Good day and welcome to the Pegasystems' Third Quarter 2020 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ken Stillwell. Please go ahead.

Thank you. Good evening ladies and gentlemen and welcome to Pegasystems' Q3 2020 earnings call. Before we begin, I would like to read our Safe Harbor statement. Certain statements contained in this presentation may be construed as forward-looking statement, as defined in the Private Securities Litigation Reform Act of 1995. The words expect, anticipate, intend, plan, believe, will, could, should, estimate, may, target, strategy, 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 that this 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 2020 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 2020 earnings and in the company's filing with the Securities and Exchange Commission, including its Annual Report on Form 10-K for the year ended December 31, 2019 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 the forward-looking statements, whether as a result of new information, future events, or otherwise. And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

Thank you, Ken. The highlight was strong. Our results to Q3 demonstrate our ability to forge through and succeed during this challenging time. Our business continues to perform well due to several major factors. Digital transformation is existential for our clients. It is central to their continued existence and prosperity and an increasing percentage of our revenue is predictable and recurring. Through Q3 our total ACV which we consider the best indicator of our improving cash flows and underlying business growth increased by 21% year-over-year in cost and currency with two-thirds of our new business coming competitive out of this quarter. We continue to extend our leadership in key markets that are less adversely affected by the pandemic. Markets such as financial services, government, healthcare and insurance often in telecom and by working with large global organizations we're grateful to work with organizations that can withstand the short-term effects of today's market and in fact find their needs increased. As noted previously we have a strong cash position to help us through this period of uncertainty so we can continue to invest for long-term growth. Now we are now more than about halfway through the transition to refer and as we start to get closer to completing this transition unsurprisingly our cash flow should and will start to improve. We anticipate that the cash and revenue will start to be a better reflection of the health of the business notwithstanding the lumpiness of any. Our team remains strong resilient and committed to the success of our clients and Pega and I remain deeply respectful of how they and our clients are engaging as we collectively navigate through this ongoing time of uncertainty. Now in terms of client trends our sample is ideally suited for organizations that continue to face immediate…

Thanks Alan. It's clear that our Pega cloud business continues to expand at a rapid pace reflecting the solid execution of our strategy to lead with Pega cloud. It's also awesome to see the improvement in Pega cloud's gross margin which have improved significantly year-over-year. For those of you that who are newer to the Pega story, we accelerated our transition to Pega cloud at the start of 2018 moving from a business that primarily sold perpetual software licenses to a business that primarily sells recurring cloud arrangements. A cloud transition typically takes a software company four to five years to complete. We estimate that we're about 60% of the way through our cloud transition. What this means is that customers have largely moved away from deploying Pega under professional licenses now almost all our new client commitments are cloud. These customers are either subscribing to Pega cloud, a cloud deployment that we manage or client cloud, a cloud deployment that our clients manage on their cloud of choice. As a result our total software revenue mix has shifted largely to recurring. In fact through the first nine months of 2020 more than 90% of our software revenue is recurring. Pega is well on its way to remaking itself as a subscription software company but this significant multi-year shift from perpetual to cloud arrangements has implications for our reported financial results as I mentioned every quarter. It delays significant revenue recognition and cash collection to future periods causing some odd upticks for revenue cash flow and profitability. We expect that revenue growth, cash flow and profitability will normalize as we finish our cloud transition in early 2023. However, we're confident that this move to a recurring revenue model in cloud computing and will help us set up for the next…

Thank you. [Operator Instructions] And we'll take our first question from Chris Merwin from Goldman Sachs. Please go ahead.

Hi this is Kevin on for Chris. Thanks for taking my question and congrats on the great quarter. I guess a question on cloud backlog which accelerates nicely in the quarter can you talk maybe a bit more about the drivers of strength there? Are you seeing improvements to sales cycles and how is duration trending for deals?

So I'll take that first. Go ahead Alan.

Go ahead.

So what I was going to say some of it is math and the fact that we had such a big cloud mixed at the quarter 66% you would expect that our revenue would be lower in the quarter and you would build more to backlog, but that if that trend continues naturally that Pega cloud backlog is the lifeline for our future revenue. So some of it is just the very strong momentum of Pega cloud that actually helps build that and some of it is the fact that clients when they look at Pega's offerings our Pega cloud offering is now much more prominent and much more interesting for our clients than when we first started to talk about it three, four, five years ago. So some of it is the momentum of just the math of a quarter but in general we're seeing more and more clients engage with us around Pega cloud. So sorry, Alan. Go ahead.

