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Pegasystems Inc
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Greetings and welcome to the Pegasystems Second Quarter 2023 Earnings Conference Call. [Operator Instructions] As a reminder: This conference is being recorded.
It is now my pleasure to introduce your host, Peter Welburn, Vice President of Corporate Development and Investor Relations. Thank you, sir. You may begin.
Good morning, everyone, and welcome to Pegasystems' Q2 2023 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 statements as defined in the Private Securities Litigation Reform Act of 1995.
The words expects, anticipates, intends, plans, believes, will, could, should, estimates, may, forecasts and guidance; or variations of such words and 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 forward-looking statements are contained in the company's press release announcing its Q2 2023 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 in 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 views 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.
Thank you, Peter; and to everyone who has joined today's call, especially those of you who've gotten up pretty early to do so.
I wanted to reinforce that at PegaWorld last month I had the opportunity to spend time with many of our clients and have very meaningful conversations. And then virtually discussions, not just the ones I have but in meeting with other Pega execs, our clients want to talk about the future of AI; and specifically about the impact of generative AI and how they should be thinking about it, how we are approaching it and how they can leverage AI responsibly and safely.
Clients are seeing that this technology will change their business in fundamental ways and are excited about the potential. At the same time, there is so much information in the market and so many opinions. They are eager to learn more and separate out the marketing hype from the reality. It's clear this technology is going to drive massive shifts in how we get work done; and in Pega's world, how applications are designed, built, evolve and supported. We believe Pega is uniquely positioned to leverage this technology, bring it to our clients in a safe and secure way and take advantage of this massive opportunity.
Now for those who attended PegaWorld. You saw this firsthand on the main stage as well as during our investor sessions. We believe that generative AI will accelerate the adoption of Pega, making it easier, faster and cheaper to deploy it; improving the client experience; and driving expansion of existing relationships. And that will translate into helping our clients leverage gen AI in their organizations to improve efficiency, save money and enhance employee and customer satisfaction.
Now nonetheless, there are concerns about the overall economic environment. And clients are being conservative in their decision-making even as they engage in these very positive conversations more deeply.
Now, taking client feedback in and evaluating the impact of this new technology, it's become clear to us that we have further opportunities to streamline how we engage with our clients. During this quarter, we will be working with our teams on ways to get even closer to our customers.
Now, because AI is so important, I want to take a minute to be able to reiterate why Pega is uniquely positioned to leverage generative AI and why this will bring special benefits to our clients.
Now, Pega has been integrating and innovating the use of artificial intelligence and automation since I founded the company, and we've gone through many evolutions. I think this is as an exciting one as I've ever seen.
I believe we understand what clients need, and we can drive value and acceleration from generative AI while preserving the scale and scope that enterprises demand. And a big piece of this that is unique to Pega is we've built an architecture that is perfectly suited to tap into the disruptive power of generative AI both today and well into the future, and we know how to monetize it. Most companies are thinking about generative AI as a code generator of one form or another, but that will really only get them so far. Going directly from prompts to code doesn't really provide the structured enterprise needs to create an enterprise-class system they can evolve.
In contrast, Pega has always been based on the concept of a business model at the center that creates a structure and a system that can evolve as the industry and customer needs change. Our architecture is built on what we call the situational layer cake. And you're going to hear me talk about the layer cake a lot, not just now but in coming quarters, as it helps to really power this revolution. It's a proprietary capability that organizes all of an enterprise's processes, rules, data models and UI into layers, so it supports building and reusing.
Now, this layer cake is the perfect place to plug-in gen AI. It can creates pace that, after the gen AI contributes, people can see the model, touch it, understand it and regenerate as needed. And it is this layer cake, this architecture, that is what Pega is uniquely able to provide our clients, a proprietary structural advantage at the heart of our products.
Now it's not something that can be easily copied or reproduced, and it allows us to develop an integrated generative AI rapidly and seamlessly. So we have been at the forefront of using AI in responsible ways, and the company's responsible AI frameworks that are trusted by our clients. And they will be critical as they build their own AI models. And the layer cake helps us there too by helping create visibility for what comes from Pega versus what a customer might build or develop independently on top of it.
Now, this combination of architecture, experience and capabilities, I believe, will make us more successful than our competitors because it will help our clients be more successful and being able to let them quickly adapt and build for change.
By the way, I think gen AI is going to be devastating to the -- most of the low-code companies that haven't taken this type of approach. As a result, you already see some players starting to talk less about using low code. And I think a lot of low-code players are going to get wiped out, but in Pega we're still talking about low code because we've always used low code to build the layer cake. We've always used low code in a way that provides the structure that was really almost presciently designed for the introduction of concepts like generative AI, so we can implement generative AI as a strength.
Now, I expect that we will monetize generative AI in three ways. First, clients will create more Pega apps and process more work on our platform. Most of our licenses are already work quantity-based. Years ago, we began moving away from seat licenses because, frankly, seats are going to go down. Or if the industry does the right thing, they should go down a lot; and we saw this coming a long, long time ago, so you can think of most of our licenses as being consumption- and capacity-based, which is exactly I believe the type of license you want in this sort of environment. I think it's good for the client and good for us.
Secondly, I do think we're going to see that the fact that we're still in this generative AI work in Pega Cloud and leading with Pega Cloud with generative AI will serve as catalysts for more clients to move from existing term or maintenance contracts to Pega Cloud subscription agreements.
And third, we will offer specific gen AI-powered add-on features, for which there will be an additional charge.
Now, we recently announced and showed at PegaWorld 20 generative AI boosters that will be available with Pega Infinity 2023 this summer, and we've just gotten started. In fact, our engineering team began this year with a gen AI-focused hackathon that resulted in more than 100 new prototypes and capabilities. Many made it in to Infinity 2023 and there's much more to come in subsequent releases. We have clients who are signing up to be early adopters already, and they are engaged and excited about these capabilities. And we're excited about working with them and seeing what we can accomplish together.
