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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good day, and welcome to the Pegasystems' Third Quarter 2019 Earnings Call. [Operator Instructions] I would like to now turn the conference over to Kenneth Stillwell, CFO. Please go ahead.
Thank you. Good evening, ladies and gentlemen. And welcome to Pegasystems' Q3 2019 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, anticipate, intense, plans, believes, will, could, should, estimates, may, targets, strategies, intends to, projects, forecasts, guidance, likely, and usually, are variations of such words and other similar expressions 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 the fiscal year 2019 and beyond could differ materially from the company's current expectations, factors that could cause the company's results to differ materially from those expressed in forward looking statements are contained in the Company's Press Release announcing its Q3 2018 earnings, and in the company's filings with the Securities and Exchange Commission, including its annual report on form 10-K for the year ended December 31, 2018 and other recent filings with the SEC. Investors are cautioned not to place undue reliance on such for looking statements, and there are no assurances that the matters contained in such statements will be achieved. Although subsequent events may cause our view to change except as required by applicable law, we do not undertake and specifically disclaim any obligation to publicly update or revise these forward-looking statements, whether as the result of new information, future events, or otherwise.
And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.
Thank you, Ken. Three Quarters of the way through the year. I'm pleased with the state of the business. We continue to make strong progress in ACV growth and our transition to Pega Cloud. We've been executing on a strategy to increase our sales capacity in response to the large opportunity ahead of us. And I'm pleased with the early returns on the effectiveness of the sales team, as reflected in our pipeline growth. Ken will provide more context on our financials in a few minutes.
Now in terms of sort of insights on the market, you know, as you aware, we're seeing lots of disruption around the world with things like Brexit and trade tariffs, and our clients are looking at how to plan for any number of changes they may face. Now, our underlying model driven low code architecture allows for our clients to adapt quickly to change and to really grow their businesses and develop their efficiencies. We continue to see enthusiasm for our software.
Now, our digital transformation technology helps organizations establish an operational backbone that can be used equally to either propel top line growth and drive bottom line efficiency shedding unnecessary technology overhead and also making operations and client engagement more efficiently.
Pega's Intelligent Automation Solutions optimize operational and employee efficiency. As I said, while our decision and capabilities improve the retention and lifetime value of client engagement by ensuring that right actions or offers are provided at the right time. This ensures not just a great client experience at the moment of outrage, but also the ability to drive preemptive customer service anticipating potential issues, so you can address them when they have a better chance of being mitigated.
Now, the market has been interesting because we have continued to see a lot of hype in the market, including crazy valuations that don't reflect business fundamentals. And this has been especially true around some of the hot technologies like what they call Robotic Process Automation or RPI that I talked about on the last quarter's earnings call.
We think there are better ways to go after the market from both the technology and marketing and solution perspective, and frankly see a validation of that in some of the recent events. As one analyst said in response to the recent layoffs of a major RPA vendor, “They're realizing that intelligent automation is a marathon, not a sprint, it pushed the hype around RPA far too aggressively.” He went on to say, “It is imperative that enterprises invest time and resources, evaluating their business processes, before taking the plunge buying software that will deliver only once the business cases have been defined.”
Now, this is very consistent with Pega's approach, and our view that RPA is great, but it should be used as an extension of true intelligent automation and true end-to-end digital process automation. And I think that bodes very well. You know, if you know our history, you know, we've been through up and down business and financial cycles, and we know the sail in both of those environments. And unlike others that appear to have gotten ahead of themselves, I don't expect you'll see us having to retrench because of overhype, should the business environment change.
Now to the clients' trends, you know, historically, we focused almost exclusively on the largest, most sophisticated clients and projects, because we feel we uniquely have the expertise and the technology to handle them. And we're still tackling those, as our clients are continuing to roll out important, new major initiatives. But we're also seeing our clients want to start quick quickly with other types of initiatives and then add value rapidly while they learn and adopt best practices. This can mean being more agile, starting small and fast, with the confidence that we can scale with them successfully to deliver what they need as things get bigger.
