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. These statements represent our views 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; • variation in demand for our products and services, including among clients in the public sector; • reliance on key personnel; • 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, 2023, 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 April 24, 2024. 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, which is 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 artificial intelligence (“AI”) 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 our clients’ specific industry. 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. Reconciliation of ACV and constant currency ACV (in millions, except percentages) March 31, 2023 March 31, 2024 1-Year Change ACV $ 1,174 $ 1,273 9 % Impact of changes in foreign exchange rates — 4 Constant currency ACV $ 1,174 $ 1,277 9 % Note: Constant currency ACV is calculated by applying the March 31, 2023 foreign exchange rates to all periods shown. 21 Cash flow (1) (Dollars in thousands) Three Months Ended March 31, 2024 2023 Cash provided by operating activities $ 180,146 $ 68,107 Investment in property and equipment (604) (11,487) Free cash flow (1) $ 179,542 $ 56,620 Supplemental information (2) Restructuring $ 3,347 $ 14,458 Legal fees 2,739 1,515 Interest on convertible senior notes 1,884 2,250 Income taxes 8,163 2,825 $ 16,133 $ 21,048 (1) Our non-GAAP free cash flow is defined as cash provided by operating activities less 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 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) The supplemental 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. ▪ Restructuring : Restructuring fluctuates in amount and frequency and is significantly affected by the timing and size of our restructuring activities. ▪ Legal fees: Legal and related fees arising from proceedings outside the ordinary course of business. ▪ 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. ▪ Income taxes : Direct income taxes paid net of refunds received. 22 Remaining performance obligations (“Backlog”) Reconciliation of Backlog and Constant Currency Backlog (Non-GAAP) (in millions, except percentages) March 31, 2023 March 31, 2024 1-Year Growth Rate Backlog - GAAP $ 1,308 $ 1,425 9 % Impact of changes in foreign exchange rates — 4 Constant currency backlog $ 1,308 $ 1,429 9 % Note: Constant currency Backlog is calculated by applying the Q1 2023 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, 2023: • “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, 2023. 23 RESULTS OF OPERATIONS Revenue (Dollars in thousands) Three Months Ended March 31, Change 2024 2023 Pega Cloud $ 130,902 40 % $ 107,879 33 % $ 23,023 21 % Maintenance 81,001 24 % 79,630 25 % 1,371 2 % Subscription services 211,903 64 % 187,509 58 % 24,394 13 % Subscription license 63,338 19 % 84,527 26 % (21,189) (25) % Subscription 275,241 83 % 272,036 84 % 3,205 1 % Consulting 54,047 17 % 53,033 16 % 1,014 2 % Perpetual license 859 — % 403 — % 456 113 % $ 330,147 100 % $ 325,472 100 % $ 4,675 1 % • The increase in Pega Cloud revenue for the three months ended March 31, 2024 was primarily due to the growth of the hosted client base as our clients continued to expand their use of Pega Cloud. • The increase in maintenance revenue in the three months ended March 31, 2024 was primarily due to continued demand for our subscription license offerings, which are generally bundled with maintenance. • The decrease in subscription license revenue in the three months ended March 31, 2024 was primarily due to a large multi-year contract recognized in revenue in the three months ended March 31, 2023. • The increase in consulting revenue in the three months ended March 31, 2024 was primarily due to an increase in consultant realization rates in the Americas. Gross profit (Dollars in thousands) Three Months Ended March 31, Change 2024 2023 Pega Cloud $ 101,305 77 % $ 77,629 72 % $ 23,676 30 % Maintenance 74,774 92 % 73,016 92 % 1,758 2 % Subscription services 176,079 83 % 150,645 80 % 25,434 17 % Subscription license 62,695 99 % 83,808 99 % (21,113) (25) % Subscription 238,774 87 % 234,453 86 % 4,321 2 % Consulting (4,135) (8) % (7,315) (14) % 3,180 43 % Perpetual license 850 99 % 400 99 % 450 113 % $ 235,489 71 % $ 227,538 70 % $ 7,951 3 % * not meaningful • The increase in Pega Cloud gross profit percent in the three months ended March 31, 2024 was primarily due to increased cost efficiency, particularly for hosting services and employee compensation and benefits, as Pega Cloud continues to grow and scale. • The increase in consulting gross profit percent in the three months ended March 31, 2024 was primarily due to an increase in consultant realization rates in the Americas. 24 Operating expenses (Dollars in thousands) Three Months Ended March 31, Change 2024 2023 Selling and marketing $ 127,695 $ 149,797 $ (22,102) (15) % % of Revenue 39 % 46 % Research and development $ 72,113 $ 75,376 $ (3,263) (4) % % of Revenue 22 % 23 % General and administrative $ 23,527 $ 23,110 $ 417 2 % % of Revenue 7 % 7 % Litigation settlement, net of recoveries $ 32,403 $ — $ 32,403 100 % % of Revenue 10 % — % Restructuring $ 163 $ 1,461 $ (1,298) (89) % % of Revenue — % — % • The decrease in selling and marketing during the three months ended March 31, 2024 was primarily due to a decrease in compensation and benefits of $17.5 million from reduced headcount as we optimized our go-to-market strategy. For additional information, see "Note 9. Restructuring" in Part I, Item 1 of this Quarterly Report. • The decrease in research and development for the three months ended March 31, 2024 was primarily due to a decrease in compensation and benefits of $1.5 million due to reduced headcount and a decrease in cloud hosting expenses of $1.2 million. • The increase in litigation settlement, net of recoveries in the three months ended March 31, 2024 was primarily due to the estimated cost to settle ongoing litigation arising from proceedings outside the ordinary course of business. 