I was going to say we've seen a number of clients think that Pega is the best company to run Pega client cloud I think is very important and when a customer is moving its entire data center infrastructure to an Azure or Google up they may want to have their Pega infrastructure since we're so tied into their systems really is part of the way they think about their technology sector but for lots of customers they're saying hey we know that you'll be able to make it easier for us to tune to grow and to build. So I think it's just maturation in the market of how we talk about it and our strong successes.

Great. That's helpful and then I guess one on cloud gross margins obviously we saw a really nice sequential improvement there more than we've seen typically. Anything to call out other than kind of general scale efficiencies that's helping that metric?

Yes. So the great thing about as I'm sure many of the great thing about software is that it's highly leveraged at the margin line. The thing with SAS is that it is also highly leveraged as you scale at the margin line if you have an efficient cloud operations or SAS operations but as we when we were a smaller scale we weren't as efficient and now that we have more scale there are technical tools that we can use like Kubernetes like hibernation like things that we can do to actually become more efficient but there's also just the natural operating leverage that the more clients you have you become better and able to handle significant client capacity and get operating leverage out of the amount of people and technologies that actually support that. So we expected our cloud to grow this year. I think we're doing even slightly better than we actually had and hopefully be at this point but remember we still do our goal is not 64% our goal is into the mid-70s. So we still have, we're still on this journey but we're very happy with where we are right now.

Great. Thanks for taking that question.

We'll now take our next question from Jack Andrews from Needham. Please go ahead.

Good afternoon. Thanks for taking my question. I was wondering if you're seeing it perhaps a culture change around Pega and your modernization efforts as you continue to penetrate organizations meaning that as you continue on your path more software is getting developed in the hands of more functional users are people now waking up to really what is the art of the possible I guess with Pega and all the possibilities or is there still some work to do on that front?

Well, it's it's organization by organization because you really need to be able to show people I think the great possibilities but our customers are doing a good job, a very good job of being able to show what's possible and being willing to talk publicly about it at considerable detail not at that as 30,000 foot level summary, but really actually talking about how for example the CEO of the bank of Australia attributed the fact that they outperformed all of their peers to what they call their customer engagement venture which they've been very public of technologies they just do a brilliant job with. So I think we are seeing that recognition that Pega can vote help them materially change their game and frankly I'm getting lots of positive feedback on the architectural changes we've been doing as part of project phoenix which is introducing a very micro services oriented very lighter approach to how Pega looks for our customers particularly for those customers who are client cloud who care tend to care about that more. Q – Jack Andrews: Right. I appreciate that just as a quick follow-up when we talk about the divergence and growth rates between Pega cloud versus client cloud do you expect that to continue or should these growth rates perhaps converge over time?

No. I think that Pega cloud will grow at a faster pace for some time because one, it's a more prominent deployment a desired deployment model for clients. That's point one. Point two is you are starting Pega cloud is slightly smaller than client cloud and so you do get the advantage of having a more accelerated percentage growth but I do see clients wanting both wanting the option of having both but I do think at least for the next couple years the math of the growth rate certainly would I would think would skew more towards Pega cloud. Q – Jack Andrews: Got it. Thanks and the congratulations to the results.

We will now take our next question from Mark Murphy from JP Morgan. Please go ahead.

Yes thank you. Nice job on that backlog piece Alan I think you had mentioned this focus on finishing up the year pretty strongly I'm wondering if you could maybe just speak to the texture of the Q4 pipeline in other words is it lumpy or is it pretty well diversified and do you have any sense that there is a fairly normal or healthy Q4 budget flush environment I guess at least for the digital transformation projects that are out there?

Well because we're mad because we're managing to ACV right which is a recurring forward-looking way I don't think for the last couple of years frankly budget flush has mattered as much as it did in the old perpetual day. The reality is that Ken said we have a lot of wood chopping before we always do but. I'm pretty comfortable that there is a lot of there too chop. That the pipeline is strong and people are certainly working really hard. We are in an unpredictable environment and not just the pandemic but politically but I'm really thrilled that we've been able to report such strength for Q1, Q2 and Q3 and I've got a lot of confidence in this team. So we're working as hard as you can here.

Yes. I understood okay and then Ken I wanted to ask you as well just on the international piece of the business are there any customer discussions or any pipeline in Europe that that's seeing impact of the COVID flare-ups in this second wave of lockdowns or is there any reason to expect some volatility in Europe?