Many of these projects center on identifying what we call focused micro journeys. Sometimes people used to describe as used cases, and as I talked about a Pega World, a series of single interactions with a customer that can change their experience in a significant and positive way. We provide structured design thinking approaches to identify key challenges and to find the right problem to solve, and the right customer journey to tackle first.
And we're working to establish an increasingly repeatable standard way to go after these. This message is resonating, and we continue to see strong new business momentum across all geographies, all applications and industries. This quarter, I'd like to highlight the great progress we're making in the government market. Government is full of what we call case management and processes and the need to drive effectiveness and efficiency. And I just returned from our government empowered event we held in Washington DC on Wednesday. Clients and prospects from around the world joined us to hear how government agencies are working with PEGA to tackle digital transformation and modernize legacy systems, all while navigating the privacy and policies since rights.
We had a terrific lineup of speakers including Suzette Kent, the Federal CIO, as well as senior representatives from the FBI, the US Census Bureau, the Department of Veteran Affairs, and the Air Force Research Laboratory. Just like our commercial clients, they're looking to digital to drive improved engagement. And governments worldwide are increasingly focusing on their constituent experience as they seek to improve satisfaction while they're driving better efficiency.
There's a big push to modernization in the government, and we're very well suited to handle that. That trend is working to our advantage and when making nice strides in the government market, adding important new business globally. This quarter for example, we won new business at one of the largest UK Government departments, who has been a long standing Pega case management client, who recently purchased Pega customer service running on Pega Cloud to provide a single advisor user interface for their 30,000 customer service center staff.
This is a first step, it was a wider program to transform customer service with this department. And the first live call was taken using the Pega Solution after just four sprints, about eight weeks from project start.
A major Department of Defense Command is using the Pega Gov Cloud in the US to improve commands overall objective of annual audit readiness, by improving financial management processes and enhancing internal audit controls. Deciding factor and choosing in Pega was our digital process automation capabilities, which as I said, include end-to-end automation, with robotics, which enabled the command to automate and integrate processes with other critical internal enterprise systems, even if they're quite old and without APIs.
The US Federal Government also selected Pega as the intelligent business process management platform for building an end-to-end grants management solution. Pega will serve as a central component of this system, orchestrating all grants lifecycle activities and maintaining key grants management data. The unified system will replace multiple legacy systems and establish common business processes across several different grants programs.
And going overseas for a moment, the French National Authority for Health shows Pega Cloud software to manage a new certification that will create quality rankings used to evaluate all French hospitals.
Now it's not just these sort of direct sales, lots of sales actually operate through partners, and our partner relationships is something that's very important, you know, we have a situation where the largest Medicare service operation chose Pega to transform the way they serve their ever growing beneficiary population, providing seamless and frictionless service experiences.
Now, in addition to government, we continue to see strength across other verticals. And it's terrific to see new business coming through a range of clients from one of the largest global CPG leaders to our relatively new consumer groups. So it's, it's actually, I think it's moving forward very much in a positive way. In terms of marketing, on our last call, I mentioned that we've been continuing to increase our focus on getting visibility and engaging with our customers. And then we had a number of regional events like the one we just had in Washington, which we call customer engagement summits. These are scheduled throughout the year, and are proven to be valuable venues to reach new audiences and increase our visibility in a targeted way.
This year long multi city global road show compliments our annual Pega World Conference. And this year on the road show, we will be face to face with nearly 10,000 additional prospects and clients around the world, about half of which are net new to Pega. Since we spoke in addition to the government powered in DC, we've also held events in Detroit, Boston, Melbourne, Munich, and Tokyo. And they're driven by amazing client stories of real work done by Pega and with Pega, which are inspiring and include organizations like Celgene, the Commonwealth Bank of Australia, Delta Dental, FordDirect, Express Scripts, the Japan Ministry of Economy, Trade and Industry, Siemens, Sanofi, and Royal Bank of Scotland.
We're very honored that our customers are willing to come and talk to others about what they're doing and what they're achieving. And we'll be continuing the series into 2020 as well. So in summary, we're pleased with the progress three quarters of the way through the year. We think we have strong momentum and we're working hard to try to finish the year as strongly as possible. We continue to see a great market opportunity. And we're confident we have the right capabilities and the right strategies to help clients succeed.
