Pegasystems Inc

NASDAQ:PEGA

Earnings Call Transcript 2023-Q1

[Operator]

Greetings, and welcome to the Pegasystems First Quarter 2023 Earnings Results. [Operator Instructions] As a reminder this conference is being recorded.

It is now my pleasure to introduce your host Kenneth Stillwell. Please go ahead.

[Kenneth Stillwell, CFO]

Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems Q1 2023 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, will, could, should, estimates, may, targets, strategies, projects, forecast, 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 2023 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 the forward-looking statements are contained in the company's press release announcing its Q1 2023 and full year 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, 2022, 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 the 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, CEO]

Thank you, Ken, and thank you to everyone on today's call. We had a terrific start in 2023. Our team executed our strategy well, leveraging our strengths, and remaining resilient in an environment that we expect will remain uncertain for some time. In Q1, we achieved ACV growth of 15% driven primarily by increasing our footprint in our existing clients, and through strength in Pega Cloud. This is exactly what we said we had tremendous opportunity, and where we should focus our sales and marketing efforts.

We also saw select new logos. Though that's not our focus for this year. Clients are responding positively to our architecture, our model, our focus on deep engagement. Pega Cloud is driving growth, and cloud margins continue to scale. It's great to see us continuing to make solid progress towards becoming a rule of 40 company, balancing growth with fiscal discipline and generating significant cash flow. Overall, our results reinforce the effectiveness of our strategy. And we see tremendous opportunity for growth. Ken will discuss our financial results in more detail in a moment.

Now, I'm spending a lot of time with our clients, both at our Cambridge based Executive Briefing Center, which continues to be solidly booked and on the road, including a trip to Europe I've just returned from. I continue to hear the same themes. Last week I was in Germany, Italy and Sweden visiting clients. And despite the anxieties in Europe, the conversations I had were optimistic, and clients continue to be deeply interested in building relationships with Pega.

Digital transformation remains a driving force as organizations are looking for solutions to better deliver personalized engagement and optimize business processes. [City] just published a spending survey that noted that digital transformation was one of the top investment priorities for CIOs in 2023. Pega has a long history of helping clients improve efficiency and effectiveness as well as to improve their customers experience. Clients are also very interested and in some ways concerned about the use of AI, especially with the newest generative technologies. They want to know how to leverage AI in responsible ways to drive automation without compromising enterprise governance or losing control of outcomes. Our approach to digital transformation and to AI is perfectly aligned to both addressing these concerns and meet these needs.

Now to talk about our approach, our three point in developing software has always been about building technology that serves business people. We provide the most powerful and scalable low code platform for AI powered decisioning and workflow automation. We make it simpler for enterprises to work smarter, unified experiences and adapt quickly. And we ensure that organizations can empower their employees without compromising enterprise IT integrity.

We're combining AI and automation to enable organizations to become autonomous enterprises that self optimized with business goals without sacrificing control. Now, as you've no doubt seen, there's an elevated interest in AI and lots of excitement and hype. And just as a reminder, since our founding four decades ago, Pega has helped enterprise clients use our AI powered solutions to automate complex business processes, improve customer experience, and drive operational efficiency. We've been evolving our capabilities as the technology and our clients’ needs are evolve. And we're in a unique position to lean on this heritage of harnessing, understanding and leveraging AI to be able to provide unique capabilities to our clients.

When we announced our generative AI plans last month, we stay true to our approach with an offering that will allow clients to use the generative AI technology of their choice with enterprise governance to make generative AI truly enterprise ready. We focus on building out used cases that maximize value and minimize risk. For example, we use generative AI to create better performing marketing copy or to generate prototype applications from just a simple sentence.

Our approach incorporates auditing and human approval that are the hallmarks of Pegas platform. This manage architectural foundation provides organizations with safety, security and reliability, suitable for the enterprise. IT managers will be able to integrate their own specific generative AI APIs into Pega infinity, and centrally manage licenses and controls to give clients flexibility to add existing or emerging generative AI APIs. A great example of our generative AI strategy coming to life is our recent inclusion in Amazon's announcement of Bedrock, a new AWS cloud service that allows developers to build and scale generative AI applications in the cloud. Because of our approach, we can easily integrate Bedrock into our platform, and have used cases and make it available to clients. At the same time, we can continue to support other cloud providers and other generative AI solutions based on our client's preferences.

Now, we've been at the forefront of providing responsible AI for years and are committed to putting the controls straight into our software to make sure that fairness and transparency and robustness all exist. We believe that rapid generative AI developments will make lower and low code providers a commodity. But on the other hand, the higher end, enterprise grade solutions like Pega are going to benefit. So we're excited about the opportunity to create additional value by augmenting our solutions for organizations.

