What changed in this filing

/stocks — the workspaceLOADING

Item 2. Management’s Discussion and Analysis

2020-10-28 compared with 2020-07-28 · 95 added, 79 removed, 150 unchanged (54% of the section changed)

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This Quarterly Report on Form 10-Q contains or incorporates forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Words such as expects, anticipates, intends, plans, believes, will, could, should, estimates, may, targets, strategies, intends to, projects, forecasts, guidance, likely, and usually, or variations of such words and other similar expressions are intended to identify forward-looking statements, which are based on current expectations and assumptions.

Words such as expects, anticipates, intends, plans, believes, will, 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 are based on current expectations and assumptions.

These forward-looking statements deal with future events, and are subject to various risks and uncertainties that are difficult to predict, including, but not limited to, statements about our future financial performance and business plans, the adequacy of our liquidity and capital resources, the continued payment of quarterly dividends, the timing of revenue recognition, management of our transition to a more subscription-based business model, variation in demand for our products and services, including among clients in the public sector, the impact of actual or threatened public health emergencies, such as the Coronavirus (COVID-19), reliance on third-party service providers, compliance with our debt obligations and debt covenants, the potential impact of our convertible senior notes and related Capped Call Transactions, reliance on key personnel, the continued uncertainties in the global economy, foreign currency exchange rates, the potential legal and financial liabilities and reputation damage due to cyber-attacks, security breaches and security flaws, our ability to protect our intellectual property rights and costs associated with defending such rights, maintenance of our client retention rate, and management of our growth.

These risks and other factors that could cause actual results to differ materially from those expressed in such forward-looking statements are described further in Part I of our Annual Report on Form 10-K for the year ended December 31, 2019, and other filings we make with the U.S.

These risks and others that may cause actual results to differ materially from those expressed in such forward-looking statements are described further in Part I of our Annual Report on Form 10-K for the year ended December 31, 2019, and other filings we make with the U.S.

Securities and Exchange Commission (“SEC”).

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BUSINESS OVERVIEW

We develop, market, license, host, and support enterprise software applications that help organizations transform the way they engage with their customers and process work across their enterprise.

We develop, market, license, host, and support enterprise software applications that help organizations transform how they engage with their customers and process work across their enterprise.

We also license our low-code Pega Platform™ for rapid application development to clients that wish to build and extend their business applications.

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We deliver applications tailored to our clients’ specific industry needs.

As of June 30, 2020, COVID-19 has not had a material impact on our results of operations or financial condition.

Cloud Transition

We are in the process of transitioning our business to primarily sell software through subscription arrangements, particularly Pega Cloud (“Cloud Transition”).

Until we substantially complete our Cloud Transition, which we expect to occur in early 2023, we expect to continue to experience lower revenue growth and lower operating cash flow growth or negative cash flow.

The actual mix of perpetual license, term license, and Pega Cloud in a given period can fluctuate based on client preferences.

Additional information on the transition’s impact can be found below and in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2019.

As of September 30, 2020, COVID-19 has not had a material impact on our results of operations or financial condition.

The ultimate impact of COVID-19 on our operational and financial performance will depend on future developments, including the duration and spread of the outbreak, impact on our clients and our sales cycles, and impact on our partners, vendors, or employees, all of which are uncertain and unpredictable.

Our shift towards subscription-based revenue streams, the industry mix of our clients, our product mix, the fact that many of our clients are well-known and of large size, and the critical nature of our products to our clients may reduce or delay the impact of COVID-19 on our business, however, it is not possible to estimate the ultimate impact that COVID-19 will have on our business.

However, it is not possible to estimate the ultimate impact that COVID-19 will have on our business.

See “Coronavirus (“COVID-19”)” under Item 1A.

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We utilize several performance metrics to analyze and assess our overall performance, make operating decisions, and forecast and plan for future periods, including:

Annual contract value (“ACV”) | +21% since June 30, 2019

Annual contract value (“ACV”) | Increased 21% since September 30, 2019

• ACV represents the annualized value of our active contracts as of the measurement date.

ACV for term license and Pega Cloud contracts is calculated by dividing the contract’s total value by the duration of the contract in years.

ACV for maintenance is calculated as maintenance revenue for the quarter then ended multiplied by four.

The contract's total value is divided by its duration in years to calculate ACV for term license and Pega Cloud contracts.

Maintenance revenue for the quarter then ended is multiplied by four to calculate ACV for maintenance.

