Kenneth Stillwell - SVP, Chief Administrative Officer & CFO Alan Trefler - Founder, CEO & Chairman of the Board.

Steven Koenig - Wedbush Securities Rishi Jaluria - D.A. Davidson & Co. Peter Lowry - JMP Securities.

Good day, everyone, and welcome to the Pegasystems' First Quarter 2018 Conference Call. Today's call is being recorded. At this time, I would like to turn the call over to Kenneth Stillwell, Chief Financial Officer, Chief Administrative Officer and Senior Vice President. Please go ahead..

Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems' First Quarter 2018 Earnings Call. Before we begin, I'd like to read our safe harbor statement. Certain statements contained in this presentation may be construed as forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995.

The words expects, anticipates, intends, plans, believes, could, should, estimates, may, targets, strategies, intends to, projects, forecasts, guidance, likely and usually or variations of such words and other similar expressions identify forward-looking statements, which speak only as of the date that 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 2018 and beyond could differ materially from the financial -- 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 Q1 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, 2017, and other recent filings with the SEC.

Investors are cautioned not to place undue reliance on such forward-looking statements, and there are no assurances that the matters contained in such statements could be achieved at.

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

Thanks, Ken. As a highlight, I'd say we're off to a strong start in 2018. As we've been discussing, a key element of our strategy is to move more and more to recurring revenue, and this quarter's results demonstrates the strategy is working.

It's always important to look at our results in context, especially as we're now reporting under the new, quite different 606 accounting standards. These new rules have the potential to further exacerbate what we've described as the lumpiness on our quarters, especially with term license sales or renewals.

And this may result in quarter-to-quarter comparisons looking odd. For instance, while our quarter-to-quarter comparison looks down relative to the recast Q1 2017 number, the first quarter 2018 actually represents about 25% of our revenue target for 2018.

Thus, we began over a year ago to talk about growth in annual contract value, or ACV, as an important indicator of our financial performance. This quarter, our term license and cloud ACV grew by 22% year-over-year, and our total ACV, which also includes maintenance on perpetual licenses, grew by 15%.

Ken will provide additional financial details later. Let me take a moment and dig into some of the strategy and differentiators. Though we still have a lot of work to do, we're pleased with our -- how our strategy is playing out.

Most importantly, we continue to see clients, existing and new, adopting our software to achieve real measurable business outcomes. We believe successful digital transformation demands both effective customer engagement and the ability to automate digital processes.

And we continue to focus on delivering the best technology in those areas, and they're both healthy growth markets. Organizations continue to choose us because we offer real value through a unique combination of our realtime omni-channel artificial intelligence that can embed itself seamlessly into work across channels.

Our end-to-end robotic automation that includes robots, process automation, case management and e-mail bots and software that actually writes our clients' software, which shows clients focus on designing customer journeys using a model-driven architecture that lets them target the right outcomes instead of writing and maintaining programming code.

Pega applications develop faster, adapt more easily and allow clients to innovate more effectively. We're the only provider in our space to truly unify realtime omni-channel AI and end-to-end robotics, with CRM on top of a future-proof architecture.

Pega's AI and machine learning capabilities are woven in from detecting the behavior of users on the front end to providing diagnostic oversight of the system itself. Throughout the system, makes recommendations and even updates the code to continually evolve.

Thus, clients can optimize for customer behavior, employee behavior and optimize the software itself. This is a powerful combination implemented on a coherent architecture and we think provides the unique advantages our competitors can't easily replicate. These differentiators continue to pile our business.

And as we see our clients and prospects progress in the digital transformation journeys, we are recognizing that it takes this type of software to be successful. We're in a great position to capitalize on that opportunity.

Now in terms of client success, during the first quarter, these key differentiators helped drive new business from both existing and new clients, both in the area of digital process automation and CRM customer engagement.

For example, we drove new business in the quarter with the marketing arm of Ford, which chose Pega to give dealers a competitive advantage in their sales and marketing programs. Using our Customer Decision Hub is the brains behind the digital dealer solutions to ensure unified brand experience for the customer.

This is a great advantage of our cloud choice offering as they're running on a private cloud. Fleet core technology. This is a technology services company and selected Pega to optimize the customer service rep agent desktop, with Pega robotics and the Pega platform, with the goal to improve customer experience and customer retention.

