PEGASYSTEMS INC 10-Q

ITEM 1. FINANCIAL STATEMENTS PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) June 30, 2022 December 31, 2021 Assets Current assets: Cash and cash equivalents $ 109,275 $ 159,965 Marketable securities 187,613 202,814 Total cash, cash equivalents, and marketable securities 296,888 362,779 Accounts receivable 171,556 182,717 Unbilled receivables 201,130 226,714 Other current assets 70,633 68,008 Total current assets 740,207 840,218 Unbilled receivables 115,901 129,789 Goodwill 81,717 81,923 Other long-term assets 320,557 541,601 Total assets $ 1,258,382 $ 1,593,531 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 21,465 $ 15,281 Accrued expenses 63,120 63,890 Accrued compensation and related expenses 73,945 120,946 Deferred revenue 269,121 275,844 Other current liabilities 7,800 9,443 Total current liabilities 435,451 485,404 Convertible senior notes, net 592,161 590,722 Operating lease liabilities 84,170 87,818 Other long-term liabilities 12,821 13,499 Total liabilities 1,124,603 1,177,443 Commitments and contingencies (Note 14) Stockholders’ equity: Preferred stock, 1,000 shares authorized; none issued — — Common stock, 200,000 shares authorized; 81,940 and 81,712 shares issued and outstanding at June 30, 2022 and December 31, 2021, respectively 819 817 Additional paid-in capital 170,251 145,810 (Accumulated deficit) retained earnings ( 15,140 ) 276,449 Accumulated other comprehensive (loss) ( 22,151 ) ( 6,988 ) Total stockholders’ equity 133,779 416,088 Total liabilities and stockholders’ equity $ 1,258,382 $ 1,593,531 See notes to unaudited condensed consolidated financial statements. 3 PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts) Three Months Ended June 30, Six Months Ended June 30, 2022 2021 2022 2021 Revenue Subscription services $ 171,832 $ 152,075 $ 341,865 $ 295,494 Subscription license 41,600 104,296 179,133 215,805 Perpetual license 2,266 12,596 9,706 18,048 Consulting 58,639 56,735 119,940 109,854 Total revenue 274,337 325,702 650,644 639,201 Cost of revenue Subscription services 36,533 29,046 68,563 57,389 Subscription license 673 585 1,295 1,205 Perpetual license 36 71 70 101 Consulting 57,873 54,829 113,384 108,283 Total cost of revenue 95,115 84,531 183,312 166,978 Gross profit 179,222 241,171 467,332 472,223 Operating expenses Selling and marketing 157,198 156,423 319,434 305,162 Research and development 74,341 64,395 145,831 126,837 General and administrative 32,723 19,161 68,487 37,431 Total operating expenses 264,262 239,979 533,752 469,430 (Loss) income from operations ( 85,040 ) 1,192 ( 66,420 ) 2,793 Foreign currency transaction gain (loss) 1,713 ( 403 ) 4,589 ( 5,501 ) Interest income 309 236 516 389 Interest expense ( 1,944 ) ( 1,959 ) ( 3,890 ) ( 3,839 ) (Loss) income on capped call transactions ( 18,945 ) 26,309 ( 49,505 ) 7,192 Other income, net 3,785 — 6,526 106 (Loss) income before provision for (benefit from) income taxes ( 100,122 ) 25,375 ( 108,184 ) 1,140 Provision for (benefit from) income taxes 186,174 ( 11,916 ) 178,491 ( 29,534 ) Net (loss) income $ ( 286,296 ) $ 37,291 $ ( 286,675 ) $ 30,674 (Loss) earnings per share Basic $ ( 3.50 ) $ 0.46 $ ( 3.51 ) $ 0.38 Diluted $ ( 3.50 ) $ 0.43 $ ( 3.51 ) $ 0.36 Weighted-average number of common shares outstanding Basic 81,847 81,316 81,764 81,161 Diluted 81,847 90,320 81,764 86,006 See notes to unaudited condensed consolidated financial statements. 4 PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME (in thousands) Three Months Ended June 30, Six Months Ended June 30, 2022 2021 2022 2021 Net (loss) income $ ( 286,296 ) $ 37,291 $ ( 286,675 ) $ 30,674 Other comprehensive (loss) income, net of tax Unrealized (loss) gain on available-for-sale securities ( 1,149 ) 121 ( 927 ) 1,131 Foreign currency translation adjustments ( 11,466 ) 1,461 ( 14,236 ) 731 Total other comprehensive (loss) income, net of tax $ ( 12,615 ) $ 1,582 $ ( 15,163 ) $ 1,862 Comprehensive (loss) income $ ( 298,911 ) $ 38,873 $ ( 301,838 ) $ 32,536 See notes to unaudited condensed consolidated financial statements. 5 PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (in thousands, except per share amounts) Common Stock Additional Paid-In Capital Retained Earnings (Accumulated Deficit) Accumulated Other Comprehensive (Loss) Total Stockholders’ Equity Number of Shares Amount December 31, 2020 80,890 $ 809 $ 204,432 $ 339,879 $ ( 2,948 ) $ 542,172 Cumulative-effect adjustment from adoption of ASU 2020-06 , net — — ( 61,604 ) 9,399 — ( 52,205 ) Repurchase of common stock ( 70 ) ( 1 ) ( 9,145 ) — — ( 9,146 ) Issuance of common stock for stock compensation plans 402 4 ( 25,513 ) — — ( 25,509 ) Issuance of common stock under the employee stock purchase plan 24 — 2,288 — — 2,288 Stock-based compensation — — 30,100 — — 30,100 Cash dividends declared ($ 0.03 per share) — — — ( 2,438 ) — ( 2,438 ) Other comprehensive income — — — — 280 280 Net (loss) — — — ( 6,617 ) — ( 6,617 ) March 31, 2021 81,246 $ 812 $ 140,558 $ 340,223 $ ( 2,668 ) $ 478,925 Repurchase of common stock ( 81 ) ( 1 ) ( 10,245 ) — — ( 10,246 ) Issuance of common stock for stock compensation plans 267 3 ( 16,199 ) — — ( 16,196 ) Issuance of common stock under the employee stock purchase plan 24 1 2,858 — — 2,859 Stock-based compensation — — 30,698 — — 30,698 Cash dividends declared ($ 0.03 per share) — — — ( 2,445 ) — ( 2,445 ) Other comprehensive income — — — — 1,582 1,582 Net income — — — 37,291 — 37,291 June 30, 2021 81,456 $ 815 $ 147,670 $ 375,069 $ ( 1,086 ) $ 522,468 