Now, we have also rolled out Pega cloud enhancements, supported by an enhanced global operations center that improves speed, scalability, agility, reliability, and security. These improvements help organizations maximize the technology investments and deliver better experiences for staff and clients. And we'll continue to make progress with Pega Launchpad, which we announced last year as our new cloud based low code application development platform that empowers software providers to build and commercialize, or post-centric business to business apps. We're excited to be working with a select group of amazing early adopters, these Pega Launchpad powered apps are being built to address the needs of new markets that they will be pursuing.

Now, we're coming up on PegaWorld Inspire our annual tradeshow and it's going to be fabulous. We'll be showcasing our new AI capabilities announcing several new offerings and demonstrating solutions at more than 40 partner booths, and featuring over 200 demos in 100,000 square feet of pure ingenuity. We're also be highlighting the success stories from more than 40 clients, including outstanding keynote presentations from Aflac. We will talk about how they are using Pega to reduce roadblocks and bottlenecks and manage staffing fluctuations and market pressures to continually deliver transformational outcomes.

Citibank, one of our very first Pega clients, who went live originally, obviously on very different technology in 1984 is using Pega to deliver on its mission of being a trusted financial services partner, leverage decision science to drive omni-channel customer centric experiences.

Rabobank from the Netherlands, who will demonstrate how they are revolutionizing customer experiences using our low code and AI capabilities, and Virgin Media, who will describe their journey to become a fully digital business, leveraging Pega's customer service case management and AI based decisioning. If you haven't yet, please check out the PegaWorld website, register and join us to hear and see all of this in person and especially feel free to join us for the investor session on Monday, June 12.

Telling summary, I'm pleased with our strong shot in 2023 and our ongoing progress to be a Rule Of 40 Case Company. Our results continue to be driven by ongoing demand from large global enterprises and for digital transformation solutions that drive automation and leverage AI.

Our strategy to focus on effort on meaningful clients is proving effective. And candidly is making us feel really good about how we're doing in the market as well as obviously winning business. We expect to face macroeconomic challenges in 2023 but I think we are well prepared and experienced with executing and challenging times. I feel confident that we are in the right space with the right capabilities and the right team. And our strategy is absolutely the right one to leverage the significant opportunity in front of us. To provide color on our financial results let me now turn it over to our COO and CFO Kenneth Stillwell.

[Kenneth Stillwell, CFO]

Thanks, Alan. Given an uncertain economic environment, it is great to see our team deliver such a strong start to 2023. The three most important metrics to measure the success of our business are annual contract value, ACV, cashflow, and backlog. So I'm going to focus my initial comments today on how we're progressing against these three critically important metrics. ACV grew 15% in constant currency year-over-year in Q1. Annual contract value growth has been and continues to be the most important metric for us. This strong result was powered by Pega Cloud ACV growth, which increased 24% in constant currency year-over-year. Pega Cloud represented approximately 67% of the $45 million of net new ACV added in the quarter and constant currency. Pega Cloud ACV continues to be the largest ACV component and the fastest growing.

Our ACV growth was bolstered by our decision to realign our go to market strategy and focus our resources on deepening our relationships with our marquee customers. Our first quarter results provided clear evidence this strategy is working. Our ACV growth was broad based and in addition, we are attracting new logos. Although that is not our primary focus for 2023.

Moving to cash flow. In Q1, we generated $68 million in operating cash flow to produce $75 million in our free cash flow metric which is a great start to 2023. We still have a lot of work to do for the year though. When we started our subscription transition in late 2017 our vision was to transform Pega's economic model and build a successful business for the long term while delivering tremendous value for our clients.

Our strong ACV growth coupled with our strong free cash flow generation is the result of many years of hard work by our team to sharpen our growth strategy and efficiency. We're now running the business as a subscription business. We're really happy with the success we've had anchoring the concept of efficient growth. And as you can see some of the results are starting to show as we progress through the first quarter numbers. We expanded Pega Cloud gross margin to 72% and we're increasing our operating leverage and we believe there's more upside to our Pega Cloud gross margin in the future.

Moving on to backlog. Total backlog increased by 14% year-over-year in constant currency to $1.34 billion driven by growth in Pega Cloud backlog. Revenue had two thirds of our net new ACV add from Pega Cloud in Q1 and that drive that combined with a lower number of term license renewals, we obviously would recognize less revenue in the quarter than we did last year in the first quarter. That's because the majority of revenue from term license deals is recognized upfront and upon renewal. In contrast, Pega Cloud revenues recognized ratably over time. Given these dynamics, revenue and non-GAAP EPS and an individual quarter can be highly variable. And sometimes it's not representative of the underlying fundamentals of what's happening in the business.

