2

Thank you, Peter, And to everyone who has joined today's call, especially those of you who've gotten up pretty early to do so. I wanted So to reinforce that at PegaWorld last month, I had the opportunity to spend time with many of our clients and have very meaningful conversations. And in virtually every discussion, not just the ones I had, but in meeting with other Pega execs, our clients want to talk about the future of AI, And specifically about the impact of generative AI and how they should be thinking about it, how we are approaching it and how they can leverage AI Responsibly and safely. Clients are seeing that this technology will change their business in fundamental ways and are excited about the potential. At the same time, there is so much information in the market and so many conflicting opinions.

Speaker 2

They are eager to learn more and separate out The marketing hype from the reality. It's clear this technology is going to drive massive shifts in how we get work done. And in Pega's world, how applications are designed, built, evolved and supported. We believe Pega is uniquely positioned to leverage this technology, bring it to our clients in a safe and secure way and take advantage of this massive opportunity. Now for those who attended PegaWorld, you saw this firsthand on the main stage as well as during our investor session.

Speaker 2

We believe that generative AI will accelerate the adoption of Pega, making it easier, faster and cheaper to deploy it, improving the client experience And driving expansion of existing relationships. And that will translate into helping our clients leverage NII in the organizations To improve efficiency, save money and enhance employee and customer satisfaction. Now nonetheless, There are concerns about the overall economic environment and clients are being conservative in their decision making even as they engage in these Very positive conversations more deeply. Now taking client feedback in and evaluating the impact of this new technology, It is clear to us that we have further opportunities to streamline how we engage with our clients. During this quarter, we will be working with our teams On ways to get even closer to our customers.

Speaker 2

Now because AI is so important, I want to take a minute To be able to reiterate why Pega is uniquely positioned to leverage generative AI and why this will bring special benefits to our clients. Now Pega has been integrating and innovating the use of artificial intelligence and automation since I founded the company. And we've gone through many evolutions. I think this is as an exciting one as I've ever seen. I believe we understand what clients need and we can We're now in acceleration from generative AI while preserving the scale and scope that enterprises demand.

Speaker 2

And a big piece of this that is unique to Pega is we've built an architecture That is perfectly suited to tap into the disruptive power of generative AI, both today and well into the future, and we know how to monetize it. Most companies are thinking about generative AI as a code generator of one form or another, But that will really only get them so far. Going directly from prompts to code Doesn't really provide the structure and enterprise needs to create an enterprise class system that can evolve. In contrast, Pega has always been based on the concept of a business model at the center That creates a structure and a system that can evolve as the industry and customer needs change. Our architecture is built on what we call the situational layer tech.

Speaker 2

And you're going to hear me talk about the layer tech a lot, Not just now, but in the coming quarters as it helps to really power this revolution. It's a proprietary capability that organizes all of an enterprise's processes, rules, data models and UI into layers. So it supports building and reusing. Now this layer cake is the perfect place to plug in GenAI. It creates a pace that after the JAI contributes, people can see the model, touch it, understand it and we generate as needed.

Speaker 2

And it is the SLAER tag, this architecture that is what Pega is uniquely able to provide our clients, A proprietary structural advantage at the heart of our products. Now it's not something that can be easily copied or reproduced And it allows us to develop an integrated generative AI rapidly and seamlessly. So we have been at the forefront of using AI In responsible ways and the company's responsible AI frameworks that are trusted by our clients and they will be critical as they build Their own AI models and the layer cake helps us there too by helping create visibility for what comes from Pega Architecture, experience and capabilities, I believe will make us more successful than our competitors because it will help our clients be more successful And being able to let them quickly adapt and build for change. By the way, I think GenAI is going to be devastating To the most of the low code companies that haven't taken this type of approach. As a result, you already see some players Starting to talk less about using low code, and I think a lot of low code players are going to get wiped out.

Speaker 2

But at Pega, we're still talking about low code Because we've always used low code to build the layer deck. We've always used low code in a way that provides the structure Sure. That was really almost presciently designed for the introduction of concepts like generative AI. So we can implement generative AI as a strength. Now I expect that we will monetize generative AI in 3 ways.

Speaker 2

1st, clients will create more Pega apps and process more work on our platform. Most of our licenses Already work quantity based. Years ago, we began moving away from seed licenses because frankly, seeds are going to go down. Or if the industry does the right thing, that should go down a lot. And we saw this coming a long, long time ago.

Speaker 2

So you can think of most of our licenses as being consumption or capacity based, which is exactly I believe the type of license You won't in this sort of environment. I think it's good for the client and good for us. Secondly, I do think we're going to see That the fact that we're doing this generative AI work in Pega Cloud and leading with Pega Cloud for generative AI will serve as catalysts for more clients to move from existing term or maintenance contracts to Pega Cloud subscription agreements. And third, We will offer specific GenAI powered add on features, for which there will be an additional charge. Now we recently announced and showed that PegaWorld 20 generative AI boosters That will be available with Pega Infinity 23 this summer.

