PEGASYSTEMS INC 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS 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 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 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”). Except as required by applicable law, we do not undertake and expressly disclaim any obligation to publicly update or revise these forward-looking statements whether as the result of new information, future events, or otherwise. BUSINESS OVERVIEW 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. Our cloud-architected portfolio of customer engagement and digital process automation applications leverages artificial intelligence (“AI”), case management, and robotic automation technology, built on our unified low-code Pega Platform, empowering businesses to quickly design, extend, and scale their enterprise applications to meet strategic business needs. Our target clients are Global 3000 organizations and government agencies that require applications to differentiate themselves in the markets they serve. Our applications achieve and facilitate differentiation by increasing business agility, driving growth, improving productivity, attracting and retaining customers, and reducing risk. We deliver applications tailored to our clients’ specific industry needs. 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. COVID-19 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. See “Coronavirus (“COVID-19”)” under Item 1A. Risk Factors for additional information. 17 Performance metrics 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”) | Increased 21% since September 30, 2019 • ACV represents the annualized value of our active contracts as of the measurement date. 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 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. 18 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, 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. For more information regarding our critical accounting policies, we encourage you to read the discussion in the following locations in our Annual Report on Form 10-K for the year ended December 31, 2019: • “Critical Accounting Estimates and Significant Judgments” in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations”; and • Note 2. “Significant Accounting Policies” in Item 8. “Financial Statements and Supplementary Data.” There have been no significant changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2019 other than those listed below. Capped Call Transactions In February 2020, we entered into privately negotiated capped call transactions (“Capped Call Transactions”) with certain financial institutions. The Capped Call Transactions cover approximately 4.4 million shares (representing the number of shares for which the Notes are initially convertible) of our common stock and are generally expected to reduce potential dilution of our common stock upon any conversion of the Notes. The fair value of the Capped Call Transactions at the end of each reporting period is determined using a Black-Scholes option-pricing model. The valuation models use various market-based inputs, including stock price, remaining contractual term, expected volatility, risk-free interest rate, and expected dividend yield, as applicable. Management applies judgment in its determination of expected volatility. We consider both historical and implied volatility levels of the underlying equity security and, to a lesser extent, historical peer group volatility levels. The Capped Call Transactions are classified as “other long-term assets” and remeasured to fair value at the end of each reporting period, resulting in a non-operating gain or loss. See "6. Debt" and “7. Fair Value Measurements” in Item 1 of this Quarterly Report for additional information. 19 RESULTS OF OPERATIONS Revenue Our Pega Cloud revenue is derived from our hosted Pega Platform and software applications. 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 September 30, Change Nine Months Ended September 30, Change 2020 2019 2020 2019 Pega Cloud $ 54,776 24 % $ 35,153 16 % $ 19,623 56 % $ 147,080 20 % $ 94,610 15 % $ 52,470 55 % Maintenance 74,670 33 % 70,371 32 % 4,299 6 % 220,587 31 % 207,406 33 % 13,181 6 % Term license 35,932 16 % 48,989 23 % (13,057) (27) % 170,455 24 % 122,257 19 % 48,198 39 % Subscription (1) $ 165,378 73 % $ 154,513 71 % 10,865 7 % $ 538,122 75 % $ 424,273 67 % 113,849 27 % Perpetual license 3,852 2 % 9,016 4 % (5,164) (57) % 16,568 2 % 43,286 7 % (26,718) (62) % Consulting 56,721 25 % 53,174 25 % 3,547 7 % 164,227 23 % 167,282 26 % (3,055) (2) % $ 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. Gross profit Three Months Ended September 30, Change Nine Months Ended September 30, Change (Dollars in thousands) 2020 2019 2020 2019 Software license $ 39,093 98 % $ 57,329 99 % $ (18,236) (32) % $ 184,669 99 % $ 162,561 98 % $ 22,108 14 % Maintenance 69,192 93 % 63,683 90 % 5,509 9 % 203,942 92 % 188,091 91 % 15,851 8 % Pega Cloud 35,059 64 % 17,329 49 % 17,730 102 % 90,842 62 % 46,841 50 % 44,001 94 % Consulting 4,808 8 % (2,536) (5) % 7,344 * 5,446 3 % 4,933 3 % 513 10 % $ 148,152 66 % $ 135,805 63 % $ 12,347 9 % $ 484,899 67 % $ 402,426 63 % $ 82,473 20 % * 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. 