For example, total revenue in Q1 was down 14% year-over-year driven by this 39% drop in term license revenue. We discussed this back in February. Our term license backlog was unusually high at $172 million in the fourth quarter of 2021. And you saw that backlog significantly impact revenue in the first quarter of 2022. Given that our term license backlog balance at the end of 2022 was significantly less than the prior year, we expected term license revenue in Q1 of '23 to decline significantly year-over-year.

We also repurchased $33 million of our $600 million convertible notes and approximately a 10% discount. This transaction was not part of a formal repurchase policy rather, as we generate cash, we will look to opportunistically retire our convertible debt. Similarly to last quarter given an uncertain economic environment, we thought it would be helpful to provide some thoughts on modeling our business. Our practice is to provide annual guidance at the start of the year, and not to update guidance unless we've done a material acquisition or something else materially happens in the business like we mentioned last year we do not provide quarterly guidance. Given our focus on increasing cash flow, we added a new metric this year free cash flow.

Our commitment to generating free cash flow is strong. As a company, we understand the value especially in an uncertain growth environment of delivering both consistent free cash flow generation and free cash flow improvement as we scale. That way, when we actually see these periods that are less certain in the growth environment when the economic climate is not as welcoming we established a solid free cash flow based business.

And as we expect our sales and marketing expenses to be higher in the first half of 2023 compared to the second half that's driven by our PegaWorld Conference being live in 2023 and as we've mentioned, as Alan mentioned earlier, for the first time since 2019.

I'm very excited that our investor session will once again be held in person in Las Vegas after a four year virtual sessions. Monday, June 12, at PegaWorld, we will host investors to discuss our long term model and our long term strategy. If you're interested in registering for the investor session, please email [e-mail]. The agenda will include updates on our go to market strategy, our product innovation, and also our financial model. We will also include time on the agenda as usual for questions and discussion.

In closing, our team executed very well in the first quarter of 2023. Of course, we're still facing with all of our other participants in the software market uncertain economic environment. So we're going to continue focusing on those three most important metrics as I mentioned, ACV, cash flow, and backlog.

Operator, please open the line for questions.

[Operator]

Thank you. We will now be conducting a question and answer session. [Operator Instructions] Your first question comes from Kevin Kumar with Goldman Sachs. Please go ahead.

[Kevin Kumar, Goldman Sachs]

Thanks for taking my question. Kenneth the guidance provided last quarter for 2023 I believe factored in some softness in the macro environment. Have you seen anything materialized in terms of lengthening of deal sales cycles or changes to close rates? Or have those held up relatively well?

[Kenneth Stillwell, CFO]

Yes, Great question, Kevin. So there is a couple aspects of that. So the first one is, in terms of our team executing against our sales campaigns in our pipeline, I think I wouldn't say there was any deterioration that we saw in Q1. I think we executed well. I think our clients are still engaging. There is very committed to their digital transformation initiatives. That said you can definitely sense that there's some level of economic concern out there as there was last year, but I think our execution against our pipeline was solid. So I think there's two pieces of that. The execution was good, but you can feel the uncertainty or the kind of the timidity that's out there in the marketplace. But we haven't seen that translate into actually like statistical deterioration of our close metrics.

[Kevin Kumar, Goldman Sachs]

Yes, that's helpful. And then curious on the comment on logo adds. I know the focus has been more on expansion within existing customers, and there's been some changes in the sales organization to focus on that. So what was that kind of the natural course of the sales process? And just curious those remaining for contributors [indiscernible].Thanks.

[Alan Trefler, CEO]

Well, it's Alan. We do get inbound customers, meaningful organizations, that either have somebody who's worked with us somewhere else, or see what leading companies are doing in the various industries. And those are the basis of how we are and will in the future, be adding new logos because, well, that's very consistent with our strategy. I will tell you that by giving ourselves the capacity to spend a lot more time with several 100 customers that are critical to us and we have significant relationships with we have absolutely uncovered the opportunity types that we had expected working with those companies and see both the upside, and candidly are really, I think, building and continuing to improve great relationships with very important organizations. So the strategy feels really good particularly in a year that's maybe a little tougher.

[Kenneth Stillwell, CFO]

I would also add one other point to that which is, I wanted to be very clear, because I think that there are some people that heard the message of our strategy that we were not entertaining new logos or that somehow new clients were not important to Pega. That that is not true. It's just not where the majority of our focus is, because we think the opportunity is with our existing clients. But as Alan said, there are lots of companies out there that look just like our clients that are not current clients of Pega. And sometimes we find them and sometimes they find us and I think that will continue to happen. I just wanted to make sure that nuance was clear.

[Kevin Kumar, Goldman Sachs]

Great. Thank you both.

