Pegasystems Inc

NASDAQ:PEGA

Earnings Call Transcript 2020-Q1

[Operator]

Good day everyone and welcome to the Pegasystems' first 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, CFO. Please go ahead, sir.

[Ken Stillwell]

Thank you. Good evening ladies and gentlemen and welcome to Pegasystems' Q1 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, could, would, should, estimate, will, 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 Q1 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.

[Alan Trefler, Founder, Chief Executive Officer]

Thank you Ken. I am pleased with our results for Q1, especially given the pandemic. Our results are indicative of the success of our strategy around accelerated growth and continuing our shift to a recurring model. Our total ACV, the best indicator of our future revenue growth, increased by 21% for the quarter year-over-year and 95% of our Q1 commitments were cloud with more than 50% of them being Pega cloud.

Now, it's impossible to talk about Q1 earnings without acknowledging the unprecedented circumstances we are in and the effect on our business as well the lives of billions of people around the world. This includes our staff, clients, partners. And we are laser focus on taking care of them and making sure they have what they need. For us, build for change isn't just a tagline, it's in our DNA. And we have navigated through many challenging times before and have always come out stronger on the other side.

Our software and corporate culture are all about change and sometimes that's about accommodating change and sometimes it's about driving change and sometimes it's both. And that's what we are seeing right now. On the client side, the crisis is levying a profound toll on those businesses with avalanches of customer service calls working to support remote workforce, adjusting to new government policies and simply figuring out how to triage new and existing work.

I have been on video calls nonstop with senior executives of many of the world's largest and most successful brands. And I expected they would be focused exclusively on their most pressing and immediate challenges. And while most are mobilizing to solve the acute need that's near and now, a large number are also thinking beyond the next mode and understand that this is time for a massive rethink. It's catalyst to build stronger businesses who have very different future in 2021 and beyond.

For example, we closed a customer service deal in Q1 with a large airline in APAC, who despite essentially being closed down understand that they will need a strong competitive customer engagement approach when travel opens up for them to win back and keep customers. We are also responding with new solutions that can help clients with their immediate crisis while enabling them to support their long term business transformation initiative.

And in many cases, we are doing it in record time. For example, recently we created a portfolio of 18 industry-specific solutions to help organizations quickly adapt to the impact of COVID-19 while establishing their building on digital transformation efforts. These solutions are designed to deliver high-impact results right now but are more than quick fixes that could become technical debt later. For example, to help banks deal with the huge influx of applications for COVID-19 emergency loan, we developed a crisis small business lending reference application. It can be configured in just days and comes with prebuilt guidelines and templates that reflect new U.S. and U.K. rules. They can easily be customized to orchestrate crisis loan programs for other countries.

And in just five days, we rolled out and developed an application for the Bavarian government to help them provide faster relief to the small and medium-sized businesses affected by COVID-19 and reduce the strain on admin staff and improve processing time. They were so proud of it that they themselves put out a press release mentioning Pega.

And in early April, we engaged with one of the U.S. state government to help them address the floods of employment applications coming into their legacy system and in less than three weeks, we were able to stand up a new mobile friendly system to streamline the process with a chatbot for additional support and that system has already collected more than 750,000 applications.

And in the private sector, several weeks ago, we helped one the largest U.S. healthcare companies, many of whose 200,000 employees and volunteers [indiscernible] developed a COVID-19 call out and scheduling application in just 72 hours to better manage staffing and scheduling requirements to support its patient population. Inspired by that work, we developed an app that is free to all of our clients to help them track and manage COVID-19 employee exposure and help them make informed decisions enabling them to keep employees safe and thinking forward to when businesses more broadly will be open. We have seen a lot of interest in the clients and partners and discussions with clients are about implementing this free application. It opened up new commercial opportunities with many.

And not related to the pandemic, but one we are very proud of, is the Internal Revenue Service, which closed actually in April. We are excited to share that Pega was selected by the IRS after a deep competitive review to power their new enterprise case management. As stated in their procurement, Pega was selected because of our ability to provide a secure end-to-end integrated case processing solution to improve operational efficiency, streamline costs and enhance taxpayer services in a highly configurable and flexible environment. The solution will provide authorized IRS employees the ability to see the entire range of issues and communications associated with their work and quickly resolve them.

Now, as a business, we are ourselves dealing with some of the same issues our clients have of having to adjust to immediate pandemic related needs while ensuring we are making smart decisions and learning about what will make us a stronger company as we get through the crisis. We of course had to pivot nearly 100% to a remote workforce. As a technology companies, this meant for us to minimum disruption. We have already had workforces working in the field, VPNs in place, tools for meetings and so on. But nonetheless, I am proud and impressed with how our entire global team has not just adapted but innovated with incredible resiliency, passion and innovation across every function.