So it is a little early with the Germany and France stuation so I mean just that's only really emerged in the last few days. What I would say though is and there hasn't no, I've not I'm none of none that I know of but what I would also say is remember the lockdowns that we had back at the beginning part of the year and our clients largely forged right through that period of time and so given that any lockdowns that you at least what I read any lockdowns that you see now are not going to be as dramatic as what we saw earlier in the year. I would think it that it would be no worse than what we saw earlier in the year and we did see some impacts here and there there's no doubt but it didn't materialize into impacting our growth trajectory. So I wouldn't say that we're at a stage right now where that is something we're preparing for which is massive spend reduction because of it anything can happen but that's not something we're thinking about right now.

[indiscernible] first half it was a little horrifying because nobody knew what to expect. If we go back to more lockdowns now I was on the video chat with a major French organization today and they understand that their digital transformation has to continue whatever happens.

Yes I see. Okay. Ken one last quick one again understanding the ACV piece and the backlog piece very, very robust and realizing term licenses are not the focus here but can you just speak to that? Were there any particular verticals or transactions on the term licensed side where that might have gone one way or the other in Q3 and just any feeling on maybe is there anything we should be thinking through on that term license piece of it for Q4?

Sure. So just to remind you that the second quarter and the third quarter are typically not big renewal quarters. It's typically our biggest real quarter is Q4 as you can imagine because that's when a lot of our historical bookings happen and sometimes the renewals leak into Q1. So in terms of revenue from term licenses which is come up front under 606 Q2 and q3 typically do not have a significant amount of that. Q4 has some and so does Q1. I think the bigger kind of behind your question a little bit is that I've been seeing and I'm very close to the deals at Pega probably even more so than most CFOs because some of the functions the report to me but I'm very close to the deals and I will tell you there are a lot of deals that start one way and go the other, start term, go cloud, start go term that happens all the time in a cloud choice model. I have been seeing more of a prominence of things landing at Pega cloud over the last five or six months and I do think that might be just the maturity of Pega cloud so what that would mean to me is that the growth rate of Pega cloud could be sustainable and that term license and the variability of term licenses wouldn't be as big of a faster as we finish the cloud transition if that's helpful.

Appreciate. Thank you very much.

Relatively what you're saying the cloud operations now reports to Ken. So he has a very close access to both implementing or helping implement and being aware and improving our cloud operations. But he's been doing a great job with that.

Got it. Thank you.

We will now take our next question from Mohit Gogia from Barclays. Please go ahead.

Hey guys thanks for taking my question and congrats on the solid quarter. Alan, I was just wondering so Q3 obviously a big quarter for everyone and you did outline some of these in that vertical but just can you give us more color as to how that business performed relative to your expectations going and the pipeline that we had going into Q3 and what are the sort of like anything to call out in terms of the shape and form of deals with the deal cycles so just wanted to get more color on the federal performance this quarter.

Yes. I didn't hear the vertical you mentioned sorry can you repeat it?

For Federal.

For federal. Well look federal I think it's not just U.S. federal but governments globally we've been seeing a lot of activity in everything from the UK government to the German government to the obviously the west government I mentioned the small Australia. The nature of that business I think was slowed by the pandemic a bit but then really kicked in and the pipeline there is all very-very nice and as we would hope and want. So I think that the being able to make governments more efficient and able to handle some of what's clearly going to be a long-term sort of set of issues isn't going away and I think we'll continue quite strongly I expect next year as well.

Right. And the follow-up question I have is on the Pega cloud piece. So the new client commitment seems to be really sort of like reflecting as you saw this quarter but just wondering as you stick here right as you look towards Q4 and also for next year our things about sort of like maybe moving the maintenance customers over the Pega cloud? Do you think that the time has come sort of like to put more formal programs in place to do that or do you think that should be discussed more initiative than you was like a sales incentive that's just so much I guess.

We're doing, that's a good question, we're doing some but unlike some companies we'd much rather sell a new piece of business on Pega cloud than move an existing customer on Pega cloud unless it's going to lead to much greater radiation. So we're not I know there are some other companies that basically gone out and said we want to get all our customers onto Pega cloud and we're doing it more as it makes sense for that customer as opposed to just trying to drive what frankly would risk being a short-term burst, a year or two burst of booking. We really want to make it so we're growing that business as opposed to just converting it is if that makes sense.

Thanks guys.

