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 impacts from public health emergencies 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 ongoing litigation with Appian Corp.; • 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, 2022, 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 26, 2023. 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 artificial intelligence-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 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 the specific industry needs of our clients. 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, revenue mix, 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, 2022 for additional information. 20 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. ACV is a performance measure that we believe provides useful information to our management and investors. In 2023, we changed our ACV calculation methodology for maintenance and all contracts less than 12 months to align with other contract types. Previously disclosed ACV amounts have been updated to allow for comparability. Constant currency ACV is calculated by applying the Q1 2022 foreign exchange rates to all periods shown. 21 Remaining performance obligations (“Backlog”) Reconciliation of GAAP Backlog and Constant Currency Backlog (in millions, except percentages) Q1 2023 1 Year Growth Rate Backlog $ 1,308 11 % Impact of changes in foreign exchange rates 28 3 % Backlog - Constant Currency $ 1,336 14 % Constant currency Backlog is calculated by applying the Q1 2022 foreign exchange rates to all periods shown. 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. 22 Free cash flow (1) (in thousands, except percentages) Three Months Ended March 31, 2023 2022 Change Cash provided by operating activities $ 68,107 $ 15,116 351 % Investment in property and equipment (11,487) (6,657) Legal fees 1,515 6,887 Restructuring 14,458 — Interest on convertible senior notes 2,250 2,250 Free cash flow $ 74,843 $ 17,596 325 % Total revenue $ 325,472 $ 376,307 Free cash flow margin 23 % 5 % (1) 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. Our non-GAAP free cash flow measures reflect the following adjustments: • Investment in property and equipment : Investment in property and equipment fluctuates in amount and frequency and is significantly affected by the timing and size of investments in our facilities. We believe excluding these amounts provides a useful comparison of our operational performance in different periods. • Legal fees : Includes legal and related fees arising from proceedings outside of the ordinary course of business. We believe excluding these amounts from our non-GAAP financial measures is useful to investors as the disputes giving rise to them are not representative of our core business operations and ongoing operational performance. • Restructuring : We have excluded restructuring from our non-GAAP financial measures. Restructuring fluctuates in amount and frequency and is significantly affected by the timing and size of our restructuring activities. We believe excluding the impact from our non-GAAP financial measures is useful to investors as these amounts are not representative of our core business operations and ongoing operational performance. • Interest on convertible senior notes : In February 2020, we issued convertible senior notes, due March 1, 2025, in a private placement. We believe excluding the interest payments provides a useful comparison of our operational performance in different periods. 23 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 of America (“U.S.”) and the rules and regulations of the SEC for interim financial reporting. Preparing 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, 2022: • “Critical Accounting Estimates and Significant Judgments” in Item 7; and • “Note 2. Significant Accounting Policies” in Item 8. 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, 2022. 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 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 March 31, Change 2023 2022 Pega Cloud $ 107,879 33 % $ 90,317 24 % $ 17,562 19 % Maintenance 79,630 25 % 79,716 21 % (86) — % Subscription services 187,509 58 % 170,033 45 % 17,476 10 % Subscription license 84,527 26 % 137,533 37 % (53,006) (39) % Subscription 272,036 84 % 307,566 82 % (35,530) (12) % Perpetual license 403 — % 7,440 2 % (7,037) (95) % Consulting 53,033 16 % 61,301 16 % (8,268) (13) % $ 325,472 100 % $ 376,307 100 % $ (50,835) (14) % The revenue changes in the three months ended March 31, 2023 generally reflect the impact of our subscription transition. Other factors impacting our revenue include: • The decrease in subscription license revenue in the three months ended March 31, 2023 was primarily due to several large software license contracts recognized in revenue in the three months ended March 31, 2022. • The decrease in consulting revenue in the three months ended March 31, 2023 was primarily due to a decrease in billable hours and realization rates. Gross profit (Dollars in thousands) Three Months Ended March 31, Change 2023 2022 Pega Cloud $ 77,629 72 % $ 63,418 70 % $ 14,211 22 % Maintenance 73,016 92 % 74,585 94 % (1,569) (2) % Subscription services 150,645 80 % 138,003 81 % 12,642 9 % Subscription license 83,808 99 % 136,911 100 % (53,103) (39) % Subscription 234,453 86 % 274,914 89 % (40,461) (15) % Perpetual license 400 99 % 7,406 100 % (7,006) (95) % Consulting (7,315) (14) % 5,790 9 % (13,105) * $ 227,538 70 % $ 288,110 77 % $ (60,572) (21) % * not meaningful The gross profit percent changes in the three months ended March 31, 2023 were primarily due to a shift in the revenue mix. 24 • The increase in Pega Cloud gross profit percent in the three months ended March 31, 2023 was primarily due to cost-efficiency gains as Pega Cloud continues to grow and scale. • The decrease in maintenance gross profit percent in the three months ended March 31, 2023 was primarily due to an increase in compensation and benefits due to increased headcount. • The decrease in consulting gross profit percent in the three months ended March 31, 2023 was due to a decrease in realization rates and consultant utilization. Operating expenses (Dollars in thousands) Three Months Ended March 31, Change 2023 2022 % of Revenue % of Revenue Selling and marketing $ 149,797 46 % $ 162,236 43 % $ (12,439) (8) % Research and development $ 75,376 23 % $ 71,490 19 % $ 3,886 5 % General and administrative $ 23,110 7 % $ 35,764 10 % $ (12,654) (35) % Restructuring $ 1,461 — $ — — $ 1,461 100 % • The decrease in selling and marketing in the three months ended March 31, 2023 was primarily due to a decrease in compensation and