December 31, 2021 81,712 $ 817 $ 145,810 $ 276,449 $ ( 6,988 ) $ 416,088 Repurchase of common stock ( 242 ) ( 2 ) ( 22,581 ) — — ( 22,583 ) Issuance of common stock for stock compensation plans 297 3 ( 12,131 ) — — ( 12,128 ) Issuance of common stock under the employee stock purchase plan 35 — 2,446 — — 2,446 Stock-based compensation — — 28,227 — — 28,227 Cash dividends declared ($ 0.03 per share) — — — ( 2,455 ) — ( 2,455 ) Other comprehensive (loss) — — — — ( 2,548 ) ( 2,548 ) Net (loss) — — — ( 379 ) — ( 379 ) March 31, 2022 81,802 $ 818 $ 141,771 $ 273,615 $ ( 9,536 ) $ 406,668 Repurchase of common stock ( 38 ) — ( 1,925 ) — — ( 1,925 ) Issuance of common stock for stock compensation plans 117 1 ( 3,252 ) — — ( 3,251 ) Issuance of common stock under the employee stock purchase plan 59 — 2,357 — — 2,357 Stock-based compensation — — 31,300 — — 31,300 Cash dividends declared ($ 0.03 per share) — — — ( 2,459 ) — ( 2,459 ) Other comprehensive (loss) — — — — ( 12,615 ) ( 12,615 ) Net (loss) — — — ( 286,296 ) — ( 286,296 ) June 30, 2022 81,940 $ 819 $ 170,251 $ ( 15,140 ) $ ( 22,151 ) $ 133,779 See notes to unaudited condensed consolidated financial statements. 6 PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Six Months Ended June 30, 2022 2021 Operating activities Net (loss) income $ ( 286,675 ) $ 30,674 Adjustments to reconcile net (loss) income to cash (used in) provided by operating activities Stock-based compensation 59,527 60,788 Deferred income taxes 169,105 ( 28,232 ) Loss (gain) on capped call transactions 49,505 ( 7,192 ) Amortization of deferred commissions 28,155 21,202 Lease expense 7,832 5,792 Amortization of intangible assets and depreciation 8,175 15,504 Foreign currency transaction (gain) loss ( 4,589 ) 5,501 Other non-cash ( 3,479 ) 3,543 Change in operating assets and liabilities, net ( 32,625 ) ( 88,170 ) Cash (used in) provided by operating activities ( 5,069 ) 19,410 Investing activities Purchases of investments ( 38,489 ) ( 51,601 ) Proceeds from maturities and called investments 34,912 68,798 Sales of investments 14,839 2,450 Payments for acquisitions, net of cash acquired ( 922 ) ( 4,993 ) Investment in property and equipment ( 11,863 ) ( 4,161 ) Cash (used in) provided by investing activities ( 1,523 ) 10,493 Financing activities Proceeds from employee stock purchase plan 4,803 5,146 Dividend payments to stockholders ( 4,908 ) ( 4,865 ) Common stock repurchases ( 41,086 ) ( 60,998 ) Cash (used in) financing activities ( 41,191 ) ( 60,717 ) Effect of exchange rate changes on cash and cash equivalents ( 2,907 ) ( 1,207 ) Net (decrease) in cash and cash equivalents ( 50,690 ) ( 32,021 ) Cash and cash equivalents, beginning of period 159,965 171,899 Cash and cash equivalents, end of period $ 109,275 $ 139,878 See notes to unaudited condensed consolidated financial statements. 7 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. BASIS OF PRESENTATION Pegasystems Inc. (together with its subsidiaries, “the Company”) has prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, they do not include all the information required by accounting principles generally accepted in the United States of America (“U.S.”) for complete financial statements and should be read in conjunction with the Company’s audited financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2021. In the opinion of management, the Company has prepared the accompanying unaudited condensed consolidated financial statements on the same basis as its audited financial statements, and these financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results of the interim periods presented. All intercompany transactions and balances were eliminated in consolidation. The operating results for the interim periods presented do not necessarily indicate the expected results for the full year 2022. Certain prior period amounts reported in our condensed consolidated financial statements and notes thereto have been reclassified to conform to the current year’s presentation. Such reclassifications did not affect total revenues, operating income, or net income. NOTE 2. MARKETABLE SECURITIES June 30, 2022 December 31, 2021 (in thousands) Amortized Cost Unrealized Gains Unrealized Losses Fair Value Amortized Cost Unrealized Gains Unrealized Losses Fair Value Government debt $ 2,989 $ — $ ( 60 ) $ 2,929 $ 2,000 $ — $ ( 10 ) $ 1,990 Corporate debt 188,350 — ( 3,666 ) 184,684 201,659 2 ( 837 ) 200,824 $ 191,339 $ — $ ( 3,726 ) $ 187,613 $ 203,659 $ 2 $ ( 847 ) $ 202,814 As of June 30, 2022, marketable securities’ maturities ranged from July 2022 to November 2024, with a weighted-average remaining maturity of 0.9 years. NOTE 3. RECEIVABLES, CONTRACT ASSETS, AND DEFERRED REVENUE Receivables (in thousands) June 30, 2022 December 31, 2021 Accounts receivable $ 171,556 $ 182,717 Unbilled receivables 201,130 226,714 Long-term unbilled receivables 115,901 129,789 $ 488,587 $ 539,220 Unbilled receivables Unbilled receivables are client-committed amounts for which revenue recognition precedes billing, and billing is solely subject to the passage of time. Unbilled receivables by expected billing date: (Dollars in thousands) June 30, 2022 1 year or less $ 201,130 63 % 1-2 years 78,813 25 % 2-5 years 37,088 12 % $ 317,031 100 % Unbilled receivables by contract effective date: (Dollars in thousands) June 30, 2022 2022 $ 81,887 26 % 2021 142,578 45 % 2020 56,283 18 % 2019 19,928 6 % 2018 and prior 16,355 5 % $ 317,031 100 % 8 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Major