Good day ladies and gentlemen, and welcome to the Pegasystems' Second Quarter 2020 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ken Stillwell. Please go ahead..

Thank you. Good evening ladies and gentlemen and welcome to Pegasystems' Q2 2020 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 statement, as defined in the Private Securities Litigation Reform Act of 1995.

The words expect, anticipate, intend, plan, believe, will, could, should, estimate, may, target, strategy, intends to, projects, forecasts, guidance, likely and usually, or variations of such words or other similar expressions, identify forward-looking statements, which speak only as of the date that this statement was made and are based on current expectations and assumptions.

Because such statements deal with future events, they are subject to various risks and uncertainties. Actual results for fiscal year 2020 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 Q2 2020 earnings and in the company's filing with the Securities and Exchange Commission, including its Annual Report on Form 10-K for the year ended December 31, 2019 and other recent filings with the SEC.

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

Although subsequent events may cause our view to change, except as required by applicable law, we do not undertake and specifically disclaim any obligation to publicly update or revise the forward-looking statements, whether as a result of new information, future events, or otherwise.

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

Thank you, Ken. Let me say that I'm pleased with our results for the first half, especially given the global pandemic. We are operating at a time of uncertainty and anxiety. I'm deeply respectful of how our team and our clients are engaging constructively and optimistically, despite the many tensions.

All results reaffirm what we said last quarter, about how we thought the pandemic would likely to affect us and our clients in the near term. Our expectation that digital transformation would remain front and center, even during COVID has held true in Q2. Our business remains robust and we're helped by several major factors.

An increasing percentage of our revenue is predictable and recurring. In the first half, our total ACV annual contract value, which we consider the best indicator of our improving cash flows and underlying business growth increased by 21% year-over-year and over 90% of our new clients [indiscernible].

Our Pega Cloud business continues to grow above 50% year-over-year. We are fortunate the digital transformation is more important than ever. And our strategy is resonating with our clients' prospects. Most of our clients are in industries that are less adversely affected by the pandemic.

Ones like financial services insurance, health care, government, telecom, instead of more heavily in areas like hospitality, travel and consumer products. Our clients tend to be large organizations that can withstand the short-term financial pressures of today's market.

We have little exposure comparatively to smaller organizations that are unfortunately struggling the worst right now. And we have a very strong cash position with more than $0.5 billion in the liquidity to help us weather this storm and continue to invest, where it makes sense for long-term growth.

We have a strong and resilient team that is committed to the success of our clients and [indiscernible]. And as I said, last year, we've navigated many challenging times in our history. And we've always come out stronger on the other end.

Now in terms of our response to the pandemic, based on what we see today, digital transformation is on everyone's mind.

Whether modernizing the customer experience or building the automated connective tissue through the operations itself though we've seen some opportunities put on hold for postponed other projects have accelerated and the news ones have been initiated. The types of challenges our clients face a few months ago, continued in some cases accelerate.

For example, needs like managing avalanches of customer service inquiries, supporting remote workforces, or adjusting to new government policies all are well supported by our technology. While we help them in the immediate term, we also see their desire to build stronger businesses for a new future.

Then this solution we introduced early in the pandemic has been well received and continue to open doors for us. And we continue to improve our software and its core to make it easier for clients to enhance the customer engagement, boost their employee satisfaction, improve their efficiency and reduce cost.

For example, since we last spoke, we launched a number of interesting new things. The first was an Ethical Bias Check, a new capability in Pega customer decision hub that helps eliminate biases hidden in the artificial intelligence driving customer engagement.

We talked about the Pega process traveler, a new cloud-based software architecture, designed to radically streamline organizations to drive work across distributed enterprises, breaking down technology silos, to unify what is across the enterprise and help improve user experience.

We introduced the Pega customer service unified messaging division, a new SaaS based application that helps customer service teams respond faster and more efficiently to customer who's flooding across different channels and do it through a single unified dashboard.

To most recently, we introduced a really cool capability called X-ray vision, the industry's first self healing, robotic process automation capability, able to detect and fix broken box without human intervention that help clients buying through faster and more durable and easier to deploy robotic process automation.

Our products continue to receive strong industry analyst attention. Since we last spoke, Gartner recognized us through their Magic Quadrant for the CRM, customer engagement center and the Magic Quadrant for multi-channel marketing hubs.

Moving to new business, our new business is boding particularly strong enough traditional areas of financial services, government, health care, insurance and via the industry the Pega really grew up on. I indicated that we expected these to be more resilient during the pandemic and that's what it's turned out to be.

For example, in health care one of the largest U.S. health care payer organizations recently merged with the leading pharmacy benefit manager. They're using Pega to bridge their multiple customer service environments to drive service standards at the corporate level.

They expect to significantly reduce operational costs while magnifying the value of the first operation through their customer base.

In financial services a large institution serving customer based in the tens and millions, it expanding its use of Pega, leveraging our AI-based customer decision [indiscernible] in the cloud provide customers with a one-to-one personalized experience across the entire enterprise and across multiple chair.