Speaker 2

And we've just gotten started. In fact, our The engineering team began this year with a Gen AI focused hackathon that resulted in more than 100 new prototypes of capabilities. Many made it into Infinity 23 and there's much more to come in subsequent releases. We have clients who are signing up to be early adopters already And they are engaged and excited about these capabilities and we're excited about working with them and seeing what we can accomplish together. Before I move on, I want to take just a few minutes and provide some additional color on PegaWorld because it was so spectacular.

Speaker 2

This was the first time we came together in person since 2019 and the energy and excitement was palpable. If you couldn't join the sessions or would just like to see all the replays that are available on pega.com, just search We have more than 3,500 attendees from around the world, representing over 47 countries. And we have inspiring keynotes from clients like Virgin Media, Rabobank, Citi and Aflac, who are all using Pega to drive their business. We have more than 80 deep dive breakout sessions with additional clients, sharing their stories from companies including BT, Google, Santander, Siemens, T Mobile, United Healthcare, Verizon and Wells Fargo. But one of my favorite breakouts was from LeasePlan, We talked about their transition to a fully digital business model.

Speaker 2

They are leveraging Pega in their center of excellence in pursuit of their vision to Becoming a car as a service organization with a strong focus on service efficiency and digital channels. This was optimized costs and Capture market growth. And they're leveraging our state of the art constellation open user experience technology and our prescriptive design system To give their clients and their staff exceptional experiences. You can find a replay of this excellent session on pega.com. Just go to PegaWorld under Events and search on Wieseplant, one word.

Speaker 2

Now, I heard there Very often, how much clients value being able to connect with peers from other companies and learn from the pega journeys of others. And they told me that attending in person, they were able to get down in just a few days what might have taken weeks or months in terms of discovery, getting questions answered, Experience in the technology and ultimately understanding the value payers can provide. I also heard positive feedback about our client first Part of the org model and the value we are, I think mutually achieving, providing a more focused and dedicated engagement team to stay close to our clients and they're excited about the new capabilities and they're really looking forward to seeing how we continue to approach Standard of AI in the future. Finding ways to accelerate development and improve the function of business users without the needs for Well, traditional longer ways to do it. So I came away feeling incredibly energized and more convinced than ever We have the right client engagement style, the right technology and a team that can drive success for our clients and for Pega, Our partners with Air Force and they also I think got both enormous value and I saw tremendous engagement between them and our clients.

Speaker 2

So as we move into the second half of the year, we're going to be looking to continue to double down and push on this strategy to improve operating effectiveness With additional improvements to our go to market alignment that will help maintain and bring even greater attention to that focus. So, in summary, we are focused on building a successful company for the long term and having our clients successfully navigate what is currently candidly a challenging We navigate what is currently candidly a challenging selling environment that we think may persist for some time. Let's face it, right now the world is uncertain and rapidly changing. But I believe we have the right strategy to succeed in this environment while building for the future. We're focusing on our client base with solutions that drive efficiency and cost savings.

Speaker 2

And we're helping our clients navigate The same set of macroeconomic conditions. We see that GenAI will rapidly change the landscape of how work gets done Massively, and we have a unique advantage that we can leverage and that I believe will be sustainable. And we are making good progress as we pursue the goal of trying to be a rule of 40 company as we exit next year, balancing growth with fiscal discipline and I'm happy to point out generating very, very significant cash flow. Now to provide more color on financial results, let me turn it over to our CFO and COO, Ken Stillwell.

Speaker 3

Thanks, Alan. Our first half results demonstrate our ability to generate increasing amounts of free cash flow, while maintaining a double digit growth rate. The most important metric to measure the success of our business continues to be the growth in annual contract value or ACV. At the midpoint of 2023, ACV grew 13% year over year. Our ACV growth was driven by the continued momentum of Pega Cloud ACV, which reached $499,000,000 at the end of the second quarter.

Speaker 3

I'm excited that our Pega Cloud SaaS business continues to be the largest and fastest growing ACV component and Pega Cloud backlog grew by 23% or $164,000,000 year over year. Pega Cloud now represents more than 2 thirds of total backlog. This growth is further evidence of the underlying strength Another key metric to measure the success of our business is cash flow. In the first half of twenty twenty three, Pega generated $114,000,000 of cash flow from operations and $123,000,000 of free cash flow, a fantastic achievement. $123,000,000 is the highest level of free cash flow dollars generated in the first half of the year in the history of the company.

Speaker 3

There are several reasons we delivered this result. 1st, in late 2017, we started the subscription transition to move from a company that sold perpetual software licenses to now a company that sells primarily subscription offerings. We embrace the Subscription based business model in response to demand from our clients who are looking for a fully managed offering as a modern way to Our technology, we also like the fact that recurring billings and those cash collections are more durable and predictable. We knew and discussed publicly the Cash flow would improve as we exited the subscription transition. Seeing Pega generate record free cash flow in the first half of the year is a great step forward In realizing the vision, we articulated more than 5 years ago.

