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 (“Quarterly Report”) 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, 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. Forward-looking statements deal with future events and are subject to risks and uncertainties that are difficult to predict, including, but not limited to: • our future financial performance and business plans; • the adequacy of our liquidity and capital resources; • the continued payment of our 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 covenants; • the potential impact of our convertible senior notes and Capped Call Transactions; • reliance on key personnel; • the relocation of our corporate headquarters; • 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; • our client retention rate; • 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, 2020, 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 update or revise these forward-looking statements publicly, whether as the result of new information, future events, or otherwise. The forward-looking statements contained in this Quarterly Report represent our views as of April 28, 2021. BUSINESS OVERVIEW We develop, market, license, host, and support enterprise software applications that help organizations simplify business complexity. Our intelligent technology and scalable architecture enables the world’s leading brands and government agencies to solve problems quickly and transform for tomorrow. Our clients are able to make better decisions and get work done using real-time artificial intelligence (“AI”) and intelligent automation on applications built on the low-code, cloud-native Pega Platform™, enabling our clients to streamline service, increase customer lifetime value, and boost efficiency. Our consulting and client success teams, along with our world-class partners, leverage our Pega Express™ methodology and low code to allow clients to design and deploy critical applications quickly and collaboratively. 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. 18 Cloud Transition We are in the process of transitioning our business to sell software primarily through subscription arrangements, particularly Pega Cloud. Until we substantially complete our Cloud Transition, which we anticipate will occur in late 2022 or early 2023, we may experience lower revenue growth and lower operating cash flow growth or negative cash flow. Operating performance and the actual mix of revenue and new arrangements in a given period can fluctuate based on client preferences for our perpetual and subscription offerings. See the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2020 for additional information. Coronavirus (“COVID-19”) As of March 31, 2021, COVID-19 has not had a material impact on our results of operations or financial condition. See “Coronavirus (“COVID-19”)” in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2020 for additional information. Performance metrics We utilize 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 20% since March 31, 2020 • ACV, as reported, 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 term license ACV. ACV is a performance measure that we believe provides useful information to our management and investors, particularly during our Cloud Transition. Reported amounts have not been adjusted for changes in foreign exchange rates. Foreign currency exchange rate changes contributed 3% to total ACV growth in 2021. 19 Remaining performance obligations (“Backlog”) | Increased 30% since March 31, 2020 • Backlog represents expected future revenue on existing non-cancellable contracts. Year to date Pega Cloud revenue | Increased 56% since the three months ended March 31, 2020 • Pega Cloud revenue is revenue 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 following accounting principles generally accepted in the United States 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, 2020: 20 • “Critical Accounting Estimates and Significant Judgments” in Item 7; and • Note 2. “Significant Accounting Policies” in Item 8. There have been no significant changes other than those disclosed in “Note 2. New Accounting Pronouncements” in Item 1 of this Quarterly Report on Form 10-Q to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2020. RESULTS OF OPERATIONS Revenue Cloud Transition We are in the process of transitioning our business to sell software primarily through subscription arrangements, particularly Pega Cloud. Revenue growth has been slower because of this transition. Revenue from Pega Cloud and maintenance arrangements is typically recognized over the contract term. In contrast, revenue from license sales is recognized when the license rights become effective, typically upfront. (Dollars in thousands) Three Months Ended March 31, Change 2021 2020 Pega Cloud $ 67,858 22 % $ 43,466 16 % $ 24,392 56 % Maintenance 75,561 23 % 73,695 28 % 1,866 3 % Term license 111,509 36 % 90,257 34 % 21,252 24 % Subscription (1) 254,928 81 % 207,418 78 % 47,510 23 % Perpetual license 5,452 2 % 3,659 1 % 1,793 49 % Consulting 