The goal is to transform currently disconnected experiences into one-to-one personalized conversation, to improve consistency, accelerates need to market and provide ongoing work. It's all about creating exceptional customer service. There is also being a lot of traction in the government throughout the world.

For example, Her Majesty's Revenue & Customs kind of like their IRS have expanded their use of Pega transformed the desktop experience for their 30,000 telephone advisors who are expected to handle about 45 million calls this year.

Running on Pega Cloud we're moving from a legacy of inefficient multiple desktop application to efficient solution that reduces handling time and post call wrap up and will lead to a better experience without employees and the taxpayer vigilance, all while driving huge savings for [indiscernible].

The new app is already live and being rolled out across the organization to terrific review. Now the IRS, the U.S. analogue from HMRC one that I mentioned that we had just won in the last quarter, but we were very excited when this quarter. They announced actually just last week, a new enterprise digitalization and case management office.

This new organization was created to spearhead their efforts to empower both taxpayers and IRS employees to rapidly resolve issues in a simplified digital environment.

In the IRS personally, they outlined their goal to stand up consolidate the case management system to overcome the challenges of having casework done on 60 plus ageing systems, most of which I have talked to each other right now. They also noted that the first release with Pega is already well underway.

And last quarter I'm mentioned the state of Bavaria, Germany chose Pega to help them provide faster relief to the small and medium sized businesses impacted by COVID. This was a great example of how we're able to sell, develop and launch apps in record time, even when working remotely.

Based on the success of that initiative, our software last quarter was chosen for a much larger project for the German Federal Government to support a new bridging aid program that will replace previous government programs. The new application will be used across all 16 stations in the country.

These projects are great examples of how flexible our technology is. We can both deliver hyper quickly and be used serious, large scale transformation. Now, as I mentioned last quarter, we pivoted quickly to function as nearly 100% remote workforce and have been operating effectively this way since March.

As you can see from our results, this new working situation has not had a material negative impact on our ability to sell a service to our client.

In many cases, we're seeing unprecedented access to senior client executives and finally can coordinate meetings much faster versus the old days when we had to get everyone in the same place, traveling is such a hassle.

We've shown we can effectively onboard new employees even while being completely remote, so we continue to hire more selectively and strategically. And since we last spoke, we held Pega world virtually and this was the first block and involved a complete reimagination review that. We weren't quite sure what to expect.

And we're frankly blown away by the results. We have more than 42,000 people register. Now, this compared to a little over 6000, we might have gotten in the in person events. And more than 26,000 attendance, those are outstanding numbers for free virtual events, where the industry standard is about 25% conversion rate, we were over 60%.

We also know the event growth of possible engagement, as we set a record for page views on pega.com in April, May and June and answered more than 1300 questions, through live Q&A during the event. We continue to draw large audiences to our archived presentation.

And we received lots of positive feedback on the format and content that does make it clear that we made the right decision to create an event that was tailored to a digital experience, rather than a lot of moving in person events online, like a big webinar.

In case you didn't attend, we'd love to hear your feedback and it's all available online and we're converting all of our second half of events virtually and are deepening the process of working through what those look like incorporating what we learn in the first half.

Now, we continue to believe that our partners and our clients, there will be no going back to business as usual. We see in our work with clients and prospects that digital transformation initiatives are of enormous importance. And I personally believe we've got some time to go before we reach any kind of news somewhat predictable normal.

But in the meantime, we're well positioned to help our clients adjust to uncertainty while planning for their long-term successes. We're confident we will do much more than disadvantages cost prices, will come out a stronger company in the long-term.

We're deeply gratified that the continued support of our staff clients and partners has been at a very high level. It's truly at times like this, that we can see strong character in those we work with. And we are committed to continue to support the greater Pega community and those around us and face very real challenges as a result of this crisis.

So in summary, I'm pleased with our first half results, especially in light of global crisis, and to provide more color on the financial results. I'm turning you over to our CFO, Ken Stillwell. Ken, it's yours..

Thanks, Alan. I want to express my best wishes for everyone's safety and well being during this unprecedented time. I'm going to start my remarks today by sharing some insights on Kevin's response to COVID-19 and a few observations on the impact of the pandemic on our clients, our employees and our industry. Starting with our customers.

To-date, the overwhelming majority of our clients and prospects digital transformation buying behavior has been largely unaffected by the pandemic, while our business has not been negatively impacted in a significant way. We did see a couple projects delayed or cancelled due to shifting priorities of some client organization.

We also saw a small number of our clients request additional flexibility with extended payment terms to help them work their way through this downturn.

Most of our clients and prospects are acting with a new sense of urgency and rethinking what they should do differently in the short-term and in the long-term to build a robust modern business architecture. As a result, in many cases, our sales teams are getting more access to senior level executives than they ever have in the past.