Client Cloud ACV is composed of maintenance ACV and ACV from term license contracts.

We believe the presentation of ACV on a constant currency basis enhances the understanding of our results, as it provides visibility into the impact of changes in foreign currency exchange rates, which are outside of our control.

All periods shown reflect foreign currency exchange rates as of June 30, 2020.

Remaining performance obligations (“Backlog”) | +30% since June 30, 2019

• Backlog represents contracted revenue that has not yet been recognized and includes deferred revenue and non-cancellable amounts that are expected to be invoiced and recognized as revenue in future periods.

Year to date Pega Cloud revenue | +55% since June 30, 2019

• Pega Cloud revenue is revenue as reported under US GAAP for cloud contracts.

All periods shown reflect foreign currency exchange rates as of September 30, 2020.

Remaining performance obligations (“Backlog”) | Increased 38% since September 30, 2019

• Backlog represents contracted revenue that has not yet been recognized and includes deferred revenue and non-cancellable amounts expected to be invoiced and recognized as revenue in future periods.

Year to date Pega Cloud revenue | Increased 55% since September 30, 2019

• Pega Cloud revenue is revenue as reported under U.S.

GAAP for cloud contracts.

CRITICAL ACCOUNTING POLICIES

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (“U.S.”) and the rules and regulations of the SEC for interim financial reporting.

The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and the related disclosure of contingent assets and liabilities.

The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses, and the related disclosure of contingent assets and liabilities.

We base our estimates and judgments on historical experience, knowledge of current conditions, and expectations of what could occur in the future given the available information.

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RESULTS OF OPERATIONS

Our license revenue is derived from sales of our applications and Pega Platform.

Our Pega Cloud revenue is derived from our hosted Pega Platform and software applications.

We expect our revenue mix to continue to shift in favor of our subscription offerings, particularly Pega Cloud arrangements, which could result in slower total revenue growth in the near term.

Revenue from Pega Cloud arrangements is generally recognized over the service period, while revenue from term and perpetual license arrangements is generally recognized upfront when the license rights become effective.

Our license revenue is derived from sales of our applications and the Pega Platform.

Cloud Transition

We are in the process of transitioning our business to primarily sell software through subscription arrangements, particularly Pega Cloud.

As revenue from Pega Cloud arrangements is generally recognized over the contract term while revenue from perpetual and term licenses is generally recognized when the license rights become effective, the shift has and is expected to continue to result in slower revenue growth during the transition.

(Dollars in thousands) Three Months Ended

June 30, Change

Six Months Ended

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September 30, Change

Nine Months Ended

September 30, Change

2020 2019 2020 2019

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Consulting 56,721 25 % 53,174 25 % 3,547 7 % 164,227 23 % 167,282 26 % (3,055) (2) %

Total revenue $ 227,375 100 % $ 205,592 100 % $ 21,783 11 % $ 492,966 100 % $ 418,138 100 % $ 74,828 18 %

(1) Reflects client arrangements (term license, Pega Cloud, and maintenance) that are subject to renewal.

• The increases in total revenue in the three and six months ended June 30, 2020 were primarily due to the increases in subscription revenue, partially offset by decreases in perpetual revenue, reflecting the shift in client preferences to subscription arrangements from other types of arrangements.

• An increasing portion of our term license contracts include multi-year committed maintenance periods.

Under such arrangements a greater portion of the total contract value has been reflected as maintenance revenue over the term of the contract.

Additionally, renewal rates in excess of 90% contributed to the increases in maintenance revenue.

• The decreases in consulting revenue in the three and six months ended June 30, 2020 were primarily due to decreases in billable hours and to a lesser extent due to reductions in billable travel expenses from reduced travel as a result of COVID-19.

$ 225,951 100 % $ 216,703 100 % $ 9,248 4 % $ 718,917 100 % $ 634,841 100 % $ 84,076 13 %

(1) Reflects client arrangements subject to renewal (Pega Cloud, maintenance, and term license).

The changes in total revenue in the three and nine months ended September 30, 2020 generally reflect our Cloud Transition.

Other factors impacting our revenue included:

• Term license revenue was higher in the three months ended September 30, 2019 primarily due to a greater number of large deals than in the three months ended September 30, 2020.

• An increasing portion of our term license contracts include multi-year committed maintenance periods instead of annually renewable maintenance.