To provide more color on the financial results, let me turn it over to Ken Stillwell, our CFO.
Thank you, Alan. We've executed well through the first three quarters of 2019. Our team delivered solid growth in ACV, continuing to increase new recurring license and cloud commitments. We continue to be excited about the huge market opportunity in front of us. We're executing on our plan to increase selling capacity and go to market resources to better penetrate our target accounts, and early returns show very healthy pipeline growth as we enter Q4.
As we continue our transition from a company that largely sold its software on a perpetual license basis to a much larger company that sells mostly on a recurring cloud license basis. ACV growth continues to be the most important metric that reflects the successful execution of our strategy. Total ACV is the sum of recurring PEGA Cloud and client cloud commitments, representing the annualized spend by our clients for subscriptions, term licenses, and maintenance.
At the end of the third quarter, our total ACV was $634 million, up $106 million or 20% consistent with our long-term target, Pega Cloud ACV grew 51% the same period. Both of these measures are in constant currency. We continue to transition our business to a recurring model leveraging our market leading cloud choice differentiation. For the first three quarters of 2019, 57% of our bookings were Pega Cloud. Those results are 7 percentage points higher than we originally anticipated. As I explained at the beginning of the year, we plan for Pega Cloud to be 50% of our new commitments in 2019. This 7-point difference in Pega Cloud results has the short term impact of reducing revenue by about $3.7 million for each one percentage point or approximately $20 million for the nine months ended September 30, 2019.
Turning to remaining performance obligation, also what we call backlog, Pega Cloud backlog increased by $100 million to $363 million at the end of Q3, an increase of 38% from one year ago. Total RPO increased by $86 million, from $522 million to $609 million, an increase of about 17% when compared with the balance as of September 30, 2018. A robust backlog is another benefit of our cloud transition. Historically, much of our bookings were taken as revenue in the current period, sometimes causing variability in our quarterly results. These days the largest portion of our bookings are cloud, most of which goes into backlog, creating a more predictable revenue and cash flow stream in the future.
Our deliberate ongoing transformation to a recurring business model continues to track as planned. As we've discussed in the past, a cloud transition typically takes a software company about five years to complete. As we begin 2020, we expect to be directionally at the midway point of our cloud transition, accomplishing this is in somewhere between four and five years. If our cloud transition continues at this pace, we expect optics to improve in 2020 &2021, and normalize during 2022. We remain very confident that the long term benefits of a recurring business model including a more predictable future revenue and cash flow stream far outweigh the skewed short-term optics around reported revenue growth and the impact to near term cash flow and reported EPS.
We're confident that a greater mix of recurring contracts is the correct long term strategic direction for our business and matches the market demand. However, in the short term, moving away from perpetual bookings, replaces large upfront cash and revenue with cash and revenue that will be received and recognized over multiple years. We expect the lag between the business we win and its revenue and the ensuing mismatch between revenue and costs to diminish over time.
The impact of our cloud transition can be seen in our reported results. Revenue for the first three quarters of 2019 total $635 million, effectively flat when compared to the first three quarters of 2018, while ACV on a constant currency basis increased 20% and cloud backlog grew 38% over the same period.
I want to reiterate that we started out the year with an expectation that Pega Cloud commitments would make up about 50% of new bookings versus the 57% we saw through the first three quarters of 2019. As a reminder, each 1% shift to Pega cloud has the potential to reduce all your revenue by approximately $3.7 million for the full year 2019. Pega cloud deals that are reflected in ACV, but it is not largely, not reflected in current period revenue. Therefore, if you adjust for the impact of this transition, and the higher cloud mix, the year-to-date, through three quarters in 2019, is approximately $20 million.
Moving next to revenue components; Pega Cloud revenue grew an amazing 63% to $95 million and maintenance revenue grew by 6% to $207 million for the first three quarters of 2019, versus the same period one year ago.
Our consulting revenue was $167 million, a year-over-year decrease of approximately 15% or $29 million from the first three quarters of 2018, which is consistent with our strategy to shift an increasing proportion of implementation effort to our FSI partners. Additionally, we had a very large government contract where we have significantly enabled the client reducing the necessary involvement from Pega, which also we consider a strategic move.