clients Clients accounting for 10% or more of the Company’s total receivables: June 30, 2022 December 31, 2021 Client A Accounts receivable * 1 % Unbilled receivables * 15 % Total receivables * 10 % * Client accounted for less than 10% of receivables Contract assets Contract assets are client-committed amounts for which revenue recognized exceeds the amount billed to the client, and billing is subject to conditions other than the passage of time, such as the completion of a related performance obligation. (in thousands) June 30, 2022 December 31, 2021 Contract assets (1) $ 12,149 $ 12,530 Long-term contract assets (2) 12,983 10,643 $ 25,132 $ 23,173 (1) Included in other current assets. (2) Included in other long-term assets. Deferred revenue Deferred revenue consists of billings and payments received in advance of revenue recognition. (in thousands) June 30, 2022 December 31, 2021 Deferred revenue $ 269,121 $ 275,844 Long-term deferred revenue (1) 5,417 5,655 $ 274,538 $ 281,499 (1) Included in other long-term liabilities. The change in deferred revenue in the six months ended June 30, 2022 was primarily due to new billings in advance of revenue recognition offset by $ 205.0 million of revenue recognized during the period that was included in deferred revenue as of December 31, 2021. NOTE 4. DEFERRED COMMISSIONS (in thousands) June 30, 2022 December 31, 2021 Deferred commissions (1) $ 123,067 $ 135,911 (1) Included in other long-term assets. Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2022 2021 2022 2021 Amortization of deferred commissions (1) $ 10,934 $ 9,706 $ 28,155 $ 21,202 (1) Included in selling and marketing expense . 9 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 5. GOODWILL AND OTHER INTANGIBLES Goodwill Change in goodwill: Six Months Ended June 30, (in thousands) 2022 2021 January 1, $ 81,923 $ 79,231 Acquisition — 2,701 Currency translation adjustments ( 206 ) 241 June 30, $ 81,717 $ 82,173 Intangibles Intangible assets are recorded at cost and amortized using the straight-line method over their estimated useful lives. June 30, 2022 (in thousands) Useful Lives Cost Accumulated Amortization Net Book Value (1) Client-related 4 - 10 years $ 63,082 $ ( 57,944 ) $ 5,138 Technology 2 - 10 years 68,064 ( 60,211 ) 7,853 Other 1 - 5 years 5,361 ( 5,361 ) — $ 136,507 $ ( 123,516 ) $ 12,991 (1) Included in other long-term assets. December 31, 2021 (in thousands) Useful Lives Cost Accumulated Amortization Net Book Value (1) Client-related 4 - 10 years $ 63,165 $ ( 57,342 ) $ 5,823 Technology 2 - 10 years 67,142 ( 58,902 ) 8,240 Other 1 - 5 years 5,361 ( 5,361 ) — $ 135,668 $ ( 121,605 ) $ 14,063 (1) Included in other long-term assets. Amortization of intangible assets: Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2022 2021 2022 2021 Cost of revenue $ 683 $ 629 $ 1,312 $ 1,258 Selling and marketing 342 373 685 746 $ 1,025 $ 1,002 $ 1,997 $ 2,004 Future estimated intangibles assets amortization: (in thousands) June 30, 2022 Remainder of 2022 $ 2,098 2023 3,925 2024 3,156 2025 2,611 2026 874 2027 327 $ 12,991 NOTE 6. OTHER ASSETS AND LIABILITIES Other current assets (in thousands) June 30, 2022 December 31, 2021 Income tax receivables $ 22,982 $ 25,691 Contract assets 12,149 12,530 Other 35,502 29,787 $ 70,633 $ 68,008 10 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Other long-term assets (in thousands) June 30, 2022 December 31, 2021 Deferred income taxes $ 6,092 $ 180,656 Deferred commissions 123,067 135,911 Right of use assets 80,646 87,521 Capped call transactions 10,459 59,964 Property and equipment 34,886 26,837 Venture investments 16,073 7,648 Intangible assets 12,991 14,063 Contract assets 12,983 10,643 Other 23,360 18,358 $ 320,557 $ 541,601 Other current liabilities (in thousands) June 30, 2022 December 31, 2021 Operating lease liabilities $ 5,341 $ 6,989 Dividends payable 2,459 2,454 $ 7,800 $ 9,443 Other long-term liabilities (in thousands) June 30, 2022 December 31, 2021 Deferred revenue $ 5,417 $ 5,655 Other 7,404 7,844 $ 12,821 $ 13,499 NOTE 7. LEASES Corporate headquarters In February 2021, the Company agreed to accelerate its exit from its previous corporate headquarters to October 1, 2021, in exchange for a one-time payment from its landlord of $ 18 million, which was amortized over the remaining lease term. The exit accelerated depreciation on the related leasehold improvements and reduced the Company’s future lease liabilities by $ 21.1 million and right of use assets by $ 20.3 million. On March 31, 2021 the Company leased office space at One Main Street, Cambridge, Massachusetts, to serve as its corporate headquarters. The 4.5 year lease includes a base rent of $ 2 million per year. New Waltham Office On July 6, 2021, the Company 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, the Company will receive an improvement allowance from the landlord of up to $ 11.8 million. This lease increased the Company’s lease liabilities and lease-related right of use assets by $ 42.1 million on August 1, 2021. Expense Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2022 2021 2022 2021 Fixed lease costs (1) $ 4,965 $ ( 3,972 ) $ 10,059 $ ( 3,672 ) Short-term lease costs 787 515 1,594 974 Variable lease costs 727 1,340 1,491 2,727 $ 6,479 $ ( 2,117 ) $ 13,144 $ 29 (1) The lower fixed lease costs in the six months ended June 30, 2021 was due to the modification of the corporate headquarters lease. 