Speaker 3

2nd, as part of the completion of the subscription model transition, we placed a greater emphasis across the organization on driving free cash flow, whether it being more disciplined on hiring or more selective with third party spend, I'm seeing numerous examples of our team members making meaningful steps to focus on improving profitability. 3rd, We're doing a better job aligning our spending with our ACV growth drivers. In other words, we're instilling better operational rigor than we have in the past. For example, We believe that more than 90% of our ACV growth this year will originate from existing clients through our high client retention rates and our cross sell and up sell activity. It's far more efficient to sell into existing clients and new logos, especially in times of greater economic uncertainty that I think we'd all agree we're experiencing today.

Speaker 3

One reminder, in a subscription based business like ours, which generates significant term license revenue, there can be a mismatch between billings and revenue. Under ASC 606, the majority of term license software revenue is recognized upfront. However, billings and cash collections occur primarily 1 year in advance in equal installments over the life of the contract. This dynamic means that we can deliver strong Cash flow, even as reported revenue in any given quarter fluctuates up or down. As a reminder, we do not provide quarterly revenue guidance.

Speaker 3

Collectively, our mid year results show that we continue to make progress on managing the company with and toward a Rule of 40 mindset. As a reminder, we define Rule 40 as the combination of ACV growth and free cash flow margin. Achieving the Rule 40 milestone A very important one for all of us at Pega. Reaching this goal will provide us with another reason to be proud of the business Generating strong free cash flow provides the fuel for Pega to invest in our business and to provide outstanding support to clients and it gives us the financial strength and flexibility to navigate through any uncertain economic environment. For example, in the first half of twenty 23, our cash and marketable security balance grew providing us with the ability to spend about $90,000,000 on repurchases of our convertible debt At the end of Q2, our outstanding convertible debt balance was approximately $500,000,000 As we outlined in our investor session during PegaWorld in June, we see 3 major levers to achieve the free cash flow margin necessary to attain The rule 40.

Speaker 3

The first is expanding total gross margin, which is a function of Pega Cloud gross margin, Term maintenance gross margin and our professional services gross margin. Improving Pega Cloud gross margin will be the biggest driver of Total gross margin improvement. We expect to improve Pega Cloud gross margin by continuing to scale Pega Cloud, increasing automation and implementing Multi tenancy in Kubernetes. On a trailing 12 month basis, Tega Cloud revenue is now $423,000,000 up from about $50,000,000 just a few years ago. In the first half of twenty twenty three, Pega Cloud gross margin improved 68% to 73% year over year.

Speaker 3

The second major lever that will drive operating leverage is in the area of sales and marketing. This is certainly the most difficult of the 3 to tackle. We continue to balance our need to invest in sales and marketing to drive ACV growth with our need to improve Sales efficiency. We certainly have a lot of work to do. In the last few months, we've received feedback from our clients, partners and employees We're evaluating all of these suggestions to improve our go to market effectiveness We plan to implement changes in the second half of the year to continue driving improvement in our go to market productivity.

Speaker 3

The 3rd and final major lever That will improve our operating leverage in the area of research and development and G and A. The approach here is simple. We plan to increase R and D and G and A spending at a Slower rate than we expect to grow the company, delivering best in class innovation to our clients continues to be critical to our success. We will continue to invest heavily in R and D. However, we believe we can do so in a manner that still improves our efficiency.

Speaker 3

As you can tell, we're very focused on growth, expanding gross margin, improving sales efficiency and increasing operating leverage. The companies that are successful in navigating uncertain economic times like the environment we're in today typically are ones that focus on growth, expense management and generating free cash flow. It's very reassuring to our clients that Pega maintains the financial strength to continue providing outstanding customer support and product innovation. Before I wrap up, I've been asked to offer a few thoughts on modeling our business in the second half of 2023. As a reminder, the Q3 of the year is typically one of the lightest term license revenue quarters The year due to seasonality.

Speaker 3

That's because we often book far fewer renewals of term license agreements in that period. In contrast, the final quarter of the year is typically a relatively stronger term license revenue quarter because we, like most enterprise software companies, Experience a higher level of contract renewals in the last quarter of the fiscal year. In conclusion, it was great seeing so many of you in person Our Investor Session in June at PegaWorld in Las Vegas, and I'm looking forward to seeing all of you as we get back on the road in August September. Operator, at this time, please open the line for questions.

Operator

Thank you. We will now be conducting a question Our first question comes from Steve Enders with Citi. Please proceed with your question.

Speaker 4

Okay, great. Thanks for taking the questions this morning. I guess I just want to ask first on kind of what you are seeing out there in the macro situation and some of the uncertainty with customer budgets. And I guess, how that relates into the sequential decline that we saw here on the ACV line in the quarter?

Speaker 3

So let me hey Steve, it's Ken. Let me hit on the second part of your question and then I'll hand over to Alan to give on the market landscape. So, it is unusual to have a decline in ACV sequentially in a quarter. It's not unheard of, Especially in a situation where we had such a strong build

Speaker 2

in the

Speaker 3

Q1. There's a lot of anomalies that pop up in a quarter around Renewals and we do have some churn in clients. It doesn't always happen linear. We actually have consumption agreements that reset at different points in the way we calculate ACV. So we tend to not look at things in such a small discrete period as quarter and think about things over a trailing 12 months kind of view.