As I mentioned earlier, our Pega Cloud transition creates a temporary mismatch between reported revenue margin EPS and cash flow. This effect is further magnified as we continue to invest in increasing go-to market resources to accelerate our growth. And with demand for Pega Cloud exceeding even our expectations, we continue to build out our cloud infrastructure to scale this significant growth engine, which also has a near term negative impact as we invest in Pega Cloud.
For the third quarter of 2019, we're reporting both GAAP and non-GAAP results. A full reconciliation of all GAAPs and non-GAAP measures is provided in the financial tables in the press release issued earlier today, and those are also available on the Investors Section of our website.
So let's turn to a few other details; we finished the period with total cash and marketable securities of $113 million. In the first three quarters of 2019, we returned about $62 million to shareholders, comprised of about $7 million in dividends and approximately $55 million in share buybacks and settlements of equity. As we finished the quarter with just over 5000 employees worldwide, an increased approximately 13% from one year ago. More than half of our employee growth is in the go-to market organization.
In summary, we continue to be energized by the size and growth of the digital transformation market opportunity in both the front and back office. I just spent the last few days with Alan speaking directly with numerous government clients and prospects during our government in power conference in Washington DC, I continue to be impressed by the value we are bringing to these organizations. Customer demand for digital transformation solutions continues to be strong, especially in the public sector, where Pega is a perfect set. Traditionally, the fourth quarter is our largest quarter and we expect this year to be no different.
In summary, we're very pleased with our year-to-date execution against our strategy, and we're focused on finishing what has been so far a solid 2019. I look forward to seeing investors over the next several weeks as we get on the road, and with that operator, we will open the call to questions.
We will now begin the question-and-answer session [Operator Instructions]. The first question comes from Steve Koenig with Wedbush. Please go ahead.
Okay, great. Thanks. Hi, Pega. Congrats on a solid quarter. Maybe two questions here for you. First one, Ken for you. Spending growth. So are you guys still kind of -- as we look at the numbers that you are kind of targeting mid-teens for the year? Looks like you are substantially above that on in Q3 if I did my numbers, right. Maybe just some color on it. Is there some quarterly variability here? Are you still kind of tracking to the original goals and where -- you know, where you anticipate spending?
Good question, Steve. So the two -- the two things to think about is our -- our go-to market investment is still on pace, to be directionally in line with what we had talked about, at the beginning of the year, which is investing in the cut of that low 20% range of investment. The one area that we've actually had increased investment year-to-date that is in the in the Pega Cloud, and that really relates to two factors. One is that our Pega Cloud business is higher, is growing at a faster pace in terms of new bookings than we anticipated, and that -- we need to invest for that faster pace. If you think about Pega Cloud, we're investing you know, in advance of the booking and, and the booking doesn't even get us revenue. So there is somewhat of a disconnect on the Cloud gross margin line, because you don't get the revenue but you do need to invest in the business and then secondarily, remember that we got our Pega FedRAMP Certification early in the year, with public sector being a very important part of our strategy, we've ensured that, that we have the right resources to support our public sector clients moving to the cloud, at an accelerated pace.
Okay. So just to follow up on that, and then I'll ask my question for Alan as well. The kind of what, what you're spending the trajectory here on cloud, as your cloud mix is shifting faster and your cloud revenue growing fast, is that something we should expect to continue? Because as I look at it looks like, you know, isn't really growing up enough next year. And so kind of does that -- does that cloud investment continue? And how long does that continue? And then I'll just ask my question for Alan now, which is about maybe just an update on project Phoenix. Kind of where are we with that? And maybe little color on are we looking to see more multi-tenancy from Pega or some aspects of that? And could there actually be sharing of components or some kind of ecosystem around that in time?
So, I'll answer your first the first part of your question, Steve, you would see because of the because of the higher growth in Pega Cloud, and the fact that that won't turn into revenue in the short term, but we need to invest for a larger client base, you would expect a little bit of a slower growth in the -- in our track to our kind of terminal gross margin target. So you would see more investment in PEGA cloud in 2020, and that would be commensurate with us having a bigger book of business. So think about the PEGA cloud being tied to the backlog just as much as it is tied to the revenue and so since the backlog is outpacing the growth that we anticipated. And if that continued in 2020, we would expect the investment to continue in 2020 as well.