For example, our sales and client success teams have quickly become adept in running virtual sales calls, operational walkthrough and design thinking workshop. As a result, we have been able to continue to prospect and close new business as well as serve our existing clients. Our people team has quickly shifted so they could continue to recruit, hire and onboard new employees through a virtual orientation program and handling all the meetings and shipping of laptops in ways that are consistent with making our team immediately productive.

We have huge space in our business and continuing to hire for key positions with appropriate productivity. We are always on the lookout for people who can help accelerate our success. It's a real positive to be such a stable yet exciting employer of choice in this market and we are seeing tremendous interest in talents looking to join Pega.

To that point, we announced today that Hayden Stafford will be joining the company from a leadership position at Microsoft in a new role as President of Global Client Engagement, effective June 1, 2020. This will be reporting to me and this position will unify Pega's corporate strategy, marketing and go-to-market function and bring together the talented teams of Doug Kra, Head of Client Success International, Tom Libretto, Head of Marketing and CMO, Jeff Taylor, Head of Business Strategy and Go-To-Market Operations and Leon Trefler, Head of Client Success Americas.

Hayden brings tremendous experience and a robust record of success at Ernst & Young, IBM, Salesforce and Microsoft. And over the last six years, HE has grown MS Dynamics Customer Service and ERP by over 300% and has grown the Dynamics Cloud products by over 40% every quarter since 2014. We are excited that he has the potential to help and lead an acceleration of our growth as he did at Microsoft.

And our events team has of course has shifted our most important Pega event to a virtual format and really working to add new elements to take advantage of the virtual environment. Our first virtual customer engagement summit came together in just a few weeks and had more than 4,700 registered and PegaWorld our marquee conference is now a free, open to all, 2.5 hour virtual event on June 2 and is shaping up to be terrific with clients keynotes from Aflac and Siemens and others and an innovation hub with 25 demos of Pega solutions and live Q&A.

Unlike other companies who seem to be taking their physical event and simply transposing them to an online format, we decided that virtual format requires a complete rethink to make it tighter, more engaging and more worthwhile for the virtual at home attendee. We will be postponing our analyst meeting to later in the year but nonetheless I hope you will tune in to PegaWorld and watch the event.

And finally, with Project Phoenix, we are already positioning our core architecture for the future to help our clients create a new generation platform. As we move past the crisis, I expect those capabilities will be more pertinent than ever.

I want to end by saying that for us and our clients, there will be no going back to business as it. Like all global crisis that have come before, this one too will bring profound change. And that's something we build to help adapt and a drive, both for ourselves and for our clients. The changes we are going to see are in how people work, how they commute, how they transact, how they move goods, procure supplies, deliver services and engage with their clients. And they will persist long after the crisis stabilizes.

We anticipate those changes will require and benefit from a new future-proof design to an organization's business architecture, which we think we are terrifically able to provide. Organizations will have to become leaner. faster, more adaptable than they thought they had to be. Digital transformation will be a mandate and business resiliency will require exceptional and scalable digital customer experiences that can quickly adapt to future changing environment. Organizations will need to better understand and put in place truly resilient suppliers and go-to-market channels.

The crisis is forcing organizations to innovate and collaborate with an intense sense of urgency and there will be much more pressure to get greater returns on IT investments, something on model driven, low code technology is suited to provide. Organizations will realize the risk involved with managing your own data centers and they will not want to build everything themselves and this will mean an accelerating move to the cloud. But we believe current organizations will want the flexibility to use the cloud of their choice and switch as needed.

Cloud choice, already a differentiator for us, we predict will become even more important. And all of these are attributes and reasons why clients have turned to Pega in the past and will continue to turn to Pega in the future. We know there is a very real and profound loss and challenge right, more for some than for others. But I have always been an optimist by nature and I believe in the resiliency and adaptability of the human spirit. Long term, we will emerge from the crisis, stronger and with great new ideas.

So in summary, we are off to a solid start in 2020, especially considering the current crisis. We will see impact from the pandemic, but we are in a good position to weather the effects and see opportunity for us and our clients to come out stronger when we are through the crisis. We are adjusting to both the short term and long term needs of our clients and we are finding them receptive.

And to provide more color on the financial about results, I will now turn this over to our CFO, Ken Stillwell. Thank you Ken.

[Ken Stillwell]

Thank you Alan. I want to start by echoing your opening comments that our number one priority right now is taking care of our employees, clients and partners. The global spread of COVID-19 has disrupted the lives of billions of people and we recognize the reality of much more challenging economic environment. I am sure you want to know about the impact of COVID-19 on our business.

In Q1, we did not see any meaningful disruption to our financial results. Overall, I am pleased with how our business has responded. Prior to the pandemic, 30% to 40% of our employees regularly worked remotely. And today, almost all of our employees are working remotely and effectively, I might add. Our sales team continues to engage and acquire customers. Our customer support and cloud teams continue to provide high level of support to our clients and partners. And our development team continues to enhance and improve our products.