Speaker 3

So like I said, it is unusual to see that happen, but It is not something that we believe is systemic and we don't think it impacts our ability to drive toward our full year results. So I'll hand back to Alan on the view on his view of the market.

Speaker 2

Yes. So I think the market is definitely being conservative. We're seeing more Approvals, sometimes popping in at the last moment, having some things that you would have expected Would have just closed in the matter of course and some which have since closed, but that just took longer. I think that In the companies that are our clients, there's just an extra level of scrutiny that is going on, Which I've seen before and in other times when there was uncertainty and I think we know how to deal with it. Well, I know we know how to deal with it.

Speaker 2

But I do know that I'm expecting that this is going to be true for a lot of other companies and it's going to be true Yes, possibly for the next quarter or 2. I don't think it affects our long term prospects in any way though.

Speaker 4

Okay. That's helpful context there and appreciate the comments around that. I guess, kind of given the budget situation that we're talking about here and the excitement around AI, how are you thinking about the path to monetization for All the new functionality that you have talked about and released at PegaWorld last month and how customers are kind of feeling about those investments in

Speaker 2

Look, customers are being bombarded with Every company they talk to and even ones I'm sure they're trying to avoid coming and offering AI miracles The hype cycle here is actually, I think it might be unprecedented to tell you the truth. The reality though is we have a lot of credibility with our clients, particularly when we can show them the real types of things That we were able to show at PegaWorld and that you could see in some of the videos that we posted. So there was a tremendous amount And I think we have a lot of confidence from our clients The way we're going to do it is going to be a way that really works. We are seeing, as we've seen in the past, a lot of customers doing their own experimentation. A lot of customers, as As you would expect, are putting their toes dipping their toes in a lot of ponds.

Speaker 2

We're seeing the same with analytics So, that there's just a lot of, oh my God, how do I figure out how to get the value out of my data? How do I drive Spence, how do I do everything from create better end to end automation You'll be able to have the AI desummarization that otherwise the human would have to do. So there's just so much Activity and interest. I think we're doing well and I've been in a lot of meetings in which we've had a discussion explaining why The Pega approach is differentiated, why it's architecturally superior. And I know customers are taking that Very, very seriously.

Speaker 2

And I expect it will lead to, as I said in the 3 ways we think of monetizing this, I think it will lead To greater usage and we're already primed for that greater usage to lead to better outcomes for them and good outcomes for us.

Speaker 4

Okay, perfect. Thanks for taking the questions.

Operator

Our next question comes from Kevin Kumar with Goldman Sachs, please proceed with your question.

Speaker 5

Thanks for taking my question. I had one on cash flow, which was very strong in the first half of the year. And I know you updated guidance during Investor Day to $180,000,000 for the year. It feels like you're tracking ahead of that number, Particularly given 4Q tends to be a strong quarter. Is that still the right way to think about that?

Speaker 5

Anything else you would call out in terms of kind of the cadence of cash flow for the year?

Speaker 3

Hey, Kevin. Thanks for your question. So it would be it will be silly for me to suggest that Being where we are at the midway point doesn't isn't a good thing in terms of us achieving our cash flow for the year. And I certainly don't think that 150 or 180 or whatever number we have is something where we'll just But I would say we're very pleased with where we are and we think it bodes well for the future of increasing cash flow

Speaker 2

for Pega. I'll also say that the mood of the company is really, I believe, come a long, long way In adopting a culture of balance, of trying to head towards rule of authority this year, rule of authority next year. And so it wasn't like the cash just fell out of the sky. It's that people are doing the right things. You're thinking about being more economical, but also how to be candid, bump up that Critical component of being a rule of 3040 company.

Speaker 2

It's part of everybody's complex. So It's one of those things that a little extra attention helps a lot.

Speaker 5

That's great. Thanks for the context there. And I had one on just On Europe, looking at the segment revenue details, it implies, I think Europe accelerated revenue growth in the first half. Is that maybe just catch up? And is there anything you'd call out in terms of potential recovering in some of those different regions And anything you're hearing from your customer base?

Speaker 5

Thank you.

Speaker 3

Yes. I will say don't Please be careful with how much you look into segment reporting for Regis on revenue, because remember a lot of our revenue Still is term license revenue under ASC 606. And so the mix and the timing can somewhat just be just happens to be The way the revenue flowed between the geos, I would say that said, we have not seen a noticeable change in the theaters in the first half of the year in terms of positive or negative. I just think sometimes the revenue Flow is different, Kevin. So that it's more that than it is actual economic changes.

Speaker 5

Understood. Thanks for taking my questions.

Speaker 2

Yes.

Operator

Our next question comes from Rishi Jaluria with RBC Capital Markets, please proceed with your question.

Speaker 6

Wonderful. Thanks, Alan and Ken for taking my questions. First, I wanted to kind of drill a little bit back into the consumption element of the business. At the Analyst Day, you had said that Part of the goal of generative AI is driving more consumption. Maybe can you give us a little bit of a reminder for Today, how much of your business is actually consumption?