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, 2023 for additional information. • The decrease in restructuring expenses during the three months ended March 31, 2024 was primarily due to efforts to optimize our go-to-market organization in the three months ended March 31, 2023. 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 March 31, Change 2024 2023 Foreign currency transaction (loss) $ (3,262) $ (2,675) $ (587) (22) % Interest income 5,281 1,485 3,796 256 % Interest expense (1,752) (1,918) 166 9 % Gain on capped call transactions 3,299 3,206 93 3 % Other income, net 1,684 6,583 (4,899) (74) % $ 5,250 $ 6,681 $ (1,431) (21) % • The change in foreign currency transaction (loss) in the three months ended March 31, 2024 was primarily due to 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, 2024 was primarily due to higher investment balances and market interest rates. • The decrease in other income, net in the three months ended March 31, 2024 was due to a gain of $3.8 million on our venture investments and a gain of $2.8 million from repurchases of our convertible senior notes in the three months ended March 31, 2023. For additional information, see “Note 8. Debt” and "Note 10. Fair Value Measurements" in Part I, Item 1 of this Quarterly Report. (Benefit from) provision for income taxes Three Months Ended March 31, (Dollars in thousands) 2024 2023 (Benefit from) provision for income taxes $ (3,038) $ 5,249 Effective income tax rate 20 % (34) % The effective income tax rate in the three months ended March 31, 2024 was primarily driven by the valuation allowance on our deferred tax assets in the U.S. and U.K., and forecasted taxable income, offset by an income tax benefit for discrete items in the three months ended March 31, 2024. 25 The Organization for Economic Cooperation and Development (“OECD”) has introduced new global minimum tax regulations, known as Pillar Two, that began to come into effect on January 1, 2024. We are monitoring this development and evaluating its potential impact on our tax rate and eligibility to qualify for the safe harbor provisions. For 2024, we currently anticipate meeting the transitional safe harbors in most jurisdictions, with any remaining top-up tax being immaterial. LIQUIDITY AND CAPITAL RESOURCES Three Months Ended March 31, (in thousands) 2024 2023 Cash provided by (used in): Operating activities $ 180,146 $ 68,107 Investing activities (132,399) (14,413) Financing activities 17,899 (29,372) Effect of exchange rate changes on cash, cash equivalents, and restricted cash (2,803) 782 Net increase in cash, cash equivalents, and restricted cash $ 62,843 $ 25,104 (in thousands) March 31, 2024 December 31, 2023 Held in U.S. entities $ 491,808 $ 263,453 Held in foreign entities 127,141 159,885 Total cash, cash equivalents, and marketable securities 618,949 423,338 Restricted cash included in other current assets 775 — Restricted cash included in other long-term assets 2,990 2,925 Total cash, cash equivalents, marketable securities, and restricted cash $ 622,714 $ 426,263 We believe that our current cash, marketable securities, cash flow provided by operations, borrowing capacity, and ability to engage in capital market transactions will be sufficient to fund our operations, convertible senior notes due on March 1, 2025, 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 operating activities in the three months ended March 31, 2024 was primarily due to growth in client collections and the impact of our cost-efficiency initiatives. 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) investing activities in the three months ended March 31, 2024 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. As of March 31, 2024, we had $502.3 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. On April 23, 2024, the Credit Facility was amended to extend the expiration date to February 4, 2025. As of March 31, 2024 and December 31, 2023, we had $27.3 million in outstanding letters of credit, reducing available borrowing capacity under the Credit Facility, but no outstanding cash borrowings. For additional information, see "Note 8. Debt" in Part I, Item 1 of this Quarterly Report. 26 Stock repurchase program Changes in the remaining stock repurchase authority: (in thousands) Three Months Ended March 31, 2024 December 31, 2023 $ 60,000 Authorizations (1) — March 31, 2024 $ 60,000 (1) On April 23, 2024, our Board of Directors extended the expiration date of our current share repurchase program from June 30, 2024 to June 30, 2025. Common stock repurchases Three Months Ended March 31, 2024 2023 (in thousands) Shares Amount Shares Amount Tax withholdings for net settlement of equity awards 32 $ 2,005 27 $ 1,107 In the three months ended March 31, 2024 and 2023, instead of receiving cash from the equity holders, we withheld shares with a value of $2.8 million and $0.6 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) 2024 2023 Dividend payments to stockholders $ 2,515 $ 2,474 Contractual obligations As of March 31, 2024, our contractual obligations were: Payments due by period (in thousands) Remainder of 2024 2025 2026 2027 2028 2029 and after Other Total Convertible senior notes (1) $ 1,883 $ 504,154 $ — $ — $ — $ — $ — $ 506,037 Purchase obligations (2) 128,610 137,788 126,585 135,247 990 — — 529,220 Operating lease obligations 12,700 16,024 11,246 10,066 9,334 30,147 — 89,517 Venture investment commitments (3) 500 500 — — — — — 1,000 Liability for uncertain tax positions (4) — — — — — — 2,175 2,175 $ 143,693 $ 658,466 $ 137,831 $ 145,313 $ 10,324 $ 30,147 $ 2,175 $ 1,127,949 (1) Includes principal and interest. (2) Represents the fixed amount owed for purchase obligations for 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.