Our business is resilient and I remain confident in our ability to deliver on the long term strategy to be the leader in digital transformation. Let me shed some light on why I feel this way. We have made some pretty significant decisions over the last few years that, well, you could choose to call that timing lucky or smart, but by the way, these things position us well in the current environment.

First, we started our transition to a recurring business several years ago. As a result, most of our business is now recurring. To be specific, our business was about 50% recurring revenue several years ago. And it's about 75% recurring revenue today which is supported by our very high net retention rates. If you include Pega consulting revenue, which is highly predictable, we have about 90% visibility into our 2020 revenue target. This shift to a business that's largely recurring means our quarterly revenue and billings should be much less vulnerable to short term disruptions from situations like the one we are seeing now. That's because a business with a higher proportion of recurring revenue and a lower of customer churn like ours is less reliant on new customer bookings to achieve its quarterly revenue and billings plan.

Second, we decided to raise $450 million of cash through a convertible debt offering in February 2020. Investor demand was oversubscribed by a significant number and we decided to increase the size of the offering to $600 million to satisfy this tremendous demand. And we did the offering at a time when the economics for the transaction resulted in an effective conversion premium of almost $200 per share. The available liquidity provides us with financial strength and flexibility to successfully navigate the market for digital transformation solutions and make the right long term decisions. No one knows exactly what's going to happen but it's an important time to be well-capitalized.

Third, remember that our core verticals such as financial services, insurance, healthcare, telecommunications and government are less directly exposed to the short term impact of this pandemic than industries such as airlines, hotels, restaurants and retail. Also, our core clients are some of the world's largest and most well known and well respected brands. In challenging economic times, unfortunately, small and medium sized businesses are often the ones that struggle most in the near term when compared to larger enterprises that have strong financial profiles to withstand short term shocks. Given the number of large enterprise and federal government clients we serve, our business doesn't have the same level of exposure as a firm that primarily sells to small and medium sized businesses. Simply stated, the underlying strength of our large enterprise customer base is a core attribute of our business. It's helped us not only weather difficult economic times in the past but also helped us score revenue through those periods and in the current period.

Finally, our digital transformation product portfolio features unique benefits that are critical to our clients. Our customer engagement suite helps our clients retain their customers. Our intelligent automation suite which includes our industry-leading business process management software helps companies reduce costs by improving efficiency and effectiveness. Our core value proposition is proving important to our clients and help Pega continue to grow during the past downturns. In other words, Pega provides strategic applications to many of the world's largest companies, which are critical to those firm's ongoing success. For example, many of our healthcare clients are right now supporting their nurses and doctors who are treating people in fighting the virus every day. Given the mission critical nature of our application and the fact that the cost, effort and time required to replace our solutions would be prohibitive in most cases. Our gross customer retention rates continue to be very strong. As a result of these and other significant decisions, we built a business that is very resilient.

So now let's turn to our financial results for Q1 2020. Especially for those of you who are new to Pega, I will start by providing a little more context regarding the evolution of our business model. Back in late 2017, we purposefully shifted Pega's business model, starting the process of moving from a company that primarily sold its software on a perpetual license basis to a much larger company that sells mostly on a subscription basis. Now that we are past the midpoint of our cloud transition, you would expect to see cash flow improve as we approach the end of the transition in 2022. During our cloud transition, the two most important metrics we have tracking to measure the impact and progress of our strategic execution are annual contract value or ACV and remaining performance obligation, RPO, also referred to as backlog.

Let me first talk about ACV. Total ACV is the sum of recurring Pega cloud and client cloud commitments representing the annualized spend from our clients for cloud term license and maintenance. Another reason ACV growth is so important is because it's the best leading indicator for future revenue growth. We entered the year with a target of increasing total ACV by at least 20% in 2020. And I am pleased to report that total ACV slightly exceeded our expectations for Q1 increasing by 21% year-over-year on a constant currency basis. At the end of Q1, our total ACV was $711 million, up from $588 million in Q1 2019. Pega cloud ACV growth grew 43%, from $127 million to $182 million in the same period. ACV growth continues to be our most important metric, reflecting the successful execution of our strategy.

So now let's turn to remaining performance obligation, also called backlog, which is another important metric. Backlog reflects client commitments not recorded as revenue as of the period reported, providing visibility in to where a significant portion of our future revenue will come from. A robust backlog is another benefit of our cloud transition. Historically, much of our bookings were taken as revenue in the current period causing variability in our quarterly results. These days, the largest portion of our bookings are cloud, most of which goes into backlog creating a more predictable revenue and cash flow stream in the future. Pega cloud backlog increased by 18% from $351 million as of March 31, 2019 to $414 million as of March 31, 2020. And total backlog increased by 19% from $633 million to $754 million during the same period. We expect about $433 million or 58% of this backlog to be recognized as revenue in one year or less as of March 31, 2020.