And they are having very effective discussions with dozens and dozens of executives, frankly very difficult to coordinate those meetings with travel schedules and the historical bias towards face-to-face in office meeting with senior executives.

The good news for us is that the increased level of executive engagement and solid execution by our sales and marketing teams resulted and it's been a strong Q2, especially given the environment that we're in, these results are exciting to see.

Clearly, many leaders are prioritizing digital transformation projects in a new way, given the structural changes in the way that people are working remotely from home, interacting through digital channels. We continue to be very optimistic about our ability to accelerate our growth based on the increased urgency of digital transformation.

Our employees have done an incredible job transitioning to working remotely. They've been working diligently with our partners and clients and continuing to execute our strategy.

It's been somewhat amazing to see how well our employees worldwide have transitioned to this new way of working and as Alan mentioned, I don't think things will ever be the way they were. And there's a lot of positives in that. Our field teams have been engaging and closing deals with customers virtually and digitally.

Only time will tell but what we saw in Q2 may represent the spark of a new way of enterprise software selling. Even after this long behind us, we will continue to see a mix of virtual as well as on site sales activity.

Wisely regarding our employees, we are focused on supporting our employees to be as productive as possible when they're working remotely and we're thinking about the most safe, efficient and effective way that our employees can have access to physical offices when that's appropriate.

Next, I'm going to share a few thoughts on the impact of the pandemic on our industry. The enterprise software industry is growing through yet another major disruption. For the last decade, the rise of subscription software has reshaped the enterprise software industry.

In the first half of 2020, we saw clear indications that the pandemic will accelerate the footprint of subscription software, given the growth of working remotely and the increased pace of digital transformation.

During our last earnings call, I explained about how our business is resilient and I remain confident in our ability to deliver on our long-term strategy to be the leader in digital transformation. So to remind you why I feel that way.

First, we've been transitioning our business from a largely perpetual software license model to a recurring license model for several years.

In the first half, more than 90% of our software revenue is recurring, which is supported by our very high net retention rate and the growth rate of our subscription revenue accelerated in Q2, then we continued to move away from professional services that they keep revenue contributor, as we engage more and more of our partners to support our clients implementing and driving value from our solution.

The shift to recurring revenue is especially important in times like these, the shift means our quarterly revenue and billings to be much less vulnerable to short-term disruption from situations like the one we're seeing now, that's because a business with a higher proportion of recurring revenue and a lower rate of customer churn like Pega is less resilient -- less reliant on new business bookings to achieve its quarterly revenue and billings plan.

Second, the key verticals that we serve financial services insurance, health care, communications, manufacturing, government are less exposed to the direct impact of the pandemic than other industries such as airline, hotels, restaurants and retail.

Many of these clients and even some in the more challenging industries now see the need for digital transformation like never before. In Q2, we saw solid demand from clients in many industries, in fact, financial services, insurance, and health care and government made up approximately 80% of our new license bookings for the quarter.

Also, our existing and target clients are the world's largest customers and brands. Many of these Global 3000 enterprises are better equipped to weather a downturn in small medium sized businesses.

Small and medium sized businesses are often the ones and unfortunately struggle most when compared to large enterprises that have strong balance sheets to withstand the short-term economic shocks.

Simply stated, the underlying strength of our large enterprise customer base is a core attribute of our business to help us not only weather difficult economic times in the past, but it's also helped us grow revenue through those periods. Our large clients, especially in North America, were major contributors to our growth in Q2.

Third, we have the liquidity necessary to weather the crisis. Earlier this year, we raised more than 500 million through a convertible debt offering. And, as I said before, whether we were lucky or there was just no really good timing and smart planning, February was the perfect time to raise this capital.

This available liquidity provides us with the financial strength and flexibility to successfully navigate the market for digital transformation solution and make the right long-term decision. Finally, our digital transformation solutions continue be mission critical to our customers.

Our customer engagement suite helps our clients retain their customers. Our intelligent automation suite which includes our industry leading business process management software helps companies reduce costs by improving efficiency and effectiveness.

Our digital transformation solutions are even more relevant during times like these because businesses with robust digital infrastructures quickly adapted operations to support remote workforces and remote operation. So now let's turn to our financial results for the first half of 2020, especially for those who are new to Pega.

I'll start by providing a little more context regarding the evolution of our business model. During our cloud transition, the two most important metrics that we used to track the progress of our strategic execution, our annual contract value or ACB and remaining performance obligation or RPO, is also known as backlog. I'm going to start with ACB.

Total ACB is the sum of recurrent Pega Cloud and client cloud commitments, representing the annualized spend from our clients for cloud to license and maintenance. Increasing ACB is critical because it's the best leading indicator for our future revenue. I'm happy to report that ACB increased year-over-year by 21% on a constant currency basis.

At the end of Q2, our total ACB is 738 million up from 611 million at the end of Q2 2019, an increase of an impressive $127 million. The majority of our ACB increase was driven by Pega Cloud, which increased by 66% from 135 million a year ago to 211 million in Q2 of this year in constant currency.