11 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Right of use assets and lease liabilities (in thousands) June 30, 2022 December 31, 2021 Right of use assets (1) $ 80,646 $ 87,521 Operating lease liabilities (2) $ 5,341 $ 6,989 Long-term operating lease liabilities $ 84,170 $ 87,818 (1) Represents the Company’s right to use the leased asset during the lease term. Included in other long-term assets. (2) Included in other current liabilities. Weighted-average remaining lease term and discount rate for the Company’s leases were: June 30, 2022 December 31, 2021 Weighted-average remaining lease term 7.5 years 7.7 years Weighted-average discount rate (1) 4.2 % 4.4 % (1) The rates implicit in most of the Company’s leases are not readily determinable. Therefore, the Company uses its incremental borrowing rate as the discount rate when measuring operating lease liabilities. The incremental borrowing rate represents an estimate of the interest rate the Company would incur to borrow an amount equal to the lease payments on a collateralized basis over the lease term in a similar economic environment. Maturities of lease liabilities: (in thousands) June 30, 2022 Remainder of 2022 $ ( 401 ) 2023 18,837 2024 16,290 2025 14,118 2026 10,507 2027 and thereafter 47,910 Total lease payments 107,261 Less: imputed interest (1) ( 17,750 ) $ 89,511 (1) Lease liabilities are measured at the present value of the remaining lease payments using a discount rate determined at lease commencement unless the discount rate is updated due to a lease reassessment event. Cash flow information Six Months Ended June 30, (in thousands) 2022 2021 Cash paid for leases $ 7,296 $ 11,605 Right of use assets recognized for new leases and amendments (non-cash) $ 2,223 $ 10,160 NOTE 8. DEBT Convertible senior notes and capped calls Convertible senior notes In February 2020, the Company issued Convertible Senior Notes (the "Notes") with an aggregate principal of $ 600 million, due March 1, 2025, in a private placement. No principal payments are due before maturity. The Notes accrue interest at an annual rate of 0.75 %, payable semi-annually in arrears on March 1 and September 1, beginning on September 1, 2020. Conversion rights The conversion rate is 7.4045 shares of common stock per $ 1,000 principal amount of the Notes, representing an initial conversion price of $ 135.05 per share of common stock. The Company will settle conversions by paying or delivering cash, shares of its common stock, or a combination of cash and shares of its common stock, at the Company’s election, based on the applicable conversion rate. The conversion rate will be adjusted upon certain events, including spin-offs, tender offers, exchange offers, and certain stockholder distributions. Beginning on September 1, 2024, noteholders may convert their Notes at any time at their election. Before September 1, 2024, noteholders may convert their Notes in the following circumstances: • During any calendar quarter beginning after June 30, 2020 (and only during such calendar quarter), if the last reported sale price per share of the Company’s common stock exceeds 130 % of the conversion price for each of at least 20 trading days (whether or not consecutive) during the 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter. 12 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) • During the five consecutive business days immediately after any five consecutive trading day period (the “Measurement Period”), if the trading price per $1,000 principal amount of Notes for each trading day of the Measurement Period was less than 98 % of the product of the last reported sale price per share of common stock on such trading day and the conversion rate on such trading day. • Upon certain corporate events or distributions or if the Company calls any Notes for redemption, noteholders may convert before the close of business on the business day immediately before the related redemption date (or, if the Company fails to pay the redemption price in full on the redemption date, until the Company pays the redemption price). As of June 30, 2022, the Notes were not eligible for conversion. Repurchase rights On or after March 1, 2023 and on or before the 40th scheduled trading day immediately before the maturity date, the Company may redeem for cash all or part of the Notes at a repurchase price equal to 100 % of the principal amount, plus accrued and unpaid interest, if the last reported sale price of the Company’s common stock exceeded 130 % of the conversion price then in effect for at least 20 trading days (whether or not consecutive) during any 30 consecutive trading day period ending on, and including, the trading day immediately preceding the date on which the Company provides a redemption notice. If certain corporate events that constitute a “Fundamental Change” occur, each noteholder will have the right to require the Company to repurchase for cash all of such noteholder’s Notes, or any portion of the principal thereof that is equal to $1,000 or a multiple of $1,000, at a repurchase price equal to 100 % of the principal amount thereof, plus accrued and unpaid interest. A Fundamental Change relates to mergers, changes in control of the Company, liquidation/dissolution of the Company, or the delisting of the Company’s common stock. Carrying value of the Notes: (in thousands) June 30, 2022 December 31, 2021 Principal $ 600,000 $ 600,000 Unamortized issuance costs ( 7,839 ) ( 9,278 ) Convertible senior notes, net $ 592,161 $ 590,722 Interest expense related to the