Turning to revenue. Total revenue for Q1 2020 was $266 million, an increase of 25% from total revenue of $213 million in Q1 2019 driven by 57% increase in cloud revenue. The 25% increase in total quarter revenue was the fastest growth we have seen since we started the cloud transition. For 2020, Pega cloud mix was expected to represent about half of our new client commitments but our performance in Q1 is fairly consistent with that. We actually had slightly more than 50% in Pega cloud. In total, approximately 95% of our new client commitment were either Pega or client cloud and approximately 5% were perpetual license.

For the three months ended March 31, 2020, we reported both GAAP and non-GAAP results and a full reconciliation of our GAAP to non-GAAP measures are provided in the financial tables in the press release issued earlier today and those are available on the Investor Relations section of our website. Non-GAAP net income was $0.05 per share compared to a net loss of $0.12 per share a year ago. Much like revenue, net income is also impacted by the cloud transition that we are going through.

So now let's turn to a few other details. Largely because of the convertible debt offering we completed in February, Pega finished the period with total cash and marketable securities of $538 million at the end of Q1 2020. In the three months ended March 31, 2020, we returned about $31 million to shareholders comprised of dividend, buybacks and net settlements of equity. We ended the quarter with just over 5,300 employees worldwide, an increase of 15% from one year ago.

Turning to our outlook for the full year 2020. As you know, we don't provide quarterly guidance or update full year guidance during the year. We acknowledge that there is increased uncertainty in this environment for all businesses. Our business is well positioned to succeed. Let me share some color on what we have been doing to monitor, prepare and respond to situation and give you some perspective.

Our leadership team meets several times a week to monitor the broad effects of COVID-19 on our business and is responding quickly to evolving events. In times like these, Pega is really benefiting from having a Founder CEO who thinks about the long term and who is committed to Pega's success, not only in the next 90 days but also over the coming quarters and years. As Alan said to me, he has seen lots of disruptive events over the years and Pega has really been resilient since its founding in 1983.

While we have not a meaningful impact to our reported financial results to-date, it's hard to know how this all is going to end up. We have seen an outpouring of new demand because intelligent automation and digital transformation solutions are very critical to the response of our clients and the ability to transform in a post COVID-19 world, not only in the medium term but the long term.

We have also seen clients change some of their spending priorities. Some projects have been delayed or in some cases canceled. Buying decisions will be pushed out for later period which could negatively impact year-over-year booking results in future periods. So we are closely watching pipeline conversion rates. We expect the natural cost efficiency associated with the COVID crisis such as reduction in travel expenses and some thoughtful hiring through the year to offset some of the revenue pressure we could experience if some companies delay spending decisions given the uncertain economic environment.

We expect that some of our clients will need additional flexibility with payment terms as they work their way through this downturn. We expect that it's going to be more difficult to acquire new logos in this environment as large enterprise clients are likely to concentrate future spend with their most important vendors. However, in a typical year, more than two-thirds of our new client commitments come from expanding with our existing clients.

That means that Pega is less reliant on landing new large customers to drive our bookings growth. It's also important to point out that we are not even 20% penetrated in our largest clients, which means we have got a solid opportunity to drive ACV and backlog growth by selling into our installed base at many of the world's largest companies. As Alan mentioned, we believe so far that 90% of all Pega's active professional services engagements are largely unaffected by working remotely.

We have also heard from our large system integrator partners like Accenture and Infosys and others that believe that they can do about 90% to 95% of their work remotely. However, in some cases, there may be project delays that could negatively impact professional services revenue recognition if those impacts occur. Despite these challenges, I believe we can learn from history.

One thing you might be curious about is, how Pega performed during the great recession of 2007, 2008 and 2009? Why was it that Pega was able to grow revenue during this period? One key reason, our digital transformation solutions helped companies reduce costs and streamline operations which is a top priority for leaders, especially during difficult economic times. In other words, the major economic disruptions that take place could actually be an accelerant to adoption of some of the solutions if they match the same challenges we saw with our clients in the last recession. And customers will increase efforts to cut cost and automate processes.

In conclusion, I believe in the resiliency of our business and I believe in the flexibility for us to not only sell as clients are growing and acquiring new customers, but also when they are trying to optimize and automate processes in their business. As I explained earlier, our revenue is largely recurring, our balance sheet is strong, our customers are stable and our value proposition is compelling, now more than ever. These are the key reasons why I remain confident in our ability to deliver on our long term strategy to be the leader in digital transformation.

Before opening the call to questions, I wanted invite you to PegaWorld, our annual customer event which will be held on Tuesday, December 2 as an interactive virtual event, as Alan mentioned earlier. You can register the event for free at pega.com. We have decided not to hold the Investor Day in June. We are looking at other rescheduling dates in August and we will provide more details as we finalize those plants.

And last, I just wanted to congratulate Pega on Hayden Stafford for joining. I have talked to Hayden a number of times through the process and I just think he is going to be terrific and can't wait to work with him.

Operator, please open call for questions.

[Operator]

[Operator Instructions]. We will take our first question from Steve Koenig with Wedbush Securities.