Singtel Office, an existing Pega marketing client, bought additional Pega cloud software to support their device services transformation, including the development of digital self-service to improve customer engagement. The new app will leverage our case management capability, robotic process automation and matchups in the cloud.

And finally, Willis Tower Watson, a group health and benefits organization, bought Pega cloud software to improve customer engagement across the group health segments. They were particularly impressed with our ability to support a rapid development environment and provide seamless customer experiences.

So we continue to be inspired by the amazing results our clients are achieving with our software. Since our last call, we've received awards and recognition from leading industry analysts like Gartner and Forrester.

For example, our digital process automation capabilities for business process management, our multichannel marketing solution, our Low Code platform as a service solution, our cloud-based Dynamic Case Management, our AI customer engagement capabilities and the capability we call the T-Switch, which ensures that the right type of AI is used to keep customers in compliance with laws.

We launched the first AI-powered Sales Coach to teach smarter selling. We introduced the industry's first KYC CLM solution that uses AI to drive relevant offers to customers during the on-boarding process, providing control and transparency banks need for regulatory compliance.

And we introduced GDPR accelerators to help our client fast-track their regulatory readiness for these new European regulations. And perhaps, most importantly, we've been working on the biggest product launch in the company's history that we'll introduce at PegaWorld. Now PegaWorld 2018 is less than a month away.

And from our point of view, it's the single, most effective customer and prospect engagement event we hold all year. Once again, we'll be in Las Vegas and expect more than 5000 attendees from around the world. Our keynotes include speakers from Aflac, Commonwealth Bank of Australia, Genworth, Google, Liberty Global and JPMorgan Chase.

You can see on PegaWorld.com descriptions of the many sessions, including speakers who will talk about, well, like Dell EMC who'll discuss transforming its customers' service organization using Pega decisioning to handle amazing legacy applications.

Philips Healthcare will discuss the development of a mobile health care platform using Pega to help integrate applications for connecting with healthcare providers, healthcare professionals and others across the healthcare continuum. PayPal will describe how it's using Pega to deliver the next generation of customer service apps.

And Raytheon will discuss its choice of Pega as its digital transformation platform to drive better business outcomes.

People come from a long distance, and Transport from New South Wales in Australia is going to be there to discuss their Internet of Things-type use of Pega cloud in 5,000 schools across the state to accelerate access to free or subsidize travel to and from school for more than 1 million students.

Our 92,000 square-foot tech pavilion will feature over 100 live demos, showcasing our software and real-world situations and hosting more than 40 partners.

Our product managers will be there to discuss our products and future directions, and we'll be launching revolutionary events in CRM through the industry's only offering, the truly unified customer engagement with digital automation. I hope you'll be able to perhaps join us at our Investor Meeting on Monday, June 4.

Stay for the Train concert, Monday night, perhaps even the rest of the event on Tuesday. So in summary, we're off to a solid start in 2018. We're confident in our strategy. We have a unique offering in the sweet spot of major growth areas and hitting client needs.

And we're excited about how our software is being adopted and our long-term growth opportunities. To provide more color on the financials, I'll turn it over to Pega's CFO, Ken Stillwell..

the market continuing to shift to cloud, the growing demand and relevance for Pega's cloud offering and our incentive structure improvement implemented in 2018. However, it's important to note that this does not change our strategy of providing choice for our clients, which we view as a differentiator in their buying process.

Our cloud revenue growth is impressive at 50% year-over-year from Q1 2017. We expect cloud to continue to be our fastest-growing revenue component. Our Q1 consulting revenue growth of 12% year-over-year is much more in line with our long-term expectations than what we experienced in 2017.

We remain highly committed to investing in our professional services ecosystem, which enables our partners to support an increasing amount of our client implementations. With such a significant amount of our new client commitments as cloud, approaching half of new business now is cloud.

There would naturally be a short-term revenue impact as cloud contracts are taken over the length of the contract versus upfront, unlike a perpetual or term arrangement. However, we are early in the year.

And although it would be great to see this level of cloud arrangements sustained, we are not certain this level of cloud arrangements sustained, we are not certain this level of cloud bookings mix will continue for the full year 2018. For the first quarter of 2018, we're reporting both GAAP and non-GAAP results.

A full reconciliation of all GAAP to non-GAAP measures is provided in the financial tables in the press release issued earlier today and are also available on the Investors section of our website. We're reporting that Q1 GAAP total revenue was $235 million, down 8% from last year, if you consider the ASC 606 adjusted total of $256 million.

