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; • potential legal and financial liabilities, as well as 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 October 23, 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. Management uses these measures to assess the performance of the company's operations and establish operational goals and incentives. 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. 22 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. 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. September 30, 2024 September 30, 2023 Change Constant Currency Change Pega Cloud $ 640,574 $ 494,571 $ 146,003 30 % 26 % Maintenance 306,753 319,250 (12,497) (4) % (6) % Subscription services 947,327 813,821 133,506 16 % 14 % Subscription license 412,678 355,055 57,623 16 % 15 % $ 1,360,005 $ 1,168,876 $ 191,129 16 % 14 % Reconciliation of ACV and constant currency ACV (in millions, except percentages) September 30, 2023 September 30, 2024 1-Year Change ACV $ 1,169 $ 1,360 16 % Impact of changes in foreign exchange rates — (28) Constant currency ACV $ 1,169 $ 1,332 14 % Note: Constant currency ACV is calculated by applying the September 30, 2023 foreign exchange rates to all periods shown. 23 Cash flow (1) (Dollars in thousands) Nine Months Ended September 30, Change 2024 2023 Cash provided by operating activities $ 250,697 $ 137,920 82 % Investment in property and equipment (4,921) (14,271) Free cash flow (1) $ 245,776 $ 123,649 99 % Supplemental information (2) Litigation settlement, net of recoveries $ 32,403 $ — Legal fees 9,232 5,867 Restructuring 4,214 21,576 Interest on convertible senior notes 3,767 4,134 Income taxes 32,246 7,913 $ 81,862 $ 39,490 (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. ◦ Litigation settlement, net of recoveries : Cost to settle litigation, net of insurance recoveries, arising from proceedings outside the ordinary course of business. See Note 15. Commitments and Contingencies in our Quarterly Report for the three months ended September 30, 2024 for additional information. ◦ Legal fees: 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 convertible senior 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. 24 Remaining performance obligations (“Backlog”) Reconciliation of Backlog and Constant Currency Backlog (Non-GAAP) (in millions, except percentages) September 30, 2023 September 30, 2024 1-Year Growth Rate Backlog - GAAP $ 1,265 $ 1,475 17 % Impact of changes in foreign exchange rates — (43) Constant currency backlog $ 1,265 $ 1,432 13 % Note: Constant currency Backlog is calculated by applying the September 30, 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 based on 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. No significant changes have been made to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2023. 25 RESULTS OF OPERATIONS Revenue (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2024 2023 2024 2023 Pega Cloud $ 144,108 44 % $ 118,040 35 % $ 26,068 22 % $ 409,096 41 % $ 340,982 36 % $ 68,114 20 % Maintenance 80,702 25 % 83,538 25 % (2,836) (3) % 242,047 24 % 245,210 25 % (3,163) (1) % Subscription services 224,810 69 % 201,578 60 % 23,232 12 % 651,143 65 % 586,192 61 % 64,951 11 % Subscription license 45,420 14 % 74,342 22 % (28,922) (39) % 193,405 19 % 200,066 21 % (6,661) (3) % Subscription 270,230 83 % 275,920 82 % (5,690) (2) % 844,548 84 % 786,258 82 % 58,290 7 % Consulting 54,364 17 % 55,976 17 % (1,612) (3) % 160,451 16 % 167,396 18 % (6,945) (4) % Perpetual license 456 — % 2,747 1 % (2,291) (83) % 1,351 — % 4,729 — % (3,378) (71) % $ 325,050 100 % $ 334,643 100 % $ (9,593) (3) % $ 1,006,350 100 % $ 958,383 100 % $ 47,967 5 % • The increases in Pega Cloud revenue for the three and nine months ended September 30, 2024 were primarily due to additional investments made by our existing clients as they continued to expand their use of Pega Cloud. • The decreases in maintenance revenue in the three and nine months ended September 30, 2024 were primarily due to our clients’ shift to Pega Cloud-based offerings, which do not generally result in maintenance revenue. • The decreases in subscription license revenue in the three and nine months ended September 30, 2024 were primarily due to several large multi-year contracts recognized in revenue in the three and nine months ended September 30, 2023. • The decreases in consulting revenue in the three and nine months ended September 30, 2024 were primarily due to decreases in consultant billable hours and utilization. Gross profit (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2024 