[Steve Koenig, Wedbush Securities]

Hi gentlemen. Thanks for fitting me in and congrats on the quarter. So I have been following you guys enough quarters that I know how your guidance approach works and I expect you guys to stay consistent with it. I am looking though for maybe some color. And I guess when I think about it, given the transition that you have made to recurring revenue and now to cloud, my thinking is you can still layer on additional ACV and grow that ACV line pretty nicely even if your new bookings were down substantially year-on-year. And I would like to avoid guessing my questions, but am I thinking about that the right way? But then beyond that, can you guys give me any color on how you are thinking about the pace of sales achievement and how it could layer in over the year? Nobody can predict the pandemic, but how are you guys planning for internally? As you said, you are hiring as you adjust your quotas in the plan for the year. So any color there would be much appreciated.

[Ken Stillwell]

Hi Steve, this is Ken. I will take a stab at that. There are going to be some things when there's an impact, but the impact will be immediate. For example, if professional services engagements scale down, that will have an immediate impact to revenue in 2020. So that would be an example of something that is, if there is any impact, it will impact revenue in the current period.

Perpetual licenses, although we only have 5% of our new incremental commitments perpetual in Q1, perpetual naturally convert into revenue. New client cloud deals that are like term licenses, for example, may have revenue in the current period. But if you think about the majority of our bookings being Pega cloud, you are right, that any booking impact wouldn't have as much revenue impact in a recurring world. So even if you did have softness in bookings, there wouldn't be as direct a correlation to revenue reduction like there would be if we were a perpetual business.

So you are absolutely thinking about that aspect, right? And there is real short term risk on professional services to the extent that you couldn't execute some of the work and also any billable travel that maybe is a component of professional services, which naturally some of that, a small amount of that does become revenue, people aren't traveling right now. So there are things that are real risks in revenue.

But if you think about a recurring business, the booking trend tends to stay with you over multiple years as opposed to an immediate impact in quarters or even within the year. So that does insulate us somewhat as a recurring business. So hopefully that helps.

[Steven Koenig]

It does. If I could ask one follow-up, it would be a financial follow-up here, which is thinking about as bookings potentially gets impacted, what that would do to your ACV? And the long term target of 20%, even if that was still solid, which I presume it is, if your bookings were down and even if they were down significantly, could you still grow? Is it possible to grow ACV double digits this year, for example, if your new and expansion bookings were, let's say, only half of what they were last? Maybe an extreme scenario, but to the extent you can help us think about those numbers and the impact on ACV, that would be helpful, too. And that's all I have for you guys and congrats again on that solid Q1.

[Ken Stillwell]

Thanks Steve. So let me take that one. So I am going to do just a simple math, which is if we didn't book $1 in a year, theoretically, our ACV would be flat. Let's just assume that we had 100% retention, which we don't have 100% retention, but we are very close. So naturally, any bookings will help to grow the total ACV number.

So you could see a haircut in bookings that was a reasonable percent, but still have a respectable ACV growth. But I would not suggest that we could grow ACV at 20% per year with having a significant reduction in bookings, if that helps. But certainly, there is some level of sensitivity that you can withstand to bookings shortfall and still stay above our long term target.

[Alan Trefler, Founder, Chief Executive Officer]

I will jump in for a second. I think it's fair to say that the intensity and the continuation of the engagement with clients have been very reassuring. We are finding that customers are taking meetings. They are spending time with us. They are engaging. And so I am personally not expecting any sort of catastrophic decline, particularly because we are in the business of making people more efficient, which is going to be important and helping people work from home and helping an organization that has become disaggregated, where their people are spread out more. We manage the flow of work and the automation of that work. So it's not surprising to me actually that customers or prospects are still willing to engage.

I think that Ken's comments about the characterization of our customers as being the stable ones, we are in a very different situation, I think, than if we have lots of SMB businesses, global customers. We have a couple. But historically, we really have been very concentrated because I think you know in the echelon of organizations that are going to make it through this and they are going to want be more efficient.

[Steven Koenig]

That's great. Thanks Alan. Thanks Ken.

[Operator]

We will move next to Rishi Jaluria with D.A. Davidson.

[Rishi Jaluria, D.A. Davidson]

Hi. Thanks for taking my questions. Nice to see continued strength in the business and glad you are all staying safe at Pega. A few questions from me. First, I wanted to, Ken, you did hint that the customers are looking for something like extended payment terms for some businesses and bottom line is, you will work with them, I think, makes a ton of sense. Just wanted to get maybe a little more getting on that in terms of deals. Are you seeing customers asking for something more like contract restructuring, doing things like ramp or doing a multiyear Pega cloud deal that may be a much a smaller thing than you want and then have it ramp up year two, year three? And then maybe just the financial impact, if there is something like that, specifically on the Pega cloud side, is that something that you would normalize for when giving us the Pega cloud ACV numbers, just given that ASC 606 will theoretically smooth out the ramp on ramped deals like that?