Notes: Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2022 2021 2022 2021 Contractual interest expense ( 0.75 % coupon) $ 1,125 $ 1,125 $ 2,250 $ 2,250 Amortization of issuance costs 720 675 1,439 1,348 $ 1,845 $ 1,800 $ 3,689 $ 3,598 The effective interest rate for the Notes: Six Months Ended June 30, 2022 2021 Weighted-average effective interest rate 1.2 % 1.2 % Future payments of principal and contractual interest: June 30, 2022 (in thousands) Principal Interest Total Remainder of 2022 $ — $ 2,250 $ 2,250 2023 — 4,500 4,500 2024 — 4,500 4,500 2025 600,000 2,250 602,250 $ 600,000 $ 13,500 $ 613,500 Capped call transactions In February 2020, the Company entered into privately negotiated capped call transactions (the “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 the Company’s common stock. The Capped Call Transactions are expected to reduce common stock dilution and/or offset any potential cash payments the Company must make, other than for principal and interest, upon conversion of the Notes, with such reduction and/or offset subject to a cap of $ 196.44 . The cap price of the Capped Call Transactions is subject to adjustment upon specified extraordinary events affecting the Company, including mergers and tender offers. 13 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) The Capped Call Transactions are accounted for as derivative instruments and do not qualify for the Company’s own equity scope exception in ASC 815 since, in some cases of early settlement, the settlement value of the Capped Call Transactions, calculated following the governing documents, may not represent a fair value measurement. The Capped Call Transactions are classified as other long-term assets and remeasured to fair value each reporting period, resulting in a non-operating gain or loss. Change in capped call transactions: Six Months Ended June 30, (in thousands) 2022 2021 January 1, $ 59,964 $ 83,597 Fair value adjustment ( 49,505 ) 7,192 June 30, $ 10,459 $ 90,789 Credit facility In November 2019, and as since amended, the Company entered into a five-year $ 100 million senior secured revolving credit agreement (the “Credit Facility”) with PNC Bank, National Association. The Company may use borrowings for general corporate purposes and to finance working capital needs. Subject to specific conditions, the Credit Facility allows the Company to increase the aggregate commitment to $ 200 million. The commitments expire on November 4, 2024, and any outstanding loans will be payable on such date. The Credit Facility, as amended, contains customary covenants, including, but not limited to, those relating to additional indebtedness, liens, asset divestitures, and affiliate transactions. The Company is required to comply with financial covenants, including: • Beginning with the fiscal quarter ended March 31, 2022 and ending with the fiscal quarter ended December 31, 2022, Pegasystems Inc. must maintain at least $ 200 million in cash, investments, and availability under the Revolving Credit Loan. • Beginning with the quarter ended March 31, 2023, a maximum net consolidated leverage ratio of 3.5 to 1.0 (with a step-up for certain acquisitions) and a minimum consolidated interest coverage ratio of 3.5 to 1.0. As of June 30, 2022 and December 31, 2021, the Company had no outstanding borrowings under the Credit Facility. NOTE 9. FAIR VALUE MEASUREMENTS Assets and liabilities measured at fair value on a recurring basis The Company records its cash equivalents, marketable securities, Capped Call Transactions, and venture investments at fair value on a recurring basis. Fair value is an exit price, representing the amount that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants based on assumptions that market participants would use in pricing an asset or liability. As a basis for classifying the fair value measurements, a three-tier fair value hierarchy, which classifies the fair value measurements based on the inputs used in measuring fair value, was established as follows: • Level 1 - observable inputs such as quoted prices in active markets for identical assets or liabilities; • Level 2 - significant other inputs that are observable either directly or indirectly; and • Level 3 - significant unobservable inputs on which there is little or no market data, which require the Company to develop its own assumptions. This hierarchy requires the Company to use observable market data, when available, and minimize unobservable inputs when determining fair value. 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 model uses various market-based inputs, including stock price, remaining contractual term, expected volatility, risk-free interest rate, and expected dividend yield. The Company applies judgment when determining expected volatility. The Company considers both historical and implied volatility levels of the underlying equity security. The Company’s venture investments are recorded at fair value based on multiple valuation methods, including observable public companies and transaction prices and unobservable inputs, including the volatility, rights, and obligations of the securities the Company holds. Assets and liabilities measured at fair value on a recurring basis: June 30, 2022 December 31, 2021 (in thousands) Level 1 Level 2 Level 3 Total Level 1 Level 2 Level 3 Total Cash equivalents $ 1,127 $ — $ — $ 1,127 $ 3,216 $ — $ — $ 3,216 Marketable securities $ — $ 187,613 $ — $ 187,613 $ — $ 202,814 $ — $ 202,814 Capped Call Transactions (1) $ — $ 10,459 $ — $ 10,459 $ — $ 59,964 $ — $ 59,964 Venture investments (1) (2) $ — $ — $ 16,073 $ 16,073 $ — $ — $ 7,648 $ 7,648 (1) Included in other long-term assets. (2) Investments in privately-held companies. 