Got it.
And then, I'll let Alan answer for the second part.
The other thing; I'll just say about expenses, we've decided to work both, for example, get our FedRAMP certification, and we're shortly going to announce that we have IRAP, which is the Australian certification, which we've been approved for. And we're doing a variety of these, being able to go through those does have some short and intermediate term expense, both in terms of going through those processes, and you have to set up and demonstrate that you can do that on an ongoing basis, but also getting people with some different skill sets and clearances that might be necessary to be able to work with those clients that will we would eventually expect will slow down here but you know, I see it for the next at least 6 to 12 months I would think. In terms of Phoenix. I'm very excited. You know when you go when you talk to clients or prospects about yes, what is a major technical change, in a lot of ways, that's almost contrary to where we were really trying to focus on business improvement.
But the level of enthusiasm since we had our first introduction in detail in June at Pega World and did the deep dive with about 150 architects from various customers, the feedback from them, and also just a whole variety of sessions we keep having about it, outpaced my expectations. And there's a huge amount of enthusiasm and the whole notion that we can move and our clients can move to just an absolutely state-of-the-art, you know, React-based front end, nodes environment, without having to like rewrite all their applications is exactly the promise of doing things correctly in a model driven way.
So there's a lot of enthusiasm. We are building multi tenancy into that capability. So we're expecting to have in effect three levels up. Some customers and smaller ones with lower risk might choose to operate on a general multi-tenant environment, which we would expect, you know, frankly, just higher returns on. Others may want to be multi-tenant for a single client. So for example, all of a single large customer of ours might be on a single multi-tenant system, which provides additional and more secure options. These are the encryption and then we still of course will have customers who will want to operate and will merit operating on a single tenant basis.
So we're building it to be able to hit all of those as well of course, continuing the whole vision of which by the way, is being endorsed by the market of client cloud choice, which I think was one of the really smart things we did.
The next question comes from Rishi Jaluria with D.A. Davidson. Please go ahead.
Alright, thanks. Alan and Ken, I can appreciate that you taking my question. Maybe I want to start with -- with the gross margin side, you know, looks like we saw actually negative gross margin from the consulting and training business and cloud gross margins declining a little bit and I understand you know there's obviously investment in cloud pretty aggressively without necessarily having the revenue yet, maybe help me understand, you know, both of these pieces, you know, what, why are we seeing especially if you're offloading more services to partners, why are we seeing services gross margins, you know, now negative, and then maybe what's the path to get from you know, where we are today? Though I believe you said in the past about 65%, cloud gross margin.
So, I'll take that -- I'll take in the order of that. The first is professional services. So we are -- we are having a lot of success, having partners be more involved in our ecosystem, than they historically were years ago and although that is -- although that's a great, you know, kind of force multiplier for us to grow the business, we still do quite a lot of implementation work for our clients. And even though our revenue is taking a hit as more partners are engaged in implementation, there's a lot of precious skill sets that we have at Pega. And we know that we will need those resources in the future as we scale the business. And so there's no knee jerk reaction that we would take to, you know, change the sizing of our teams, because you know, our resources and our professional services team are the best, you know, that are out there and we would think that we would want them or we would want to make sure that they are used to support, you know, sometimes our professional services team members go to work for our clients.
So the professional services margin is something that will settle over time as opposed to being something that we would -- we would try to right size quarter-to-quarter. On the gross margin for Pega Cloud, that -- the timeless, the kind of longer term target margin was to be above 70%, actually. The 65% certainly will be somewhere, you know, it will -- it will not be a linear move to 70%, but 65% will be probably a step in that journey. We expected our gross margin to be, you know, honestly a few percentage points higher than where it is right now. But given the scale growth of cloud, the fact that we need to invest in advance, as Alan mentioned, we have not only FedRAMP, we have international cloud environments like IRAP certifications, etcetera, that require us to make sure we're ahead of the game. So some of that investment, we had to kind of pull up a little bit in cloud, it doesn't impact our longer term margin targets. It's more the timing of investments coming on the front end of the cloud growth as opposed to a more linear investment.