It's exciting to see the Pega Cloud portion of our business exceed 200 million and ACB for the first time in our history, nearly doubling in size about 18 months. Client cloud increased by 11% from June 30, 2019.

ACB continues to be our most important metric reflecting the successful execution of our strategy and whilst 21% increase in strong ACB growth. We believe there's an opportunity to continue to accelerate our ACB growth in the future. We're investing in go-to-market resources to capture increasing share of our clients spend for digital transformation.

Let's turn to remaining performance obligation are also called backlog, which is another important metric. That reflects the client's commitment not recorded as revenue as of the period reported, providing visibility into where portion of our future revenue and billings will come from. A robust backlog is another benefit of our cloud transition.

Historically, tomorrow bookings were taken as revenue in the current period, which caused 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.

Pega Cloud backlog increased 26% from 362 million as of June 30, 2019 to 457 million as of June 30, 2020.

And total backlog increased by 30% from 628 million on last June 2019 to 817 million as of the end of Q2 2020, which increases especially impressive because our backlog tends to grow at a slower pace during the middle part of our financial year, due to the higher concentration of business activity that typically occurs in the fourth quarter of the year for enterprise software companies.

Turning to revenue, total revenue for the first half of 2020 was 493 million, an increase of 18% from total revenue in the first half of 2019. And that was driven by 55% increase in Pega Cloud. As we were in a cloud transition, the impact of the cloud shift on revenue growth is really important to understand.

We've been moving away from professional license bookings replacing large upfront cash and revenue with cash and revenue we'll be receiving and recognized over many years.

During the first half of our cloud transition revenue growth was a lagging indicator because subscription revenue is recognized over time, versus perpetual license revenue, which is recognized upfront. Given this since 2017, we focused on ACB growth, which is that leading indicator of successfully executing our strategy.

Now that we past the midpoint of our cloud transition, revenue in ACB growth have started to converge and will continue to do so during the remaining two years of our transition.

In the first half of our success in closing new and expansion Pega Cloud and client cloud deals drove our growth in term license cloud and maintenance revenue, which make up our recurring revenue sources.

Total subscription revenue for the first half of 2020, increased by 38% year-over-year, soaring from 270 million to 373 million, a leap of $103 million. Professional services revenue declined about 6% or just under 7 million for the first half of 2019, compared to the first half of 2020.

It's important to note that more than half of this decrease nearly all decrease for the quarter is due to the reduction in reimbursable billable expenses for travel, as our service teams are executing project work at our clients' location.

Additionally, a few of our professional services engagement were not able to be done remotely, which has impacted our professional services revenue. In the first half of 2020 Pega Cloud mix was about half of our new client commitments consistent with our expectation.

In total, over 90% of our new client commitments were either Pega Cloud or client cloud, with the remaining being perpetual license arrangements.

For the three months ended June 30, 2020, we reported both GAAP and non-GAAP results and a full reconciliation of all GAAP and non-GAAP measures are provided in the financial table in the press release that we issued earlier today, and those numbers are also available on the Investor Relations section of our Web site.

Non-GAAP net loss was $0.28 per share, compared to a net loss $0.30 per share a year ago, much like revenue, net income will be less impacted as we exit the cloud transition over the next couple of years.

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 and the impact of near term cash flow and reported EPS. So let's turn to a few other details.

You may recall that we had a successful convertible offering in the first quarter. Pega finished the period, the second quarter, with total cash and marketable securities of 512 million on June 30, 2020, compared to 538 million at the end of the first quarter.

During the first half of season, we returned about 48 million to shareholders via dividends, buybacks and net settlements in equity. We ended the quarter with just over 5500 employees worldwide, an increase of about 13% from one year ago. We're very disappointed that we couldn't provide a strategy upgrade during Pega world.

But we have decided to hold a [book show] [ph] investor briefing on Tuesday, August 25. As you can probably imagine, this will be virtual and it will be an update on the progress of our transition to be an as a service business. If you're interested in joining that session, please email pegainvestorrelations@pega.com.

In conclusion, at the midpoint of the year, we're very pleased with the way our business is performing. As we look ahead, we acknowledge that there's increased uncertainty in the current environment for all this and we are certainly facing obstacles of our own.

However, we believe that Pega remains unusually well positioned to continue delivering on the strategy to be the leader in digital transformation. And with that operator, we're ready to take questions..

Thank you. [Operator Instructions] We'll take our first question from Rishi Jaluria with D.A. Davidson. Please go ahead..

Hi, guys. Thanks so much for taking my questions and [indiscernible] continued strengthen the business. What are the start out with -- maybe you had an update on some of the hiring plans especially when it comes to new sales reps and alongside that the sales rep side, you have been hiring them over the past two years.

Just how are you feeling now in terms of sales coverage and generally those [indiscernible]?.