benefits of $12.2 million. • The increase in research and development in the three months ended March 31, 2023 was primarily due to an increase in compensation and benefits of $2.5 million, attributable to increases in headcount and incentive compensation. The increase in headcount reflects additional investments in developing our solutions. • The decrease in general and administrative in the three months ended March 31, 2023 was primarily due to a decrease in legal fees and related expenses arising from litigation proceedings outside the ordinary course of business of $15.9 million. We expect to continue to incur additional costs for these proceedings. See "Note 15. Commitments and Contingencies" in Part I, Item 1 of this Quarterly Report and “Risk Factors” in Part I, Item 1A of our Annual Report for the year ended December 31, 2022. • The increase in restructuring in the three months ended March 31, 2023 was primarily due to an impairment of $1.2 million on our operating lease right of use assets primarily due to the closure of leased office space in Poland. Other income and expenses (Dollars in thousands) Three Months Ended March 31, Change 2023 2022 Foreign currency transaction (loss) gain $ (2,675) $ 2,876 $ (5,551) * Interest income 1,485 207 1,278 617 % Interest expense (1,918) (1,946) 28 1 % Gain (loss) on capped call transactions 3,206 (30,560) 33,766 * Other income, net 6,583 2,741 3,842 140 % $ 6,681 $ (26,682) $ 33,363 * * not meaningful • The decrease in foreign currency transaction (loss) gain in the three months ended March 31, 2023 was 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 increase in interest income in the three months ended March 31, 2023 was primarily due to an increase in market interest rates. • The change in gain (loss) on capped call transactions in the three months ended March 31, 2023 was due to fair value adjustments for our capped call transactions. • The increase in other income, net in the three months ended March 31, 2023 was due to a gain from the repurchase of convertible senior notes and from our venture investments portfolio. 25 Provision for (benefit from) income taxes Three Months Ended March 31, (Dollars in thousands) 2023 2022 Provision for (benefit from) income taxes $ 5,249 $ (7,683) Effective income tax rate (34) % 95 % The effective income tax rate in the three months ended March 31, 2023 was impacted by the valuation allowance on our U.S. and U.K. deferred tax assets and current taxes payable in the U.S. as a result of projecting taxable income that cannot be fully offset by net operating losses and available tax credits. LIQUIDITY AND CAPITAL RESOURCES Three Months Ended March 31, (in thousands) 2023 2022 Cash provided by (used in): Operating activities $ 68,107 $ 15,116 Investing activities (14,413) (6,082) Financing activities (29,372) (35,918) Effect of exchange rate changes on cash, cash equivalents, and restricted cash 782 (310) Net increase (decrease) in cash, cash equivalents, and restricted cash $ 25,104 $ (27,194) (in thousands) March 31, 2023 December 31, 2022 Held by U.S. entities $ 229,214 $ 248,389 Held by foreign entities 94,668 48,832 Total cash, cash equivalents, and marketable securities $ 323,882 $ 297,221 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 external financing if we require additional capital resources. If it becomes necessary or desirable to repatriate foreign funds, we may be required to pay federal, state, and local income and foreign withholding 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. Subscription licenses and services are typically 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 provided by operating activities in the three months ended March 31, 2023 was primarily due to our subscription transition and improved client collections. In addition, in the three months ended March 31, 2023 and 2022, we paid $1.5 million and $6.9 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 costs for these proceedings. See "Note 15. Commitments and Contingencies" in Part I, Item 1 of this Quarterly Report for additional information. Investing activities The change in cash (used in) investing activities in the three months ended March 31, 2023 was primarily driven by an increase in office space-related capital expenditures. 26 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 the three months ended March 31, 2023, we paid $29.9 million to repurchase $33 million in aggregate principal amount of convertible senior notes. As of March 31, 2023, we had $567 million in aggregate principal amount of convertible senior notes outstanding. See "Note 8. Debt" in Part I, Item 1 of this Quarterly Report for additional information. 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 March 31, 2023, we had no outstanding cash borrowings under the Credit Facility but had $27.3 million in outstanding letters of credit which reduces our 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) Three Months Ended March 31, 2023 December 31, 2022 $ 58,075 Authorizations (1) — March 31, 2023 $ 58,075 (1) On April 25, 2023, our Board of Directors extended the expiration date of our current share repurchase program to June 30, 2024, and the amount of stock we are authorized to repurchase has been increased to $60 million. Common stock repurchases Three Months Ended March 31, 2023 2022 (in thousands) Shares Amount Shares Amount Repurchases paid — $ — 242 $ 22,583 Stock repurchase program — — 242 22,583 Tax withholdings for net settlement of equity awards 27 1,107 141 12,128 27 $ 1,107 383 $ 34,711 In the three months ended March 31, 2023 and 2022, instead of receiving cash from the equity holders, we withheld shares with a value of $0.6 million and $6.1 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. Three Months Ended March 31, (in thousands) 2023 2022 Dividend payments to stockholders $ 2,474 $ 2,454 Contractual obligations As of March 31, 2023, our contractual obligations were: Payments due by period (in thousands) Remainder of 2023 2024 2025 2026 2027 2028 and after Other Total Convertible senior notes (1) $ 1,772 $ 4,253 $ 569,126 $ — $ — $ — $ — $ 575,151 Purchase obligations (2) 98,303 117,729 127,367 131,146 133,500 14 — 608,059 Operating lease obligations 14,003 17,642 14,562 10,917 9,863 39,380 — 106,367 Investment commitments 1,000 — — — — — — 1,000 Liability for uncertain tax positions (3) — — — — — — 3,578 3,578 $ 115,078 $ 139,624 $ 711,055 $ 142,063 $ 143,363 $ 39,394 $ 3,578 $ 1,294,155 (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 cannot reasonably estimate the timing of this cash outflow due to uncertainties in the timing of the effective settlement of tax positions. 27