[Kenneth Stillwell, CFO]

Thank you.

[Operator]

Next question, Rishi Jaluria with RBC. Please go ahead.

[Richard Poland, RBC Capital Markets]

Hi, this is Richard Poland on Rishi. Thanks for taking my question. So I guess the first one is a two part question around generative AI and kind of what you're doing on that lane. So it sounds like a lot of the value proposition is the security and compliance that you're kind of wrapping around some of the AI technologies. And it's really exciting opportunity. But just kind of if you could just elaborate a little bit on how you're differentiating against the other generative AI type solutions out there and then just a follow up on that is just how you think about the monetization opportunity long term. Thanks.

[Alan Trefler, CEO]

Sure. So I think we've got a structural advantage compared to lots of other companies. Because Pega has always been a model driven company. What that means is you create a model of how you want your business to run. And from that model, our system actually writes the software. We're using the generative technology to basically inform the model. So for instance, you can say, hey, I want to define a process for home equity loan. And generative AI will do a terrific job of identifying one of the stages you would go through, what would a schema, data schema look like that would capture the information that you would need, what would for example sample data look like. You might use to be able to test it.

And all of those are components that go into our model. It gives you such an amazing opportunity to really jumpstart, but also simplify a lot of things about how you apply technology to your business. So those are the types of examples; things that really leverage, an architecture that I think is extremely well suited and candidly, a lot of the companies have been talking about low code. I think are in enormous trouble because low code apps that don't fit a real enterprise standard, and don't have the right structures. I think in many cases just going to be replaced by people using generative AI to write the code but there's a huge market for things that are a little more sophisticated, need to be updated routinely. So you don't just do it once and use it, but you want to be updated, updated, again, updated six months later.

And those are the types of things that I think we have a structural advantage for towards what we are doing. Monetizing it, I think this is absolutely going to drive additional demand for Pega and a variety of use cases. And with our clients in general, when they use our software more, it gives us a chance to get paid more. And that's good for them. And it's good for us. So I think that this has candidly a lot of appropriate excitement in addition to the hype, we feed, which is nonstop, but we're not affected by that. It's just part of I think having a pretty mature understanding of what AI is about. And we were on this technology long before it broke into mainstream media.

[Richard Poland, RBC Capital Markets]

Thank you, Alan. That's super insightful. And then maybe one for Ken. Just as we think about the pace of Pega Cloud gross margin expansion, and it's been really solid in the past recent years. How should we think about that kind of going forward? I know, one of the previous targets, I think was in the mid to high 70s range by 2025. Is that kind of the track, we should still think about Pega Cloud gross margins? Thanks.

[Kenneth Stillwell, CFO]

Sure. So maybe it's interesting to paint the picture. When we first started the Pega Cloud the first couple of years, our gross margin was 35%, then it was 45%. Then it was 50%. And then when it was about 50%, we set a target of 70%. And now that we've surpassed them, and then we moved the target to 75%, a couple of years ago, and then we kind of said, well maybe we could do high 70s. And so naturally that can't go on forever, of course, right? Because at some point, you do hit a point where the efficiency is got to stabilize. But I think like best in class SaaS companies would strive to have gross margins that begin with an eight, right? And so we want to be best in class, and we're starting to get some good scale. So I think 75 to high 70s is maybe a mile marker on that journey to being a best in class SaaS company from gross margin standpoint. Maybe that's the way I'll frame it.

[Alan Trefler, CEO]

I would just throw in, that the way this has been achieved, has been to excellent collaborative work of the team both in terms of putting extensive automation into our cloud operations that both save money but also make the system more reliable and more effective for our clients. Being able to rework so you may have heard me talk about Project Phoenix, actually about five years ago is when we talked about that. We have to rework the system to be cloud oriented and micro services oriented architecture. There is a lot of what I would describe as non-financially related improvements that go beyond just what we would get from scale. And that's what makes me excited and things that we can't raise the bar forever. But we do have a little more we can go.

[Richard Poland, RBC Capital Markets]

Thank you. Very helpful, guys.

[Operator]

Next question, Steve Enders with Citi. Please go ahead.

[Steve Enders, Citi]

All right, great. Thanks for taking the question here. I guess maybe just following up on the AI discussion. I guess how do you think about where you have a right to win, and will be kind of focusing on your AI initiatives and embedding that in the product versus maybe looking at the rest of the technology ecosystem and partnering with other technology vendors or third parties to embed some of that functionality into your products set.