14 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Changes in venture investments: Six Months Ended June 30, (in thousands) 2022 2021 January 1, $ 7,648 $ 8,345 New investments 400 500 Sales of investments ( 165 ) ( 400 ) Changes in foreign exchange rates ( 290 ) 14 Changes in fair value: included in other income 5,978 100 included in other comprehensive income 2,502 1,220 June 30, $ 16,073 $ 9,779 The carrying value of certain other financial instruments, including receivables and accounts payable, approximates fair value due to these items’ short maturity. Fair value of the Notes The Notes’ fair value (including the conversion feature embedded in the Notes) was $ 482.5 million as of June 30, 2022 and $ 642.0 million as of December 31, 2021. The fair value was determined based on the Notes’ quoted price in an over-the-counter market on the last trading day of the reporting period and classified within Level 2 in the fair value hierarchy. NOTE 10. REVENUE Geographic revenue Three Months Ended June 30, Six Months Ended June 30, (Dollars in thousands) 2022 2021 2022 2021 U.S. $ 147,725 54 % $ 189,297 58 % $ 364,997 55 % $ 383,865 60 % Other Americas 16,261 6 % 14,058 4 % 62,012 10 % 25,959 4 % United Kingdom (“U.K.”) 28,831 11 % 32,553 10 % 59,763 9 % 60,765 10 % Europe (excluding U.K.), Middle East, and Africa 45,238 16 % 45,798 14 % 94,374 15 % 97,457 15 % Asia-Pacific 36,282 13 % 43,996 14 % 69,498 11 % 71,155 11 % $ 274,337 100 % $ 325,702 100 % $ 650,644 100 % $ 639,201 100 % Revenue streams Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2022 2021 2022 2021 Perpetual license 2,266 12,596 $ 9,706 $ 18,048 Subscription license 41,600 104,296 179,133 215,805 Revenue recognized at a point in time 43,866 116,892 188,839 233,853 Maintenance 78,326 78,782 158,042 154,343 Pega Cloud 93,506 73,293 183,823 141,151 Consulting 58,639 56,735 119,940 109,854 Revenue recognized over time 230,471 208,810 461,805 405,348 Total revenue $ 274,337 $ 325,702 $ 650,644 $ 639,201 Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2022 2021 2022 2021 Pega Cloud 93,506 73,293 $ 183,823 $ 141,151 Maintenance 78,326 78,782 158,042 154,343 Subscription services 171,832 152,075 341,865 295,494 Subscription license 41,600 104,296 179,133 215,805 Subscription 213,432 256,371 520,998 511,299 Perpetual license 2,266 12,596 9,706 18,048 Consulting 58,639 56,735 119,940 109,854 274,337 325,702 $ 650,644 $ 639,201 15 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) Remaining performance obligations ("Backlog") Expected future revenue from existing non-cancellable contracts: As of June 30, 2022: (Dollars in thousands) Subscription services Subscription license Perpetual license Consulting Total Maintenance Pega Cloud 1 year or less $ 204,974 $ 320,102 $ 46,810 $ 6,681 $ 32,159 $ 610,726 54 % 1- 2 years 57,862 200,135 10,711 4,505 7,919 281,132 25 % 2- 3 years 28,403 96,861 2,126 2,252 2,574 132,216 12 % Greater than 3 years 18,447 81,069 1,680 — 424 101,620 9 % $ 309,686 $ 698,167 $ 61,327 $ 13,438 $ 43,076 $ 1,125,694 100 % As of June 30, 2021: (Dollars in thousands) Subscription services Subscription license Perpetual license Consulting Total Maintenance Pega Cloud 1 year or less $ 214,645 $ 281,793 $ 46,146 $ 6,707 $ 17,863 $ 567,154 56 % 1- 2 years 59,164 194,841 15,708 234 2,675 272,622 26 % 2- 3 years 36,076 88,855 909 — 762 126,602 12 % Greater than 3 years 26,564 37,246 255 — 693 64,758 6 % $ 336,449 $ 602,735 $ 63,018 $ 6,941 $ 21,993 $ 1,031,136 100 % Major clients Clients accounting for 10% or more of the Company’s total revenue: Three Months Ended June 30, Six Months Ended June 30, (Dollars in thousands) 2022 2021 2022 2021 Total revenue $ 274,337 $ 325,702 $ 650,644 $ 639,201 Client A * 13 % * * NOTE 11. STOCK-BASED COMPENSATION Expense Three Months Ended June 30, Six Months Ended June 30, (in thousands) 2022 2021 2022 2021 Cost of revenue $ 6,579 $ 5,849 $ 12,957 $ 11,774 Selling and marketing 12,633 14,748 23,591 28,468 Research and development 7,355 6,343 14,701 13,113 General and administrative 4,733 3,748 8,278 7,433 $ 31,300 $ 30,688 $ 59,527 $ 60,788 Income tax benefit $ ( 543 ) $ ( 6,192 ) $ ( 905 ) $ ( 12,183 ) As of June 30, 2022, the Company had $ 195.7 million of unrecognized stock-based compensation expense, net of estimated forfeitures, which is expected to be recognized over a weighted-average period of 2.1 years. Grants Six Months Ended June 30, 2022 (in thousands) Shares Total Fair Value Restricted stock units 1,237 $ 104,059 Non-qualified stock options 4,351 $ 99,506 16 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) NOTE 12. INCOME TAXES Effective income tax rate Three Months Ended June 30, Six Months Ended June 30, (Dollars in thousands) 2022 2021 2022 2021 Provision for (benefit from) income taxes $ 186,174 $ ( 11,916 ) $ 178,491 $ ( 29,534 ) Effective income tax rate (benefit rate) 165 % ( 2,591 ) % The change in the effective income tax rate (benefit rate) in the six months ended June 30, 2022 was primarily due to the recognition of a $ 191.9 million valuation allowance on the Company’s deferred tax assets. The Company recognizes deferred tax assets to the extent that it believes that these assets are more likely than not to be realized. Future realization of deferred tax assets ultimately depends on