But as I mentioned earlier, this reduction should be viewed in the context of the $35 million in revenue in the year-ago period from that large renewal that became effective in Q1 of '17. I'm pretty happy with the revenue performance, considering that most new client commitments were cloud in Q1 2018.

It's awesome to see such a noticeable move to cloud. Moving on to our balance sheet. The new accounting standard, as mentioned previously, requires Pega to book the total value of a term arrangement as revenue upfront even though the billings under these arrangements will happen over the life of the arrangement.

As such, we now have an asset called unbilled receivable. There's both the short-term and a long-term component. This primarily shows the significant future cash flows related to our recurring term arrangements. These balances will shift as invoices are created and new orders are received.

No significant committed cloud cash flows are included in this unbilled receivable, as cloud revenue is taken ratably over the duration of the agreement. We had really nice improvement in billed, days sales outstanding and reduction to our accounts receivable driving very healthy operating cash flow in Q1 2018.

In fact, it was the strongest operating cash flow for a Q1 in our history, producing $56 million within the quarter compared to $31 million for the first quarter of 2017. We finished the period with total cash and marketable securities of $255 million. On headcount, we finished the period with approximately 4,300 employees, up 9% from March 31, 2017.

The growth in headcount, consistent with previous periods, is disproportionately concentrated in lower-cost territories as we expand our global client base and enter new markets. In summary, we're pleased with the solid start to the year and with the progress toward meeting our fiscal year 2018 and beyond financial goals.

For those of you who have not yet planned to join us at PegaWorld, please reach out to me as you don't want to miss this awesome event. We have an Investor Day event planned at noon on Monday, June 4, as Alan mentioned, and we look forward to seeing many of you there. And with that, operator, we will open the call to questions..

If you don't mind, I've got a multipart question for Ken, and then a question for Alan. So starting with Ken. So just trying to make sense of the results here.

If we were to replace the term and cloud revenue with term and cloud ACV on a quarterly basis, so dividing ACV by four, and then keep all the other revenue lines, we'd probably get a better picture of kind of your recurring revenue -- of your revenue run rate. And if I do that, what I calculated was you actually grew 4% year-on-year in the quarter.

So not a fantastic result, probably not what you were shooting for, but it was against a very tough comp, which you knew about. So maybe is that the right way to think about it? And do you think you can do better than this? And any thoughts on what you're shooting for, for business growth now..

Yes. So Steve, so the way -- to do that type of comparison, what you want to do is you want to take last year's ACV for term and cloud and use that as a comparison for Q1 of '17 and use this year's as a comparison for Q1 of '18. You don't want to compare just this year to last year's number.

So I think if you did that comparison, you would see a more significant growth because the ACV grew 22% year-over-year and our other revenue line items grew -- say, maintenance, professional services, et cetera.

The only impact that we have is -- that actually skews the overall revenue growth that you're talking about is the movement away from perpetual licenses.

And so if you take the perpetual licenses out, I think you've got to make sure that you're factoring that in because it could skew the movement that we are actually moving largely to recurring, and the perpetual has some headwind because we're moving away from perpetual licenses..

Okay. So we'll circle back on that, Ken. But if I may just add, then, how should we think about the recurring contracts mix here? How do we model that? How can we think about that? We have the -- we used to have a bookings mix. But now how do we think about it? And then if you don't mind, I do have a follow-up question for Al..

So is your question, Steve, what was the recurring mix approximately in Q1?.

Yes..

It was approximately 80% recurring..

And are you getting that by using 606 revenue?.

No. I'm using that based on ACV commitments and perpetual licenses normalized to be an ACV equivalent..

Using what kind of duration there?.

We typically have a conversion from perpetual converted to recurring of about 3:1..

Okay. That's very helpful. A quick one for Alan, if I may. So Alan, the -- I'm curious, any thoughts on the transformation of your go-to-market model, and how that's working? I know that you've only got one quarter under the bell of the new sales comp plan. But I'm sure there's lots of components here.

Any data points on achieving higher velocity? And then kind of a second part of the question is this new Gartner concept about highest productivity application Platform-as-a-Service noted that Pega was top for data process and business logic functionality.

What more do you need to do to get perceptions -- get awareness and perception in the marketplace of Pega's -- the strength of Pega's technology there?.

