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; 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, 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 from new information, future events, or otherwise. The forward-looking statements contained in this Quarterly Report represent our views as of October 27, 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 enable 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. 20 Cloud Transition We are transitioning our business to sell software primarily through subscription arrangements, particularly Pega Cloud. Until we substantially complete our Cloud Transition, which we expect will occur in 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 each 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 September 30, 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 use 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 22% since September 30, 2020 • 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 term license ACV. ACV is a performance measure that we believe provides useful information to our management and investors, particularly during our Cloud Transition. Note: Foreign currency exchange rate changes contributed 1-2% to total ACV growth in 2021. 21 Remaining performance obligations (“Backlog”) | Increased 23% since September 30, 2020 • Backlog represents expected future revenue from existing non-cancellable 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 about 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: • “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. 22 RESULTS OF OPERATIONS Revenue Cloud Transition We are 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 while revenue from license sales is recognized when the license rights become effective, typically upfront. (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2021 2020 2021 2020 Pega Cloud $ 78,369 31 % $ 54,776 24 % $ 23,593 43 % $ 219,520 25 % $ 147,080 20 % $ 72,440 49 % Client Cloud $ 118,609 46 % $ 110,602 49 % $ 8,007 7 % $ 488,757 54 % $ 391,042 55 % $ 97,715 25 % Maintenance 83,188 32% 74,670 33% 8,518 11% 237,531 26% 220,587 31% 16,944 8% Term license 35,421 14% 35,932 16% (511) (1)% 251,226 28% 170,455 24% 80,771 47% Cloud subscription (1) $ 196,978 77 % $ 165,378 73 % $ 31,600 19 % $ 708,277 79 % $ 538,122 75 % $ 170,155 32 % Perpetual license 2,874 1 % 3,852 2 % (978) (25) % 20,922 2 % 16,568 2 % 4,354 26 % Consulting 56,416 22 % 56,721 25 % (305) (1) % 166,270 19 % 164,227 23 % 2,043 1 % $ 256,268 100 % $ 225,951 100 % $ 30,317 13 % $ 895,469 100 % $ 718,917 100 % $ 176,552 25 % (1) Reflects client arrangements subject to renewal (Pega Cloud, maintenance, and term license). The revenue changes in the three and nine months ended September 30, 2021 generally reflect our Cloud Transition. Other factors impacting our revenue include: • The increases in perpetual and term license revenue were primarily due to several large software license contracts recognized in revenue in the nine months ended September 30, 2021. • An increasing portion of our term license contracts include multi-year committed maintenance periods instead of annually renewable maintenance. 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 upon the effectiveness of the license rights as term license revenue. In the three months ended September 30, 2021, multi-year committed maintenance contributed $4.8 million to maintenance revenue growth and reduced term revenue growth by $1.0 million. In the nine months ended September 30, 2021, multi-year committed maintenance contributed $12.6 million to maintenance revenue growth and reduced term revenue growth by $22.0 million. • Maintenance renewal rates of higher than 90%. • The changes in consulting revenue in the three and nine months ended September 30, 2021 were primarily due to changes in billable hours. 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 September 30, Change Nine Months Ended September 30, Change (Dollars in thousands) 2021 2020 2021 2020 Pega Cloud $ 52,845 67 % $ 35,059 64 % $ 17,786 51 % $ 147,388 67 % $ 90,842 62 % $ 56,546 62 % Maintenance 77,895 94 % 69,192 93 % 8,703 13 % 221,457 93 % 203,942 92 % 17,515 9 % Software license 37,639 98 % 39,093 98 % (1,454) (4) % 270,186 99 % 184,669 99 % 85,517 46 % Consulting 3,667 6 % 4,808 8 % (1,141) (24) % 5,238 3 % 5,446 3 % (208) (4) % $ 172,046 67 % $ 148,152 66 % $ 23,894 16 % $ 644,269 72 % $ 484,899 67 % $ 159,370 33 % • The changes in gross profit and gross profit percent in the three and nine months ended September 30, 2021 were primarily due to our Cloud Transition, revenue growth, and cost-efficiency gains as Pega Cloud grows and scales. • The decrease in consulting gross profit percent in the three months ended September 30, 2021 was due to a decrease in consultant utilization in North America. 