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, intends to, projects, forecasts, guidance, likely, and usually or variations of such words and other similar expressions identify forward-looking statements, which speak only as of the date the statement was made and 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”). Investors are cautioned not to place undue reliance on such forward-looking statements, and there are no assurances that the results included in such statements will be achieved. Although subsequent events may cause our view to change, except as required by applicable law, we do not undertake and expressly disclaim any obligation to publicly update or revise these forward-looking statements whether as the result of new information, future events, or otherwise. The forward-looking statements in this Quarterly Report represent our views as of October 25, 2023. NON-GAAP MEASURES Our non-GAAP financial measures should only be read in conjunction with our consolidated financial statements prepared in accordance with GAAP. We believe that these 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. They are not a substitute for financial measures prepared under U.S. GAAP. A reconciliation of GAAP and non-GAAP measures is located with each non-GAAP measure. 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. 21 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. 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, the Company revised its ACV methodology for maintenance and all contracts less than 12 months as its overall client renewal rate exceeds 90%. The impact of the change was $3 million and 0.3% of Total ACV or less for all quarters in 2022. Previously disclosed ACV amounts have been updated to allow for comparability. This simplification, made possible by improvements to the Company’s financial systems, ensures that ACV for all contract types and lengths is consistently calculated as the total contract value divided by the duration in years. Previously, ACV for maintenance was calculated as the maintenance revenue for the quarter then ended, multiplied by four, and ACV for contracts less than 12 months was equal to the contract’s total value. The Company believes the simplified methodology better represents the current value of its contracts and better aligns its definition with comparable companies. Reconciliation of ACV and Constant Currency ACV (in millions, except percentages) Q3 22 Q3 23 1-Year Change ACV $ 1,040 $ 1,169 12 % Impact of changes in foreign exchange rates — (22) Constant Currency ACV $ 1,040 $ 1,147 10 % Note: Constant currency ACV is calculated by applying the Q3 2022 foreign exchange rates to all periods shown. 22 Cash flow (1) Note: Starting in the third quarter of 2023, the Company has calculated free cash flow as cash provided by (used in) operating activities less investments in property and equipment. To ensure comparability, previously disclosed amounts have been updated. (Dollars in thousands) Nine Months Ended September 30, 2023 2022 Margin (2) Margin (2) Cash provided by (used in) operating activities $ 137,920 14 % $ (13,446) (1) % Investment in property and equipment (14,271) (22,285) Free cash flow $ 123,649 13 % $ (35,731) (4) % Additional information (3) Legal fees $ 5,867 $ 37,944 Restructuring 21,576 — Interest on convertible senior notes 4,134 4,500 Other — 3,266 $ 31,577 $ 45,710 (1) Our non-GAAP free cash flow is defined as cash provided by (used in) operating activities less investment in property and equipment. Investment in property and equipment fluctuates in amount and frequency and are significantly affected by the timing and size of investments in our facilities. We provide information on free cash flow to enable investors to assess our ability to generate cash without incurring additional external financings. This information is not a substitute for financial measures prepared under U.S. GAAP. (2) Operating and Free Cash Flow Margin are calculated by comparing the respective cash flow to Total Revenue. (3) The additional information discloses items that affect our cash flows and are considered by management not to be representative of our core business operations and ongoing operational performance. • Legal fees: Includes legal and related fees arising from proceedings outside the ordinary course of business. • Restructuring : Restructuring fluctuates in amount and frequency and is significantly affected by the timing and size of our restructuring activities. • Interest on convertible senior notes : In February 2020, we issued convertible senior notes, due March 1, 2025, in a private placement. The Notes accrue interest at an annual rate of 0.75%, payable semi-annually in arrears on March 1 and September 1, beginning September 1, 2020. • Other : Includes fees related to capital advisory services, canceled in-person sales and marketing events, and incremental costs incurred integrating acquisitions. 