[Alan Trefler, CEO]

Well, we're definitely building our generative capabilities to be able to partner. We talked about the partnership with AWS. Partnership with the other major AI providers also is central to how we're going to go to market. So we see being able to use the super rapidly emerging large language model capabilities that are going to continue to evolve as something that needs to be part of our open architecture there. We, of course, also have some of our own AI capabilities, when it comes to what we call the customer decision hub. And what we call process AI which is the ability to use AI in processes to be able to make them learning and self optimizing which is not really a generative technology, but is also very powerful from both benefit and a cost savings and a customer service perspective.

So I feel really well-equipped to be able to be a significant player not that we're going to come up with something super general because I think that's going to be an insanely competitive space, but within types of customers that we know we can serve, that have enterprise needs that actually fit perfectly with the types of things we're considering and doing. We're getting great feedback from the early clients are showing us that we're absolutely on the right track and going to be delivering things here that there would be excited to use.

[Steve Enders, Citi]

Okay, understood and appreciate the thoughts there. I guess mean, for Ken really good cash flow in the quarter, and [indiscernible] kind of accounted for half of the initial guide that you put out for the year there. Was there anything one time in nature that maybe not pulling into the quarter or anything that we should be thinking about it as we think about cash, the paper cash flow throughout the rest of the year here going forward?

[Kenneth Stillwell, CFO]

Yes, sure. Steve, just a reminder that, typically, our billings are higher in Q4 and Q1 which would mean that our collections would be typically higher in Q4 and Q1. Now, that said, we do have a lot of cash outlays in Q1 because like, for example, we have our annual CICP payment that goes out. We have, so we have a higher, it's a higher payment of a commission quarter typically, because Q4s are typically higher in bookings. So there were some offsets to that, but I would say Q4 and Q1 are typically stronger, free cash flow quarters, and Q2 and Q3 are typically less strong just because of the nature of our bookings and billings. But that said, Q1 was very strong in terms of free cash flow.

[Steve Enders, Citi]

Okay, appreciate the great answer there. Thanks again for taking the questions.

[Kenneth Stillwell, CFO]

Sure.

[Operator]

Next question, Jake Roberge with William Blair. Please go ahead.

[Jake Roberge, William Blair]

Hey, thanks for taking my questions. Alan, just wanted to dig deeper into your comment that generative AI could commoditize lower end low code use cases. Could you just talk a little bit more about what Pega's history in the AI world and its positioning and more mission critical workflows help you really take advantage of the opportunities from the AI team moving forward?

[Alan Trefler, CEO]

Well, sure, and I also can just explain why I think our positioning and our technology provides a moat that is consistent with our enterprise approach. When Pega goes into a customer, the types of things we talked about with a “low code” customer is we talked about building a low code app factory what does that mean? Well, that means I'm able to build apps quickly. But it also means the apps have a structure that lets them be hooked together, that doesn't have them be really isolated things. And that also lets them leverage the other enterprise assets, like the interfaces, like some of the controls, the other types of things that are going to be either consistent or related across apps. This ability to have what we call a layer cake, where certain things go across the entire customer enterprise and other things might vary with say different divisions of a bank or of an insurance company, or that might vary with types of work, or applications, those all fit into a cake. They run in a way that really is complementary to each other. I think that really lends itself to being super distinguished from companies that have just a bunch of little apps running around.

And any company that's been betting their future on generating low code apps, that do kinds of simple things, or that run on a mobile device, we've experimented with generating little mobile apps that are actually quite remarkable in some ways that look exactly like the demos from some of our competitors. I think that you're going to find the market is really going to, it's going to end up really shaking out the market. Because I think [indiscernible] is just going to go away.

[Jake Roberge, William Blair]

Very helpful. Thanks for that color, and then Ken how do you feel about the pace of your subscription transition at the start of this year? Have you seen any impact of the migration as a result of the macro? And do you feel like Pega is still on track to complete the transition this year and be a role for the business as you exit 2024?

[Kenneth Stillwell, CFO]

So the subscription, those are good questions. I'm going to tease a couple of them out first. The subscription transition pace, I think is I'm very happy with it. There has been some maybe it took a little longer to get through the kind of financial transformation subscription, probably by six months to a year than what I had originally kind of envisioned in my mind. I thought it would take four to five years, or like five to six years, but in general, close enough, but it, so I think that went well. Not every client is going to want Pega Cloud. let's just that's an important way, it really ties to our cloud choice. Now, we want every client to have Pega Cloud. But the reality is not everyone has the used case, or may choose to want to manage it themselves, depending on lots of things that might be decided within their environment. But that's okay. But I think it's such a significant amount of our clients will. In terms of clients, who've chose to move workloads on to Pega Cloud, I mean, we have not pushed clients, or in some cases, forced clients, like other companies have done to say you have no choice, you must move, because we understand that our clients and our relationship is different than the typical software company.