23 Operating expenses (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2021 2020 2021 2020 % of Revenue % of Revenue % of Revenue % of Revenue Selling and marketing $ 152,479 59 % $ 132,053 58 % $ 20,426 15 % $ 457,641 51 % $ 395,684 55 % $ 61,957 16 % Research and development $ 64,728 25 % $ 60,024 27 % $ 4,704 8 % $ 191,565 21 % $ 177,620 25 % $ 13,945 8 % General and administrative $ 20,176 8 % $ 17,907 8 % $ 2,269 13 % $ 57,607 6 % $ 49,192 7 % $ 8,415 17 % • The increases in selling and marketing in the three and nine months ended September 30, 2021 were primarily due to increases in compensation and benefits of $15.8 million and $63.8 million, attributable to increases in headcount, sales commissions, and equity compensation. The increase in headcount reflects our efforts to increase our sales capacity to deepen relationships with existing clients and target new accounts. • The increases in research and development in the three and nine months ended September 30, 2021 were primarily due to increases in compensation and benefits of $5.1 million and $16.9 million, attributable to increases in headcount. • The increases in general and administrative in the three and nine months ended September 30, 2021 were primarily due to increases in compensation and benefits of $0.4 million and $3.8 million, attributable to increases in headcount and equity compensation, and increases in legal and other professional services fees of $2.7 million and $6.1 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 decreases in facilities expenses of $2.1 million and $5.5 million in selling and marketing, $2.0 million and $5.6 million in research and development, and $1.0 million and $2.8 million in general and administrative, in the three and nine months ended September 30, 2021. Other income (expense), net (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2021 2020 2021 2020 Foreign currency transaction gain (loss) $ 518 $ 4,236 $ (3,718) (88) % $ (4,983) $ 2,545 $ (7,528) * Interest income 166 243 (77) (32) % 555 1,092 (537) (49) % Interest expense (1,908) (5,956) 4,048 68 % (5,747) (13,791) 8,044 58 % (Loss) income on capped call transactions (14,735) 18,989 (33,724) * (7,543) 19,816 (27,359) * Other income, net 2 — 2 * 108 1,374 (1,266) (92) % $ (15,957) $ 17,512 $ (33,469) * $ (17,610) $ 11,036 $ (28,646) * * not meaningful • The changes in foreign currency transaction gain (loss) in the three and nine months ended September 30, 2021 were 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 decreases in interest income in the three and nine months ended September 30, 2021 were primarily due to declines in market interest rates. • The decreases in interest expense in the three and nine months ended September 30, 2021 were 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 September 30, Change Nine Months Ended September 30, Change (in thousands) 2021 2020 2021 2020 Contractual interest expense (0.75% coupon) $ 1,125 $ 1,125 $ — $ 3,375 $ 2,700 $ 675 Amortization of debt discount — 3,807 (3,807) — 9,060 (9,060) Amortization of issuance costs 677 565 112 2,025 1,345 680 $ 1,802 $ 5,497 $ (3,695) $ 5,400 $ 13,105 $ (7,705) • The decreases in the (loss) income on capped call transactions in the three and nine months ended September 30, 2021, were due to fair value adjustments driven by changes in our stock price. • The decrease in other income, net in the nine months ended September 30, 2021, was due to larger fair value adjustments on equity securities held in our venture investments portfolio in the nine months ended September 30, 2020. 24 (Benefit from) income taxes Three Months Ended September 30, Nine Months Ended September 30, (Dollars in thousands) 2021 2020 2021 2020 (Benefit from) income taxes $ (24,826) $ (25,053) $ (54,360) $ (61,182) Effective income tax benefit rate 68 % 48 % During the nine months ended September 30, 2021, the change in our effective income tax benefit rate was primarily due to the impact of discrete tax items on a proportionately larger (loss) before income taxes in the nine months ended September 30, 2020. The most significant discrete items were excess tax benefits from stock-based compensation and the impact of changes in statutory tax rates applicable to our U.K.