Good day, ladies and gentlemen, and welcome to Pegasystems Fourth Quarter 2011 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to hand the conference over to Mr. Craig Dynes, Chief Financial Officer. Sir, you may begin.

Good evening. Welcome to the Pegasystems' 2011 Q4 Earnings Conference Call. With me here at the Morgan Stanley Investor Conference in San Francisco is Alan Trefler, Pegasystems' Founder and CEO. Before I introduce Alan, I will start with our Safe Harbor statement and then provide my financial commentary. Certain statements contained in this presentation may be construed as forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. The words anticipates, projects, expect, plans, intends, believes, estimates, targets, forecasts and could and other similar expressions identify forward-looking statements, which speak only as of the date the statement was made. Because such statements deal with future events, they are subject to various risks and uncertainties. Actual results from the fiscal year 2012 and beyond could differ materially from the company's current expectations. Factors that could cause the company's results to differ materially from those expressed in forward-looking statements are contained in the company's press release announcing its Q4 2011 earnings and in the company's filings with the Securities and Exchange Commission, including its report on Form 10-K for the year ended December 31, 2011, and other recent filings with the SEC. The company undertakes no obligation to revise or update forward-looking statements as a result of new information since these statements may no longer be accurate or timely. On our Q3 call, we reminded everyone that our individual quarters can be lumpy, and down quarters are often followed by a significant annual growth. Our Q4 results showed this pattern to be true, with record Q4 bookings and revenue as well as record annual bookings and revenue. Q4 license signings were the largest in our history. For the year, the aggregate value of license signings was up more than 75% as compared to 2010. In addition to driving license…

Thank you, Craig. And good evening to those of you on the phone. Pega knocked the ball out of the park in Q4, yielding exceptional results for 2011 while setting the stage for continued growth. We set all-time company records for license bookings, revenue and license backlog. We closed more deals and more verticals in more countries than ever before. It's exciting to see how the world's best brands and most respected companies are buying Pegasystems' technology to do things they never thought software could do for their businesses. Our wins range from seamless multichannel customer experience initiatives to major Next-Best-Action decisioning and personalized retention and cross-sale programs. In light of the difficult economy, we adjusted our focus to highlight areas of traditional strength, helping our clients achieve significant operational productivity improvement and cost reductions. It is incredibly exciting to see and hear clients talk about the uses of our technology and the staggering returns they are obtaining, and I will touch further on some specific examples in a few minutes. In 2011, our continued R&D investment has yielded a focused portfolio of industry-leading products. These include major new product releases: PegaRULES Process Commander, our unified rules and Business Process Management platform; additionally, new versions of Customer Process Manager, our leading multichannel customer service solution; the industry's first fully unified decisioning and process management capability, what we call Decision Strategy Manager, combining predictive and adaptive analytics in a unified platform with rules and processes; and the market's most sophisticated and agile Next-Best-Action marketing solution for retention, cross-sell and upsell. These offerings work to a common architecture to enable our client's agility and the unprecedented ability to improve customer centricity while saving money. We've also delivered numerous industry frameworks. These helped organizations more rapidly and inexpensively achieve the benefits of Business…

[Operator Instructions] Our first question comes from Richard Davis from Canaccord.

Alan, one thing, two parts. One, you kind of touched on a little bit but just you mentioned you're dealing with some of the social media guys. Is it more about customer experience and things like that? Kind of just if you could elaborate a little bit on that. And then second, as I've been out talking to companies, some of these new tools companies in San Diego and several in San Francisco, and so their models tend to be very low-entry prices, a lot of digital fulfillment, which then translate to the high gross margins. Sales and marketing in many cases at these firms are 15% of revenues, R&D is 35% of revenues. They do spend a lot, but they get a roughly 30% operating margin. So nobody complains about your growth because it's very good, but they do whine about the margins. Can or do you see your margins higher either through business model or scale at some point? Maybe it's not 2012. But is this a business that should be -- can generate 25% margins? I mean you're at $0.5 billion of revenues, so a lot of companies of that size do those kind of things. So philosophical on the second one, technical on the first one.