Well, I can answer that you blanked out a little bit. But if I understand your correctly, you're asking how we're feeling about the sales reps and tenure and what we're hiring. I think that the increased sales force has been able to do two things.

One, I think it's given us greater liability, which proved really to be extremely helpful during this pandemic, because you have a lot more what I would describe as sort of a counter engagement, then sort of trying to bounce off, customers if you don't have enough reps to fully cover them.

And on top of that, I think we've demonstrated that we've been able to grow as a result of hiring new sales reps. So the thing I'm pleased about is that I believe our onboarding and our education have really moved extremely effectively to this remote environment, but for our sales teams, and for the other folks that we're hiring.

So I think we're going to continue to be able to develop productivity effectiveness as we grow the sales force and also looking to make the sales force we have more effective to be..

That's helpful.

And I wanted to get a sense of -- as we look at strong ACB growth that you have pulling off so far this year, probably there are some -- anything from customers that indicates that there's been some going forward of projects or IT project in the back half of this year and then the first half, or is there just been kind of [indiscernible] plan and the pipeline growth in the back half of the year looked fairly strong so far this year?.

I was seeing a lot of evidence that people are going sacrifice their second half for the first half. I actually see more people cancelled things that they didn't think were critical just throughout the year so that they could maintain their focus on things that aren't critical.

Thankfully, the digital transformations that we do, I think tends to fall more in the critical bucket of both the immediate stuff that we can do to get something off the ground, but also the fact that we can offer people a path to a well architected long-term effective solution.

So I have no basis to evaluate this part of Pega, the second half problem like you might [indiscernible]..

And last one from me, and I will jump off. Can you [indiscernible] mention there were some services part that can't be done remotely.

Can you give us a little bit more color on -- what is preventing that from happening, and then maybe some color around that? What does that mean, right? Does that mean that this four deals that were already closed? I'm adding to say, the time until the customer goes live, shipped out and doesn't reflect all the closed deals.

Waiting for more color around that [indiscernible]?.

Sure, Rishi. So I would say that just to clarify, it is very rare that we will see a client not be able to support a remote professional services work. I mean, it does happen. I mentioned that because in full disclosure, it will happen, now and again, but it is not something that is common and it certainly is not happening in any big way.

But I would even tell you that I actually am surprised how well people are able to work remotely. So I would say in general, I think the environment is quite frankly, better in terms of effectiveness than I would have anticipated back in March.

But that said, some clients are not as comfortable don't have the technical infrastructure, culturally may not be as effective at working remotely. And quite frankly, those are many times the clients that actually are the most in need for digital transformation. So I do think it does happen.

And I feel like -- just in the interest of full disclosure, we should mention that it can happen, but it's certainly not something that's happening often..

I think that's a good question. I mean, it's not just us to be to be able to work remotely, which I think we've demonstrated that we could do at scale. The client participants in those projects also need to be able to or need to be comfortable working remotely. But as Ken said, this is not a material part of it..

We'll take our next question from Chris Merwin with Goldman Sachs. Please go ahead..

I wanted to ask a bit about the use cases for the product, the deals you're winning or even those that are in the pipeline.

Are you starting to see some different use cases for the low code platform and particularly in light of how many customers seemingly are looking to digitally transform key systems where in terms of impetus might not have been in place before? So just curious if there's been any evolution there that you've seen more recently?.

Well, I think the evolution has been that which I view as encouraging is that a number of organizations have realized that even the things that they didn't think were problems actually are problems. And so you're able to have more engaged conversations with senior people about how they actually create a digital transformation strategy.

Whereas a lot of times, I think, before, there was a little less of a strategic focus, but being able to do the low code, your high speed deliveries, but also have those strategic conversations, I think puts us in a pretty advantage position. Just think about how we describe what we do.

We do basically customer engagement, work involving, expert systems and artificial intelligence, generally to help make good decisions. We provide process automation to drive that work done. And then we provide an environment that makes that work across channels and across different back end systems.

That is a recipe that is strongly beneficial for any organization trying to do a transformation..

Okay, that's great. And just one other question, if I could, Ken, it looks like the backlog actually accelerated from 20% growth last quarter I think 30% growth this quarter.

Can you talk a bit about what caused that big step up and any other color you could share but the cadence and bookings as you move through the second quarter and [indiscernible]?.

Yes. So Chris, couple things that are interesting.

The first thing that's interesting is that as we hire more account executives and actually get into a stronger cadence with our clients around faster yield cycles and really getting started with Pega Cloud and accelerating off of that, kind of that minimum lovable product, as you might call it, to be able to -- and reduce the kind of the deployment cycle of our clients out there in cloud.

What you see is, as you see more business activity moving throughout the year, meaning everything is the Q4 deal that's really large as a whale. It's kind of log jam at the end of the year. So that's one promising thing around this Q2. This was by far the strongest Q2 that we've ever had.

Now, you would expect that as we're growing, it was a very solid Q2 especially given COVID. Second thing is, it's a demonstration of our duration of contract length holding up, which is really a sign that clients are continuing to think about their investments in Pega on a very long-term basis.

