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, intellectual property rights claims and other related claims by third parties against us, including related costs, damages, and other relief that may be granted against us; • 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 October 26, 2022. BUSINESS OVERVIEW We develop, market, license, host, and support enterprise software that helps organizations build agility into their business so they can adapt to change. 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 2000 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 operating results 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. 21 Coronavirus (“COVID-19”) As of September 30, 2022, COVID-19 has not had a material impact on our results of operations or financial condition. See “ Actual or threatened public health emergencies could harm our business ” 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 and 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”) 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. 22 Remaining performance obligations (“Backlog”) Reconciliation of GAAP Backlog and Constant Currency Backlog (in millions, except percentages) Q3 2022 1 Year Growth Rate Backlog $ 1,148 11 % Impact of changes in foreign exchange rates 74 7 % Backlog - Constant Currency $ 1,222 18 % Note: Constant currency measures are calculated by applying foreign exchange rates for the earliest period shown to all periods. The above constant currency measures reflect foreign exchange rates applicable as of Q3 2021. We believe that non-GAAP financial measures help investors understand our core operating results and prospects, consistent with how management measures and forecasts our performance without the effect of often one-time charges and other items outside our normal operations. The supplementary non-GAAP financial measures are not meant to be superior to or a substitute for financial measures prepared under U.S. GAAP. 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. We recorded a valuation allowance of $191.9 million in income tax expense during the three months ended June 30, 2022. See "Note 12. Income Taxes" in Part I, Item 1 of this Quarterly Report for additional information. There have been no other significant changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2021. 23 RESULTS OF OPERATIONS Revenue Subscription transition We are transitioning our business to sell software primarily through subscription arrangements. This transition has impacted the optics of revenue growth as revenue from subscription service arrangements, which includes Pega Cloud and maintenance, 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 2022 2021 2022 2021 Pega Cloud $ 97,359 36 % $ 78,369 31 % $ 18,990 24 % $ 281,182 31 % $ 219,520 25 % $ 61,662 28 % Maintenance 77,526 29 % 83,188 32 % (5,662) (7) % 235,568 25 % 237,531 26 % (1,963) (1) % Subscription services 174,885 65 % 161,557 63 % 13,328 8 % 516,750 56 % 457,051 51 % 59,699 13 % Subscription license 31,112 11 % 35,421 14 % (4,309) (12) % 210,245 23 % 251,226 28 % (40,981) (16) % Subscription 205,997 76 % 196,978 77 % 9,019 5 % 726,995 79 % 708,277 79 % 18,718 3 % Perpetual license 9,223 3 % 2,874 1 % 6,349 221 % 18,929 2 % 20,922 2 % (1,993) (10) % Consulting 55,511 21 % 56,416 22 % (905) (2) % 175,451 19 % 166,270 19 % 9,181 6 % $ 270,731 100 % $ 256,268 100 % $ 14,463 6 % $ 921,375 100 % $ 895,469 100 % $ 25,906 3 % The revenue changes in the three and nine months ended September 30, 2022 generally reflect the impact of our subscription transition. Other factors impacting our revenue include: • The United States Dollar has strengthened against foreign currencies in the markets we operate, which reduced total revenue growth in the three and nine months ended September 30, 2022 by approximately 5 percent. • The decreases in subscription license revenue in the three and nine months ended September 30, 2022 were primarily due to several large software license contracts recognized in revenue in the three and nine months ended September 30, 2021. • The decreases in maintenance revenue in the three and nine months ended September 30, 2022 were primarily due to changes in foreign currency exchange rates and the continuing shift to Pega Cloud. • The increase in consulting revenue in the nine months