Under such arrangements, a greater portion of the total contract value is recorded as maintenance revenue, which is recognized over the contract term, rather than as term revenue, as the license rights become effective which is usually shortly after contract execution.

In the three and nine months ended September 30, 2020 multi-year committed maintenance contributed $2.9 million and $7.7 million to maintenance revenue growth.

In the nine months ended September 30, 2020 multi-year committed maintenance reduced term revenue growth by $10.2 million.

• Maintenance renewal rates remained over 90% in the nine months ended September 30, 2020.

• The decrease in consulting revenue in the nine months ended September 30, 2020 was primarily due to lower billable travel expenses as a result of COVID-19.

The increase in consulting revenue in the three months ended September 30, 2020 was primarily due to increased billable hours which more than offset the impact of reduced billable travel expenses due to COVID-19.

Three Months Ended

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Six Months Ended

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Nine Months Ended

September 30, Change

(Dollars in thousands) 2020 2019 2020 2019

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$ 148,152 66 % $ 135,805 63 % $ 12,347 9 % $ 484,899 67 % $ 402,426 63 % $ 82,473 20 %

The recent shift in our revenue mix toward Pega Cloud arrangements has resulted in slower total gross profit growth as Pega Cloud grows and scales.

The increases in gross profit in the three and six months ended June 30, 2020 were primarily due to increases in term and Pega Cloud revenue, which reflects the shift in client preferences to subscription arrangements from other types of arrangements.

The increases in the three and six months ended June 30, 2020 in gross profit percent were primarily due to the:

• increases in the three and six months ended June 30, 2020 in Pega Cloud gross profit percent, driven by cost efficiency gains as Pega Cloud grows and scales, and

• decreases in the three and six months ended June 30, 2020 in consulting gross profit percent, primarily due to increases in consulting resource availability in anticipation of future projects.

Our consulting resource availability is impacted by several factors, including the scope and timing of new implementation projects, and our level of involvement in implementation projects compared to our consulting partners and enabled clients.

* not meaningful

• The changes in gross profit in the three and nine months ended September 30, 2020 were primarily due to our Cloud Transition, revenue growth, and cost efficiency gains as Pega Cloud grows and scales.

• The increase in consulting gross profit in the three months ended September 30, 2020 was primarily due to an increase in consultant utilization.

Consultant utilization is impacted by several factors, including the scope and timing of new implementation projects and our level of involvement in implementation projects compared to our consulting partners and enabled clients.

To support our long-term strategy, we intend to grow and increasingly leverage our partners and enabled clients for future implementation projects, which may reduce the future growth rate.

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2020 2019 2020 2019

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General and administrative $ 17,907 8 % $ 14,843 7 % $ 3,064 21 % $ 49,192 7 % $ 41,693 7 % $ 7,499 18 %

• The increases in sales and marketing in the three and six months ended June 30, 2020 were primarily due to increases in compensation and benefits of $29.2 million and $51.6 million, attributable to increases in headcount and equity compensation.

• The increases in selling and marketing in the three and nine months ended September 30, 2020 were primarily due to increases in compensation and benefits of $24.4 million and $76.0 million, attributable to increases in headcount and equity compensation.

The increases in headcount reflect our efforts to increase our sales capacity to deepen relationships with existing clients and target new accounts.

These increases were partially offset by decreases in travel and entertainment of $8.1 million and $8.9 million as a result of COVID-19 and decreases in PegaWorld costs as a result of the cancellation of the live event portion.

The three months ended June 30, 2020 include a reduction of expenses of $2.8 million due to the favorable settlement of cancellation fees owed to vendors of the live event portion.

• The increases in research and development in the three and six months ended June 30, 2020 were primarily due to increases in compensation and benefits of $8.6 million and $15.7 million, attributable to increases in headcount and equity compensation.

• The increases in general and administrative in the three and six months ended June 30, 2020 were primarily due to increases in compensation and benefits of $0.8 million and $2.2 million, attributed to increases in headcount and equity compensation.

These increases were partially offset by decreases in travel and entertainment of $8.5 million and $17.4 million as a result of COVID-19.

• The increases in research and development in the three and nine months ended September 30, 2020 were primarily due to increases in compensation and benefits of $7.8 million and $23.6 million, attributable to increases in headcount and equity compensation.

• The increases in general and administrative in the three and nine months ended September 30, 2020 were primarily due to increases in compensation and benefits of $0.8 million and $3.0 million, attributed to increases in headcount and equity compensation, and increases in professional services fees of $1.5 million and $4.2 million.