Sure. So tactically, we're doing a number of very interesting things around social media. It's been an important initiative set for us. We've got these brilliant integrations, for example, that allows somebody to just pop Pega right into their Facebook environment of their corporation and really engage with their customers in the multichannel where the customer can start on Facebook, call the call center and then pop into the web to finish something. We've also done some very interesting work in conjunction with a variety of partners around mining the social media streams from, for example, Twitter, to be able to make customers better served and part of a true multichannel experience. So we put quite a bit of work into that. I'm actually very happy with the way that that's working. Regardless sort of theoretical margins, look, we've made a decision that we're going to invest both in R&D and in selling and the sales force. I think there's no question that this can be a 25-plus point profit business at scale. It's just that where we are now, we really think that there's so much uncovered territory, both in terms of, frankly, organizations that we're in but aren't fully covered, and organizations that we have yet to touch but is still in the Fortune 200. But it makes sense to accelerate the growth and, frankly, one of the considerations we have for 2012 is we are going to accelerate that growth, which is why I think the margins will be lower. But if we chosen to, we could have definitely had higher margin numbers. The issue would have been how rapidly can we grow in 2013 and '14. I think this business at some point is going to explode. We need to be positioned to take advantage of it.

Our next question comes from Nathan Schneiderman from Roth Capital.

I was just curious, Alan. When you're looking at the business and thinking about the success this quarter and then in comparison to what happened last quarter, can you give us your perspective on this? Were there -- was this just the -- do you feel the idiosyncrasy of a lumpy, inherently lumpy business? Or are there certain problems that you identified that you put corrective actions in place and that have a positive impact?

I think the main driver is the lumpiness of the business. And we talked about it, I think it's nice to see that lumps can be extremely, extremely positive as well as, obviously, we took a hit in Q3. I think as I said in the Q3 call, that we were a little surprised by the mood having flipped as rapidly as it did from customer acquisition to "Oh, my God, let's save money." We normally play with the foot in both in camps. We did some re-weighting in Q4 as, we are doing going into Q1, to really emphasize projects and uses of our technology that drive more immediate returns. And I think that was important in Q4 as the economy is tough, I think that will continue to be important. But we're also continuing to push with the other foot, as it were. So it's not like we did a major shift, we just did some recalibrating to emphasize cost benefit.

And Alan, you possibly said this during your presentation, I was -- for some reason I didn't hear you very clearly on my line, though. But what did -- I thought I heard you referenced pipeline growth, but I didn't actually hear the number. But how much was pipeline up year-over-year?

The pipeline was up year-over-year, I'd say from memory, over 20%.

Okay. Great. And then...

Maybe more than...

35%.

35%, all right. Craig [indiscernible].

Okay. Great. Final question for you. I was just curious on the big deal front, if you could share with us the number of deals exceeding $5 million and the number of deals exceeding $10 million?

Yes, sure. Not being a fisherman, it's kind of odd that we've chosen to use aquatic life to sort of categorize our deal. But in the quarter, we got 2, what I would call whale-ish deals. Those are things we would normally think of as being 15 or more. We got a couple of -- a number of tunas that I would think of as being in the sort of 8 to 15 range. And just a good collection of business along the entire rest of the spectrum, some smaller deals with introductory customers, some nice follow-up pieces of business in the 2 to 4 range. Which those are some of my most favorite deals because they're part of what builds reliability when you've got more of those and some of the huge ones that swing in and out.

Our next question comes from Justin Furby from William Blair & Company.

This is Justin in for Laura. I guess maybe to start just sort of following up on the pipeline commentary. Alan, you mentioned it's up I think 35%. Can you talk a little bit about, I guess, maturity, and then maybe pipeline coverage today versus where it was a year ago?

One of the things we're very happy about that I mentioned was that I think we're doing a much better job this year and over the last 18 months around engaging with partners, which is, I think, a key element of our strategy as we think about how we want to grow this business. We think that's going to be key. So we have a very, very material increase in the work with partners that was around either cultivating the pipeline or driving it forward. And I think that's very healthy, and it represents a maturation in the business. I'll also tell you that the pipeline grew nicely pretty much across the board where we saw good, solid growth in both new and traditional sectors. Which is important because part of what's led to the expense investments, is we place meaningful bets in some verticals beyond our traditional ones. Verticals like, for example, the government; verticals like life sciences, oil and gas, energy. These verticals I think have been showing excellent, excellent opportunity. We saw, for example, market improvement in our federal vertical. Most exciting, though, is our telecommunications vertical has just really broken out to be, from my perspective, now a fully mainstream vertical with the scale and the opportunity to build momentum as a result of wins all around the globe. So I'd say the pipeline was healthy and not concentrated, which is very much what we're trying to do with the business.