sufficient taxable income within the available carryback or carryforward periods. The Company’s deferred tax valuation allowance requires significant judgment and uncertainties, including assumptions about future taxable income based on historical and projected information. On a quarterly basis, the Company reassess the need for a valuation allowance on its existing net deferred tax assets by tax-paying jurisdiction, weighing positive and negative evidence to assess its recoverability. In making such a determination, the Company considers all available and objectively verifiable negative and positive evidence, including future reversals of existing taxable temporary differences, committed contractual backlog (“Backlog”), projected future taxable income inclusive of the impact of enacted legislation, tax-planning strategies, and results of recent operations. The weight given to the potential effect of negative and positive evidence is commensurate with the extent to which it can be objectively verified. As of June 30, 2022, the Company’s Backlog balance was not sufficient to recover our net deferred tax assets. The Backlog balance and other unsettled circumstances, impacting the Company’s operations, reduced the Backlog’s weight as objectively verifiable positive evidence to generate sufficient taxable income to recover its net deferred tax assets. These unsettled circumstances include growing and extended geopolitical turmoil, increasing inflation, and an uncertain global economic outlook. As of June 30, 2022 the combination of the above factors caused the Company to conclude there is no longer sufficient objectively verifiable positive evidence to support that it is more likely than not the Company will generate sufficient future taxable income to recover the Company’s net deferred tax assets. Accordingly, the Company recorded a valuation allowance of $ 191.9 million in income tax expense during the three months ended June 30, 2022. NOTE 13. (LOSS) EARNINGS PER SHARE Basic (loss) earnings per share is calculated using the weighted-average number of common shares outstanding during the period. Diluted (loss) earnings per share is calculated using the weighted-average number of common shares outstanding during the period, plus the dilutive effect of outstanding stock options, RSUs, and convertible senior notes. Calculation of (loss) earnings per share: Three Months Ended June 30, Six Months Ended June 30, (in thousands, except per share amounts) 2022 2021 2022 2021 Net (loss) income $ ( 286,296 ) $ 37,291 $ ( 286,675 ) $ 30,674 Weighted-average common shares outstanding 81,847 81,316 81,764 81,161 (Loss) earnings per share, basic $ ( 3.50 ) $ 0.46 $ ( 3.51 ) $ 0.38 Net (loss) income $ ( 286,296 ) $ 37,291 $ ( 286,675 ) $ 30,674 Interest expense associated with convertible debt instruments, net of tax — 1,351 — — Numerator for diluted EPS $ ( 286,296 ) $ 38,642 $ ( 286,675 ) $ 30,674 Weighted-average effect of dilutive securities: Convertible debt — 4,443 — — Stock options — 3,266 — 3,416 RSUs — 1,295 — 1,429 Effect of dilutive securities — 9,004 — 4,845 Weighted-average common shares outstanding, assuming dilution (1) (2) (3) 81,847 90,320 81,764 86,006 (Loss) earnings per share, diluted $ ( 3.50 ) $ 0.43 $ ( 3.51 ) $ 0.36 Outstanding anti-dilutive stock options and RSUs (4) 3,569 19 3,873 22 (1) In periods of loss, all dilutive securities are excluded as their inclusion would be anti-dilutive. (2) The shares underlying the conversion options in the Company’s Notes are included using the if-converted method, if dilutive in the period. If the outstanding conversion options were fully exercised, the Company would issue an additional approximately 4.4 million shares. 17 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) (3) The Company’s Capped Call Transactions represent the equivalent of approximately 4.4 million shares of the Company’s common stock (representing the number of shares for which the Notes are initially convertible). The Capped Call Transactions are expected to reduce common stock dilution and/or offset any potential cash payments the Company must make, other than for principal and interest, upon conversion of the Notes, with such reduction and/or offset subject to a cap of $ 196.44 . The Capped Call Transactions are excluded from weighted-average common shares outstanding, assuming dilution, in all periods as their effect would be anti-dilutive. (4) Outstanding stock options and RSUs that were anti-dilutive under the treasury stock method in the period were excluded from the computation of diluted (loss) earnings per share. These awards may be dilutive in the future. NOTE 14. COMMITMENTS AND CONTINGENCIES Commitments See "Note 7. Leases" for additional information. Legal Proceedings In addition to the matters below, the Company is, or may become, involved in a variety of claims, demands, suits, investigations, and proceedings that arise from time to time relating to matters incidental to the ordinary course of the Company’s business, including actions concerning contracts, intellectual property, employment, benefits, and securities matters. Regardless of the outcome, legal disputes can have a material effect on the Company because of defense and settlement costs, diversion of management resources, and other factors. In addition, as the Company is a party to ongoing litigation, it is at least reasonably possible that our estimates will change in the near term and the effect may be material. As of June 30, 2022 and