23 Remaining performance obligations (“Backlog”) Reconciliation of Backlog and Constant Currency Backlog (Non-GAAP) (in millions, except percentages) Q3 22 Q3 2023 1-Year Growth Rate Backlog - GAAP $ 1,148 $ 1,265 10 % Impact of changes in foreign exchange rates — (33) Constant currency backlog $ 1,148 $ 1,232 7 % Note: Constant currency Backlog is calculated by applying the Q3 2022 foreign exchange rates to all periods shown. 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. 24 RESULTS OF OPERATIONS Revenue (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2023 2022 2023 2022 Pega Cloud $ 118,040 35 % $ 97,359 36 % $ 20,681 21 % $ 340,982 36 % $ 281,182 31 % $ 59,800 21 % Maintenance 83,538 25 % 77,526 29 % 6,012 8 % 245,210 25 % 235,568 25 % 9,642 4 % Subscription services 201,578 60 % 174,885 65 % 26,693 15 % 586,192 61 % 516,750 56 % 69,442 13 % Subscription license 74,342 22 % 31,112 11 % 43,230 139 % 200,066 21 % 210,245 23 % (10,179) (5) % Subscription 275,920 82 % 205,997 76 % 69,923 34 % 786,258 82 % 726,995 79 % 59,263 8 % Consulting 55,976 17 % 55,511 21 % 465 1 % 167,396 18 % 175,451 19 % (8,055) (5) % Perpetual license 2,747 1 % 9,223 3 % (6,476) (70) % 4,729 — % 18,929 2 % (14,200) (75) % $ 334,643 100 % $ 270,731 100 % $ 63,912 24 % $ 958,383 100 % $ 921,375 100 % $ 37,008 4 % • The increases in Pega Cloud revenue for the three and nine months ended September 30, 2023 were primarily due to the growth of the hosted client base as our clients continued to expand their use of Pega Cloud. • The increases in maintenance revenue in the three and nine months ended September 30, 2023 were primarily due to continued demand for our subscription license offerings which are generally bundled with maintenance. • The increase in subscription license revenue in the three months ended September 30, 2023 was primarily due to increased license deliveries in the three months ended September 30, 2023. The decrease in subscription license revenue in the nine months ended September 30, 2023 was primarily due to several large multi-year contracts recognized in revenue in the nine months ended September 30, 2022. • The decrease in consulting revenue in the nine months ended September 30, 2023 was primarily due to lower consultant realization rates in the Americas. • The decreases in perpetual license revenue in the three and nine months ended September 30, 2023 reflects our strategy of promoting subscription-based arrangements. Gross profit (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2023 2022 2023 2022 Pega Cloud $ 88,553 75 % $ 68,673 71 % $ 19,880 29 % $ 250,943 74 % $ 194,350 69 % $ 56,593 29 % Maintenance 77,119 92 % 71,671 92 % 5,448 8 % 225,696 92 % 219,296 93 % 6,400 3 % Subscription services 165,672 82 % 140,344 80 % 25,328 18 % 476,639 81 % 413,646 80 % 62,993 15 % Subscription license 73,713 99 % 30,484 98 % 43,229 142 % 198,095 99 % 208,322 99 % (10,227) (5) % Subscription 239,385 87 % 170,828 83 % 68,557 40 % 674,734 86 % 621,968 86 % 52,766 8 % Consulting (1,228) (2) % (2,267) (4) % 1,039 46 % (8,866) (5) % 4,289 2 % (13,155) * Perpetual license 2,723 99 % 9,120 99 % (6,397) (70) % 4,678 99 % 18,756 99 % (14,078) (75) % $ 240,880 72 % $ 177,681 66 % $ 63,199 36 % $ 670,546 70 % $ 645,013 70 % $ 25,533 4 % * not meaningful • The increases in Pega Cloud gross profit percent in the three and nine months ended September 30, 2023 were primarily due to increased cost efficiency, particularly for hosting services, as Pega Cloud continues to grow and scale. • The decrease in maintenance gross profit percent in the nine months ended September 30, 2023 was primarily due to an increase in compensation and benefits as a result of increased headcount. • The increase in consulting gross profit percent in the three months ended September 30, 2023 was primarily due to higher consultant utilization in the Americas. The decrease in consulting profit percent in the nine months ended September 30, 2023, was primarily due to lower consultant realization rates in the Americas. 