And we need to be respectful of how much, how mission critical the Pega applications are, and how hard it might be to just shift over to another environment. That said, we do have clients, every kind of year, every quarter having those conversations and some have begun to move and some move new workloads. The most important thing for us, I think, though, is that two thirds of our clients have seen Pega Cloud meaning they may not have all of their stake on Pega Cloud, but they have something there.

And I think that they know the value. And over time that migration, as you mentioned, will happen what to the extent that the clients kind of want to. In terms of the economic kind of maybe if you have headwind in the economy, does that mean people move or not move to Pega Cloud. I think it's kind of like the maybe the punch line of your question. And I would say that really depends on whether the client views a movement to a vendor cloud, like Pega Cloud is going to solve some other financial inefficiencies that they may have, or some optimization that they may have inside their organization. That is absolutely true for some of our clients.

For other clients, they may not be ready to move, because they may not have, they may not want to use some of those resources in the short term to make that move. So I would say that last part, it really depends, I would say, overall, the economic environment probably is a little bit helpful to have clients think about Pega Cloud when it's a tougher environment. But that's not a universal point.

[Alan Trefler, CEO]

Yes. It's also beneficial customers are under pressure in terms of retaining some of the right skilled staff. This once again, obviously, it's super easy when we're operating and running it. But just to make it a little more tangible for folks we've got some customers, very large customers where we have systems that literally-literally do 10s of millions of cases a month that are so woven into their [Audio Gap] heavy duty, a combination of automation and driving [Audio Gap] on Amazon or Google Cloud, and they want to basically pick up their data center and move their data center in total including apps that may not run on the cloud that might be billing and accounting systems that would have to run in a non vendor cloud.

[Audio Gap] vendors who know how to do it best, or whether they want to do it by picking up their data center and/ or data centers and moving them on that. And there's some of these [Audio Gap].

[Unidentified Analyst]

Sounds great. Thanks for taking my questions.

[Kenneth Stillwell, CFO]

Thank you.

[Operator]

Next question Pinjalim Bora with JP Morgan. Please go ahead.

[Pinjalim Bora, JP Morgan]

Hey, thanks for taking the question. Ken, I'll try one more time on the SCF performance seems pretty strong. It seems like the change in working capital was positive after a long time in Q1. And then it seems like the SBC jumped a little bit. I want to just make sure there's not a onetime thing that's driving this just thinking through what should we expect for the year on free cash flow.

[Kenneth Stillwell, CFO]

Sorry, Pinjalim I heard that I heard the free cash flow point. But I did you say SBC for the second point?

[Pinjalim Bora, JP Morgan]

The stock base comp seems, jumped a little bit and seems like, go ahead.

[Kenneth Stillwell, CFO]

Yes. I'll explain. I thought I just like you, you were a little bit faint on the volume. That's why. It's okay. So yes. Free cash flow. If you think about that maybe the way to think about free cash flow is to think about billings and billings connected a little bit to the revenue cycle. If you think about the revenue cycle through the year, our largest quarters for revenue are typically Q1 and Q4. Our softest quarters revenue are Q2 and Q3.

Our billings are not materially different than that across the year which means our billings would be higher in Q1 and Q4, and a little bit lesser in Q2 and Q3 but our costs are relatively consistent across the year. And so if you now take billings and costs and you translate that into cash flow, our cash flow would typically be stronger in Q1 and Q4 and less strong in Q2 and Q3. So hopefully, that's helpful to give a little bit of color on the cash flow.

On stock base comp, one of the biggest is that there is a adjustment I shouldn't say adjustment, there is a higher stock base comp in the beginning and through 2023 because of two factors, primarily one, we actually adjusted our vesting period from five to four years for stock based compensation, which will play it a little bit into the kind of near term acceleration, but not there. I would kind of call that a onetime thing. And then the second one is that we actually did an equity grant that was out of cycle in the second half of 2022.

And that is in the calculation for 2023 that certainly would not be something that would repeat. So there's a little bit there. There is some one time pressure up on that that is not that is not a structural change to our stock based compensation strategy.

[Pinjalim Bora, JP Morgan]

Yes. Understood. Very clear. One for Alan. Obviously, we have heard a lot of AI in this call and you're doing a lot of things around AI. I want to ask you about how do you think about kind of the potential to capture incremental value from the efficiency that customers will gain from using AI capabilities, versus kind of the potential pressure on seats that those efficiencies might actually drive?

[Alan Trefler, CEO]

So I think for a lot of folks, the automation that occurs, is going to put potential pressure on seats, because candidly, if you can do things in an automated channels, or self service becomes better or the chatbots become better that obviously affects, for example, the number of contact center seats you have. However, to the extent that it's being run through us, and we are the tooling that I think companies find is best to use to manage those client interactions, including the automated ones. We've really moved away from user based pricing [Audio Gap] got a couple of seats, and think of automating those, because candidly it's better for the customer, and it's fine. [Audio Gap].