2023 2024 2023 Pega Cloud $ 113,625 79 % $ 88,553 75 % $ 25,072 28 % $ 319,261 78 % $ 250,943 74 % $ 68,318 27 % Maintenance 74,317 92 % 77,119 92 % (2,802) (4) % 222,952 92 % 225,696 92 % (2,744) (1) % Subscription services 187,942 84 % 165,672 82 % 22,270 13 % 542,213 83 % 476,639 81 % 65,574 14 % Subscription license 45,036 99 % 73,713 99 % (28,677) (39) % 191,901 99 % 198,095 99 % (6,194) (3) % Subscription 232,978 86 % 239,385 87 % (6,407) (3) % 734,114 87 % 674,734 86 % 59,380 9 % Consulting (5,087) (9) % (1,228) (2) % (3,859) (314) % (17,413) (11) % (8,866) (5) % (8,547) (96) % Perpetual license 453 99 % 2,723 99 % (2,270) (83) % 1,339 99 % 4,678 99 % (3,339) (71) % $ 228,344 70 % $ 240,880 72 % $ (12,536) (5) % $ 718,040 71 % $ 670,546 70 % $ 47,494 7 % • The increases in Pega Cloud gross profit percent in the three and nine months ended September 30, 2024 were primarily due to increased cost efficiency, primarily for hosting services and employee compensation and benefits, as Pega Cloud continues to grow and scale. • The decreases in consulting gross profit percent in the three and nine months ended September 30, 2024 were primarily due to decreases in consultant utilization rates. Operating expenses (Dollars in thousands) Three Months Ended September 30, Change Nine Months Ended September 30, Change 2024 2023 2024 2023 Selling and marketing $ 127,669 $ 131,598 $ (3,929) (3) % $ 395,125 $ 425,253 $ (30,128) (7) % % of Revenue 39 % 39 % 39 % 44 % Research and development $ 74,157 $ 74,955 $ (798) (1) % $ 221,695 $ 224,262 $ (2,567) (1) % % of Revenue 23 % 22 % 22 % 23 % General and administrative $ 35,694 $ 27,321 $ 8,373 31 % $ 84,641 $ 73,893 $ 10,748 15 % % of Revenue 11 % 8 % 8 % 8 % Litigation settlement, net of recoveries $ — $ — $ — * $ 32,403 $ — $ 32,403 * % of Revenue — % — % 3 % — % Restructuring $ 2,485 $ 17,822 $ (15,337) (86) % $ 3,283 $ 21,450 $ (18,167) (85) % % of Revenue 1 % 5 % — % 2 % * not meaningful 26 • The decreases in selling and marketing during the three and nine months ended September 30, 2024 were primarily due to decreases in compensation and benefits of $2.4 million and $27.5 million, respectively, from reduced headcount as a result of our effort to optimize 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 September 30, 2024 was primarily due to a decrease in compensation and benefits of $1.1 million. The decrease in research and development for the nine months ended September 30, 2024 was primarily due to a decrease in cloud hosting expenses of $1.8 million and a decrease in compensation and benefits of $1.5 million. • The increases in general and administrative during the three and nine months ended September 30, 2024 were primarily due to increases in compensation and benefits of $3.1 million and $7.2 million, respectively, due to increases in incentive-based compensation. • The increase in litigation settlement, net of recoveries in the nine months ended September 30, 2024 was primarily due to the cost to settle 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 decreases in restructuring expenses during the three and nine months ended September 30, 2024 were primarily due to efforts to optimize our go-to-market organization and office space. 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 2024 2023 2024 2023 Foreign currency transaction (loss) gain $ (4,405) $ 1,994 $ (6,399) * $ (7,230) $ (3,971) $ (3,259) (82) % Interest income 6,769 2,532 4,237 167 % 18,835 5,831 13,004 223 % Interest expense (1,639) (1,533) (106) (7) % (5,047) (5,229) 182 3 % (Loss) on capped call transactions (689) (2,294) 1,605 70 % (667) (449) (218) (49) % Other income, net — 6,383 (6,383) (100) % 1,684 18,668 (16,984) (91) % $ 36 $ 7,082 $ (7,046) (99) % $ 7,575 $ 14,850 $ (7,275) (49) % * not meaningful • The changes in foreign currency transaction (loss) gain in the three and nine months ended September 30, 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 increases in interest income in the three and nine months ended September 30, 2024 were primarily due to higher investment balances and higher interest rate yields. • The changes in (loss) on capped call transactions in the three and nine months ended September 30, 2024 were due to fair value adjustments for our capped call transactions. • The decrease in other income, net in the three months ended September 30, 2024 was due to a gain of $6.4 million on our venture investments in the three months ended September 30, 2023. The decrease in other income, net in the nine months ended September 30, 2024 was due to a gain of $7.9 