Okay. And then in terms of the competitive environment, I mean any -- who are you seeing the most in competitive situations? Any material change over the last quarter? Just a general update there would be helpful.

Yes, we see the seller stack guys, the guys like IBM and Oracle. Most of the people we sell to already have 2 or 3 things, like call BPM, sitting on the shelf. The thing that I've seen that's been really helpful is we've had a number of clients who've tried something else and are now returning to us, many of whom are referenceable about that change of experience. And I view that as very positive. I think the unified architecture we have continues to get a highly differentiated assessment with our customers, which is key. So it continues to be competitive, but we obviously are able to differentiate ourselves, as you can see from the results.

Okay. And then just one last one, if I may. Craig, on the $500 million guide for '12, if you sort of think about it in terms of license versus maintenance versus pro services, obviously, the last couple of years, the services and maintenance have been sort of above the license side of things. Do you expect that dynamic to play out in '12, particularly given the fact that you've seen material increases in near-term piece of the business?

No. The trend is going to be a little different going forward. We're really making a conscious effort to sort of more slow growth our Professional Services organization just because we have so much more partner involvement now. Partners actually lead in the vast majority of all implementations. So that doesn't mean we're going to be out of the services business. We're going to be in it, but we really encourage them to take the lead in these projects. But we're still going to hire up, and we're still going to grow services because partners often need help and we want to fill in where they need that help.

So the composition of our services staff I expect will become more senior and more -- the way we're referring to it internally now is we're calling it Pega Consulting. So we will still have the capacity to do the occasional project if a customer demands it, but our real goal is to empower our customers and our partners to really be able to drive this engine. So over time, you should expect our mixes to change to reflect that.

Okay. So is it reasonable to think of license growth in the sort of 20% range for 2012?

Well, we didn't give specific guidance on total revenue. But the license has to grow around 20% at least to get to the number, possibly more than that. Our maintenance business is pretty steady, but that grow is sort of a little lagging but in lockstep with the license revenue growth.

Our next question comes from Steve Koenig from Longbow Research.

I want to ask you about annual and quarterly achievement, and let me start with the annual side. I don't want to sound snide in this question but I do want to ask it, so I'll just put it out there. And the question really is on your guidance now, you've missed your initial guidance on both the top line and the bottom line, for 2 consecutive years. And so I'm wondering, what makes you feel better about this year's guidance? Is there anything different systematically, or were those things just -- were those onetime anomalies? What can give us some comfort with the guidance you put out for the year?

So I think you can get some comfort from looking at the specific license backlog that we disclosed, looking at the momentum of the business. And the fact that we disclosed an awful lot of information about what is in deferred and what is in our term and perpetual license backlog. And I think those can provide a level of comfort. The reality is that Q4 was just an enormous, enormous quarter. But a lot of it went into backlog, which we're really not at all unhappy about. If some more of it have gone into the current period, it would've changed the numbers. Part of that is the lumpiness. And I do believe this is going to be an extremely powerful growth business. I think we've demonstrated things that should create a level of confidence. But the reason we talk about lumpiness is we don't want investors who are going to overreact to the fact it is lumpy to at all be surprised.

So I mean the key metric for us is the bookings growth. And as I said in the script, it was up 75%. In this economy, that's a fantastic achievement, so we're pretty pleased with the performance.

Okay. Great. So I think that's kind of a good lead in for my next question. I realize -- I think it's prudent for you to condition investors to expect lumpiness given the back-end loading and given the fact that you don't encourage end-of-quarter discounting, which I think that's a good thing in terms of your NPV. I am wondering, though, is there anything that you can do or are doing to reduce just the extreme rollercoaster ride that investors have to take quarter-to-quarter to invest in Pega in terms of either -- go ahead.