[Kenneth Stillwell, CFO]

Thanks Pinjalim.

[Operator]

Next question, Steve Koenig with SMBC Nikko. Please go ahead.

[Steve Koenig, SMBC Nikko]

Hi, Gentlemen, thanks for taking my questions. Congratulations on a great start to the year. Just maybe a housekeeping question or two for Ken and then a question for Alan. Ken you mentioned that 67% I think it was a net new ACV cloud. Just so I'm clear you guys based on an assumption cloud percentage of new client commitments. And that guide, I think, was 60% to 70% for the year. Is that the same definition that you're using is this net new ACV being cloud or what like, what was the percent of new client commitments? Was it was it the same definitionally?

[Kenneth Stillwell, CFO]

Yes, Steve, we did. We're trying to be very consistent with that metric to what our reported metric is because it can sometimes get confusing when we use a metric that may be across one or two quarters versus one quarter. So that was the reason. But yes, it's essentially the same measure. We just felt like it'd be much easier to talk about that metric, because that will translate into revenue, that will translate into billings and the backlog, etc.

[Steve Koenig, SMBC Nikko]

Got it. That makes sense, we can calculate that from the financial. So that's great. Okay, so you're on track with your guide so far in terms of your cloud assumption, is my takeaway there. And then we also noticed the cloud, ACV and RPO was very good and a quarter better than we expected and cloud was especially good. The cloud ACV was a bit higher than we would have predicted based on the revenue results, cloud revenue. And so I'm wondering, were there some back end loaded cloud deals that should help cloud revenue next quarter, and then on the same line, just you had an outlet, the subscription licenses would be relatively level for Q1 through Q3. Is that still kind of your thinking here? And then one last one for Alan if you don't mind.

[Kenneth Stillwell, CFO]

So revenue lags ACV for sure. So when we booked deals, they typically don't have really any revenue impacts in the quarter. I'm generalizing. But so there's definitely a lagging effect there. And yes, we don't, we think that for our term license revenue for 2023, that would be more back end loaded, because that's when the renewals are happening. That is a correct statement as well, that if you want to hit Alan with his question.

[Steve Koenig, SMBC Nikko]

Got it. Great. Thanks. Super. So moving yet another question on generative AI. But very relevant here, I think, Alan one of the kind of knocks on Pega I guess over the years is that there's not as many Pega developers, as there are Java developers. So kind of hard, that's the hardest part wanting to overcome that. But you got to more and more Pega trained developers, a lot of partners, you've grown your ecosystem very well, and really focused on that. This generative AI capability, to build models, even or to help build a model that you talked about earlier does that fundamentally make the current Pega trained developers more productive or can that be used to democratize development of a model?

And then along the same lines, like, does the model even need to be transparent to users if this AI gets good enough what, like, why not have the AI from the language model, build the process model and then have the whole thing, turn that Pega turn that into code soup to nuts? So anyway, just some random questions for you hopefully that's coherent?

[Alan Trefler, CEO]

No, I think they're good questions. And they're certainly top of mind. So Pega historically, in addition to perhaps there being fewer developers than Java, which is kind of a high bar to jump over. We've also, at times been criticized for being a little hard to use or requiring a learning curve, which we've been working to improve. But it's one of the things that takes work. I think that the advent of generative AI takes a massive makes change to both of those. It will make existing developers very much more productive. But it really opens up the use of the technology to a much more to use your word democratize a group of citizen developers where we can leverage the structure we have, because a lot of the citizen developer stuff has the risk of not really providing the right guidance for an enterprise.

So we can provide that guidance and control with like our layer cake, but still make it so that the instructions don't require any sort of deep Pega knowledge, but can be interpreted from language. Now, relative to your question of why go into the model at all. The real challenge, when you look at demos and think about this stuff, is not just how you create a little app, certainly for customers who have more than what I would describe as a single small [app need]. But if you need to create a system that does a number of things and talks to a number of backends. You need some structure that captures how that system works. Because when you want to go make changes to that system, you need to be able to go to a structure to make the changes. You don't want to go around regenerating things all the time, that would be super unreliable, really easy to introduce bugs. And because we have this model, that's the center of our architecture I think we're uniquely qualified to not just be able to capture like a little process flow. But to be able to capture the really robust things you need to build an app of how you edit and validate data, how you actually send it out to different backend systems, how you decide what the right controls are, if the thing is going to post a transaction, who needs to approve it; all of those types of things are in our model.