Speaker 6

And as we think about the actual adoption of generative AI solutions, How that impacts the mix of consumption versus subscription, and maybe what does that do to some of the leading metrics like ACV and RPO that we're all still looking at? And then I've got a follow-up.

Speaker 3

So let me start with that and then Alan can fill in the gaps. So Just a reminder for us, when we say consumption, we don't Mean a contract that is paid by the Drake with no commitments from the clients. What we mean is that the contract is Based on a usage or a consumption metric and that increase in that metric allows a sharing of value between our clients getting more value from using the solution and us achieving more value from those commitments. When you think about our contract consumption, meaning a model that our contracts are based on a consumption or usage metric, It's well above 50% of our contracts are actually using a usage type metric or consumption type metric. In terms of the amount of our ACV or revenue, it is driven by variances from contractually committed Arrangements with our clients, meaning overages or variances, it's still a relatively small part of our business that comes From clients going over their contractual.

Speaker 3

Normally what happens with clients is when they get to that point, we re contract with them with new commitments.

Speaker 2

So most of the agreements, and I think just to clarify what Ken is saying there, because I think it's a really interesting and important point. We did some things several years ago when we began wanting to move to a more non seat based model, A model was based on the quantity of work to converge the concepts of subscription and consumption. So what we found is that clients really don't like it when the amount they have to pay bounces around too much From one quarter to another, makes it hard for them to budget. It can feel unpredictable, particularly if it ends up being driven by Some external circumstance that suddenly something falls a lot more items or a lot more exceptions, all the calls to the call center. So the quarter to quarter variation was something we wanted to avoid.

Speaker 2

But on the other hand, we want to accommodate customers whose business was increasing Even if their seats were decreasing. So what we basically typically do, as Ken said, to avoid having it bounce too much for a customer from quarter to quarter Instead of doing overage charges, we use the increased level of use, the increased consumption to reset a new subscription price. So that it reflects itself in the go forward ACV. And it becomes something that candidly is a lot easier for the customer to budget And understand and I think it's actually easier for us to administer, but I don't believe that was the motivation. Does that make sense, Rajiv?

Speaker 6

Yes, that's a very, very thorough answer. Really appreciate it guys.

Speaker 3

And then, I want to I'm going to answer one part of your question that we didn't answer, backlog, RPO. When you move to more consumption or usage based models, there is a chance to decline a contract duration would come down slightly. And so that could actually be a headwind to RPO growth Slightly, not materially, but slightly. So that's your second the one part of your question there, just to clarify that. And the reason why that is, is we want Faster iterations of measuring our clients' usage to be able to grow ACV, longer durations tend to lock in usage for longer periods of time.

Speaker 3

So that's the RPO answer.

Speaker 6

Okay, great. And just to clarify that Shouldn't have an impact on CRPO or RPO with 1 year or under, correct?

Speaker 3

No, no. It would be highly unlikely to impact current RPO. Yes.

Speaker 6

Okay. Really helpful. Thanks. And then, one other piece of feedback we got when we were talking to partners at PegaWorld Is that generally, I can really help speed up time to value. Maybe based on your customer conversations, How do we think about the potential for this to reduce implementation times, reduce sales cycles, And kind of lead to maybe over time, better Net new business showing up in the model.

Speaker 6

Maybe help us understand how you're thinking about that. Thanks.

Speaker 2

I think it's going to be huge. When I did my closing at PegaWorld, and the video is still up there, I talked about 4 things But I expected to come back to that audience with the following year. And I want you to know that the company is Galvanize around working as hard as we can to make sure we deliver on these things. The first with what we call pegging your fingertips. So using the power of generative AI, including some of the things that are going to be in 2023, to be able to make it so the system It's giving people building the software advice.

Speaker 2

It's also going to be able to give end users who are using the software advice And even do work for them. So that was the first of the 4. The second was we expect to double developer productivity As a direct result of the implementation of these features. And relative to what you were asking about, I think this It's unquestionably going to increase the velocity of sales cycles and it's going to make it easier for customers to get a lot more done With the same dollars. And so we're working to get our partners excited about how this will let them do more The same amount, which should improve their sales cycles as well.

Speaker 2

And the final 2, as you may remember, were the concepts of Launchpad and the autonomous enterprise.

Speaker 6

Perfect. Thank you, guys.

Operator

Our next question comes from Pinjalim Bora with JPMorgan. Please proceed with your question.

Speaker 7

Great. Hey, guys. Thanks for taking the questions. I wanted to ask you one thing that you were talking in the script about More opportunity to further streamline sales, additional improvements to go to market. Is there any way to kind of tease that out?

Speaker 7

What other things are you thinking that you can apply?

Speaker 2

Yes. We've just begun sharing that with the company And I'm going to spend some time today talking with the company as a whole about what we're doing. But in principle, we're going to make it so in Couple of the roles and functions that historically have been kind of segmented out are going to become less siloed In the front office of the go to market, the work of people that we call success managers and People we call account executives and other sorts of roles and functions that are in there that were specialists In certain areas, we're going to work to bring them under a common organizational and management structure. So that I believe is once again going to continue to make us more effective. Certainly gotten feedback from our clients that It will be easier for them to deal with more focused teams.