[Ken Stillwell]

So Rishi, a couple of parts with your question there. The first one is, which types of clients would ask for, say, delayed payment terms? A very low percentage of our traditional customers in our verticals are going to be in that situation. It does happen. We are not insulated from that. But if you think about the types of clients that we have, we are not in the most susceptible verticals. So it does happen. It is not a widespread occurrence. And it isn't at this point and I wouldn't suspect that it would be unless there is some massive change to the economic kind of climate even worse than what we are looking at now. So I think that's point one.

Second point is, we have had very little discussions over the years with our clients asking to cancel or restructure contracts within the contract period but quite frankly, even at the end of the contract period. And that I don't suspect or have not seen noticeable discussions with clients suggesting that that's different now. And the question that you asked about clients wanting to ramp deals or have certain accommodations that really, independent of COVID-19 or actually any economic cycle, that is a reasonable request for clients as they implement the system and start to see value over time that naturally, they increase the usage over time and they expect to pay increasing amounts over time. So that particular phenomena is not unique to the situation right now. That is part of being kind of a recurring business.

The one thing that does help us in this environment, that Alan kind of touched on a little bit with the SMB comment a second ago, is that because our average duration of a contract is multiple years, we don't sell, say, month-to-month or quarter-to-quarter with small businesses, those are the most vulnerable relationships, anything that can be canceled within a month or a quarter. And since most of our clients are thinking about us and using us for very strategic long term projects, we hope and we have not seen a significant change in the relationships that our clients have with us. And so we believe our resiliency will help us a lot there.

[Rishi Jaluria, D.A. Davidson]

Okay. Great. That's helpful. Then I wanted to ask about your product gross margin. So you saw hit the 60% mark this quarter. Some nice margin expansion versus last year. Just wondered if you could give us a little bit more color on what you are seeing on the product gross margin side outside of just the accounting treatment of having cloud start to lay it on itself?

[Ken Stillwell]

Well, if you remember, last year I talked about how when you build a cloud infrastructure, quite frankly, any technology infrastructure, the investments do happen in kind of stair steps. It's not a linear progression. And we were ramping the cloud infrastructure and quite frankly, still not completely. And we aren't yet at this point completely optimized with the Pega cloud infrastructure, but we are getting better. And I think what you are starting to see now is you are starting to see us really get some of that operating leverage as we get a larger Pega cloud business.

So I think really, quite frankly, it's as we had planned for it to be. We thought we would actually do better even in 2019, but as I mentioned, because of the significant investments with FedRAMP and other initiatives in 2019, it's kind of that operating margin expansion really is being pushed into 2020. So this was kind of what we had hoped and expected to see in the margin for cloud.

[Rishi Jaluria, D.A. Davidson]

Got you. Thank you. And then just with your contact center, your clients, whether using Pega on the contact center, given that everyone, even the contact centers are working remotely, working from home, maybe help us understand how is Pega better enabling those customers to work remotely? And especially, I mean, even if things start to open up, it's probably not going to happen all at once. There might be some on-off that's a little bit longer lasting. And maybe alongside that, with all the rise in remote work and people working from home, is that maybe accelerating the pipeline or inbound interest or demand for Pega cloud relative to before?

[Alan Trefler, Founder, Chief Executive Officer]

So we are seeing good pull on Pega cloud as we talked about. And I think that's exciting and it should be able to let us continue to grow that business which obviously is a huge source of value for us and our investors. The thing about working at home, we have had contact center workers work using Pega from their homes for a decade. So this is not a new phenomenon for many of our customers.

A lot of our customers historically have wanted, even if they had a large contact center which of course many of them do, they want to do, for example, overflow work at home so that they can tap up a group of part-time workers or people who are staying home with children who can work a couple of hours a day and help take the load at peak times. So we are very well equipped to be able to support that.

The thing that is appealing, I think, to our clients and to our prospects, is that because we do a better job of automating the business processes and building that literally into the system itself, it just makes it easier to train new workers and to tap into a new workforce and to also frankly make them more efficient. So I think all of those are going to be good pull for us going forward outside of this immediate window as well.

[Rishi Jaluria, D.A. Davidson]

All right. Got it. And last one from my end and I will hop off. But without giving the formal guidance or anything like that, just want to get a sense, anything in this environment that would make you change your thought process of your 2022 targets that you have laid out over the past couple of years, $1.3 billion of ACV, $1.6 billion in revenue?

[Alan Trefler, Founder, Chief Executive Officer]

Yes. As you, I think, may know, it's never been our practice to update our guidance during the year. I think that quarterly guidance can trap companies into really short term thinking and bad negotiations with customers. So we just don't do that. So not in a position to really comment on that. I can tell you that the tenor of the business is strong and obviously there are disruptions.

Ken said something interesting which is, obviously, the part of services revenue is billable expenses, which accounting makes you put into revenue for some reason. That's obviously not going to happen if people aren't extrapolating it. But that's better for the customers actually. It makes it easier for them to take advantage of it. But I don't think we are prepared to make any specific updates.

