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; • reliance on key personnel; • global economic and political conditions and uncertainty, including continued impacts from the ongoing COVID-19 pandemic and the war in Ukraine; • reliance on third-party service providers, including hosting providers; • compliance with our debt obligations and covenants; • the potential impact of our convertible senior notes and Capped Call Transactions; • foreign currency exchange rates; • the potential legal and financial liabilities and damage to our reputation due to cyber-attacks; • security breaches and security flaws; • our ability to protect our intellectual property rights, costs associated with defending such rights, as well as intellectual property rights claims and other related claims by third parties; • 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, 2021, Part II of this Quarterly Report on Form 10-Q, 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 due to new information, future events, or otherwise. The forward-looking statements in this Quarterly Report represent our views as of April 28, 2022. BUSINESS OVERVIEW We develop, market, license, host, and support enterprise software that helps organizations simplify business complexity. Our powerful low-code platform for workflow automation and AI-powered decisioning enables the world’s leading brands and government agencies to hyper-personalize customer experiences, streamline customer service, and automate mission-critical business processes and workflows. With Pega, our clients can leverage our intelligent technology and scalable architecture to accelerate their digital transformation. In addition, our client success teams, world-class partners, and clients themselves leverage our Pega Express™ methodology to design and deploy mission-critical applications quickly and collaboratively. Our target clients are Global 3000 organizations and government agencies that require solutions to distinguish themselves in the markets they serve. Our solutions achieve and facilitate differentiation by increasing business agility, driving growth, improving productivity, attracting and retaining customers, and reducing risk. Along with our partners, we deliver solutions tailored to our clients’ specific industry needs. Subscription transition We are transitioning our business to sell software primarily through subscription arrangements. Until we fully complete our subscription transition, which we expect will occur in 2023, our revenue and operating cash flow may be impacted. 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, 2021 for additional information. 19 Coronavirus (“COVID-19”) As of March 31, 2022, 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, 2021 for additional information. Ukraine Our direct financial exposure to Ukraine, Russia, and Belarus is not material. In 2021, before Russia's invasion of Ukraine, we made a business decision to stop pursuing new clients in Russia and closed our local office. For the year ended December 31, 2021 total revenue from clients located in Ukraine, Russia, and Belarus was less than $4.0 million. However, the ultimate impact of Russia’s invasion of Ukraine on our business will depend on future developments, including the duration and spread of the conflict, the impact on our people, partners, clients, and vendors in neighboring countries, and globally, all of which are uncertain and unpredictable. 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 21% since March 31, 2021 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 subscription license and Pega Cloud contracts. Maintenance revenue for the quarter then ended is multiplied by four to calculate ACV for maintenance. ACV is a performance measure that we believe provides useful information to our management and investors, particularly during our subscription transition. Foreign currency exchange rate changes were a 1% to 2% headwind to ACV growth since March 31, 2021. 20 Remaining performance obligations (“Backlog”) | Increased 20% since March 31, 2021 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, 2021: • “Critical Accounting Estimates and Significant Judgments” in Item 7; and • “Note 2. Significant Accounting Policies” in Item 8. 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, 2021. RESULTS OF OPERATIONS Revenue Subscription transition We are transitioning our business to sell software primarily through subscription arrangements. This transition has impacted revenue growth as revenue is recognized differently for subscription services than license sales. 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. 