Other income (expense), net

(Dollars in thousands) Three Months Ended

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2020 2019 2020 2019

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• The changes in foreign currency transaction gain (loss) in the three and six months ended June 30, 2020 were primarily due to the impact of fluctuations in foreign currency exchange rates associated with our foreign currency-denominated cash, accounts receivable, and intercompany receivables and payables held by our United Kingdom (“U.K.”) subsidiary.

• The increases in the gain on capped call transactions in the three and six months ended June 30, 2020 were due to fair value adjustments on the Capped Call Transactions, entered into in connection with our issuance of the Notes.

Debt" in Item 1 of this Quarterly Report for additional information.

• The decreases in interest income in the three and six months ended June 30, 2020 were due to the decreases in market interest rates.

• The increase in other income, net in the six months ended June 30, 2020 was due to a gain from our venture investments portfolio.

• The increases in interest expense in the three and six months ended June 30, 2020 were due to our issuance of $600 million in aggregate principal amount of our convertible senior notes (“Notes”) on February 24, 2020.

• The changes in foreign currency transaction gain (loss) in the three and nine months ended September 30, 2020 were primarily due to the impact of fluctuations in foreign currency exchange rates associated with our foreign currency-denominated cash, accounts receivable, and intercompany receivables and payables held by our United Kingdom (“U.K.”) subsidiary.

• The decreases in interest income in the three and nine months ended September 30, 2020 were due to the decreases in market interest rates.

• The increases in interest expense in the three and nine months ended September 30, 2020 were due to our issuance of $600 million in aggregate principal amount of the Notes on February 24, 2020.

Debt" in Item 1 of this Quarterly Report for additional information.

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Three Months Ended

June 30, Change Six Months Ended

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September 30, Change Nine Months Ended

September 30, Change

(in thousands) 2020 2019 2020 2019

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Amortization of debt discount 3,807 — 3,807 9,060 — 9,060

Amortization of issuance cost 558 — $ 558 780 — $ 780

Amortization of issuance costs 565 — 565 1,345 — 1,345

$ 5,497 $ — $ 5,497 $ 13,105 $ — $ 13,105

• The increases in the gain on capped call transactions in the three and nine months ended September 30, 2020 were due to fair value adjustments on the Capped Call Transactions entered into in connection with our issuance of the Notes.

Debt" in Item 1 of this Quarterly Report for additional information.

• The increase in other income, net in the nine months ended September 30, 2020 was due to a gain from our venture investments portfolio.

(Benefit from) income taxes

Three Months Ended

June 30, Six Months Ended

September 30, Nine Months Ended

September 30,

(Dollars in thousands) 2020 2019 2020 2019

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This fluctuation may continue in future periods, depending on our future stock price in relation to the fair value of awards, the timing of the vestings of RSU awards, the exercise behavior of our stock option holders, and the total value of future grants of stock-based compensation awards.

During the six months ended June 30, 2020, our effective income tax rate benefit increased primarily due to the excess tax benefits from stock-based compensation and a carryback claim benefit as a result of the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”), partially offset by Global Intangible Low-Taxed Income (“GILTI”).

During the nine months ended September 30, 2020, our effective income tax rate benefit increased primarily due to the excess tax benefits from stock-based compensation and a carryback claim benefit as a result of the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”).

LIQUIDITY AND CAPITAL RESOURCES

Six Months Ended

Nine Months Ended

September 30,

(in thousands) 2020 2019

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(in thousands)

June 30, 2020 December 31, 2019

September 30, 2020 December 31, 2019

$ 415,358 $ 23,437

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52,670 44,926

Total cash and cash equivalents

Total cash, cash equivalents, and marketable securities

$ 468,028 $ 68,363

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and foreign taxes upon repatriation.

Due to the complexity of income tax laws and regulations, and the effects of the Tax Reform Act, it is impracticable to estimate the amount of taxes we would have to pay.

Cash (used in) provided by operating activities

Due to the complexity of income tax laws and regulations, and the Tax Reform Act’s effects, it is impracticable to estimate the amount of taxes we would have to pay.

Cash (used in) operating activities

We are in the process of transitioning our business to primarily sell software through subscription arrangements, particularly Pega Cloud.

As cash from Pega Cloud and term arrangements is generally collected over the contract term while cash from perpetual licenses is generally collected when the license rights become effective, the shift has and is expected to continue to impact our cash collections.