20 Operating expenses (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2020 2019 2020 2019 % of Revenue % of Revenue % of Revenue % of Revenue Selling and marketing $ 132,053 58 % $ 115,237 53 % $ 16,816 15 % $ 395,684 55 % $ 341,064 54 % $ 54,620 16 % Research and development $ 60,024 27 % $ 52,492 24 % $ 7,532 14 % $ 177,620 25 % $ 152,802 24 % $ 24,818 16 % General and administrative $ 17,907 8 % $ 14,843 7 % $ 3,064 21 % $ 49,192 7 % $ 41,693 7 % $ 7,499 18 % • 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 $8.5 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 September 30, Change Nine Months Ended September 30, Change 2020 2019 2020 2019 Foreign currency transaction gain (loss) $ 4,236 $ (1,970) $ 6,206 * $ 2,545 $ (3,577) $ 6,122 * Interest income 243 598 (355) (59) % 1,092 1,865 (773) (41) % Interest expense (5,956) (42) (5,914) (14,081) % (13,791) (42) (13,749) (32,736) % Gain on capped call transactions 18,989 — 18,989 * 19,816 — 19,816 * Other income, net — 323 (323) (100) % 1,374 378 996 263 % $ 17,512 $ (1,091) $ 18,603 * $ 11,036 $ (1,376) $ 12,412 * * not meaningful • 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. See "6. Debt" in Item 1 of this Quarterly Report for additional information. Interest expense related to the Notes: Three Months Ended September 30, Change Nine Months Ended September 30, Change (in thousands) 2020 2019 2020 2019 Contractual interest expense (0.75% coupon) $ 1,125 $ — $ 1,125 $ 2,700 $ — $ 2,700 Amortization of debt discount 3,807 — 3,807 9,060 — 9,060 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. See "6. 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. 21 (Benefit from) income taxes Three Months Ended September 30, Nine Months Ended September 30, (Dollars in thousands) 2020 2019 2020 2019 (Benefit from) income taxes $ (25,053) $ (17,520) $ (61,182) $ (43,158) Effective income tax rate 48 % 32 % The inclusion of excess tax benefits from stock-based compensation in the provision for income taxes has increased the variability of the effective tax rates in recent periods. 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 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 Nine Months Ended September 30, (in thousands) 2020 2019 Cash provided by (used in): Operating activities $ (26,257) $ (13,462) Investing activities (210,701) 53,448 Financing activities 449,630 (61,941) Effect of exchange rates on cash and cash equivalents 183 (363) Net increase (decrease) in cash and cash equivalents $ 212,855 $ (22,318) (in thousands) September 30, 2020 December 31, 2019 Held by U.S. entities $ 415,358 $ 23,437 Held by foreign entities 52,670 44,926 Total cash, cash equivalents, and marketable securities $ 468,028 $ 68,363 We believe that our current cash, cash flow from operations, and borrowing capacity will be sufficient to fund our operations and quarterly cash dividends for at least the next 12 months. Whether these resources are adequate to meet our liquidity needs beyond that period will depend on our growth, operating results, and the investments required to respond to the possible increased demand for our services. If we require additional capital resources to grow our business, we may seek to finance our operations from available funds or additional external financing. If it became necessary to repatriate foreign funds, we may be required to pay U.S. and foreign taxes upon repatriation. 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. 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. 22 Cash (used in) provided by investing activities 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: (in thousands) Amount Principal $ 600,000 Less: issuance costs (14,527) Less: Capped Call Transactions (51,900) $ 533,573 A portion of the proceeds of the Notes was used to fund the Capped Call Transactions with the remainder to be used for working capital and other general corporate purposes. See "6. Debt" in Item 1 of this Quarterly Report for additional information. 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. See "6. Debt" in Item 1 of this Quarterly Report for additional information. Stock repurchase program (1) Changes in the remaining stock repurchase authority: (in thousands) Nine Months Ended September 30, 2020 December 31, 2019 $ 45,484 Authorizations (2) 20,516 Repurchases (18,828) 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 current stock repurchase program’s expiration date to June 30, 2021 and increased the remaining stock repurchase authority to $60 million. Common stock repurchases Nine Months Ended September 30, 2020 2019 (in thousands) Shares Amount Shares Amount Tax withholdings for net settlement of equity awards 599 $ 59,613 514 $ 34,871 Stock repurchase program 204 18,828 321 20,286 803 $ 78,441 835 $ 55,157 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. Dividends 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. 23 Contractual obligations As of September 30, 2020, our contractual obligations were: Payments due by period (in thousands) 2020 2021 2022-2023 2024-2025 2026 and thereafter Other Total Purchase obligations (1) $ 21,627 $ 56,689 $ 61,117 $ 173 $ — $ — $ 139,606 Investment commitments (2) 300 500 — — — — 800 Liability for uncertain tax positions (3) — — — — — 5,441 5,441 Operating lease obligations 5,490 22,887 43,888 13,187 9,959 — 95,411 $ 27,417 $ 80,076 $ 105,005 $ 13,360 $ 9,959 $ 5,441 $ 241,258 (1) Represents the fixed or minimum amounts due under purchase obligations for hosting services and sales and marketing programs. (2) Represents the maximum funding that would be expected under existing venture investment agreements. Our investment agreements generally allow us to withhold unpaid committed funds at our discretion. (3) We are unable to reasonably estimate the timing of the cash outflow due to uncertainties in the timing of the effective settlement of tax positions.