A lot of it changes with our ability to achieve greater scale. So frankly, we are much less lumpy with the $500 million target than we were when we were back -- it wasn't that long ago that we did $162 million, and I guarantee you, we were lumpier then than we are now. So some of it is as we get past $750 million, which we're going to try to get past as fast as possible, you're going to see, I expect, the lumpiness to materially decline. The second thing is as we improve our coverage so that we've got deeper coverage in multiple industries, some of the secular trends that affect one industry more than another will also, frankly, be much better. And as we increase our client base so that we're doing more radiation, we're inside the customer, we're selling out into other areas as opposed to penetrating, we find that radiation is far more reliable as you would expect as it relates to lumpiness than when you're just trying to get that first-time buyer and a client to trust you for the first time and to step up. So we do have very specific things that we're working on to attempt to reduce the lumpiness, and to improve the channel to the partners and the other sorts of things we're looking to do to reduce our cost of delivery and our cost of going in. But I think we need to be candid, and we're not going to let the fact that we're lumpy allow us to miss what we think is a spectacular opportunity here, which I guarantee you we're all very focused on.

[Operator Instructions] And our next question comes from Brian Murphy from Sidoti & Company.

I just wanted to follow up on the guidance and the margin questions. Alan, is it fair to assume that -- or I guess I should say, does the guidance assume that license revenue will start to outpace service revenue in 2012?

From a growth rate point of view, we absolutely expect it will. But from an absolute number point of view, we have, I think -- it's going to take more than one year to close that gap, I would expect. Craig, what would you think?

Yes, regardless of when you look at the profitability, that the guidance we're giving on non-GAAP EPS is up 26% from this year. We also are focused, as I said, on backlog. We're also focused on cash flow, and we did almost $50 million operating cash flow in the year. So there's a bunch of other metrics as well. But margin is important, we realize it, and I think it's a scale thing for us.

And can you guys just talk about expectations for sales force productivity in 2012?

Just want me talk in general, or do you have a specific question?

Well, no, I mean just general commentary would be helpful. But, and if you could, tie it in with kind of sales and marketing as a percentage of sales, should we continue to expect that to go up in 2012?

So I think we're really trying to hold that fairly constant, I would say. Because the challenge you have is, and we're going to do quite a bit of hiring in this plan around our sales force expansion in anticipation of 2013. The reality is it does take really 6 months for somebody to begin to really start to engage with the clients the way we need around the opportunity. It's the nature of the business. So one of the challenges we've had is over the last 3 years, we've increased the sales force quite a bit, and of course that really takes the average tenure of the sales force down. So we're looking to perhaps slightly increase sales force productivity this year in light of the fact that the sales force is still going to be growing quite a bit. So it should be a lot, but not massively.

That's very helpful. And just one last question, did you close any warrants deals in the oil and gas vertical this quarter?

No. There weren't any -- nothing large in that vertical.

The pipeline is great, though.

There was one what I would describe as mahi-mahi as opposed to perhaps a tuna or whale.

And our next question comes from Raghavan Sarathy from Dougherty & Company.

A couple of questions for Alan and then a few for Craig. Just in terms of the backlog composition, I'm surprised that you're signing more term licenses now than when you did during the recession. In the recession, you were signing a lot of perpetual license when we thought you'd be signing term licenses. So I was kind of wondering, can you give us some color on what's driving customers to choose more term licenses now when supposedly economy has improved? Are some other factors, business decisions driving them to choose term license or maybe even technology reasons?

I would tell you that I'm a little surprised as well. So I'm not going to say that -- I'm unprepared to draw any major conclusions, other than to say that the decision about how a client buys, be it term or perpetual, is one that appears to be very, very situational. And sometimes we go in thinking the best arrangement with the customer will be a term, and they suddenly decide that they have some latitude in their capital budget. I think one of the things that has been happening is that a lot of the financial services organizations, which is a meaningful part of our business still, a lot of them are sensitive to capital these days. And the term license allows them to run as an operating expense, so that's fine. But we're happy either way. We think that, frankly, there's a certain volatility reducing impact the term licenses have that actually make me rather happy.

And then Craig, if -- I'm sorry, Alan, if I heard you right, you said the license pipeline generated with partners is over $1 billion. That's just like a huge number. Can you clarify what kind of -- is that well-qualified, or help us understand that figure.

So that would be a number, wouldn't be generated by partners, that would either be generated by partners or deals in which we are working in conjunction with the partner.

Associated with the partner.

