Good day and welcome to the Pegasystems' Third Quarter 2018 Earnings Results Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Ken Stillwell, Chief Financial Officer. Please go ahead.

Thank you. Good evening ladies and gentlemen and welcome to Pegasystems Q3 2018 earnings call. Before we begin, I'd like to read our Safe Harbor statement. Certain statements contained in this presentation may be construed as forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. The words expects, anticipates, intends, plans, believes, could, should, estimates, may, targets, strategies, intends to, projects, forecasts, guidance, likely and usually or variations of such words or 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. Because such statements deal with future events, they are subject to various risks and uncertainties. Actual results for fiscal year 2018 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 Q3 2018 earnings and in the company's filings with the Securities and Exchange Commission, including its annual report on Form 10-K for the year ended December 31, 2017 and other recent filings with the SEC. Investors are cautioned not to place undue reliance on such forward-looking statements, and there are no assurances that the matters contained 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 specifically disclaim any obligation to publicly update or revise these forward-looking statements, whether as a result of new information, future events, or otherwise. And with that, I'll turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Thank you, Ken. Right now I'm in the midst of a busy week with clients. I'm actually in London, dialed in remotely. But if the connection goes bad, I'm sure Ken will step in until I can reconnect. In terms of some highlights, I'm pleased -- really pleased with our year-to-date results. They reflect our strong business momentum. And I continue to be encouraged with the progress we're making as we focus on delivering the best solutions for digital transformation. As I said, one of our key goals is to accelerate growth and the cloud. Our performance today is a good example of the progress we're making. We continue to see acceleration in our move to the cloud and recurring arrangements. Year-to-date, cloud represented 51% of all new deals, about double the rate from a year ago. This faster than anticipated move to cloud arrangements is really good for our business long time and our strong underlying business trends are also reflected in license and cloud ACV, which grew 36% from a year ago. Total ACV, which includes maintenance on former types of licenses, grew a healthy 20% from a year ago as well to $537 million. As you know, it can be a lumpy business. So, I'm particularly pleased to see a strong Q3 following on a strong Q2. In a moment, Ken will provide additional financial details. I'd like to touch on some of our strategy and differentiators. We continue to focus our efforts on delivering the best solutions for digital transformation. And we believe that requires both effective customer engagement capabilities and the capability to do serious digital process automation. Now, the strategy is driven by our six core differentiators; our real-time omnichannel AI; our end-to-end automation and robotics; our journey-centric rapid delivery; the Situational Layer Cake…

Thanks Alan. Year-to-date 2018 has highlighted the very positive momentum we're seeing in the business. Not only did we have the strongest Q3 in Pega's history, we also experienced significant growth sequentially over Q2 of 2018, which by the way was a very solid quarter as well. We experienced a continued acceleration of our ACV growth and consistent shift towards cloud commitments. As we've discussed in the past, our strategy has been to accelerate growth with a much higher mix of term and cloud commitments. Year-to-date, cloud commitments were 51% of total commitments. The associated short-term revenue trade-off that occurs with a significant movement to the cloud is, well, today, pretty well understood by the market. Over time, we can leverage the movement to recurring contracts by expanding our margin as we gain operating leverage. That said, I want to reiterate that if one just looks at our reported year-to-date revenue, it would lead to an incorrect conclusion about the growth of the business. Our year-over-year term and cloud subscription ACV growth of 36% is more indicative of our overall business momentum. Year-to-date 2018, our mix of new commitments was 90% term and cloud subscription. Conversely, perpetual deals dropped to only 10% year-to-date 2018. This confirms our belief that customers are increasingly comfortable with contracting under recurring arrangements and aided by cloud -- by Pega's Cloud Choice differentiation. We had anticipated the cloud portion of new commitments would increase to 30% for the full year 2018 versus the actual 51% we're experiencing year-to-date. As I've said throughout the past few quarters, it's a pretty significant shift, but really welcomed. The short-term revenue impact to the shift is obvious if you look at the topline revenue, impacting our year-to-date revenue by at least $40 million. Let me talk a little more…

Thank you. [Operator Instructions] And we'll take our first question today from Rishi Jaluria with D.A. Davidson.