[Rishi Jaluria, D.A. Davidson]

Okay. Got it. Thank you so much guys. I appreciate it.

[Operator]

Next we will move on to Steve Enders with KeyBanc.

[Steven Enders]

Hi guys. Thanks for taking the question. I hope everyone is staying safe in this crazy environment. I just want to get a best sense of how the pipeline is shaping up now? I know that you mentioned some deals getting delayed and some deals may now get canceled. Just kind of wondering how you see that kind of shaping up for the rest of the year and how much new pipeline is currently being generated?

[Alan Trefler, Founder, Chief Executive Officer]

So I can tell you there's a lot of new pipeline being generated and the year-over-year pipeline is up quite materially. Obviously, all of that has to be rescrubbed and reconsidered. But we have been through a part of that process and there's lots of new opportunities that are being recorded and a very, very, I would say, intense cadence of activity between us and our prospects. So it's a mess, right? I mean so who knows exactly what's going to happen but we see a lot of energy because of what our software does and because of the value it has to clients.

[Steven Enders]

Okay. Great.

[Ken Stillwell]

Steve, I would add one just quick comment on that. The thing that I think has been most interesting and I am sure that many of you on the call can attest to this. The amount of activity in business that continues to move on through this work remote is quite frankly shocking. Like I mean I am surprised that we are able to do it at Pega. I am surprised that you guys are able to do it. So I mean, it is really promising to see people really just kind of trudging along through this in a big way. And that's really encouraging, quite frankly, to see the infrastructure hold up, the networks hold up and the people really continuing to move on with their businesses. And so that's one promising thing that we have seen through this.

[Steven Enders]

Okay. That's good to hear. And I just want to ask about bringing on Hayden. What are kind of the key initiatives that he will be kind of tackling as he gets ramped up and where is kind of the most worthy job to kind of transform the business?

[Alan Trefler, Founder, Chief Executive Officer]

Well, I think he's got a lot of experience of growing a business in the sectors that we operate in and turning it into a more than $3 billion business and doing that at pace. So I think it will be terrific to work with him. We have done a lot. It's frankly quite amazing to hire somebody you have never actually physically met. But we have spent an awful lot of time together. And I think he's going to work terrifically and the team's all met him. And I am anticipating that he will hit the ground running and really help us accelerate our go-to-market, which is what this is all about.

[Steven Enders]

Okay. Great. Thank you.

[Operator]

[Operator Instructions]. We will move next to Yun Kim with Rosenblatt Securities.

[Yun Kim, Rosenblatt Securities]

Thank you. Hi Alan and Ken. Congrats on a good quarter. It seems like you guys are doing a lot better than most out there. It sounds like some of your parts of your business is actually benefiting from the current environment. Alan, just to kind of better understand where you are seeing some of the positives in your business? Can you describe, is there more of a smaller incremental projects and deals that you are seeing some of those deals where you are making progress? Some of those that are already closed in the month of April? Are they with existing customers? Are they part of a multiyear project that's ongoing and it's just the next phase of the project that just got signed? Just trying to get a better sense of which parts of your business that's tracking well versus obviously there are other parts that's probably not doing as well. Thanks.

[Alan Trefler, Founder, Chief Executive Officer]

Well, if you think about it, there are use cases that are immediate and that people are really trying to get something done to help them as in some of the examples that I gave with some of the governments and some of the large companies that are trying actually to respond to the issues that are in hand. And so those obviously can really close at pace and they are happening.

But I have been actually pleasantly almost surprised a little by two things. One, the willingness of senior leaders to frankly make themselves available. One of the things that I found as interesting is my productivity, I think is, soon our workday is up. My productivity is up because I no longer have to coordinate meetings with senior people in different countries. They are very, very open and I think hopefully that's going to continue even after we are able to travel. So there's a real receptivity to talking about what the right business architecture for the future is.

Now this has put such pressure on their businesses, I think people have realized that they are going to have to think differently about things. I think some organizations are frustrated by the amount they spend on IT and they realize that they are not going to be able to program their way out of where they are into a digitally transformed environment. And a lot of organizations are realizing that they are going to have to remarket and recapture customers, some of whom may not be able to continue doing business with them. So we are seeing a lot of energy in what I would describe as a business architecture discussion.

And one of the things that I think is cool relative to the team's ability to adapt is we used to do these design thinking sessions, like I mentioned in my script. We call it catalyst. That can be very effective in either a couple of days or two weeks to get organizations to think completely differently. We have been able to completely virtualize that which I had thought would be quite difficult, but have been doing and getting a lot of receptivity of catalyst sessions. And it's actually easier to set up in some ways because all of those customers don't have to travel to the same place to meet as a team. So there's a huge amount of energy in the selling motion and we just need to work hard to see if we can convert them into all the business we would like to have with them.