25 Operating expenses (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2023 2022 2023 2022 Selling and marketing $ 131,598 $ 153,517 $ (21,919) (14) % $ 425,253 $ 472,951 $ (47,698) (10) % % of Revenue 39 % 57 % 44 % 51 % Research and development $ 74,955 $ 75,342 $ (387) (1) % $ 224,262 $ 221,173 $ 3,089 1 % % of Revenue 22 % 28 % 23 % 24 % General and administrative $ 27,321 $ 26,043 $ 1,278 5 % $ 73,893 $ 94,530 $ (20,637) (22) % % of Revenue 8 % 10 % 8 % 10 % Restructuring $ 17,822 $ — $ 17,822 100 % $ 21,450 $ — $ 21,450 100 % % of Revenue 5 % — % 2 % — % • The decreases in selling and marketing during the three and nine months ended September 30, 2023 were primarily due to decreases in compensation and benefits of $18.6 million and $45.0 million, respectively. The decreases were due to reduced headcount as we optimize our go-to-market strategy. For additional information, see "Note 9. Restructuring" in Part I, Item 1 of this Quarterly Report. • The increase in research and development for the nine months ended September 30, 2023 was primarily due to additional investments in our products and services. • The changes in general and administrative in the three and nine months ended September 30, 2023 were primarily due to an increase of $2.3 million in the three months ended September 30, 2023 and a decrease of $21.4 million in the nine months ended September 30, 2023 in legal fees and related expenses arising from proceedings outside 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 and “Risk Factors” in Part I, Item 1A of our Annual Report for the year ended December 31, 2022 for additional information. • The increases in restructuring expenses during the three and nine months ended September 30, 2023 were primarily due to our efforts to optimize our go-to-market organization. For additional information, see "Note 9. Restructuring" in Part I, Item 1 of this Quarterly Report. Other income and expenses (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2023 2022 2023 2022 Foreign currency transaction gain (loss) $ 1,994 $ 3,826 $ (1,832) (48) % $ (3,971) $ 8,415 $ (12,386) * Interest income 2,532 520 2,012 387 % 5,831 1,036 4,795 463 % Interest expense (1,533) (1,992) 459 23 % (5,229) (5,882) 653 11 % (Loss) on capped call transactions (2,294) (6,876) 4,582 67 % (449) (56,381) 55,932 99 % Other income (loss), net 6,383 (29) 6,412 * 18,668 6,497 12,171 187 % $ 7,082 $ (4,551) $ 11,633 * $ 14,850 $ (46,315) $ 61,165 * * not meaningful • The changes in foreign currency transaction gain (loss) in the three and nine months ended September 30, 2023 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, 2023 were primarily due to increases in market interest rates. • The decreases in interest expense in the three and nine months ended September 30, 2023 were due to our repurchases of Convertible Senior Notes in the nine months ended September 30, 2023. For additional information, see "Note 8. Debt" in Part I, Item 1 of this Quarterly Report. • The changes in (loss) on capped call transactions in the three and nine months ended September 30, 2023 were due to fair value adjustments for our capped call transactions. • The increase in other income (loss), net in the three months ended September 30, 2023 was due to a $6.4 million increase in the value of equity securities held in our venture investments portfolio. The increase in other income (loss), net in the nine months ended September 30, 2023, was due to a $7.9 million gain from repurchases of our convertible senior notes and a $10.9 million increase in the value of equity securities held in our venture investments portfolio. For additional information, see “Note 8. Debt” and "Note 10. Fair Value Measurements" in Part I, Item 1 of this Quarterly Report. 26 Provision for income taxes Nine Months Ended September 30, (Dollars in thousands) 2023 2022 Provision for income taxes $ 15,395 $ 190,239 Effective income tax rate (26) % (100) % The effective income tax rate in the nine months ended September 30, 2023 was primarily driven by the valuation allowance on our deferred tax assets in the U.S. and U.K. and projected taxable income in the U.S., partially offset by available tax credits and losses in the U.S. LIQUIDITY AND CAPITAL RESOURCES Nine Months Ended September 30, (in thousands) 2023 2022 Cash provided by (used in): Operating activities $ 137,920 $ (13,446) Investing activities (24,176) 10,104 Financing activities (85,031) (43,484) Effect of exchange rate changes on cash, cash equivalents, and restricted cash (1,621) (5,513) Net increase (decrease) in cash, cash equivalents, and restricted cash $ 27,092 $ (52,339) (in thousands) September 30, 2023 December 31, 2022 Held by U.S. entities $ 217,735 $ 248,389 Held by foreign entities 118,574 48,832 Total cash, cash equivalents, and marketable securities $ 336,309 $ 297,221 We believe that our current cash, cash flow provided by 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 have to pay federal, state, and local income taxes as well as foreign withholding taxes upon repatriation. However, estimating the taxes we would have to pay is impracticable due to the complexity of income tax laws and regulations. Operating activities The change in cash provided by (used in) operating activities in the nine months ended September 30, 2023 was primarily due to growth in client collections, the impact of our cost-efficiency initiatives, and lower legal fees and related costs arising from proceedings outside the ordinary course of business. We expect to continue to incur additional costs for these proceedings. For additional information, see “Note 9. Restructuring” and "Note 15. Commitments and Contingencies" in Part I, Item 1 of this Quarterly Report. Investing activities The change in cash (used in) provided by investing activities in the nine months ended September 30, 2023 was primarily due to our investments in financial instruments and reduced investment in property and equipment as we optimize our office space. 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 nine months ended September 30, 2023, we paid $89 million to repurchase $97.7 million in aggregate principal amount of convertible senior notes. As of September 30, 2023, we had $502 million in aggregate principal amount of convertible senior notes outstanding due on March 1, 2025. For additional information, see "Note 8. Debt" in Part I, Item 1 of this Quarterly Report. 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, 2023 and December 31, 2022, we had $27.3 million in outstanding letters of credit, which reduced the Company’s available borrowing capacity under the Credit Facility and no outstanding cash borrowings under the Credit Facility. For additional information, see "Note 8. Debt" in Part I, Item 1 of this Quarterly Report. 27 Stock repurchase program Changes in the remaining stock repurchase authority: (in thousands) Nine Months Ended September 30, 2023 December 31, 2022 $ 58,075 Authorizations (1) 1,925 September 30, 2023 $ 60,000 (1) On April 25, 2023, our Board of Directors extended the expiration date of our current share repurchase program from June 30, 2023 to June 30, 2024, and the amount of stock we are authorized to repurchase was increased to $60 million. Common stock repurchases Nine Months Ended September 30, 2023 2022 (in thousands) Shares Amount Shares Amount Stock repurchase program — — 279 24,508 Tax withholdings for net settlement of equity awards 39 1,654 253 17,575 39 $ 1,654 532 $ 42,083 In the nine months ended September 30, 2023 and 2022, instead of receiving cash from the equity holders, we withheld shares with a value of $1.0 million and $11.5 million, respectively, for the exercise price of options. These amounts are not included in the table above. Dividends We intend to pay a quarterly cash dividend of $0.03 per share. However, the Board of Directors may terminate or modify the dividend program without prior notice. Nine Months Ended September 30, (in thousands) 2023 2022 Dividend payments to stockholders $ 7,458 $ 7,368 Contractual obligations As of September 30, 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) $ — $ 3,767 $ 504,154 $ — $ — $ — $ — $ 507,921 Purchase obligations (2) 43,491 134,122 126,065 120,745 134,060 177 — 558,660 Operating lease obligations 4,775 17,976 14,870 10,853 9,808 39,299 — 97,581 Venture investment commitments (3) 500 500 — — — — — 1,000 Liability for uncertain tax positions (4) — — — — — — 2,017 2,017 $ 48,766 $ 156,365 $ 645,089 $ 131,598 $ 143,868 $ 39,476 $ 2,017 $ 1,167,179 (1) Includes principal and interest. (2) Represents the fixed amount owed for purchase obligations of software licenses, hosting services, and sales and marketing programs. (3) Represents the maximum funding under existing venture investment agreements. Our venture investment agreements generally allow us to withhold unpaid funds at our discretion. (4) We cannot reasonably estimate the timing of this cash outflow due to uncertainties in the timing of the effective settlement of tax positions.