Associated with the partner, so where the partner is playing an active role. We're trying to get our partners to generate pipeline, and some of them are actually doing a pretty good job of it now. But that's not anywhere close to $1 billion at this stage. And for it to be considered pipeline as we discussed it, it's got to be pretty well-qualified. It's got to be an opportunity that's specific and we could put a dollar amount on where we're identifying the locus of buying activity and they have a bona fide need. So we don't consider the front-end garbage of the pipeline to be part of it. We have categories for that, that we leave out of our pipeline discussion.

Did you mention a figure? Maybe I misheard.

Yes, I mentioned, I believe, $1 billion.

That would be of total pipeline.

Okay. That's pretty big. And then question for Craig, I think there was some question around license revenue growth. But the one thing I noticed that you were -- yes, you had a pretty strong license revenue growth. But if I look at the perpetual license growth or the backlog for the 2012, that's only $22 million, $23 million. Obviously, that's a big driver in terms of your EPS. And I was wondering, how should we think about your perpetual license revenue and overall mix?

Well, as you said earlier, Ragh, the customers decision to buy term or perpetual is up to them, and it's pretty unpredictable. Perpetual license revenue definitely hits the P&L faster than term license. It can swing at any point in time in the year, as we amended our guidance at the end of last year because of the term license pipeline. And just like you said earlier, in 2009, we were expecting people go to term licenses, and they did, and they went to perpetual. So it's highly unpredictable. And I also, like Alan said, we don't like to make predictions because as soon as we do, we're proven wrong.

But you have non-GAAP EPS of $0.91. That assumes, obviously, some significant tick up in perpetual license for the back half of the year...

Oh, yes, definitely.

But Craig base s those estimates on what we see happening in the market in the last couple of quarters. So we bake in sort of current...

Yes, we look in a historical model and then we look at the pipeline and we, in the short term, the shorter term, we can see which way the licenses are going to go. In the longer term, it's often difficult to look at a license out in Q3 and Q4 and figure out whether it's going to be term or perpetual.

And then 2 quick questions. So maybe I missed, did you mention what is the tax rate assumption in your non-GAAP EPS guidance, and then...

Yes. It's about 32%, 33% going forward. It should be much more normalized than the 2011 rate was.

And then in terms of the difference between GAAP and non-GAAP EPS, is this only amortization of intangibles, or there's going to be other onetime items like we saw in the last quarter?

There's basically 3 items. The amortization of intangible, the FAS 123R charge, and the last one is the noncash duplicate rent that the accounting generates and one-time moving charges so that we can get to a more run rate, or more normalized financial statement.

Okay. Great. That was $6.1 million, is that right?

Yes. There's a reconciliation on the press release.

Our next question comes from Mark Schappel from The Benchmark Company.

Most of my questions have been answered, but just one question, Alan. Based on the quarter's good results, is it fair to assume that you captured all the large deals that failed to close at the end of the September quarter?

No. I'm sorry, did you ask if we captured all the large deals in the September quarter?

That failed to close in September, yes.

Failed to close in September. I don't think we actually -- so I thought you asked if we had closed all the large deals that we had hoped in Q4, and actually there was some more that we could have closed in Q4, things that we're still working on. The Q3 ones, I don't think we were really depending on it. It was just -- there was sort of a sluggishness across the board. So we actually did an excellent job of closing the Q3 ones. But we weren't counting on any major deal in Q3. We just saw slowness, I think, across the board in a couple of geographies in Q3, largely especially driven by Europe, frankly, where folks came back at the end of August into September and there was just a malaise. Thankfully, in Q4, we were able to break through that and actually get some of that business to close, and some of it is still being pursued into this year. All right. Well, we're in an interesting situation here where we need to bring this to a close because we're actually at the Morgan Stanley Technology Conference. And Craig and I are about to go downstairs and do our fireside chat interview in front of the audience, so we wanted to make sure we did that in light of actually having our financial results announced, so we couldn't probably have said anything at that point in time. I will tell you that we're working hard. We're thinking that there is tremendous opportunity in this business, which is why we're continuing to invest. And if you want to see an interesting example of how clients are getting real, tangible benefit from this, there's a 4-minute video on our website or that you can YouTube, that is…

Bye now.

Ladies and gentlemen, thank you for participating in today's conference. This concludes our program. You may all disconnect, and have a wonderful day.