Now we're not -- we see actually are not encouraging our sales teams to extend the life of contracts. But I think there was some, there's always some focus around when you sell fast, when you sell cloud, the duration can compress, and therefore, cause a less efficient selling cycle if you're selling one-year versus a three-year.

And I think what you're seeing is that not only is the business activity up, but the durations are holding, very steady and specifically around Pega Cloud. So it's just a really great sign of our retention rate, the continued investment and the momentum of Pega. Cloud..

We'll take our next question from Steve Enders with KeyBanc..

I'm going to check on the last quarter that pipeline was up really strong year-over-year, just wondering where pipeline stands today and how the top of funnel performed as you as you moved through the quarter?.

The pipeline is still strong.

The pipeline we have doesn't wiggle around that much during the quarter, if you think about it, but we still see plenty of opportunities primarily with customers we've had some contact with, they're large customers or small customers, because this environment here makes it much harder to go slamming into lots of small businesses.

But we have lots and lots of runway at our top 10 customers have enormous amount of additional ACB opportunity as we continue to perform well for them. So the pipeline is not concerned at all..

Okay. Got you. That's helpful.

Just want to check, have been hearing from some other vendors reporting so far about income to pay being a real differentiator in the quarter in the ability to get deals, just wondering how you're seeing the environment today to either capture new customers or to take incremental opportunities within your current customer base..

So I think incumbency is helpful. And incumbency in very large organizations that are well suited to what we do is doubly helpful. I think if you're selling a product, if you're selling an HR system or something where they can only buy one, obviously incumbency can be a limitation.

There's so many ways that these organizations can continue to apply what we do that we're having and I would have to say the strategic compensation accelerated in the last four or five months in terms of where we want to go together in terms of partnership. So incumbency definitely helped.

I'm asked sometimes when we worried that we're going to sell out the world's biggest companies that we're in. And the answer to that is not remotely, so much upside, because we've never been a company to sell these stupid enterprise licenses which a lot of clients -- without it being reasonable. That's just never been in our DNA.

So we have real upside as we continue to perform, it's really come with us to do that..

I would add another piece of color on that. Steve. If you think about Pega's business traditionally, about two-thirds to 75% of our bookings each and every year, come from our existing clients.

So certainly incumbency has led to lots of Pega growth over time, but it's really important to have a balanced view, you have to really cover those incumbent organizations. So Pega can continue to further penetrate to Alan's point. But that said, we've generated a lot of new logo growth as well in the first half.

And so I don't think that then all of the businesses just going to be incumbent. So I do think that is certainly would view incumbency in a time of any economic pressure or stress. But I do think our opportunity to both continue to enrich the relationships that we have with our existing clients.

But also gather very large and significant logos as we actually build kind of new fertile ground to continue to expand. I think the opportunity for digital transformation really provides that. So we've always been dependent on continuing to sell to our clients, but I think that we've also generated lots of new relationships in the first half as well..

We'll take our next question from Mohit Gogia with Barclays. Please go ahead..

And I'll offer my congratulations on the solid quarter, despite the pandemic. My first question is for Alan. I wanted to dig more into this federal vertical. See you guys have previously discussed that being your fastest vertical last year and obviously some interesting things you have outlined through the first half.

So wanted to see what is working well, there is essentially a competitive landscape not just in the [indiscernible], but also in the border enterprise softwares with a lot of activity.

So I just want to begin with what is working there and whether you can use the table maybe sort of like increase your ventilation and increase the growth rates in some of the other tables? And then I have a follow-up question..

Let me make sure, I understood which vertical you were asking about this sort of cut out, if you just --.

The federal vertical..

Federal vertical. Yes, so look, we were not very deep in federal if you go back five years, and it's been absolutely terrific and it's to my mind only getting better. It's not just the recently announced big IRS, you could imagine the sort of competitive environment around some of that is key.

But if you think about all the other parts of the government that we're working with, from defense to being the systems at, the U.S. Marshals chose to modernize, the desire to try to create efficiency. That's huge.

And we're seeing that not just in the government of the U.S., but we're also seeing it in places like Australia as I mentioned, when we talked earlier about the U.K. So that is an excellent vertical for us.

And we are doubling down on it, great place to be able to put additional selling resources and also to build the right partnerships because those are so important when selling to government. So I was thrilled.

And even in places I mentioned, the German government, for example, another example of a new logo for us, and also work with the government in France. So we're seeing a lot of stuff in lot of places..

Thank you. So the follow up question to Ken. You alluded to that obviously 21 percentage [indiscernible] despite the pandemic is pretty strong when some of the other vendors are feeling some of the heat from COVID-19. But you also alluded to that there is an opportunity going forward maybe accelerate the ACB growth rate.

So I was wondering if you can dig into some of these vectors that you think or maybe in the near to mid-term or more important when it comes to opportunity to accelerate that. I think you mentioned that two-third of the ACB growth or other new bookings come from existing clients.