53,119 17 % 54,514 21 % (1,395) (3) % $ 313,499 100 % $ 265,591 100 % $ 47,908 18 % (1) Reflects client arrangements subject to renewal (Pega Cloud, maintenance, and term license). The total revenue change in the three months ended March 31, 2021 generally reflects our Cloud Transition. Other factors impacting our revenue include: • An increasing portion of our term license contracts include multi-year committed maintenance periods instead of annually renewable maintenance periods. Under multi-year committed maintenance arrangements, a larger portion of the total contract value is recognized as maintenance revenue over the contract term rather than as term license revenue upon the effectiveness of the license rights. In the three months ended March 31, 2021, multi-year committed maintenance contributed $3.4 million to maintenance revenue growth and reduced term revenue growth by $5.5 million. • Maintenance renewal rates of higher than 90%. • The decrease in consulting revenue in the three months ended March 31, 2021 was primarily due to a decrease in billable travel expenses as a result of COVID-19. As part of our long-term strategy, we intend to continue growing and leveraging our ecosystem of partners on implementation projects, potentially reducing our future consulting revenue growth. Gross profit Three Months Ended March 31, Change (Dollars in thousands) 2021 2020 Software license $ 116,311 99 % $ 93,232 99 % $ 23,079 25 % Maintenance 69,775 92 % 68,119 92 % 1,656 2 % Pega Cloud 45,301 67 % 25,933 60 % 19,368 75 % Consulting (335) (1) % (1,221) (2) % 886 73 % $ 231,052 74 % $ 186,063 70 % $ 44,989 24 % • The changes in gross profit in the three months ended March 31, 2021 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 March 31, 2021 was primarily due to an increase in consultant utilization. Consultant utilization is impacted by several factors, including the timing and scope of new implementation projects and the extent of our involvement compared to our consulting partners and enabled clients. 21 Operating expenses (Dollars in thousands) Three Months Ended March 31, Change 2021 2020 % of Revenue % of Revenue Selling and marketing $ 148,739 47 % $ 136,024 51 % $ 12,715 9 % Research and development $ 62,442 20 % $ 58,727 22 % $ 3,715 6 % General and administrative $ 18,270 6 % $ 15,630 6 % $ 2,640 17 % • The increase in selling and marketing in the three months ended March 31, 2021 was primarily due to an increase in compensation and benefits of $25.4 million, attributable to increases in headcount and equity compensation, partially offset by decreases in travel and entertainment of $6.0 million and sales and marketing events of $7.9 million due to COVID-19. The increase in headcount reflect our efforts to increase our sales capacity to deepen relationships with existing clients and target new accounts. • The increase in research and development in the three months ended March 31, 2021 was primarily due to an increase in compensation and benefits of $4.6 million, attributable to increases in headcount and equity compensation. • The increase in general and administrative in the three months ended March 31, 2021 was primarily due to an increase in compensation and benefits of $1.1 million, attributable to increases in headcount and equity compensation, and an increase in professional services fees of $1.6 million. • In February 2021, we agreed to accelerate our exit from our Cambridge, Massachusetts headquarters to October 1, 2021, in exchange for a one-time payment from our landlord of $18 million. This agreement was the primary contributor to a decrease in facilities expense of $2.1 million in selling and marketing, $1.7 million in research and development, and $0.3 million in general and administrative in the three months ended March 31, 2021. Other income (expense), net (Dollars in thousands) Three Months Ended March 31, Change 2021 2020 Foreign currency transaction (loss) $ (5,098) $ (5,947) $ 849 14 % Interest income 153 607 (454) (75) % Interest expense (1,880) (2,306) 426 18 % (Loss) on capped call transactions (19,117) (18,592) (525) (3) % Other income, net 106 1,374 (1,268) (92) % $ (25,836) $ (24,864) $ (972) (4) % • The change in foreign currency transaction (loss) in the three months ended March 31, 2021 was primarily due to the impact of fluctuations in foreign currency exchange rates associated with our foreign currency-denominated cash, receivables, and intercompany balances held by our subsidiary in the United Kingdom. • The decrease in interest income in the three months ended March 31, 2021 was primarily due to a decrease in market interest rates. • The decrease in interest expense in the three months ended March 31, 2021 was primarily due to our adoption of ASU 2020-06 on January 1, 2021. See "Note 2. New Accounting Pronouncements" in Item 1 of this Quarterly Report for additional information. Interest expense related to the Notes: Three Months Ended March 31, Change (in thousands) 2021 2020 Contractual interest expense (0.75% coupon) $ 1,125 $ 450 $ 675 Amortization of debt discount — 1,497 (1,497) Amortization of issuance costs 673 222 451 $ 1,798 $ 2,169 $ (371) • The increase in the (loss) on capped call transactions in the three months ended March 31, 2021 was due to fair value adjustments. • The decrease in other income, net in the three months ended March 31, 2021 was due to an increase in the value of our venture investments portfolio in the three months ended March 31, 2020. 