Rafeal E. Brown - Chief Financial Officer, Chief Administrative Officer and Senior Vice President Alan Trefler - Founder, Chairman and Chief Executive Officer.

Steven R. Koenig - Wedbush Securities Inc., Research Division Mark W. Schappel - The Benchmark Company, LLC, Research Division Jeremy Benatar - Sidoti & Company, LLC Brian Murphy - Merriman Capital, Inc., Research Division Noah Steinberg - G2 Investment Partners Management LLC Jim Gentrup.

Greetings, and welcome to the Pegasystems Second Quarter Fiscal 2014 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Rafe Brown, Chief Financial Officer of Pegasystems Inc..

Good evening, ladies and gentlemen. Certain statements contained in this presentation, including but not limited to, statements related to future earnings, bookings, revenue and mix of license revenue, may be construed as forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995.

The words anticipates, projects, expects, plans, intends, believes, estimates, targets, forecasts and could and other similar expressions, identify forward-looking statements, which speak only as of the date the statement was made. Because such statements deal with future events, they are subject to various risks and uncertainties.

Actual results for fiscal year 2014 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 earnings earlier today, and in the company's filings with the Securities and Exchange Commission, including its quarterly report on Form 10-Q for the quarter ended June 30, 2014, its annual report on Form 10-K for the year ended December 31, 2013, and other recent filings with the SEC.

Although subsequent events may cause the company's views to change, the company undertakes no obligations to revise or update forward-looking statements, whether as a result of new information, future events or otherwise, since these statements may no longer be accurate or timely.

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

one, trying to make it easier for prospects to see how Pega can help them; and two, to improve their ability to be hands-on with our technology. Regarding making it easier for prospects to see, we think there are many things we can do.

We'll be investing in our digital marketing platform to make it easier for prospects to research and understand our offerings and to improve our engagement with clients and prospects throughout the sales cycle.

We're going to continue to invest in the verticalization of our technology, which builds on the elements of our architecture that are very effective in capturing best practices and gives customers just an easier and better starting point to work to become digital.

And regarding improving access to our technology, we're going to be looking to significantly improve client access, both during the selling process, and as they continue to sort of land and expand themselves inside the organization.

We're going to increase the partnerships we have, with business process outsourcers, who want to offer their applications on Pegasystems' multi-tenant Build for Change cloud platform.

And with investments in our core Build for Change platform, we're going to take our unified model-driven architecture, which is so powerful in many client bases, and continue to enhance it and make it possible for customers to find it easier to access and more accessible, to perhaps be able to offer a test drive, so that people will be able to come touch the system.

And we'll be able to really open the aperture up to folks, who today, we only deal with through what I would describe as more traditional selling channels. Now these investments will be complemented with our continued aggressive hiring of account execs to ensure distribution capacity for increased growth into 2015.

So it's clear to us that we have very, very significant things we can do and that there are major opportunities emerging. Our excellent first half results enable us to invest in building this business into the very significant firm we feel it could become.

Working to deepen our backlog in the second half of 2014 and prepare for 2015 growth, while maintaining our non-GAAP EPS guidance for the year of approximately $0.78 a share. Now to provide more color on these financial results, I'll let -- turn it over, for some additional discussion, to Rafe Brown. Thanks, Rafe..

Deferred license and cloud revenue as posted on our balance sheet; and off-balance sheet licensing and cloud commitments that are signed but as yet unbilled. As a reminder, you can find detail of both elements in our 10-Q and a summary table in our press release, both of which were filed earlier today.

We finished the quarter with $354 million of total license and cloud backlog. This A&D [ph] number includes only approximately $2 million of acquired Antenna backlog. For year-over-year comparison purposes, total backlog, as of Q2 2013, was $284 million, including cloud backlog.

Thus, at the end of Q2, backlog has increased $69 million, or 24% over the prior year. For your reference, please note that we have added a table to our press release showing our historic backlog trend, including cloud backlog. We have had a strong start to 2014, and we are particularly pleased to have built backlog in the first half of the year.

While visibility of future revenues is increasing, work of course remains to achieve our revenue and EPS targets for the year. This said, we do believe we will modestly exceed our previously issued non-GAAP revenue guidance of approximately $580 million for the full year 2014.

The additional visibility we have on the year affords us the opportunity to accelerate our investments in the product, cloud and distribution resources Alan discussed earlier in the call.