Yes, and I will add one clarification that two years ago we weren't ready to do that. We didn't have, we weren't as confident to take on all the new growth of Pega cloud and convert client. That is no longer a gate. We feel very comfortable to move clients but to Alan's point we want to move them when they're looking at increasing their footprint with Pega that's the opportune time to actually make that transition not just go to clients that are perfectly comfortable in the environment and try to in some way force them or invent them to move unnecessarily. We're trying to do that in an orderly fashion.

And we'll now take our next question from Patrick Walravens from JMP Securities. Please go ahead.

Hi, this is Mark on for Pat. Thank you so much for taking my question. So you mentioned in terms of the strength in the robotic process segments. So I was wondering have you seen any changes in that after that and then thank you.

Sure. so it's interesting because people who are new to the story may not be aware. We view robotic process automation as very much an adjunct to end-to-end automation. There is been a lot of talk about how dropping these robots in is going to just automatically revolutionize the way the companies work and the reality is as we entirely expect it organizations are finding that what they really want to do is hook their robots into a backbone where the backbone is in control as opposed to having all these little disjoint robots doing it and that we now support with our recent releases we support hooking into other brands of robots. So they don't have to rip them out but we've had some very large organizations that have said boy it's really clear that when you have a Pega end to end process you're automating and you're using a Pega robot that everything works exactly in the right way and you're not biasing things towards like robotic desktops. So it's not just getting better scores with analysts which we love getting we're seeing customers really starting to understand that more deeply and that drives not just our robotic process automation part of our business which is doing nicely but it also drives the entire Pega infinity and dead story.

Got it. Thank you so much.

We'll now take our next question from Yun Kim from Capital Partners. Please go ahead.

Thank you. so hey first congrats on a very strong quarter Alan and Ken, do you focus more on increasing your penetration within your large customer base should we expect to see client cloud growth perhaps we accelerate here from the current low teams to mid teams or even higher or do you expect those large existing customers to also dig into adopt Pega cloud more meaningfully for new projects especially on larger size projects?

Well it's interesting. We've seen some of those very large additional penetrations come into Pega cloud and that's been really quite it's really quite gratifying. We have some enormous systems running on Pega cloud. So as Ken said earlier a lot of times the decision as to which form of agreement they want ends up flipping back and forth right up to the very last last moment and so it's almost hard for me to give you guidance as to what that trend line is firmly going to be but there's a lot of enthusiasm about it.

Okay, great.

One additional point Ken. Just one additional quote so we get about 75% in 2020 what 75% of our new bookings are with our existing logos. So given that our cloud percentage is so high I think you could do the math just quickly and know that our existing clients are buying Pega and cloud at a pretty pretty hefty pace as.

Okay, great. That sounds really good. It seems like there is transition point coming up or already been there but it can on Pega cloud sounds like obviously the new customer ad has been pretty consistently strong for that cloud business but can you give us any sense on how the velocity of the expansion or even really the expansion rate has been trending for that business? Thanks.

Yes. So I don't think there's a good metric I could disclose right now on that. Now let me explain why. The common NRR or net retention rate or net expansion rate really applies to clients that have a deployment and they're increasing usage. If you look at the growth of Pega cloud for us I would say most of it is coming actually from new client environments going on to Pega cloud as opposed to somebody starting off with a hundred users and moving to a thousand. So I think at some point in the future that'll be a more interesting metric for right now most of our Pega cloud growth is actually new client environments going on to Pega cloud which then gives us the room to grow off of that initial footprint. So I think we're still early in Pega cloud in terms of that being the most meaningful metric.

Okay. Great thank you so much.

Yes.

We'll now take our next question from Steve Enders from KeyBanc. Please go ahead.

All right great. Thanks for taking the question. I'm just wondering in other words six months into under the pandemic and everyone working from home have you seen any change in the mix of project use cases that customers are bringing into you?

Yes. I think that they've gotten more strategic in the early days you had a lot of sort of panic reaction but the discussions we're having now are really consistent if you want to get a real understanding of the vision that I think is resonating extremely well. I have my 16-minute keynote from Pega world in June and this concept of a center out business architecture to really think about the work and decisions your business is making is really resonating and those are more strategic initiatives and there is a lot of time and a lot of attention that organization being spent on those.

Okay. That's great. And then I guess just on the cloud side I know you're saying that you think that I think Pega cloud is I guess more ready for some of these customer use cases should we expect I guess from here the mix of new business coming in to turn more towards the two-thirds cloud missed this quarter versus kind of a 50% expected or how should we kind of think about that from here?

I'm going to leave that crystal ball to Ken.