21 (Dollars in thousands) Three Months Ended March 31, Change 2022 2021 Pega Cloud $ 90,317 24 % $ 67,858 22 % $ 22,459 33 % Maintenance 79,716 21 % 75,561 23 % 4,155 5 % Subscription services 170,033 45 % 143,419 45 % 26,614 19 % Subscription license 137,533 37 % 111,509 36 % 26,024 23 % Subscription 307,566 82 % 254,928 81 % 52,638 21 % Perpetual license 7,440 2 % 5,452 2 % 1,988 36 % Consulting 61,301 16 % 53,119 17 % 8,182 15 % $ 376,307 100 % $ 313,499 100 % $ 62,808 20 % The revenue changes in the three months ended March 31, 2022 generally reflect the impact of our subscription transition. Other factors impacting our revenue include: • The increase in perpetual revenue in the three months ended March 31, 2022 was primarily due to license rights becoming effective in the three months ended March 31, 2022 related to software license contracts entered into in prior years. • The increase in consulting revenue in the three months ended March 31, 2022 was primarily due to an increase in consultant billable hours in North America. Gross profit (Dollars in thousands) Three Months Ended March 31, Change 2022 2021 Pega Cloud $ 63,418 70 % $ 45,301 67 % $ 18,117 40 % Maintenance 74,585 94 % 69,775 92 % 4,810 7 % Subscription services 138,003 81 % 115,076 80 % 22,927 20 % Subscription license 136,911 100 % 110,889 99 % 26,022 23 % Subscription 274,914 89 % 225,965 89 % 48,949 22 % Perpetual license 7,406 100 % 5,422 99 % 1,984 37 % Consulting 5,790 9 % (335) (1) % 6,125 * $ 288,110 77 % $ 231,052 74 % $ 57,058 25 % * not meaningful • The increases in gross profit and gross profit percent in the three months ended March 31, 2022 were primarily due to the impact of our subscription transition, revenue growth, and cost-efficiency gains as Pega Cloud grows and scales. • The increase in consulting gross profit percent in the three months ended March 31, 2022 was due to an increase in consultant realization rates in North America. Operating expenses (Dollars in thousands) Three Months Ended March 31, Change 2022 2021 % of Revenue % of Revenue Selling and marketing $ 162,236 43 % $ 148,739 47 % $ 13,497 9 % Research and development $ 71,490 19 % $ 62,442 20 % $ 9,048 14 % General and administrative $ 35,764 10 % $ 18,270 6 % $ 17,494 96 % • The increase in selling and marketing in the three months ended March 31, 2022 was primarily due to an increase in compensation and benefits of $8.9 million and an increase in employee travel and entertainment of $2.6 million. • The increase in research and development in the three months ended March 31, 2022 was primarily due to an increase in compensation and benefits of $5.7 million, attributable to increases in headcount and incentive compensation. The increase in headcount reflects additional investments in developing our solutions, particularly for Pega Cloud. • The increase in general and administrative in the three months ended March 31, 2022 was primarily due to an increase of $15.4 million in legal fees and related expenses arising from proceedings outside the ordinary course of business. We have incurred and expect to continue to incur additional expenses for these proceedings in 2022. See "Note 14. Commitments and Contingencies" in Part I, Item 1 and “Risk Factors” in Part II, Item 1A of this Quarterly Report for additional information. 22 Other income and expenses (Dollars in thousands) Three Months Ended March 31, Change 2022 2021 Foreign currency transaction gain (loss) $ 2,876 $ (5,098) $ 7,974 * Interest income 207 153 54 35 % Interest expense (1,946) (1,880) (66) (4) % (Loss) on capped call transactions (30,560) (19,117) (11,443) (60) % Other income, net 2,741 106 2,635 2,486 % $ (26,682) $ (25,836) $ (846) (3) % * not meaningful • The increase in foreign currency transaction gain (loss) in the three months ended March 31, 2022 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 increase in interest income in the three months ended March 31, 2022 was primarily due to increases in market interest rates. • The increase in the (loss) on capped call transactions in the three months ended March 31, 2022, was due to fair value adjustments for our capped call transactions. See "Note 9. Fair Value Measurements" in Part I, Item 1 of this Quarterly Report for additional information. • The increase in other income, net in the three months ended March 31, 2022, was due to fair value adjustments on equity securities held in our venture investments portfolio in the three months ended March 31, 2021. (Benefit from) income taxes Three Months Ended March 31, (Dollars in thousands) 2022 2021 (Benefit from) income taxes $ (7,683) $ (17,618) Effective income tax benefit rate 95 % 73 % During the three months ended March 31, 2022, the change in our effective income tax benefit rate was primarily due to the impact of discrete tax items which were proportionately larger on a lower loss before income taxes. 