In fact, we believe the time is right to invest in the momentum we are seeing and plan to invest further revenue upside, if it becomes available, back into the business as well. Hence, we reiterate our non-GAAP earnings guidance for the year of approximately $0.78 per share. Turning to cash.

For the first half of the year, the company produced $74 million of operating cash flow, an increase of 15% over the prior year. Free cash flow, which we define as operating cash flow less CapEx, was $71 million, up 14% over the prior year. We finished the quarter with total cash and marketable securities of $216 million.

During the first half, the company repurchased 420,000 shares for $8 million. And at the end of the quarter, we had a balance of $6 million available for repurchases for the remainder of the year. On headcount, we finished the quarter with approximately 2,790 employees, up approximately 27% from the same point last year.

Though notably, approximately 10% of this growth is as a result of the Antenna acquisition. In summary, we are very pleased with our first half results. We have a lot of work to do to close out the year, but with the power of Pega 7 and the momentum of PegaWORLD behind us, we are looking forward to an exciting second half of 2014.

With that, operator, we will open the call to questions..

[Operator Instructions] Our first question comes from the line of Steve Koenig from Wedbush Securities..

Let's see, I'd like to -- I'll do one and one follow-up, if you don't mind. So there's clearly a lot of things going right, going well for Pega right now, and a lot of things that you talked about that had helped you in the quarter and in the half. And you talked about big deals, potentially less seasonality, the product cycle, the partner ecosystem.

I guess 2 things I'd like to zero in on for more color.

One would be how is the Pega 7 product cycle helping you? And secondly, maybe a little bit on specific new marketing initiatives that may have already been bearing fruit in the first half and what might be important in the second half?.

Sure. So I'll tell you there is -- the feedback on Pega 7 has been terrific, both in terms of a lot of the core capabilities that we put in, where we actually invested about 1 million hours of engineering effort in the Pega 7 initiative, and I'll tell you, we've gotten a lot of good results from that.

But also some of the other things that we've done to either, I think, get on the front foot or otherwise position ourselves well in areas such as the collaboration and the co-browsing and some of the social aspects, which historically we had not put as much energy in.

We've really brought ourselves, we feel, to superiority, not just parity, in these areas. And the continued product cycle of Pega 7 is going to, I think, really, really push us much more aggressively into mobile on the back of what we've done with Antenna.

And the level of excitement in the firm is palpable, and that comes from dealing with clients who are finding the technology really, really appealing. Relative to marketing, we brought on a new CMO in February, and he's busily working to, I think, try to improve our marketing. He's been making a number of staff and organizational changes.

We've been upgrading our website, which is much better since he came and has a lot of big changes planned in the Q4 range. So I think that we've kicked that off, but it's going to take us, I believe, through the end of the year to get to where we want to get, but we're planning to do a big push as we enter 2015..

Okay, that's great. And Alan, if I may ask one follow-up. I know that Pega has a presence in the cloud, and you have rolled out some SaaS applications as well.

But beyond what you've rolled out in these SaaS applications and your current presence in the cloud, can you elaborate a little bit more on your vision for Pega in the cloud, down the road here? And then maybe, either for Rafe or Alan, what would this do to subscriptions in your mix over time? And how quickly will they grow?.

Sure. So I think conceptually, we've always believed that the cloud was going to be very important.

And one of the actual differences between us and a lot of the other players in the various spaces in which we work, is that from Day 1, for this generation, we built it so the entire configuration environment, the whole way you define the systems, was actually done through a web browser.

Which today, people are saying, "Well, yes, that makes sense," but I guarantee you, when we began rolling this stuff out in the, this generation out in the 2005, 2006 range, people we're just coming and telling us we were out and out wrong.

And this gives us, I think, a long heritage and a deep understanding of how to build systems of this sophistication in the cloud. Historically, the cloud was not a prime focus, simply because the public cloud was of less interest to some of the really large companies. The folks at JPMC will tell you, that they have a private cloud.

They basically created their own cloud, which is running Pega. They've got about 40, 50 instances of Pega running on it, and they believe that they can do that with greater security and cost-effectiveness compared to some of the other ones out there. So we do find that even large companies now are sort of softening up a bit.

But what we've seen, as we want to work more flexibly with clients, and as we want to move to a broader penetration of the market, we think cloud can be tremendously valuable. And now, we have dozens of production cloud customers.