Well, I think some of that is going to -- have to do with some of the marketing rollouts that we're going to be doing in PegaWorld in terms of getting visibility. We were pleased that for the first time, has been included in that Gartner report.

And entering the Gartner report, you rarely enter the absolute number one, though we set our goals as getting there and think we have the right sorts of things to do it. And we've got to do some additional work here around improving some of our processes through which we upgrade and support customers.

I think we can do things, not for Gartner doing that, it's for, once again, just continuing this transition to being a true cloud company and being an as-a-service company. So I think there are things that would just come from another couple of quarters of experience.

I'm really quite happy with the leadership that we brought in, in the last year to really help us get our cloud capabilities and our high-performance application capabilities up to the absolute highest levels. So a lot of this is simply execution. It is new.

The shift of sales force in -- on one day from a total contract value model, which obviously over-incentivizes duration, and I think has its own collection of foibles to a much more ACV-aligned model with a big change. I think we knew it was going to be a big change.

I'm pretty happy with the way it's getting down, though, we've got to get those reflexive behaviors to change in -- particularly, the folks that have been around for a while. Operator We'll go next to Rishi Jaluria with D.A. Davidson..

It's good to see some continued improvement on the cash flow side. A couple kind of quick housekeeping and financial related stuff for Ken, and then one for Alan. Ken, I think just starting out, we saw some good improvement in cloud gross margins on a year-over-year basis. I know you talked a little bit in your prepared remarks about that.

But can you help us understand what's driving that cloud improvement other than general scale? And how should we be thinking about kind of the glide path, like, to your longer-term model of getting to, I believe it was 60% gross margins on cloud and about $100 million in revenue, if I'm not mistaken..

Yes. So I think, I mean, you really -- not to let you answer your own question, but you really hit the main point. I mean, I've said for a while that one of the biggest factors that we need to expand margin in cloud is just more customers. I mean, because there's a lot of fixed costs, the fixed headcount, the fixed AWS infrastructure costs.

So I think a lot of the scaling you see is just the natural scaling. Now are to be going to be able to grow margin by 5% every single year? That'll be nice to see. I think it really depends on the volume level of all customers. It might excel -- we might grow margin by more than that if cloud continues to grow at such as significant pace.

The only caveat to that is as we get more customers on our cloud and we actually really become where cloud is a much bigger part of our business, we need to make sure that we don't underinvest in our cloud, right, that we don't get into situations where there's a lesser experience for our customers on cloud. And that's really important to us.

So we're being thoughtful about not trying to force the cloud to over perform on gross margin at this smaller scale that it is..

We're all implementing a lot of automation as you would expect, and that obviously all helps in terms of votes of the customer experience and self-service, but also in terms of costs. But when let me comment on cash flow.

I think that increasingly, looking at cash flows, which are going to be I think highly related to ACV, is going to be the clearest way to see what's going on in many respects based on some of these 606 changes, at least until we get the preponderance of that recurring revenue business to be on cloud..

Okay. Got it. That's helpful. And, Ken, kind of as I go through the Q and look at some of the new disclosures around metrics like long-term unbilled receivables and other unbilled receivables, contract assets.

How should we be thinking about these metrics relative to, I guess, kind of some of the older metrics we used to look at like license and cloud commitments is not on the balance sheet and backlog and kind of different breakdowns within deferred revenue, short term and long term?.

I'm going to be very honest with you. I think there's little that you can take out of the changes in the unbilled assets that are meaningful in the way that we used to think about looking at changes and backlog compared to revenue. I wish that weren't the case.

But the reality is the unbilled doesn't have cloud in it and the performance obligation, they only has things longer than one year in it, that's another disclosure we do. So there's a lot of gaps in there.

We are going to work hard on trying to produce an additional metric here in the future that actually gives a view into the changes in kind of next 12 months cash flows, which I think is really what is important to validate that ACV growth. So that's one that I think is very important. And also, just one thought to consider, Rishi.

As we -- as our duration may come down slightly as we move to faster deals and more kind of the agility of being a cloud company, our duration coming down may alter some of those comparisons we have when you look at total contract value. So that's one caveat that I would say. Even if you did look at it, that's one thing to not forget..

Okay, that's helpful.

And just from a housekeeping perspective, were there any whales or extraordinarily large deals in the quarter?.