Hey Alan and Ken, thanks for taking my questions and nice to see some continued cloud momentum. Alan, let me start with you. I believe in your prepared remarks, you talked about ServiceNow as a competitor and maybe I missed it in the past. This is the first time I've heard you talk about ServiceNow as a competitor on a conference call. So, maybe if you could square a little bit into -- on what angles you're competing against ServiceNow. And since it's a company a lot of us know well, how are you thinking about your differentiation versus them?

Well, we see ServiceNow as a company that's also seeking to be a platform company, seeking to be a CRM firm and talking about digital transformation. And we're routinely asked by clients how we should see ourselves -- or how they should see us compared to Salesforce or ServiceNow because to some degree, we run into those folks all the time. And we recently scored some pretty major wins in organizations that had large deployments of both of those firms. And so as they grow, we are, of course, going to see them more. And we do want to make sure we're alert in the market to all possible competitors and they have been mentioned as well.

Got it. Okay, that's helpful. And Ken, as we look at your remaining performance obligations -- and by the way, thank you for coming up with a catchier name than committed not yet recognized revenue. But since this is a new metric for us, how should we be thinking about the sequential changes at least from Q2 to Q3 here? I mean I think it looks like we saw about a $50 million increase in cloud performance obligations sequentially, but would just want to get some context around that number.

So, good question, Rishi. So, there are some things in the remaining performance obligation that are probably less relevant to look at quarter-to-quarter. For instance, the amount of perpetual revenue that hasn't been taken to revenue. That will move -- that will have different seasonality changes, depending on contracts, et cetera. So, I would say that's probably less helpful. But certainly, the cloud one, if you look at the next 12 months; that is really a leading indicator to the amount of commitments that are already under contract for cloud. And so as our cloud business grows, you would expect the next 12 months of cloud commitments to grow. Not always in a linear fashion to our actual underlying growth because timing of renewals can be slightly less linear, but that's a helpful one. And in additional -- additionally, term is an interesting one because as you know, under 606, term commitments, when booked, largely come into revenue upfront. But there are some situations when they don't like if there's usage tranches or there's things that cause that revenue to be earned over time. So, it's helpful that you can actually use that, coupled with our revenue, to be able to understand the total amount of commitments that were made to Pega in a specific time period, similar to the way that we use backlog under the old accounting standard.

Okay, got it. That's helpful. And then last one for me, I'll jump off. But as we think about the numbers -- and I don't want to read too much into this, but if I know it's correct, you've done 51% of new sales being cloud year-to-date. Last quarter, it was 54%. Q1 was 48%. Does that mean that declined sequentially from Q2 to Q3? Or am I thinking about this wrong?

It may have declined a couple of percentage points. But I would say it's still been in a fairly narrow range through the first three quarters of about 50%. So, I certainly wouldn't suggest that a slight movement like that would indicate any market trend change. What I would say is we're seeing about 50%. And the conclusion I would draw from that is largely consistent for each of the first three quarters.

Okay, great. Thanks a lot guys.

Thanks Rishi.

[Operator Instructions] We now have from Mark Schappel with Benchmark.

Hi. Thank you for taking my questions. Alan, starting with you, your public sector has been a big focus of the company. Obviously, 3Q is a big public sector quarter. And you referenced a couple of good deals this quarter. With respect to the delivery mechanism in the government and the shift to cloud, what are your government customers? What's their approach to cloud versus licenses? Are they still hanging on to licenses or are you starting to see them adopt -- or starting to adopt cloud deals?

Yes, we're seeing them adopt cloud deals. The interesting thing that's an option for us is the entire -- the whole question of Cloud Choice because we give them a lot of options as to whether a government customer might choose to use a cloud from Pega or whether a government customer might choose, for example, to move it to one of the AWS or Azure-type instances that they might use externally. Or some of them actually are still focusing on having some level of private cloud. We deal with a number of agencies actually in several countries that have an extreme security expectation. And frankly, some of those agencies would never buy from an American cloud company to run on the American cloud because of some of the laws that have been passed, which could make them subject to U.S. subpoenas. So, in those cases, I think we're seeing the move to cloud. It just may want to be a cloud that they choose to run. I think that's great for us from a positioning point of view. It really enforces the value of that Cloud Choice proposition.