[Yun Kim, Rosenblatt Securities]

Okay. Great. And Alan, you mentioned in your prepared remarks and also regarding the set of industry-specific solutions that you guys introduced early in the month. What has been the response so far? And is this kind of a blueprint on how you may navigate your go-to-market, at least in the near term?

[Alan Trefler, Founder, Chief Executive Officer]

Yes. It certainly has caused those teams, my industry teams, in particular, but also my horizontal teams, to think differently about how they want to bring their thinking and thought leadership to market. And this will definitely have an approach. The teams rallied together and in literally less than a week, they had pooled together the framework for how we wanted to bring solutions to the market and how we would evaluate them. And I am just really impressed with the work and the agility that they pulled off.

And you can go check them out on pega.com. It's something that's generating interest from customers. Interestingly, not just in those areas, but also in other areas once you begin having the discussion about how do you create truly a virtual organization, which our customers understand they now need to be.

[Yun Kim, Rosenblatt Securities]

Okay. Great. And then Ken, in terms of the current model transition and obviously, there's a great level of uncertainty out there, is there any variables in the model that we should take note just because of the uncertainty that we are going to enter this year due to COVID-19? For instance, do you expect like a Pega cloud bookings mix? If that mix comes in much higher this year, would that actually impact your ARR from ACV growth?

[Ken Stillwell]

Yes. So just the way to think about the business is, the first is, I think I have mentioned a few times that I think there's probably some risk on fully delivering the amount of professional services through the year that we would have hoped. I am just trying to be practical about the fact that you cannot do everything remote, even though you could do most of it. And overall in majority, there's still some impact there.

And I think if you assume that the cloud mix is the same, I would think that there would be, most companies in software would think that there was in current environment, more kind of downside pressure on their bookings plan than upside opportunity, I would say, in the short term. I think that's a reasonable thing that we are hearing in the market. But if you think about the cloud mix, could we move more to cloud because the environment is more conducive to Pega cloud?

I think that's a great opportunity for us. And certainly if that happens, every 1% movement to Pega cloud away from kind of a 50% that is what we actually talked about at the beginning of the year, has about a $3.7 million impact in short term revenue. So I think so you are thinking about the revenue pressure from more cloud, which will be a good thing in the long term, I definitely think there's something there.

In terms of ACV growth, whether a deal books Pega cloud or client cloud, there is not a significant change in the ACV growth based on a few percentage points difference within the year. That is not a material component of ACV growth.

[Yun Kim, Rosenblatt Securities]

Great. Thanks for that clarification. Thanks Ken.

[Ken Stillwell]

Sure. And just while I have, before the next question, I just wanted to clarify. I was made aware that I mentioned PegaWorld as December 2. And I made an error. I apologize. I said December, I meant June 2. So we welcome you to join us on June 2 for a free registration at pega.com. So I apologize for the misstep there.

[Operator]

We will move next to our next question in the queue from Mark Schappel with Benchmark.

[Mark Schappel, Benchmark]

Hi. Thanks for taking my question. And I will start off by saying, a good way to start off the year and good job in the quarter. Alan, a question for you. Could you just provide some additional details around the IRS deal that you mentioned in your prepared remarks? For instance, maybe how long the deal was percolating in the pipeline? And is this a Pega cloud deal?

[Alan Trefler, Founder, Chief Executive Officer]

Well, government deals tend to go on for quite some time, as you may know. So this has been going on. It's been highly competitive, as you can imagine, a transformation of the IRS. And it's obviously going to come into revenue over years. It is not a Pega cloud deal. We are expecting that it will be a client cloud implementation. Lots of these folks really want to, in effect, move their entire data centers to the cloud. And if it makes sense for us to be a part of that, to be able to get the right interfaces to the right systems easily, then that's, from our point of view, just fine.

[Mark Schappel, Benchmark]

Okay. Great. And then the healthcare vertical is a vertical that the company has increasingly focused on here and you mentioned that in your prepared remarks. And in the headlines, you are seeing a lot about the move to telehealth as being one of the healthcare technology trends that's, at least, captured recent attention. I was just wondering if there's ways of tapping into that trend. Maybe you can just speak to some of the other trends you are seeing in healthcare that you are able to enable?

[Alan Trefler, Founder, Chief Executive Officer]

Yes. We have shown for actually, a couple of years ago, we showed how Pega and our care management solution can work beautifully with the Cisco Video environment and as well as others. And so I think that frankly telehealth is going to require more systems to coordinate and manage. And so it's going to be I think ultimately it's going to be quite good for us when we get through the other end of this.

[Mark Schappel, Benchmark]

Okay. Great. That's all for me. Thank you. Good job in the quarter.

[Alan Trefler, Founder, Chief Executive Officer]

And I think we have run to the top of the hour. So I think, perhaps, it's time for us to thank you and say goodbye. And now we are working extremely hard and I think we are doing all the right stuff. So with that, thank you very much everybody and have a great evening.

[Operator]

Everyone, we do thank you very much for your participation today. That does conclude our call. You may now disconnect.