We've done a big investment and we'll continue to invest in deepening our cloud infrastructure and staff, building out a world-class, 24/7 network operations center, which we've now rolled out. It's operating both out of North America and out of India both, so we can support our clients well.

And we see that as a big part of our go-forward strategy, to really, as I said, open the aperture on who we market to and who we sell to.

Was that helpful, Steve?.

Yes, it is helpful.

I'm just wondering if you could comment maybe on how soon do we see does that begin to impact your revenue mix, with subscriptions becoming a much bigger part of the mix, or impacting your financials because of the ratability of subscriptions?.

Steve, I think one of the great things about cloud is that they help you build backlog, but it also, of course, takes longer for that to start peeling off into revenue. But we do see it increasing. As I talked about the cloud subscription numbers, as opposed to the license subscription, just to be clear, is growing nicely.

We got a boost from Antenna in that respect. But even breaking that out, you can see it's a very fast line item of growth for us.

And the other thing that's really part of that is in Q1 we started including cloud backlog in our overall backlog metrics, because we're seeing really nice growth there of people coming to us and wanting to go with Pega Cloud.

So I think it's going to continue to grow and grow quickly, and we're investing to make sure that happens and moves along, even faster if we can..

Our next question comes from the line of Mark Schappel from Benchmark..

Alan, just starting off with you.

I was wondering if you could just talk about, a little bit about some of the -- a very good license quarter, wondering if maybe there's a little -- it's a few deals that have come in a little bit earlier than planned than maybe you had anticipated?.

Well, I think the quarter was a very well executed quarter. And I'll tell you, as we entered this year, we sort of resolved that we were going to try not to save it all for Q4.

On the basis -- and we actually talked about that, and we talked about some changes to both how we just talked to the sales force and how we really managed day-to-day, and also some small incentives that we put in, to try to move things up a bit in the year.

I can't tell you on the back of 2 quarters whether I'm sure that, that's working or this is just the vagaries of statistics, but it sure felt good. And I really do feel like that we weren't relying on any miracle to make the revenue number for the quarter.

We were able to, as I think Rafe mentioned, we did book one whale in the quarter, but it didn't impact revenues. So it all went to backlog. So we really feel good about having actually gotten positive backlog for the first half. That's not a normal state of affairs for us. So we'll see to what extent this becomes a permanent pattern.

But I think we actually executed well pretty much across the board and you're seeing the results..

Okay, great.

And then with respect to that large deal, just a little more color, if you could provide for us, that would be helpful, like what industry it was in or maybe use case?.

Yes, it was a large financial services company that has been doing business with us for more than 5 years, had really adopted us as part of their multinational strategy. They were large clients, became much larger clients.

Really wanted to have -- use us for everything from how they on-boarded their customers in the lending setting, to being able to provide customer service, to being able to really do what we're really big on, this end-to-end digital concept, where you can actually go from touch point to a customer all the way through to execution, and really put the control of that much more in the hands of the business.

So a really good example of where they used both technical teams from IT, but business people involved in doing the bids, working with partners. So I think it's just a culmination of a large strategic relationship. And the thing I love about these sorts of relationships is they're not one and done.

We expect that we will continue to get money from this customer in the future as they continue to further roll out the Pega technology..

Okay, great.

And then Rafe, did currency play a role in the quarter at all, on either the top or bottom line?.

So on a year-over-year basis, we've gotten, I think the currencies that work to help the top line, but also to bring up the expenses with them. I think we've had pretty parity from an EPS perspective on that. And obviously, a bit of a mixed bag going from currency to currency.

But overall, there's been a little bit of an uplift from that, but not huge..

Our next question comes from the line of Jeremy Benatar with Sidoti & Company..

Can you maybe talk about what you're seeing in EMEA and APAC? Is there anything specific that's working well out there?.

Yes, EMEA was -- so I think that, in general, we're seeing good activity across the board. I think we're seeing the financial services sector come back in both areas. APAC, we're still hoping for a big end to the year.

It was not as quick in the uptake in the first half, but I don't think that, that's meaningful in any particular way, it's just that some of the normal vagaries that we get.

Japan is turning into a very significant success story for us, in terms of both signing some really, really key marquee names and also being able to start to generate some meaningful business. It's a long -- it's been a long time coming. But as we said last year, we really thought we had begun a breakthrough.