Great. Thanks. And then, Ken, in your prepared remarks, I believe you noted that the company plans to increase investment in the sales and marketing area. I was wondering if you could just expand on that a little bit such as where you plan to focus those investments in terms of, say, geography, sector, customer size?

So, we have some primary markets, geography and also verticals, where we've been very successful over the years. And as you can imagine, at our size, we have a lot of runway to improve our coverage of some of these very, very viable and interesting enterprise organizations. So, I think I would be less focused on Denver versus Boston versus the U.K and more just highlighting the fact that we have a lot of runway to really grow the business to a much bigger size than what we are right now. And naturally having customer-facing capacity is important to be able to drive that. Alan [Indiscernible]

Yes, I can jump in. You're not going to see us running into slews of new geographies because we've done actually quite a bit of analysis this year. And we've decided that what we really want to do is increase our density in a number of organizations that we might be covering with a fraction of a person or that we might be covering with an individual when the scale of the company and the scale of the opportunity in it would mean that to cover it effectively, you need to be several times just one person. And so by taking that as a strategy, I actually feel really good that we're going to be able to improve the reliability of our selling because we're not going into experimental new places. I mean, just talking about the government for a moment, to properly cover the opportunities we have in government, we could be several times our current size in that team and still, frankly, have what I would consider only partial coverage. So, I feel good that we know where and how to increase the density and to increase that coverage, which should be more reliable than if we say we're running into a whole bunch of new geographies.

Great. Thank you. And then finally, Ken, again for you. With respect to operating margins in the quarter, where do you estimate operating margins would have been if it wasn't for the aggressive shift to the cloud?

So, if you adjust -- if you think about the cloud -- the impact of moving to a much higher cloud percentage and really have to think, Mark, not just of the 30% to the 50%, but you have think about what our cloud percentage was last year, which was in the low 20s to where we are, which is, just call it, 50%, 51%, if you compare that, that's a fairly significant amount of impact, which actually all hits the bottom-line, to your -- which is where your question is coming from. We've looked at it kind of in a -- get a directional estimate of where our margin would be. Then our margin would be somewhere in the high teens, right, which is slightly better than where we would have been last year. But once again, we're growing at a faster pace and we're actually increasing selling capacity to prepare for kind of the next year and the follow-on year growth. And that helps to offset what would have otherwise been greater margin expansion. The problem with it is the accounting because of the -- pushing the revenue out under cloud arrangements really obfuscates that natural inherent margin we have because you won't see that until you have a number of cloud years kind of stacked in, which we're really only in about the first 18 months of that big shift to cloud.

Got it. Thank you. That's helpful. That's all from me.

Thanks Mark.

[Operator Instructions] We do have a question from Stephen Bersey with MUFG.

Hey guys nice quarter. Just wondering if you're noticing any trends as far as industry vertical and acceptance or pushback to cloud adoption.

Yes, this is Alan. I'll say that -- so cloud has become truly a mainstream capability and desire across, I would say, pretty much all the verticals. So, there are specific applications where customers are not as interested for a variety of special security or other sorts of reasons, but the cloud has been really subject to a huge transition. With hindsight, I wish we had accelerated our transition and I referenced to this three years ago. But since we've put the pedal down, we're seeing the results that we want. And so we think that's just going to continue. I'm -- frankly, I was a little surprised that in some of the industries that folks have become so accepting, but at this point, we're all in.

Thanks guys.

[Operator Instructions]

I think with that -- I'm sorry, is there another question?

There are no questions, sir.

Well, on that take, I'm just going to wrap it up. It's a little bit late here in London and it's been a long week. But I want to thank everyone and let you know that we're working very diligently on your behalf and are really pleased with what's going on and how we think we can continue to drive success. Talk to you all soon.

That does conclude today's conference call. Thank you for your participation. You may now disconnect.