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 Three Months Ended March 31, (in thousands) 2022 2021 Cash provided by (used in): Operating activities $ 15,116 $ 21,650 Investing activities (6,082) 15,489 Financing activities (35,918) (34,794) Effect of exchange rates on cash and cash equivalents (310) (1,536) Net (decrease) increase in cash and cash equivalents $ (27,194) $ 809 (in thousands) March 31, 2022 December 31, 2021 Held by U.S. entities $ 251,554 $ 274,813 Held by foreign entities 80,618 87,966 Total cash, cash equivalents, and marketable securities $ 332,172 $ 362,779 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 and to meet our known long-term cash requirements. 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. We may utilize available funds or seek additional external financing if we require additional capital resources. If it becomes necessary to repatriate foreign funds, we may have to pay U.S. and foreign taxes upon repatriation. However, due to the complexity of income tax laws and regulations, it is impracticable to estimate the amount of taxes we would have to pay. 23 Operating activities We are transitioning our business to sell software primarily through subscription arrangements. This transition has impacted and is expected to continue impacting our billings and cash collections, as the timing of billings and cash collections generally differs between our subscription and perpetual license arrangements. Subscription licenses and services are generally billed and collected over the contract term, while perpetual license arrangements usually are billed and collected upfront when the license rights become effective. The change in cash provided by operating activities in the three months ended March 31, 2022 was primarily due to our subscription transition and increased costs as we made investments in our Pega Cloud offering and selling and marketing activities to support future growth. In addition, in the three months ended March 31, 2022 we incurred $17.4 million in legal fees and related expenses arising from proceedings that originated outside of the ordinary course of business. We expect to continue to incur additional expenses for these proceedings. See "Note 14. Commitments and Contingencies" in Part I, Item 1 of this Quarterly Report for additional information. Investing activities The change in cash (used in) provided by investing activities in the three months ended March 31, 2022 was primarily driven by our investments in financial instruments and an acquisition in 2021. 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 thousands) Amount Principal $ 600,000 Less: issuance costs (14,527) Less: Capped Call Transactions (51,900) $ 533,573 In November 2019, and as since amended, we entered into a five-year $100 million senior secured revolving credit agreement with PNC Bank, National Association. As of March 31, 2022, we had no outstanding borrowings under the Credit Facility. See "Note 8. Debt" in Part I, Item 1 of this Quarterly Report for additional information. Stock repurchase program Changes in the remaining stock repurchase authority: (in thousands) Three Months Ended March 31, 2022 December 31, 2021 $ 22,583 Authorizations (1) — Repurchases (2) (22,583) March 31, 2022 $ — (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 Three Months Ended March 31, 2022 2021 (in thousands) Shares Amount Shares Amount Repurchases paid 242 $ 22,583 67 $ 8,846 Repurchases unpaid at period end — — 3 300 Stock repurchase program 242 22,583 70 9,146 Tax withholdings for net settlement of equity awards 141 12,128 197 25,509 383 $ 34,711 267 $ 34,655 During the three months ended March 31, 2022 and 2021, instead of receiving cash from the equity holders, we withheld shares with a value of $6.1 million and $10.1 million, respectively, for the exercise price of options. These amounts are not included in the table above. 24 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 without prior notice. Three Months Ended March 31, (in thousands) 2022 2021 Dividend payments to stockholders $ 2,454 $ 2,427 Contractual obligations As of March 31, 2022, our contractual obligations were: Payments due by period (in thousands) Remainder of 2022 2023 2024 2025 2026 2027 and thereafter Other Total Convertible senior notes (1) $ 2,250 $ 4,500 $ 4,500 $ 602,250 $ — $ — $ — $ 613,500 Purchase obligations (2) 49,936 14,311 9,198 13,072 13,750 — — 100,267 Operating lease obligations 3,887 20,317 17,141 14,352 10,664 48,381 — 114,742 Liability for uncertain tax positions (3) — — — — — — 1,705 1,705 $ 56,073 $ 39,128 $ 30,839 $ 629,674 $ 24,414 $ 48,381 $ 1,705 $ 830,214 (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.