And it looks to me like that's going to continue and accelerate..

Okay, great.

And can you also give us a little more color on the different verticals overall in the quarter? Were there any surprises there?.

I think the traditional verticals were -- I think the traditional verticals actually really did quite well. We saw financial services, insurance, health care were up nicely year-over-year. One of our new verticals, energy, performed well, but it's small. So on a percentage basis, that makes it easier. But it wasn't a single vertical..

Our next question comes from the line of Brian Murphy from Merriman Capital..

Alan, can you talk a little bit about your partners, and how if it all, the concentration of business is changing? For instance, are you guys still working as much with IBM Global Services as you have in the past?.

Well, I would say that we have not been seriously working with IBM Global Services for the last, I'd say, 3 or 4 years. An interesting thing has happened with IBM. When they started, they really prided themselves on being objective. But I think if you surveyed the customer base, that's long gone.

And IBM Services is largely there to promote IBM products, not exclusively, but for the lion's share. So we've decided that, that service relationship, which years ago, had been a pretty important one, was one that has really, I think, been deemphasized in recent years, though we still do projects with them that go well.

The interesting thing that we're seeing is some new companies who you'd think of as more strategic in terms of their positioning, really taking very high level of interest. And we have companies like McKinsey.

McKinsey actually did a couple of sessions at PegaWORLD, which were extremely well-received, really linking us into their sort of transformational agenda. Accenture has been tremendous, they actually published a whole paper, which you can get off the website, about how they see Pega being central to transformative initiatives.

And Ernst & Young, for instance, which earlier this year did the interesting thing of actually buying a small Pega-only consultancy, to be able to jump-start the way that they came to market.

So we're seeing some interest from what I would think of as these extremely well-established strategic firms, as well as seeing some of our other more Indian and other types of partners working themselves to try to become more strategic and seeing Pega as a capability that can really, really help them do that.

So I think we're very well-positioned for where the partner ecosystem is trying and working to move, as they look to differentiate themselves further going forward..

Are they developing their own -- I don't want to say package, but more standardized applications on your platform?.

Yes, actually they are. At PegaWORLD, if you went around, there were dozens of partners -- there were a couple of dozen partners who had built Pega frameworks or applications to go to market, to try to differentiate themselves.

Some of which were capability-based to sort of horizontal in terms of being able to help people build systems in general and some of which were vertical and offer actually industry-specific solutions to be able to go to market.

So I think this is a really interesting trend and we're going to see more of it going forward, as the partners are looking to be able to show prospects that they really get it..

Our next question comes from the line of Noah Steinberg with G2 Investment Partners..

I had question for you. First off, just -- this is the first time -- I've been following the company for a while, this is the first time the company has changed and raised its guidance. Not -- you've lowered in the past, but this is the first time I remember the company raising their guidance or alluding to beating the guidance.

I just want to understand what gave you the confidence to do that..

Well, I think the performance in the first half, through the combination of the revenue that was achieved in the first half and the visible backlog additions, which you can see in the schedules, meant that we didn't feel with a straight face, we could say nothing. It is not our [indiscernible]..

You could exceed it by a little bit, though?.

Well, we still have a lot of work to do to complete the year. So if you've been listening to calls for a long time, as I know you have, this is certainly the strongest first half that we've seen..

Right.

And then on the large deal that you guys did, and it went into backlog and it wasn't recognized as revenue, was that -- did that show up in the off-balance sheet, perpetual license to recognize by end of 2014? Or will that be recognized? Because that number was fairly high in the footnotes in the 10-Qs, so just curious whether that's going to show up this year? Or that will be spread over many years or a few years? And secondly, if you do any other big deals in the back half of the year, will we see them -- are you going to try to put those into backlog as well, as opposed to recognizing them on the income statement?.

Yes, Noah, the backlog from that particular deal will be spread over the remainder of this year and the vast majority of next year..

And relative to -- it's not like we have control over what deals come in as term, which would end up in backlog, or what deals would come in perpetual. We ultimately work to try to make sure we do something rational with our clients.

But I would tell you, it is sort of my preference and I think I alluded to it in my various statements, that it's our goal to try to enter next year with meaningful increases in backlog. I mean, that's one way in which we can become more revenue predictable on at least the half basis, if not on a consistent quarter basis.

So we're really putting our sort of heads and hearts into figuring out what we can do to achieve that, all of which frankly gets easier with scale, because the law of large numbers helps you..