So obviously expansion rates, an upward trajectory for expansion rates, maybe as one vectors. But was wondering, if you can drill into the business aspect. Thanks guys..

Yes, sure. So I'll mention a couple things that I think are interesting. The first thing is, if you looked at our net retention rate, if you kind of reverse engineer our net retention rate at 21%, ACB growth, our net retention rates, somewhere in the 113% to 116% kind of range.

So if you just think about that 113%, 116% net retention or net expansion year-over-year for our existing clients.

If you take that percentage and you think about the impact of digital transformation and the fact that we even in our largest clients, we're not even 10% or 20% penetrated on what we could sell them that really ties to our strategy around density of hiring account executive and really further creating relationship kind of equity around the largest organizations, making sure that we're covering the different buyers, the different business units and further penetrate it.

That's a tremendous opportunity. Another example of an opportunity is that you just asked about early, the federal state, even just looking at the U.S.

federal state, that vertical is so relevant for Pega they're going through digital transformation, the government is looking at Cloud burst, which is that much more relevant and now with our strategy over the last few years of really pushing as cloud being our primary go-to-market, that vertical is one of the emerging and fastest growing but still not 10% of Pega's business yet.

So if you think about that as an opportunity and ignore new logos and all of the other opportunities across the business, we can accelerate our ACB just on those two dimensions noticeably. So I think that's what's exciting as we have so much opportunity with our existing installed base or existing client base.

And then we have these verticals like a federal vertical, that's just one country. It's just one buyer, really within that country.

And I think there's just a tremendous amount of opportunity or wins [indiscernible] IRS, really just demonstrating how credible we are in that in that space, even with being relatively -- that being a relatively less mature vertical in terms of the growth rate.

So I think that there's just opportunity like that in all the countries and other verticals, but I'm just giving you a sense of why we believe that we can accelerate our growth rate and we want to continue to invest in that..

We'll take our next question from Yun Kim with Rosenblatt. Please go ahead..

Obviously, Pega Cloud had a spectacular quarter, sequential ACB business actually was up record. And I just want to talk more about the trends that you're seeing in that particular business.

What are the trends around the deal size? If our customers making bigger commitment, or what's the thinking by higher deal volume, any trend that you're seeing between new and existing customers for the Pega Cloud business? Thank you..

Ken, I will let you answer statistically but viscerally the businesses coming across the entire continuum. So it wasn't driven by a couple of monster deals. This was exactly like you wanted, Ken, give some more specifics..

Yes. Well, I can give you one measure that'll answer your question. It's the average deal size of take Pega Cloud versus the average deal size of client cloud was largely the same for the first half of the year. So that metric probably answers your question.

We're not doing lots and lots of clients, but we're not doing just a small number of very large ones. It's really down the middle Pega Cloud..

Remember that Pega Cloud and client class that's over 90% of our revenue. So yes, that's really -- that's the business, that's over bits of perpetual of all contracts aren't -- as they shouldn't, aren't driving our business.

You can see that in the percentage of revenue perpetual going down, which is frankly a delight and the recurring revenue and recurring commitments growing up..

And Alan, obviously, the digital transformation, secular trend is definitely resonating with your business. Can you update us on traction with the large global system innovators, obviously, [indiscernible] also embrace digital transformation initiatives out there..

Yes. I think, they're definitely extremely interested. We are engaging with them and show them the relationship that really deepened.

I will point out that in just the last three, four months, we've actually brought in a new Head of Pega Ecosystem, very experienced woman, who brings tremendous background in terms of being able to build those relationships with those sorts of particularly the larger size and the new leader of our go-to-market, which we announced just started June 1.

Haydon Stafford also has a tremendous background working with both Salesforce and Microsoft Dynamics CRM in building extremely material relationships with partner organizations. So we are committed to the partners, I think you're going to see that being an increasing area of emphasis. And I think a lot of leverage to that as well..

Okay, great. Good to hear.

So you can in terms of the current model transition, we are seeing Pega Cloud accelerate versus decline, would that affect margin, at least in the near term? And also, how should we think about margin benefit coming from the total revenue now that line is going to start going faster given that the model transition has passed the midpoint..

As Pega Cloud continues to accelerate, you do have some variable costs with Pega Cloud, but you get a much bigger operating leverage or operating lever as Pega Cloud gets larger. So net-net of that change, the combination of those two factors, I think will not impact our margins, positively or negatively as Pega Cloud.

A little bit more variable costs, but also better operating leverage and operating scale efficiency.

To your second part of your question, which is, what should happen over the next couple years? Well, when you get through a cloud transition, you wash away all your perpetual revenue at the beginning and it takes you a series of years to build that back in the business.

And so normally, when you start a cloud transition and you end the cloud transition, or start a recurring transition ended, your margin profiles look similar when you start a new, because once you end it, that's when the operating leverage can really be exhibited on the business model. And so we will exit this transition in 2022.