million from repurchases of our convertible senior notes and a decrease of $9.3 million in the gain from our venture investments in the nine months ended September 30, 2024. For additional information, see “Note 8. Debt” and "Note 10. Fair Value Measurements" in Part I, Item 1 of this Quarterly Report. Provision for income taxes Nine Months Ended September 30, (Dollars in thousands) 2024 2023 Provision for income taxes $ 8,369 $ 15,395 Effective income tax rate (73) % (26) % Our effective income tax rate for the nine months ended September 30, 2024, is impacted by the jurisdictional mix and timing of the actual compared to projected earnings (losses). It is also impacted by the valuation allowance on our deferred tax assets in the U.S. and U.K. and a near break-even year-to-date pretax loss resulting in a not meaningful effective income tax rate. 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. 27 LIQUIDITY AND CAPITAL RESOURCES Nine Months Ended September 30, (in thousands) 2024 2023 Cash provided by (used in): Operating activities $ 250,697 $ 137,920 Investing activities (215,999) (24,176) Financing activities 26,949 (85,031) Effect of exchange rate changes on cash, cash equivalents, and restricted cash 4,591 (1,621) Net increase in cash, cash equivalents, and restricted cash $ 66,238 $ 27,092 (in thousands) September 30, 2024 December 31, 2023 Held in U.S. entities $ 464,232 $ 263,453 Held in foreign entities 238,758 159,885 Total cash, cash equivalents, and marketable securities 702,990 423,338 Restricted cash included in other current assets 184 — Restricted cash included in other long-term assets 11,232 2,925 Total cash, cash equivalents, marketable securities, and restricted cash $ 714,406 $ 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, settlement of our 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 nine months ended September 30, 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 nine months ended September 30, 2024 was primarily due to our investments in financial instruments and reduced investment in property and equipment as we optimized 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 September 30, 2024, we had $502.3 million in aggregate principal amount of convertible senior notes outstanding. 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 $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 September 30, 2024 and December 31, 2023, we had $27.3 million in outstanding letters of credit under the Credit Facility, reducing available borrowing capacity, but no outstanding cash borrowings. For additional information, see "Note 8. Debt" in Part I, Item 1 of this Quarterly Report. 28 Stock repurchase program Changes in the remaining stock repurchase authority: (in thousands) Nine Months Ended September 30, 2024 December 31, 2023 $ 60,000 Authorizations (1) — Repurchases (2) (11,749) September 30, 2024 $ 48,251 (1) On April 23, 2024, our Board of Directors extended the expiration date of our share repurchase program from June 30, 2024 to June 30, 2025. On October 22, 2024, our Board of Directors extended the expiration date of our share repurchase program from June 30, 2025 to December 31, 2025 and increased the authorized repurchase by $250 million to $310 million as of that date. (2) All purchases under this program have been made on the open market. Common stock repurchases Nine Months Ended September 30, 2024 2023 (in thousands) Shares Amount Shares Amount Repurchases paid 164 $ 11,249 — $ — Repurchases unpaid at period end 7 500 — — Stock repurchase program 171 11,749 — — Tax withholdings for net settlement of equity awards 48 2,987 39 1,654 219 14,736 39 1,654 In the nine months ended September 30, 2024 and 2023, instead of receiving cash from the equity holders, we withheld shares with a value of $3.3 million and $1.0 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) 2024 2023 Dividend payments to stockholders $ 7,626 $ 7,458 Contractual obligations As of September 30, 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) $ — $ 504,154 $ — $ — $ — $ — $ — $ 504,154 Purchase obligations (2) 51,146 142,370 127,548 135,488 990 — — 457,542 Operating lease obligations 4,094 18,276 13,754 13,503 12,939 31,932 — 94,498 Venture investment commitments (3) — 500 500 — — — — 1,000 Liability for uncertain tax positions (4) — — — — — — 867 867 $ 55,240 $ 665,300 $ 141,802 $ 148,991 $ 13,929 $ 31,932 $ 867 $ 1,058,061 (1) Includes principal and interest. (2) Represents the fixed amount owed for purchase obligations including 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.