Right. And last question -- sorry for a bunch here, but the sales and marketing expenses are up quarter-on-quarter, and I'm guessing a bunch had to do with PegaWORLD, and you said commissions as well.

Was it mostly PegaWORLD? Or was it commissions? Because I see on the headcount on the sales and marketing side, it wasn't up tremendously, so just curious, or maybe you're giving more money to your CMO to spend?.

We'll keep the last one private, but you can imagine how that's going. The answer is, I think in truth, it was both, right? PegaWORLD was a lot bigger this year than it has been in prior years, and of course, that requires additional investment to put on something that big and that impressive. So that's a key piece of it.

But then also, as we talked about in the call or in the script itself, we had a good, great performance from the sales team and that does drive variable comps. So both of those items have been combined and showing up there..

And of course, the irony is that the way we -- since we don't defer the comp expense to match with when the revenue comes in, because we're more conservative than that, it's sort of ironic that a spectacular bookings quarter can lead to in-quarter EPS pressures to a degree. But frankly, from a business perspective, we'll take that all day..

Our next question comes from the line of Jim Gentrup from Val Vista Capital Management..

Just one, actually one quick follow-up, because most of my questions have been answered.

But on the sales and marketing in the second half of the year, should we then expect a little better leverage because of the -- just because of the ways it's rolling off and the fact that you had already incurred the expenses for the whale deal, the commission expenses.

Should we expect a little more tempering, a little better leverage in the second half?.

Well, the things that work towards leverage are just our scale. The things that work against them is that we're working hard to become a much better marketing organization. Historically, that has not been a strength.

And so we are, actually, bringing on staff with deeper and broader experience, thinking about how we create our web presence and what we need to do to be able to become a very effective digital marketing organization, and that's going to add to expense.

The other thing, of course, is that we're going to be hiring salespeople to be able to, in the traditional way, continue to build our business. And finally, I'd hate to convey to you that I believed that, that was going to be our only whale for the year.

And so, that doesn't mean I have any whales guaranteed, but we see a couple in the harbor, and we'd be glad to land them and have them hit either revenue and backlog. So I wouldn't be quick to assume that..

Okay, all right, fair enough. And then on Antenna, just your thoughts, again, I didn't hear all the comments on Antenna. I guess you said it's operating at a loss, and can you just give us a little better idea of when you can fully integrate that, as well as and kind of turn profitable in that area..

Yes, I think the turning point for that is going to be early next year. I think through the rest of this year, we got some great customers with Antenna, and I think we just decided they deserve a high level of attention.

And that's what we're doing and I think it's going to lead to some very nice cross-sell opportunities of some of the BPM and other technologies that we have. That's part of what requires us to invest..

So Alan, I'm sorry to interrupt, but that then sounds like that's more of a function of revenue growth from Antenna than is opposed to cost-cutting in that area then?.

We're not intending -- we're going to grow the revenue. We don't see -- it's not like we're contemplating any sort of cutback in the mobile-related expense. If anything, I think that, that will continue to grow. But we think that, that's going to become better on the top line and that's the way to address that shortfall..

And the last question I have is just the spending environment. It sounds like Europe is coming back and APAC wants to invest more in this area, or that's what I'm assuming or inferring, correct me if I'm wrong. But can you just talk a little bit more about the propensity for companies to spend a little bit in this environment, loosening up.

Is it -- what are you seeing out there?.

one, engage with their clients better; and two, to the extent that there are still, and there are going to be regulatory pressures that they're under, being able to have better control of your processes, being able to show the regulators exactly what you're doing, but still being able to change at a rapid rate is increasingly appealing.

That was part of the story we got at both Bank of New York Mellon and at PayPal, when they spoke at PegaWORLD. So I guess we're wrapping up now. As we do, I want to tell you that there was another interesting milestone that happened recently, and that was my book was published.

It's called Build for Change, and it's about really revolutionizing customer engagement through continuous digitalization.

It's available on Amazon and lots of other bookstores, and I hope those of you who are interested in the company will find this, which actually, is not an ad for the company, it's really a book intended to affect a broader audience, will find this as sort of representative about a lot of the thinking that goes into how we see the demographic shifts that are happening occur, and also how we think technology needs to be applied differently in the future.

So hopefully some of you will have a chance to enjoy that. Take care, everyone..

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