ended September 30, 2022 was primarily due to an increase in consultant billable hours in North America. Gross profit (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2022 2021 2022 2021 Pega Cloud $ 68,673 71 % $ 52,845 67 % $ 15,828 30 % $ 194,350 69 % $ 147,388 67 % $ 46,962 32 % Maintenance 71,671 92 % 77,895 94 % (6,224) (8) % 219,296 93 % 221,457 93 % (2,161) (1) % Subscription services 140,344 80 % 130,740 81 % 9,604 7 % 413,646 80 % 368,845 81 % 44,801 12 % Subscription license 30,484 98 % 34,815 98 % (4,331) (12) % 208,322 99 % 249,415 99 % (41,093) (16) % Subscription 170,828 83 % 165,555 84 % 5,273 3 % 621,968 86 % 618,260 87 % 3,708 1 % Perpetual license 9,120 99 % 2,824 98 % 6,296 223 % 18,756 99 % 20,771 99 % (2,015) (10) % Consulting (2,267) (4) % 3,667 6 % (5,934) * 4,289 2 % 5,238 3 % (949) (18) % $ 177,681 66 % $ 172,046 67 % $ 5,635 3 % $ 645,013 70 % $ 644,269 72 % $ 744 — % * not meaningful The gross profit percent changes in the three and nine months ended September 30, 2022 were primarily due to a shift in the revenue mix. • The increases in Pega Cloud gross profit percent in the three and nine months ended September 30, 2022 were primarily due to cost-efficiency gains as Pega Cloud grows and scales. • The decrease in Maintenance gross profit percent in the three months ended September 30, 2022 was primarily due to a decrease in maintenance revenue. • The decreases in consulting gross profit percent in the three and nine months ended September 30, 2022 were due to increases in consultant availability. 24 Operating expenses (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2022 2021 2022 2021 % of Revenue % of Revenue % of Revenue % of Revenue Selling and marketing $ 153,517 57 % $ 152,479 59 % $ 1,038 1 % $ 472,951 51 % $ 457,641 51 % $ 15,310 3 % Research and development $ 75,342 28 % $ 64,728 25 % $ 10,614 16 % $ 221,173 24 % $ 191,565 21 % $ 29,608 15 % General and administrative $ 26,043 10 % $ 20,176 8 % $ 5,867 29 % $ 94,530 10 % $ 57,607 6 % $ 36,923 64 % • The increase in selling and marketing in the nine months ended September 30, 2022 was primarily due to an increase in employee travel and entertainment and marketing events of $10.7 million. • The increases in research and development in the three and nine months ended September 30, 2022 were primarily due to increases in compensation and benefits of $7.5 million and $19.6 million, attributable to increases in headcount and incentive compensation. The increases in headcount reflects additional investments in developing our solutions. • The increases in general and administrative in the three and nine months ended September 30, 2022 were primarily due to increases in compensation and benefits of $2.9 million and $5.7 million, facilities expenses of $1.1 million and $2.8 million, and legal fees and related expenses arising from litigation proceedings outside the ordinary course of business of $0.4 million and $24.0 million. 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. Other income and expenses (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2022 2021 2022 2021 Foreign currency transaction gain (loss) $ 3,826 $ 518 $ 3,308 639 % $ 8,415 $ (4,983) $ 13,398 * Interest income 520 166 354 213 % 1,036 555 481 87 % Interest expense (1,992) (1,908) (84) (4) % (5,882) (5,747) (135) (2) % (Loss) on capped call transactions (6,876) (14,735) 7,859 53 % (56,381) (7,543) (48,838) (647) % Other (loss) income, net (29) 2 (31) * 6,497 108 6,389 5,916 % $ (4,551) $ (15,957) $ 11,406 71 % $ (46,315) $ (17,610) $ (28,705) (163) % * not meaningful • The increases in foreign currency transaction gain (loss) in the three and nine months ended September 30, 2022 were primarily due to the impact of fluctuations in foreign currency exchange rates associated with foreign currency-denominated cash and receivables held by our subsidiary in the United Kingdom. • The increases in interest income in the three and nine months ended September 30, 2022 were primarily due to increases in market interest rates. • The changes in (loss) on capped call transactions in the three and nine months ended September 30, 2022 were 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 (loss) income, net in the nine months ended September 30, 2022 was due to gains on our venture investments portfolio. Provision for (benefit from) income taxes Three Months Ended September 30, Nine Months Ended September 30, (Dollars in thousands) 2022 2021 2022 2021 Provision for (benefit from) income taxes $ 11,748 $ (24,826) $ 190,239 $ (54,360) Effective income tax rate (benefit rate) 100 % (68) % During the nine months ended September 30, 2022, the change in our effective income tax rate (benefit rate) was primarily due to the recognition of a $191.9 million valuation allowance recognized at June 30, 2022, on our U.S. and U.K deferred tax assets. As a result of recording the valuation allowance, we are no longer recording any income tax benefit on our U.S and U.K losses. The $11.7 million provision for (benefit from) income taxes for the three months ended September 30, 2022 primarily represents non-U.K. foreign income taxes. 25 LIQUIDITY AND CAPITAL RESOURCES Nine Months Ended September 30, (in thousands) 2022 2021 Cash provided by (used in): Operating activities $ (13,446) $ (5,321) Investing activities 10,104 42,730 Financing activities (43,484) (91,431) Effect of exchange rates on cash and cash equivalents (5,513) (1,466) Net (decrease) in cash and cash equivalents $ (52,339) $ (55,488) (in thousands) September 30, 2022 December 31, 2021 Held by U.S. entities $ 226,640 $ 274,813 Held by foreign entities 49,071 87,966 Total cash, cash equivalents, and marketable securities $ 275,711 $ 362,779 We believe that our current cash, cash flow from operations, borrowing capacity, and ability to engage in capital market transactions 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. 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 subscription licenses and services 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. The change in cash (used in) operating activities in the nine months ended September 30, 2022 was primarily due to our subscription transition and increased costs as we made investments in research and development to support development of our offerings partially offset by strong client collections. In addition, in the nine months ended September 30, 2022 and 2021, we incurred $32.4 million and $8.4 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 provided by investing activities in the nine months ended September 30, 2022 was primarily driven by our investments in financial instruments and an increase 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 since amended, we entered into a five-year $100 million senior secured revolving credit agreement (the “Credit Facility”) with PNC Bank, National Association. As of September 30, 2022, we had no outstanding cash borrowings under the Credit Facility but had $27.3 million in outstanding letters of credit which reduce the available borrowing capacity. 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) Nine Months Ended September 30, 2022 December 31, 2021 $ 22,583 Authorizations (1) 60,000 Repurchases (2) (24,508) September 30, 2022 $ 58,075 (1) On June 2, 2022, we announced that our Board of Directors extended the current stock repurchase program’s expiration date to June 30, 2023. (2) All purchases under this program have been made on the open market. 26 Common stock repurchases Nine Months Ended September 30, 2022 2021 (in thousands) Shares Amount Shares Amount Repurchases paid 279 $ 24,508 245 $ 31,788 Repurchases unpaid at period end — — 3 400 Stock repurchase program 279 24,508 248 32,188 Tax withholdings for net settlement of equity awards 253 17,575 462 59,819 532 $ 42,083 710 $ 92,007 During the nine months ended September 30, 2022 and 2021, instead of receiving cash from the equity holders, we withheld shares with a value of $11.5 million and $47.1 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 without prior notice. Nine Months Ended September 30, (in thousands) 2022 2021 Dividend payments to stockholders $ 7,368 $ 7,310 Contractual obligations As of September 30, 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) $ — $ 4,500 $ 4,500 $ 602,250 $ — $ — $ — $ 611,250 Purchase obligations (2) 7,925 14,802 15,479 17,594 14,492 14 — 70,306 Operating lease obligations (4,717) 18,804 16,841 14,778 11,257 48,397 — 105,360 Liability for uncertain tax positions (3) — — — — — — 1,242 1,242 $ 3,208 $ 38,106 $ 36,820 $ 634,622 $ 25,749 $ 48,411 $ 1,242 $ 788,158 (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.