As client preferences continue to shift in favor of Pega Cloud arrangements, we could continue to experience slower operating cash flow growth, or negative cash flow, in the near term.

Cash from most Pega Cloud and term arrangements is collected over an average service period of three years, while cash from most perpetual license arrangements is collected upfront, shortly after the license rights become effective.

The primary driver of the decrease in the six months ended June 30, 2020 was the recent shift in our revenue mix toward Pega Cloud arrangements and increased costs as we accelerated investments in our Pega Cloud offering and selling and marketing activities to support future growth.

In the six months ended June 30, 2020, COVID-19 did not have a material impact on our cash flows from operations.

In the nine months ended September 30, 2020, COVID-19 did not have a material impact on our cash flows from operations.

See “Coronavirus (“COVID-19”)” under Item 1A.

Risk Factors for additional information.

The change in cash (used in) operating activities in the nine months ended September 30, 2020 was primarily due to our Cloud Transition and increased costs as we accelerated investments in our Pega Cloud offering and selling and marketing activities to support future growth.

Cash (used in) provided by investing activities

The change in cash (used in) provided by investing activities in the six months ended June 30, 2020 was primarily driven by investments in property and equipment at several of our office locations.

The change in cash (used in) provided by investing activities in the nine months ended September 30, 2020 was primarily driven by purchases of financial instruments and investments in property and equipment at several of our office locations.

Cash provided by (used in) financing activities

Convertible senior notes

In February 2020, we issued $600 million in aggregate principal amount of our convertible senior notes (“Notes”) due March 1, 2025, which provided proceeds as follows:

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Debt" in Item 1 of this Quarterly Report for additional information.

In November 2019, and as amended in February 2020 and July 2020, we entered into a five -year $ 100 million senior secured revolving credit agreement (the “Credit Facility”) with PNC Bank, National Association (“PNC”).

As of June 30, 2020 and December 31, 2019, we had no outstanding borrowings under the Credit Facility.

Credit facility

In November 2019, and as amended in February 2020, July 2020, and October 2020, we entered into a five-year $100 million senior secured revolving credit agreement (the “Credit Facility”) with PNC Bank, National Association (“PNC”).

As of September 30, 2020, we had no outstanding borrowings under the Credit Facility.

Debt" in Item 1 of this Quarterly Report for additional information.

Stock repurchase program (1)

Changes in the remaining stock repurchase authority:

(in thousands) Six Months Ended

(in thousands) Nine Months Ended

September 30, 2020

December 31, 2019 $ 45,484

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Repurchases (18,828)

June 30, 2020 $ 57,801

September 30, 2020 $ 47,172

(1) Purchases under this program have been made on the open market.

(2) On June 15, 2020, we announced that our Board of Directors extended the expiration date of the current stock repurchase program to June 30, 2021 and increased the remaining stock repurchase authority to $60 million.

(2) On June 15, 2020, we announced that our Board of Directors extended the current stock repurchase program’s expiration date to June 30, 2021 and increased the remaining stock repurchase authority to $60 million.

Common stock repurchases

Six Months Ended

Nine Months Ended

September 30,

(in thousands) Shares Amount Shares Amount

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803 $ 78,441 835 $ 55,157

Activity in period (2)

521 $ 45,292 622 $ 39,943

(1) Represents activity under our stock repurchase program.

(2) During the six months ended June 30, 2020 and 2019, instead of receiving cash from the equity holders, we withheld shares with a value of $31.2 million and $23.1 million, respectively, for the exercise price of options.

During the nine months ended September 30, 2020 and 2019, instead of receiving cash from the equity holders, we withheld shares with a value of $49.5 million and $31.6 million, respectively, for the exercise price of options.

These amounts have been excluded from the table above.

Six Months Ended

Nine Months Ended

September 30,

(in thousands) 2020 2019

Dividend payments to shareholders $ 7,206 $ 7,105

We currently intend to pay a quarterly cash dividend of $0.03 per share, however, the Board of Directors may terminate or modify the dividend program at any time without prior notice.

We currently intend to pay a quarterly cash dividend of $0.03 per share.

However, the Board of Directors may terminate or modify the dividend program at any time without prior notice.

Contractual obligations

As of June 30, 2020, our contractual obligations were:

As of September 30, 2020, our contractual obligations were:

Payments due by period

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Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-Q

Item 2. Management’s Discussion and Analysis