Speaker 2

And I think of it as just really a continuation of some of the things we started in January. I do believe it will improve sales efficiency, but that is not the primary driver here.

Speaker 7

Got it. Understood. And Ken, going back to kind of the sequential decline in ACV, Was the macro sequentially worse in Q2 versus Q1? Anything to note there?

Speaker 3

I don't believe the macro was worse. I think our performance in Q1 was better than our performance in Q2 and naturally that contributes. But that Pindjal, that actually happens in a business like ours where we have Smaller numbers of deals where the deals are larger value, you tend to not get kind of like it's not like a statistical like kind of trend in terms of the bookings. So that's not that unusual to see in our business.

Speaker 7

Understood. Thank you.

Operator

Our next question comes from Jake Roberge with William Blair. Please proceed with your question.

Speaker 4

Hey, guys. Thanks for taking my questions.

Speaker 8

Just wanted to dig deeper into your comments that generative AI can Monetize just those lower end use cases in low code, could you just talk more about why your platform's positioning helps you take advantage of AI? And then just from a Timing perspective, when do you think we can actually start seeing AI layer into model? Is that something that's more Q4? Or do you think that's more of a

Speaker 2

Could you repeat the second question? I'm sorry. You said when can we start seeing?

Speaker 8

Yes. It was just really around the timing of when we could start seeing AI layer into the model. Is that something that starts generating revenue in Q4 or is that more of a 2024

Speaker 2

So a couple of different things there, all of which I think are terrific actually. So The reality is a lot of what you see are people building systems using AI by Using them as an accelerator for traditional coding, think about Copilot, using it to even generate in the low code Entire systems. The trouble with the system that's generated like that is it's really hard to change. It doesn't have a structure that makes it easy for you to go in and say, oh, Italy wants to do something differently. How do I go change this set of things for Italy?

Speaker 2

Because candidly, when the generated stuff happens, it tends to kind of get generated In Club Serve, in a way that's not necessarily organized to change. The layer cake in Pega Let's you organize the key dimensions of change. We find that in businesses, in enterprise business, change typically happens for 1 of 3 reasons. You generally get a general way you want to do a process or make a set of decisions and they will vary based on a product variation For a customer variation or a jurisdictional variation, a locational variation. And we have built those dimensions Into this layer cake.

Speaker 2

So when you want to make a change or how something works for Italy or how you handle particular high value set of clients, You got a place to go. You got a place to go in the layer cake that you can regenerate those pieces As opposed to having to deal with something that looks a lot more like soup. Now the soup doesn't matter as much in small systems. So I think it's going to be used extensively there. But in anything that you think of as an enterprise solution, really important to have that structure.

Speaker 2

And this will be hitting the streets this year. So this is going to be something that When 23 ships this summer, this is going to be in the hands of customers.

Speaker 8

Okay, helpful. And then just We're obviously hearing a lot about platform consolidation just given the uncertain macro. Have you seen any changes to the competitive environment or even with your GSI partnerships, just as some of the larger software platforms like Microsoft and ServiceNow invest more in the space? And then on the other end, have you started to benefit at all just as customers may look to consolidate like a point solution RPA or

Speaker 2

Yes. We're seeing actual some real benefits from platform consolidation in the pipeline And actually in real implemented systems where some of our clients are using us to do more of their Yes, about more of their workflows. And I think that's actually a larger source of benefit for us than the consolidation across different product Like process mining versus work automation. Yes, I do think we are going to see some consolidation. And I would expect based on where our history has been when this sort of thing has happened That is beneficial for us.

Speaker 8

Thanks for taking my questions.

Speaker 2

Yes.

Operator

Our next question is comes from Vinod Vasanthasathyan from Barclays. Please proceed with your question.

Speaker 5

Hi, guys. Thanks for taking my questions. I just want to follow-up on some of the macro and Gen AI questions you've talked about. So far, it seems like you're seeing some offsetting demand factors between Gen AI starting to help, but macro still being kind of more of a negative factor. When do you expect this tug of war to kind of start to favor Gen AI over macro and kind of start to show up in a stronger pipeline and then Really start to show up in net new ACV growth?

Speaker 2

Yes. I think the net new ACV I think the tug of war Is won by real things in the hands of real customers. If you look at what's out there, there's a lot of stuff, Including ours, which hasn't fully hit the street yet. And I think as that hits the street, we're going to see it do A much harder tug in that direction. I also think some of the macro just represents greater conservatism, just Extra layers of approvals or run it by the CFO at the end, twice.

Speaker 2

That was not candidly present as much As we entered the year, but isn't it all shocking, given the uncertainty and that everybody is trying to save money in this So I'm very excited. We need to be able to achieve our rule of 40 ambition We need a good breadcrumb and we're still psyched to be able to do that.

Speaker 5

Understood. And then just maybe on the Rule of 40, your progression and scaling of Pega Cloud and gross margins. At PegaWorld, I saw you guys were Hoping to adopt externalized services for microservices, I think by Infinity 24 with a more full Deployment by the year after that, how should we think about kind of modeling Pega Cloud gross margin as you kind of hit those milestones?