So between now and 2022 and beyond, you'll see improvements in our operating margin each and every year, so we kind of get some more of that fine plus model, which will still be out in like, say the 2023 time period.

So you should see operating margin improvement and operating cash flow improvements, it's just kind of better each year that you go through it now that we're past the hardest point..

We'll take our next question from Mark Schappel with Benchmark. Please go ahead..

Nice job in the quarter. Very Nice job. So I was starting with you -- in your prepared remarks, you touched on your new messaging solution and the RPA X-ray Vision solution, I believe.

I was wondering if you could just go into a little more details on those two products and how they differ from other solution in the marketplace?.

Sure.

I didn't hear the first one, once again, my line is little [dropppy] [ph], what was the first one?.

So in your prepared remarks, you touched on your new solution, one was a new messaging solution, another one called I think X-ray vision. I was wondering if you could just go into a little bit more detail..

I got it. Thanks. I just wanted to make sure I heard properly. So we selectively acquire a company and bring them into the mix and weave them in to what would be a cogent solution for our clients.

And both -- so last year, we bought a company called In The Chat, which brought very, very sophisticated messaging technology and also actually brought a great leader, who's the GM, General Manager of our customer service business, into the company. And this represents the rolling out of that technology is part of the platform.

And it really is a perfect example of where communications technology and process automation technology really go hand in hand together, and it demos beautifully. And there's a lovely augmentation system. You may remember several years ago, we bought a robotics player, something called OpenSpan.

And we integrated robotics into what Pega offers, frankly, completely different ways of the robot first time people who I think -- it was interesting Gartner put robotics into the truck, disillusioned it a couple of months ago, because robotics projects are not incredibly fragile, particularly when people start putting lots of business logic in the robots.

But we're able to do with our solution is to be able to make the way less bracket by keeping the business logic work along the product channel and in an omni-channel sort of position in the center of their business. And then just using the robot, when you have to go the last bit if there's not an automated [indiscernible].

And this X-ray capability actually takes that architecture that was already established and makes it tremendously less fragile, tremendously more able to self heal even if the backend systems change, doesn't break the robots. Robots actually understand how to find the right data and do the right thing.

And I just think it's another example of bringing great technology to the outside, but making it even better by weaving it in to a service background and AI back then.

Does that make sense?.

It does. Great. Thank you. Helpful..

We'll take our final question from Steve Koenig with SMBC Nikko..

Just want to answer question and one follow-up, Ken, can you just help connect the dots on how the numbers, I'm looking at the cloud percentage of new commitments was 50% for the first half in total, I think it ran maybe a little high in Q1, maybe a little lower in Q2, but cloud ACB accelerated sharply. So just maybe help me understand that.

And then I got one more specific question for you guys..

Yes. So the cloud ACB did not accelerate because of a mix shift, which is your -- I see where you're going with the question. So you're right. It is just the bookings more strong in Q2, which actually and the percentage of Pega Cloud was high enough such that it led to an acceleration..

Okay, that's helpful thing, Ken. And then just my last question, I'm curious, maybe just on, your initiative that you embarked on a couple of years ago now to [good deal] [ph] velocity. And now you made a reference to some of the code deals earlier shows that coming, I heard you that duration is steady and that's a good thing.

But wondering about deal velocity? And then, I'll just add as well, any color on any major competitor take-off in the quarter as well. And that's it for me..

Sure. So we work in a highly competitive world. So every piece of business, we're winning somebody else's losing, that's just the way it goes. We show very well competitively particularly in the sweet spots, which I think our view on low-code deals all the way back to our original vision of being a model driven platform.

So places where we, I just think pretty solidly win is when the company does not want to adopt low-code as a series of little standalone islands, department things that they'd like to give those department and the business users the power to be able to drive chain, while at the same time having something that can scale for the enterprise and really support the right of the standards, security and other sorts of things.

You might remember years ago, lotus notes the kind of the low-code system of its day, all of those systems are either long dead or considered just dreadful technical debt. That's what -- somebody remembers those stories, or knows about those stories. That's when we consistently I think, are highly, highly successful.

So the idea of the low-code app factory for business, there's not a bunch of tiny little systems hanging around. But it's really a way to think about the enterprise. That's when we are enormously advantaged. And frankly, I think more and more enterprises [indiscernible]. So I understand the question..

With that I know, we're down the hour. Let me just wrap up by saying thank you to all the investors that have been interested in us and stood by us as we've gone through these incredibly hard times. The Pega team is working extremely diligently. I think we're working well with our clients.

I think we all need to have a level of care and patience to make sure we're getting through all this. And I'm thrilled that this is, I think, tested our team and made and shown it to be extremely strong. And whatever happens in the future, we need to continue to build out that strength and we'll be working hard on your behalf.

So with that, let me say thank you and have a great evening..

Ladies and gentlemen, this concludes today's conference. We appreciate your participation. You may now disconnect..