So we're going to get away from the whale discussion because we're really focused on ACV, and it's really not an apples-to-apples compare. We still do significant-sized commitments with our customers, so I don't want to mis-state that we're changing our business model such that, that won't be the case.

But we're going -- at Investor Day, I'm going to supply I think some additional metrics that, around the segmentation of our customer base, that will be a little bit more consistent with how you might think of a recurring business..

The trouble with whale speak is it strongly encourage the kind of five and seven year deals that builds up the total contract value.

So I think the accounting team here at Pega did an unbelievably good job in battling through the complete recast on the 606, which -- the alternative, which a lot of companies are going to do, will just be to just put the two 17 number in it with an asterisk next to it, which frankly is kind of useless.

We still have to, I believe, do some work to figure out what some of those right metrics are to bring clarity. And I do expect, under some new definition, you will hear us talk about the children of whales or whale relatives describe the extent to which this concentration in what we're selling and the level of the customer investment.

We just weren't in a position to put that all together on the back of this recast. That was just an enormous amount of work..

Just to follow up on one last point that Alan was making. As we -- our cloud business, as a percentage of revenue, is still less than 10% of our business.

But as cloud and recurring contracts now are more than 50% of our business, when you add all the recurring, we really need to add and augment some of our operating metrics that are much more relevant in a recurring business. So we started to do that, and we'll continue to improve that through the year..

Okay. Got it. That's helpful. And then last one for you Alan. I know you alluded to this on the last earnings call and, obviously, there's the 8-K that came out a quarter ago. But you talked about kind of maybe looking at the landscape of potential M&A opportunities and then issuing some new potential Class B shares for that.

I just wanted to see if there's any updates on that, and you have any thoughts for how the landscape in terms of strategic acquisitions, be it existing businesses or tuck-in technological acquisitions might look..

Yes, relative to that letter, which was really just an opportunity to let us talk freely with investors and others to get opinions about things. We're not on a time frame for doing anything, I just want to say. We've begun having a couple of conversations. I'll expect there will be more in the coming months and the quarters.

In terms of M&A, we have opened our aperture some, but most of the stuff that we're looking at is still, I would say, in the more traditional smaller range that we've been able to finance some cash.

The one thing I will also say is nothing should be read into either that letter or discussion of M&A that we're going to lose our mines and become a rationale about prices. I just want to say for the record because I had a couple of investors who asked me does this signal some major personality shift. But I will tell you, it does not.

So consider yourself reassured if you would. Operator [Operator Instructions]. We'll go next to Greg McDowell with JMP Securities..

This is Pete Lowery in for Greg.

Can you help us just a bit on the modeling side with respect to term and cloud ACV seasonality for the rest of the year? How should we think about the puts and takes there?.

Yes, good question. So the change in ACV, and I kind of highlighted this a little bit when I talked about the term revenue where you would expect the Q2 and the Q3 to be lower in term revenue than a Q1 and a Q4.

I think that, that's a fair way to think about ACV change as well, right, that ACV changes would be kind of larger in the Q1 and the Q4 periods and maybe less large in the Q2 and Q3. That's not to say that, that will be every single year and every single quarter you'll see that.

But I think that just based on the way that software businesses typically have that -- the unfortunate back-end loading of new customer commitments, and we're an enterprise software and we have the same trend.

So although we are also trying to do things to not have that -- the bookings push towards the later part of the year, I think it's fair that ACV growth in Q2 and Q3 would be less impactful in Q1 and Q4..

So I haven't seen anything that would cause me to change from the traditional expectation. Given that our sales staff has their comp plans and, at the end of the year, there's something of an extra push expected by both them and customers. This was our first year into it, of course, so we'll learn as we do.

But there's no reason to believe that that's going to change. Operator And with no further questions in the queue, I would like to turn the call back over to Alan Trefler for any additional or closing remarks..

Well, I'd like to thank everybody, and once again, invite folks to PegaWorld, listen to speakers. We're very excited that organizations of these magnitudes, these credibilities and with that sort of exciting set of stories to tell about what they're really doing are going to be there.

One thing I'll say about PegaWorld is I think a lot of conferences are just kind of rah-rah shows. This is a very content-rich content -- contact -- context for our customers and for our investors to come see what's really going on. And I encourage you to do that and I think you will be psyched. See you there. Thanks, everyone..

This does conclude today's conference. We thank you for your participation. You may now disconnect..