Speaker 3

Yes. So we wanted to get the way I would frame it is way back when we started this like 5 years ago, we said we want to get Pega Cloud gross margin to 70%. A couple of years ago, we said we're going to change that number to 75%. We're now pretty close to 75% and we've talked about that there's no reason why that number can't go and approach 80 In the coming years. So I would model it kind of in a more linear fashion.

Speaker 3

That is probably one part of our business that It does have linearity in terms of the scaling. So I would probably think about it that way.

Speaker 2

And we're putting improvements online every quarter.

Speaker 5

Got it. Thanks. Appreciate it.

Speaker 2

Yes.

Operator

Our next question comes from Fred Havemeyer with Macquarie. Please proceed with your question.

Speaker 9

Thank you very much. Good to speak, Alan. Good to speak, Ken. I think I was coming in with more Technical focused question, but something here kind of tickled by fancy. So I wanted to ask, I think maybe it's for Alan, as we think about the opportunity here to potentially We improve how customer service, sales, etcetera are done with the aid of generative AI.

Speaker 9

I mean, you have all of the pieces in place to do things like autonomous agents for enterprise and the like. But just wanted to ask you, what do you think about the opportunities kind of augment or improve how customer service is done more efficiently with generative AI?

Speaker 2

I think it's enormous. I think it's enormous in an assisted sense. And I also think that it's going to really fundamentally change the way self-service works as well, which is why I'm glad we're not Tied to seek help because, let's face it, one of the big cost savings that people are achieving and want to achieve is The reduction of waiver that they have trouble finding anyway. And so I think it's going to be a really perfect storm in that direction. And I do think that we do have a terrific collection of the parts to deliver on that for our clients.

Speaker 2

I think it will be

Speaker 9

great. I'm looking forward to seeing what you'll be doing there. I guess the next one is Just with respect to your partners as well, how are they approaching their strategy recommendations at the moment related to No code, low code and generally they are to their clients. Are they kind of also in a place where they're Experimenting with or helping the clients experiment with new technology. And is there any sort of a headwind that this experimentation is doing to platform like low code, no code platform

Speaker 2

I think there is a lot of experimentation going on throughout the entire business system, Because candidly, people are trying to figure out what's real and what's hype. The partner engagement I've had though has been extremely Enthusiastic about what we're doing. I'm not sure that they're as enthusiastic about everybody, but I'm sure the company I'm

Operator

Our next question comes from Mark Schaeffer with Loop Capital Markets. Please proceed with your question.

Speaker 10

Hi, thanks for taking my question. And on LaunchPad, you discussed the offering in more detail at the recent Investor Day. I was wondering if you could just bring us up to date on the status of your early adopter program for Launch Pat, and maybe just talk a little bit about some of the parts and capabilities of the offering that your partners are most excited about.

Speaker 2

So, I'm thrilled actually with the feedback from our early adopters. The early adopter program is oversubscribed And the partners are showing enormous enthusiasm. Just so folks know, If you haven't been plugged into Launchpad, Launchpad is a way of bringing the way we've historically thought about work driven systems to partners who want to capture their own IP and offer their own IP to subscribers Powered by Pega. And it was built specifically for this. And I think it's really unique in the market in being able to do that.

Speaker 2

And that is the feedback We've gotten from the organizations that we've done the early work with. So we've been reluctant to make any projections for this year because It is a nascent technology, but I'm expecting that I will be able to talk about LaunchPad's contribution To the financial strength of the business next year, because I think it's going really well.

Speaker 10

Great. Thank you.

Operator

Our next question comes from Tom Blakey with KeyBanc Capital Markets. Please proceed with your question.

Speaker 11

Hey, Alan and Ken, thanks for squeezing me in here. Great stuff here. I'm trying to balance out these 2 moving parts on the macro, it seems to have gotten incrementally a little more headwindy and AI, Which you seem more bullish on, Alan. In terms of the $1,400,000,000 calendar 2023 guide, it seems like maybe AI could be incremental here. But just trying to understand kind of where we are like when the guidance was set and where we are now in terms of balancing these two points out.

Speaker 11

And I have a follow-up on free cash flow.

Speaker 3

So let me take that one on the revenue side. So Tom, I think it is this has happened to us in a Few years where when there the Pega Cloud momentum creates a little bit of variability on the accounting revenue piece of it, right? So if you look at where we started the year, the revenue number can move around because of that mix of Pega Cloud. I think when you think about Our ACV and our billings, which are kind of those are very integrally connected, I would say that's kind of where the macro Got it. And I just want to separate revenue from ACV a little bit.

Speaker 3

So I think revenue is definitely a little bit more of a wild depending on the mix of the contracts. So that's an unfortunate reality for our business. But setting that up in terms of the ACV and the billings, I think maybe I'll leave you, Alan, to think about how you think about the macro now versus maybe where we started the year.