December 31, 2021, the Company has no accrued losses for litigation. Pegasystems Inc. v. Appian Corp. & Business Process Management Inc. On July 3, 2019, the Company filed suit in Massachusetts federal court against Appian Corp. (“Appian”) and Business Process Management, Inc. (“BPM”) relating to a BPM “Market Report” that Appian had used to promote itself against the Company. Pegasystems Inc. v. Appian Corp. & Business Process Management Inc., No. 1:19-cv-11461 (D. Mass). On April 15, 2022, each of the parties filed motions for summary judgment with the court . These motions were heard on July 15, 2022 and no decision has been rendered as of the date of this filing . The Company continues to believe the counterclaims brought by Appian against the Company are without merit, and the Company intends to vigorously pursue its claims against Appian and defend against the counterclaims brought against the Company in this matter. The Company is unable to reasonably estimate possible damages or a range of possible damages in this matter given the Company’s belief that the damages claimed by Appian fail to satisfy the required legal standard, the status of the proceeding, and due to the uncertainty as to how a jury may rule if this ultimately proceeds to trial. Appian Corp. v. Pegasystems Inc. & Youyong Zou As previously reported, the Company is a defendant in litigation brought by Appian in the Circuit Court of Fairfax County, Virginia (the “Court”) titled Appian Corp. v. Pegasystems Inc. & Youyong Zou, No. 2020-07216 (Fairfax Cty. Ct.). On May 9, 2022, the jury rendered its verdict finding that the Company had misappropriated one or more of Appian’s trade secrets, that the Company had violated the Virginia Computer Crimes Act, and that the trade secret misappropriation was willful and malicious. The jury awarded damages in the amount of $ 2,036,860,045 for trade secret misappropriation and $ 1.00 for the violation of the Virginia Computer Crimes Act. Since the jury rendering its verdict, the Company and Appian have filed post-trial motions with the court. On May 26, 2022, the Company filed a motion for judicial investigation of juror misconduct. Appian filed its opposition on June 17, 2022. A hearing on that motion is scheduled for July 28, 2022. On June 8, 2022, the Company filed a motion to set aside the verdict, Appian filed a response with the court on July 8, 2022, and the Company filed a reply to Appian’s filing on July 22, 2022. Also on June 8, 2022, Appian filed a motion for attorneys’ fees and costs and for post-judgment interest, seeking an award of attorneys’ fees in the amount of approximately $ 22.6 million, costs in the amount of approximately $ 4.2 million, and post-judgment interest at the rate of 6 % per annum. The Company filed its opposition to that motion on July 8, 2022. Appian filed a reply brief on July 22, 2022. The Court has not yet set a date for a hearing on the motions filed on June 8, 2022. As of the date of this Quarterly Report on Form 10-Q, the court has not yet ruled on the post-trial motions or entered a judgment in this matter. The Company intends to appeal any judgment against it, if such a judgment is entered. The Company continues to believe that it did not misappropriate any alleged trade secrets and that its sales of the Company’s products at issue were not caused by, or the result of, any alleged misappropriation of trade secrets. The Company is unable to reasonably estimate possible damages because of, among other things, uncertainty as to the outcome of post-trial motions, any appellate proceedings, and/or any potential new trial resulting from the post-trial motions or the appellate proceedings. 18 PEGASYSTEMS INC. NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued) City of Fort Lauderdale Police and Firefighters’ Retirement System, Individually and on Behalf of All Others Similarly Situated v. Pegasystems Inc., Alan Trefler, and Kenneth Stillwell On May 19, 2022, a lawsuit was filed against the Company, the Company’s chief executive officer and the Company’s chief operating and financial officer in the United States District Court for the Eastern District of Virginia Alexandria Division, captioned City of Fort Lauderdale Police and Firefighters’ Retirement System, Individually and on Behalf of All Others Similarly Situated v. Pegasystems Inc., Alan Trefler, and Kenneth Stillwell (Case 1:22-cv-00578-LMB-IDD). The complaint generally alleges, among other things, that the defendants violated Section 10(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and Rule 10b-5 promulgated thereunder and that the individual defendants violated Section 20(a) of the Exchange Act, in each case by allegedly making materially false and/or misleading statements, as well as allegedly failing to disclose material adverse facts about the Company’s business, operations, and prospects, which caused the Company’s securities to trade at artificially inflated prices. The complaint seeks unspecified damages on behalf of a class of purchasers of the Company’s securities between May 29, 2020 and May 9, 2022. The Company believes the claims brought against the defendants are without merit, and intends to vigorously defend against these claims. The Company is unable to reasonably estimate possible damages or a range of possible damages in this matter given the stage of the lawsuit, the Company’s belief that the claims are without merit, and there being no specified quantum of damages sought in the complaint. 19