And they're visible. They actually can make sense to the business people. And now our models will be able to be constructed in this really exciting and staggeringly, I think, well staggeringly powerful way. So that's why we're really excited about what this does for us. And it's not just going to be one turn of the crank. This is going to really influence I think the business that we're in quite a bit for years.

[Steve Koenig, SMBC Nikko]

Got it. Hey, thanks a lot. Congrats again.

[Kenneth Stillwell, CFO]

Thank you.

[Operator]

Next question, Joe Mearus with Truist Securities. Please go ahead.

[Joe Mearus, Truist]

Thanks so much, guys. Just have one question. Just about the whitespace within the current customer base. I think in the past, you've spoken to it being quite large. I am just curious if you could remind us of the size there. And then maybe just qualitatively, how that fits into different buckets whether it's selling to different geographies, or new product cases, and then maybe just how task mining with ever flow might help kind of even broaden that opportunity? Thanks so much.

[Kenneth Stillwell, CFO]

So I'll take the first part, then Alan may take the process mining part. So. we often think about this, we naturally Joe, we can never get this perfect, right because you're speculating how big the market is, but we can use market data from third party companies that do this for a living, and we can we know our spend is, and we kind of have a directional idea of what we think would be a reasonable target.

And when you look across our client base we are well below 10%, penetrated single digits, kind of mid single digits penetration. And when you go out and say, well, what would that look like after three to four years of growth with this client, we may be approached 10%. So I think even in our largest clients we've talked about maybe we're 25%, 30% penetrated some of our largest clients in terms of what we might be able to get from them.

So I think the number is almost ridiculously high to talk about how much we could tackle that $100 billion market that we have out there. So I think we been in business for a long time, 40 year anniversary, actually, this month as a company, but I don't think we should mistake that and the relationship we have for our clients, and the things that we are, we are deeply penetrated in those clients in terms of the opportunity set. Alan, you want to maybe talk about Everflow?

[Alan Trefler, CEO]

Yes. I can. That's absolutely correct. And when I go talk to the government of [indiscernible], Last week, when I was in Germany, we have such a tiny fraction of what we're able to do for those governments and same for the commercial enterprises as well where there's really, in all that, a few cases, staggering upside. And candidly, the customers liked the attention, and they deserve the attention.

So I think this is going to be a win win for everybody. Everflow is just a wonderful tool to help people just get a better understanding of what's going on with their processes. And I think it's less than Everflow itself generates large amounts of ACV. I think it's more than the use of Everflow is part of the discovery of how you can do better automation, and how you can apply the Pega platform technology to be able to handle the things that Pega workflows are good at.

[Joe Mearus, Truist]

Awesome, thank you so much.

[Operator]

Next question, Vinod Srinivasaraghavan with Barclays. Please go ahead.

[Vinod Srinivasaraghavan, Barclays]

Hi. Thank you for taking my question. Just one for me. You've talked about usage baseline before and you've talked about a little bit earlier. Can you talk about how did usage patterns with customers purchasing the product in this way trend throughout the quarter?

[Kenneth Stillwell, CFO]

So just to be clear, we think about the usage based contracts what we're really talking about is the ability for our clients to bring on new use cases, new workloads to expand their footprint of Pega in a frictionless way. And as they do that, naturally the volume that they use where they see value from that we get a small fraction of that value that is created by the client.

In terms of usage across the year, some clients haven't very consistent because it's a very predictable and repeatable process. Some have peaks and troughs through the year because of the nature of the business like loan originations might be bigger and the spring might be in other parts of the year for example but in terms of the quarter, there weren't, I wouldn't say that there's trends that we're tracking on usage. What I would say is that the majority of our engagement with clients were engaging in this way so that we can actually help our clients have a frictionless way to adopt and not have to go back in kind of a traditional perpetual world, if you go back many years where they had to actually go through a sizing it up in a purchasing process and trying to identify the need and go through a very rigorous and overhead heavy internal process.

We want our clients to be able to get value from Pega in a frictionless way. And that's really a very important part of the usage base model.

[Alan Trefler, CEO]

And will often calculate the usage based on a trailing 12 month average so that individual quarters won't bounce up and down and usage won't vary month to month. Customers and, both customers and us, I think are happier when that's a little smoother. And so that's how we intent to do this.

[Vinod Srinivasaraghavan, Barclays]

Got it. Thank you appreciate it.

[Alan Trefler, CEO]

So with that, let me thank everybody for attending. You were excited about where we are. We're working hard. And I want you guys to know, particularly the ones who want to see brilliant generative AI capabilities that Pega world is going to be I think enormously exciting this year, the MGM Grand it’s June 11 through 13th, Investor Day on the 12th and look forward to seeing you on Vegas. Thank you very much.

[Operator]

This concludes today's teleconference. You may disconnect your lines at this time and thank you for your participation.