Speaker 2

Yes. Look, on a macro basis, the economic Certainty and the fact that we have seen like some more approvals come into the mix is obviously A challenge, one we've seen before, but I will tell you from a macro point of view, Gen AI is a huge and not short term Factor here, and I think it's going to this is going to fundamentally change our business And a number of other businesses in a very, very big way over the next 12 to So I'm very, very bullish. I'd love to be able to put out a quarter where there wasn't some bit of mixed results. We're working towards that. And if you have that cash flow is very positive.

Speaker 2

I will return to that. You had a question you said about cash flow?

Speaker 11

Yes, I did. And before I get to that, Alan, just while I have you there on the huge comment on GenAI, there's been some Sole of vendors and big titans out here talking about monetization there. Do you want to offer up maybe some visibility very early on here that you see in terms like for like uplift in terms of pricing or monetization per clients given that 90% of ACV is going to come from existing

Speaker 2

Yes. I think the biggest aspect of monetization is going to be because we're going to accelerate our clients' Use of the technology, so that they're going to use it more. I think some of the vendors you're referring to are stuck with more of a seat model. They're going to have to figure out how to fix it. We don't have that problem.

Speaker 2

So we're really in a good place that as customers get excited about this and want to use it, It's going to lead to greater volumes and that will lead directly to monetization. We will have some add on things that are separately priced, But I don't expect that we're going to do something onerous to our clients like I think some customers are worried about from other vendors. I've heard some numbers brought forward on seat pricing that I think are going to be anxiety producing They are customer base. We don't have to do that with our customer base to turn the system on. Yes.

Speaker 11

I guess you know what I was referring to, Alan. Thank you. That's very And on the impressive free cash flow here, I'm just wondering, your Converge is still trading, I think, at a 8% or 9% discount here, Ken. Not calling out anything specifically, but I'd like to know what your updated thinking is there. I know things are probably a little bit more, For lack of a better word, happy for you here again.

Speaker 11

So, but just an update on capital structure, capital return and also how it kind of like maybe possibly impacts That rule of 40 as you move things around here with a much potentially better balance sheet going forward. That'd be helpful. Thank you.

Speaker 3

Well, I think that we were never aggressively in the market to buy back Those were opportunistic where some investors were looking to get out of their position And we felt like there was an interesting IRR to do so. And actually, if the stock price goes up and as we get closer to maturity, that becomes There becomes less arbitrage, so to speak, on that versus what we can get at overnight rates. So I would say we're still we'll consider There are opportunities when they come in, but we're not aggressive we're not aggressively going out nor did we on the other transactions. I think it's more just Sign that we have a lot of confidence in the durability of the business and the cash flow of the business and we felt like we're very comfortable taking that $100,000,000 out of

Speaker 11

Convert. And then just from a longer term perspective, so just letting from a strategic perspective then, just letting the cash build?

Speaker 3

Yes. I mean, we have naturally from a capital allocation standpoint, we have a near term event if we wanted to have, which is To basically take out the converts and not to re up them or to refinance them. So naturally, that's something that's out there that We want as much flexibility as we can with our options.

Speaker 2

We're at time, but I see there are A couple of more people in the queue will very quickly take 2 more questions.

Speaker 5

Thanks guys.

Speaker 2

Thank you.

Operator

Our next question comes from Patrick Walravens with Citizens JMP. Please proceed with your question.

Speaker 5

Great. Thank you. So Alan, my question is, do you have enough sort of PhD level AI talent Do what you want to do. I mean, you have Peter van der Putten and then you added Christian, right? But how much do you need?

Speaker 2

I have Rob Walker too, who is a pretty good PhD and has been with us on the main stage of PegaWorld. And we have a

Speaker 6

And then can I ask as long as it's

Speaker 5

can we get an update on the lawsuit? There's Not a lot you can say, but whatever you can say.

Speaker 2

We're in the appeal waiting process and I'm looking forward So getting that in front of the judges, I'll just say that. All right, great.

Speaker 5

Thank you.

Speaker 2

And I think we are at time. So we will have to call it. Let me just tell everyone, thank you very much. We're working hard for you. We're actually generating cash.

Speaker 2

I know Ken and I are both very excited about and we will continue to keep you all updated.

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Key Takeaways

  • Generative AI leadership: Pega’s proprietary “situational layer cake” architecture uniquely embeds safe and scalable generative AI, aiming to accelerate app deployment, improve customer experience and monetize via increased usage, cloud subscriptions and add-on features.
  • Pega Cloud momentum: Annual Contract Value for Pega Cloud grew 13% year-over-year to $499 million in Q2, while Cloud backlog rose 23% to $164 million, now accounting for over two-thirds of total backlog.
  • Record free cash flow: In H1 2023, Pega generated $123 million of free cash flow—the highest first-half cash flow in company history—driven by its subscription-centric model and disciplined expense management.
  • Economic headwinds: Clients remain cautious amid macroeconomic uncertainty, leading to a sequential Q2 ACV decline driven by extended approval cycles and deal timing anomalies.
  • Path to Rule of 40: Pega is targeting a Rule of 40 balance by expanding gross margins (pushing Cloud margins toward 75–80%), improving sales efficiency and controlling R&D/G&A spend relative to growth.
AI Generated. May Contain Errors.
Earnings Conference Call
Pegasystems Q2 2023
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