I mean I think I think so specifically we're talking about Pega cloud so your question was around Pega club growth rate sorry I keep broke there for a second.

No, it was about I think [indiscernible].

Yes. The mix, the Pega cloud mix. So I keep saying that the mix at 50% is something that we've seen more quarters than we haven't as you know but every once in a while a quarter jumps up a little bit I don't know if that's a trend or if that just happens to be an anomaly of a quarter but I'll tell you the feeling I have is the Pega cloud has momentum let me just say it that way but the mix could stay at 50. I just felt it's hard for me to guess but I will say that I would be surprised if the percentage dropped well below 50 for a number of sequential quarters. I think that's not the way the business feels to me.

Just quick follow up on that do you think there is anything related to you know work from home and I guess less ability to go into data centers that could be having an impact on that near term mix?

Absolutely. That has the factor I mean there is no doubt. I mean our clients companies in general pretty much everybody you talk to is reimagining the workplace, reimagining the work location and they realize that if they have call centers that call center doesn't need to be everybody going into an actual building together and so if you just use call center as a just one of the use cases I definitely think people are going to move to more browser-based interactions and they're going to need to have people in different locations and that plays right into digital transformation Pega and also mega cloud.

All right. Great thanks. Really appreciate the question.

Well now take our next question from [indiscernible] from Benchmark. Please go ahead. pleased to be a part of this recognition of women in technology.

Hi thank you for taking my question. Alan starting with you just building on one of the prior questions on your federal business which has been building quite nicely over the past few years. The government sector is a very large space especially the federal sector. I was wondering if you can just review the type of government use cases where you believe Pega is particularly strong.

So one of the things that Pega is extremely strong at is process automation and case management which is at the heart of our business and if you look at government it is full of what you refer to as case management whether it's actually processing applications, licensing of businesses, handling requests for help or assistance all of these fit perfectly into the model and if you go to our website and you'll watch my keynote you'll see something when government people see this they say boy this was really designed for the type of work of that we're doing. So it's an awesome fit for modernizations and they know they need to monitor.

Great. Thank you and then again one for you a question on extended payment terms last quarter you mentioned that you're seeing some customers request some extended payment terms. I was wondering if you're still some customers ask for that?

So it does happen infrequently but it does happen but I'll use a better metric for that and Mark and it is DSO. If you look at days sales outstanding our days sales outstanding at the end of Q3 have they peaked in Q2 and they've now come back to Q4 and Q1 levels of last year so I think what happened was in Q2 of this year Q2 June 30 you did see some people dragging out payments a little bit that seems to have corrected at the end of Q3.

Great. Thank you. That's all thanks.

We will now take our next question from Rishi Jaluria from D.A. Davidson. Please go ahead.

Hey Alan, Ken thanks so much for taking my question. I wanted to start by going back to new logo land. It sounds like it's healthy and definitely the, from your end sounds uh better than at the beginning of the pandemic or even last quarter. Can you speak a little bit to what why are you seeing better traction with the new logo landings is that just customers you know deeper into the pandemic and out of treehouse mode are more willing to have these conversations is it better sales execution and better adapting to the current selling environment is it investments in product that you've been paying off maybe help us understand that.

Sure and sadly I think this is going to have to be the last question because we're already five minutes late for another call. But I would say that a lot of it is changes in our behavior in terms of stepping back thinking about how we need to reach out differently being more focused. I actually think a lot of this is in our hands and also being more selective about where we go because some of the folks who you would have perhaps marketed to in January as new logos are clearly not the right places to go now though we have had buys I think I mentioned on the previous earnings call about how you know Cassay the airline decided to think he did us to help him get out of you know the current problems and what controls it so we do find these odd exceptions but I think we're trying to be more selective and smarter about where we are.

Okay. That's helpful.

We will talk about Rishi. Thank you.

Yes I'll share the rest of my question for the call back. Thanks.

All of our investors and the analyst and everybody who joined us and the Pega staffs and customers who would be on the call. Thank you very much everybody. Now we have a lot of work to do but we're working really hard and we're feeling like we're all in the same boat but we're all in the same storm but we're in very different boats and you know thankfully -- has made it through these first three quarters I think in if you look at ACV growth and if you look at backlog which are the two things we think are the critical ways to judge how a business is done our business has done it's been terrific. So thanks everybody thank you everyone for your support and look forward to talking to you at the end of the next quarter. Bye everybody.

And with that this does conclude today's call. Thank you for your participation. You may now disconnect.