All right. Thanks, Ken, that's helpful. And then a two-parter for Alan. First just wanted to get a sense of if you're seeing any changes in the buying behavior from customers, and any sort of color you can share on MIA and especially after what you told us last quarter, and then maybe just wanted to get a sense of where you are in terms of the journey to increase your sales coverage, and you know, maybe how far we are in that direction and getting to the ideal sales coverage that you'd want to see? Thanks.
Sure. So one of the things that was gratifying is we saw some resurgence in the MIA. You know, it's a very unpredictable environment we're all dealing with here, but certainly there is strength and a lot of interest, both in the UK but also in some other parts of Europe as well. Relevant to the growing out of the sales team, we're making good progress. We've done a lot of work to, I think, improve our recruitment approach. And that's both in terms of being more effective and engaging candidates. And also, I think, frankly, being really, really quite selective. What I'm excited about on that front, is we're actually finding people who are themselves, for example, making quote at very large competitors, actually now very open about talking to us, and in many cases joining us, and I think that's because they've competed against us. They see we're becoming more effective. And frankly, I think we have a lot going for us in terms of the culture of the business and commitment to client success in a very genuine way. So I would say that we're going to continue to do that and continue to grow that.
We did do a big push in marketing spend, as you know, through Q2 and Q3. You know, regarding a lot of these conferences and these events, I'm definitely seeing a return from them. So those are not going to continue to increase even at a proportional race, but we are going to continue them in sort of the style in a way that we're doing them today as we go into next year.
And one thing to add one thing that, Rishi on the question about MIA. If you look at the performance of our sales team with respect to kind of growth in ACV and you look across the world, our performance to kind of our plan has been fairly consistent across the geographies. So using that as one measure, it's not the only measure, you know, it looks like there is demand for our solutions in in all of our major regions.
All right, that's all. Thanks.
The next question comes from Pat Walravens with JMP Securities. Please go ahead.
Hi, this is Naz [ph] for Pat. Thank you so much for taking my questions. You highlight the success in the federal and I'm just wondering, could you talk about how's the sales motion different there and maybe what your partner's strategy in that sector?
Can you repeat the sector, I'm sorry.
Public sector, correct.
So obviously, you're dealing with more partners in the public sector, and the sales are very much linked to having good partners. So our sales teams are engaging both with the ultimate department, but also with the partners as well. We're seeing, I would say an acceleration in that sector. It's very exciting. I would tell you that the growth in the sector has actually been extremely encouraging on a year-to-date basis. So as these guys pursue monetization, we're just a terrific way for them to save money. And for them to also get closer to the citizens. So, partners I think are more enthused, I do think that you're going to see us having a lot of wins in the next year. And if you're coming off the government empowered event, it was just yesterday, it was just awesome. It was extremely invigorating and exciting. And they're even videos that are going to be put up on the website and things will let other people share it. So it's all good from what I see.
Thanks, and maybe just a quick follow-up. Is IPA a popular topic with the federal customers?
Yes, I think I think desktop and process robotics is a popular topic with absolutely with customers. You know, there's really been a lot of attention paid to that sector. And I think at one point there was a lot of confusion as to whether that was like the cure-all miracle Band-Aid that was going to render everything obsolete. I think customers are getting a lot smarter and understanding better that, you know, their initial, a lot of these companies were selling $5000 and $10,000 deals to enormous companies that, frankly, I would classify as just experimentation. Based on those experiments, we're finding that people have a finer understanding of how if you are going to use robots, you really do need end-to-end process automation system to be able to tie them together. And that's what you need for Intelligent Automation. Just putting Intelligent Automation as a buzzword on your website doesn't do it. So I think the increasing sophistication of buyers, and that very much is true in the federal government as well, is extremely beneficial for us as we continue to compete in the RPI market as well as the DPA market.
That's great. Thank you.
[Operator's Instructions] This concludes our question-and-answer session. I would like to turn the conference back over to Alan Trefler, Founder and CEO; please go ahead.
Thank you. And thank you, Ken, and thank you to all our investors. Now, we're working hard on your behalf. And we're really excited and got to go back to work now. So, thank you very much all.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.