-based deferred tax assets. Stock-based compensation increases the variability of our effective tax rates. The impact on our effective tax rate in each period depends on our profitability and the tax deductions from our stock compensation activity, which depend upon our stock price and the award holders' exercise behavior. LIQUIDITY AND CAPITAL RESOURCES Nine Months Ended September 30, (in thousands) 2021 2020 Cash provided by (used in): Operating activities $ (5,321) $ (26,257) Investing activities 42,730 (210,701) Financing activities (91,431) 449,630 Effect of exchange rates on cash and cash equivalents (1,466) 183 Net (decrease) increase in cash and cash equivalents $ (55,488) $ 212,855 (in thousands) September 30, 2021 December 31, 2020 Held by U.S. entities $ 267,378 $ 399,138 Held by foreign entities 84,470 66,030 Total cash, cash equivalents, and marketable securities $ 351,848 $ 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 needed to support our operations. If we require additional capital resources to grow our business, we may utilize available funds or additional external financing. If it becomes necessary to repatriate foreign funds, we may have 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 transitioning our business to sell software primarily through subscription arrangements, particularly Pega Cloud. This transition has impacted and is expected to continue to impact the timing of our billings and 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 (used in) operating activities in the nine months ended September 30, 2021 was primarily due to a significant increase in client collections. Corporate headquarters In February 2021, we agreed to accelerate our exit from our previous corporate headquarters to October 1, 2021, in exchange for a one-time payment from our landlord of $18 million, which was paid in October 2021. The accelerated exit from this lease reduced our future lease liabilities by $21.1 million. On March 31, 2021 we leased office space at One Main Street, Cambridge, Massachusetts, to serve as our corporate headquarters. The 4.5 year lease includes a base rent of $2 million per year. New Waltham Office On July 6, 2021, we entered into an office space lease for 131 thousand square feet in Waltham, Massachusetts. The lease term of 11 years began on August 1, 2021. The annual rent equals the base rent plus a portion of building operating costs and real estate taxes. Rent first becomes payable on August 1, 2022. Base rent for the first year is approximately $6 million and will increase by 3% annually. In addition, we will receive an improvement allowance from the landlord of up to $11.8 million as part of the lease. This lease increased our lease liabilities and lease-related right of use assets by $42.1 million on August 1, 2021. 25 Investing activities The change in cash provided by (used in) investing activities in the nine months ended September 30, 2021 was primarily driven by investments in financial instruments, an acquisition, and a decrease in office space related capital expenditures. Financing activities Debt financing In February 2020, we issued $600 million in aggregate principal amount of convertible senior notes which mature on 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 September 30, 2021, we had no outstanding borrowings under the Credit Facility. See "Note 8. Debt" in Item 1 of this Quarterly Report for additional information. Stock repurchase program Changes in the remaining stock repurchase authority: (in thousands) Nine Months Ended September 30, 2021 December 31, 2020 $ 37,726 Authorizations (1) 38,467 Repurchases (2) (32,188) September 30, 2021 $ 44,005 (1) On June 8, 2021, we announced that our Board of Directors extended the current stock repurchase program’s expiration date to June 30, 2022 and increased the remaining common stock repurchase authority to $60 million. (2) All purchases under this program have been made on the open market. Common stock repurchases Nine Months Ended September 30, 2021 2020 (in thousands) Shares Amount Shares Amount Tax withholdings for net settlement of equity awards 462 $ 59,819 599 $ 59,613 Stock repurchase program 248 32,188 204 18,828 710 $ 92,007 803 $ 78,441 During the nine months ended September 30, 2021 and 2020, instead of receiving cash from the equity holders, we withheld shares with a value of $47.1 million and $49.5 million, respectively, for the exercise price of options. These amounts are not included in 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. Nine Months Ended September 30, (in thousands) 2021 2020 Dividend payments to stockholders $ 7,310 $ 7,206 Contractual obligations As of September 30, 2021, our contractual obligations were: Payments due by period (in thousands) Remainder of 2021 2022 2023 2024 2025 2026 and thereafter Other Total Convertible senior notes (1) $ — $ 4,500 $ 4,500 $ 4,500 $ 601,488 $ — $ — $ 614,988 Purchase obligations (2) 7,386 64,810 18,361 5,271 429 — — 96,257 Operating lease obligations 961 9,948 19,607 16,482 13,607 58,381 — 118,986 Liability for uncertain tax positions (3) — — — — — — 1,677 1,677 $ 8,347 $ 79,258 $ 42,468 $ 26,253 $ 615,524 $ 58,381 $ 1,677 $ 831,908 (1) Includes principal and interest. (2) Represents the fixed or minimum amounts due under purchase obligations for hosting services and sales and marketing programs. (3) We are unable to reasonably estimate the timing of this cash outflow due to uncertainties in the timing of the effective settlement of tax positions. 26