22 (Benefit from) income taxes Three Months Ended March 31, (Dollars in thousands) 2021 2020 (Benefit from) income taxes $ (17,618) $ (23,810) Effective income tax benefit rate 73 % 48 % During the three months ended March 31, 2021, the increase in our effective income tax benefit rate was primarily due to excess tax benefits from stock-based compensation and fair value adjustments for the capped call transactions, which were proportionally larger on a lower loss before income taxes. Stock-based compensation increases the variability of our effective tax rates. The impact of stock-based compensation on a given period depends on our profitability, the attributes of our stock compensation awards we grant, and award holders' exercise behavior. LIQUIDITY AND CAPITAL RESOURCES Three Months Ended March 31, (in thousands) 2021 2020 Cash provided by (used in): Operating activities $ 21,650 $ (18,323) Investing activities 15,489 (12,562) Financing activities (34,794) 502,174 Effect of exchange rates on cash and cash equivalents (1,536) (1,510) Net increase in cash and cash equivalents $ 809 $ 469,779 (in thousands) March 31, 2021 December 31, 2020 Held by U.S. entities $ 342,016 $ 399,138 Held by foreign entities 100,342 66,030 Total cash, cash equivalents, and marketable securities $ 442,358 $ 465,168 We believe that our current cash, cash flow from operations, and borrowing capacity will be sufficient to fund our operations, stock repurchases, 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 future growth, operating results, and the investments required to support our operations. 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, it is impracticable to estimate the amount of taxes we would have to pay. Operating activities We are in the process of transitioning our business to sell software primarily through subscription arrangements, particularly Pega Cloud. This transition has and is expected to continue to impact our billings and timing of cash collections. Pega Cloud, term license, and maintenance arrangements are generally billed and collected over the contract term, while perpetual license arrangements are generally billed and collected upfront when the license rights become effective. As client preferences shift in favor of Pega Cloud arrangements, we could experience slower operating cash flow growth, or negative cash flow, in the near term. The change in cash provided by (used in) operating activities in the three months ended March 31, 2021 was primarily due to a significant increase in client collections. In February 2021, we agreed to accelerate our exit from our Cambridge, Massachusetts headquarters to October 1, 2021, in exchange for a one-time payment from our landlord of $18 million, which is expected to be paid in the last quarter of 2021. The accelerated exit from this lease reduced our future lease liabilities by $21.1 million. Investing activities The change in cash provided by (used in) investing activities in the three months ended March 31, 2021 was primarily driven by investments in financial instruments, an acquisition, and a decrease in office space related capital expenditures. Financing activities In February 2020, we issued $600 million in aggregate principal amount of convertible senior notes due March 1, 2025. In November 2019, and as amended as of February 2020, July 2020, and September 2020, we entered into a five-year $100 million senior secured revolving credit agreement with PNC Bank, National Association. As of March 31, 2021, we had no outstanding borrowings under the Credit Facility. See "Note 8. Debt" in Item 1 of this Quarterly Report for additional information. 23 Stock repurchase program Changes in the remaining stock repurchase authority: (in thousands) Three Months Ended March 31, 2021 December 31, 2020 $ 37,726 Repurchases (1) (9,146) March 31, 2021 $ 28,580 (1) Purchases under this program have been made on the open market. Common stock repurchases Three Months Ended March 31, 2021 2020 (in thousands) Shares Amount Shares Amount Tax withholdings for net settlement of equity awards 197 $ 25,509 257 $ 23,011 Stock repurchase program 70 9,146 87 6,000 267 $ 34,655 344 $ 29,011 During the three months ended March 31, 2021 and 2020, instead of receiving cash from the equity holders, we withheld shares with a value of $10.1 million and $15.3 million, respectively, for the exercise price of options. These amounts have been excluded from the table above. Dividends We 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. Three Months Ended March 31, (in thousands) 2021 2020 Dividend payments to stockholders $ 2,427 $ 2,388