Before I move on, I want to take just a few minutes and provide some additional color on PegaWorld because it was so spectacular. This was the first time we came together in person since 2019 and the energy and excitement was palpable. If you couldn't join the sessions or would just like to see all of the replays, they're available on pega.com. Just search on PegaWorld replays. We had more than 3,500 attendees from around the world, representing over 47 countries. And we had inspiring keynotes from clients like Virgin Media, Rabobank, Citi and Aflac, who are all using Pega to drive their business. We had more than 80 deep-dive breakout sessions with additional clients sharing their stories from companies including BT, Google, Santander, Siemens, T-Mobile, UnitedHealthcare, Verizon and Wells Fargo, but one of my favorite breakouts was from LeasePlan, who talked about their transition to a fully digital business model. They are leveraging Pega in their center of excellence in pursuit of their vision to becoming a car as a service organization with a strong focus on service efficiency and digital channels.
There's one of them optimized costs and capture market growth. And they're leveraging our state-of-the-art Constellation open-user experience technology and our prescriptive design system to give their clients and their staff exceptional experiences. You can find a replay of this excellent session on pega.com. Just go to PegaWorld under events and search on LeasePlan, one word.
Now I heard there -- very often how much clients value being able to connect with peers from other companies and learn from the Pega journeys of others. And they told me that, attending in person, they were able to get done in just a few days what might have taken weeks or months in terms of discovery, getting questions answered, experiencing the technology and ultimately understanding the value Pega can provide.
I also heard positive feedback about our client-first target board model; and the value we are, I think, mutually achieving providing a more focused and dedicated engagement team to stay close to our clients.
And they're excited about the new capabilities. And they're really looking forward to seeing how we continue to approach generative AI in the future, finding ways to accelerate development and improve the function of business users without the needs for, well, traditional, longer ways to do it, so I came away feeling incredibly energized and more convinced than ever that we have the right client engagement style, the right technology and a team that can drive success for our clients and for Pega.
Our partners were there in force; and they also, I think, got about enormous value. And I saw tremendous engagement between them and our clients. So as we move into the second half of the year, we're going to be looking to continue to double down and push on this strategy to improve operating effectiveness with additional improvements to our go-to-market alignment that will help maintain and bring even greater attention to that focus.
So, in summary. We are focused on building a successful company for the long term; and to having our clients successfully navigate what is currently, candidly, a challenging selling environment that we think may persist for some time. Let's face it. Right now the world is uncertain and rapidly changing, but I believe we have the right strategy to succeed in this environment while building for the future.
We're focusing on our client base with solutions that drive efficiency and cost savings and we are helping our clients navigate the same set of macroeconomic conditions. We see that gen AI will rapidly change the landscape of how work gets done, massively, and we have a unique advantage that we can leverage and that I believe will be sustainable. And we are making good progress as we pursue the goal of trying to be a Rule of 40 company as we exit next year, balancing growth with fiscal discipline and, I'm happy to point out, generating very, very significant cash flow.
Now to provide more color on financial results, let me turn it over to our CFO and COO, Ken Stillwell.
Thanks, Alan. Our first half results demonstrate our ability to generate increasing amounts of free cash flow while maintaining a double-digit growth rate. The most important metric to measure the success of our business continues to be the growth in annual contract value or ACV. At the midpoint of 2023, ACV grew 13% year-over-year. Our ACV growth was driven by the continued momentum of Pega Cloud ACV, which reached $499 million at the end of the second quarter.
I'm excited that our Pega Cloud SaaS business continues to be the largest and fastest-growing ACV component. And Pega Cloud backlog grew by 23% or $164 million year-over-year. Pega Cloud now represents more than two-thirds of total backlog. This growth is further evidence of the underlying strength and momentum of our subscription transition.
Another key metric to measure the success of our business is cash flow. In the first half of 2023, Pega generated $114 million of cash flow from operations and $123 million of free cash flow, a fantastic achievement. $123 million is the highest level of free cash flow dollars generated in the first half of a year in the history of the company. There are several reasons we delivered this result.
First, in late 2017, we started the subscription transition to move from a company that sold perpetual software licenses to now a company that sells primarily subscription offerings. We embraced the subscription-based business model in response to demand from our clients who are looking for a fully managed offering as a modern way to access our technology.
We also like the fact that recurring billings and thus cash collections are more durable and predictable. We knew and discussed publicly that cash flow would improve as we exited the subscription transition. Seeing Pega generate record free cash flow in the first half of the year is a great step forward in realizing the vision we articulated more than 5 years ago.
Second, as part of the completion of the subscription model transition, we placed a greater emphasis across the organization on driving free cash flow. Whether it being more disciplined on hiring or more selective with third-party spend, I'm seeing numerous examples of our team members making meaningful steps to focus on improving profitability. Third, we're doing a better job aligning our spending with our ACV growth drivers.
In other words, we're instilling better operational rigor than we have in the past. For example, we believe that more than 90% of our ACV growth this year will originate from existing clients through our high client retention rates and our cross-sell and upsell activity. It's far more efficient to sell into existing clients than new logos, especially in times of greater economic uncertainty that I think we'd all agree we're experiencing today.
One reminder; in a subscription-based business like ours which generates significant term license revenue, there can be a mismatch between billings and revenue. Under ASC 606, the majority of term license software revenue is recognized upfront. However, billings and cash collections occur primarily 1 year in advance, in equal installments, over the life of the contract. This dynamic means that we can deliver strong cash flow even as reported revenue in any given quarter fluctuates up or down. As a reminder, we do not provide quarterly revenue guidance.
Collectively, our mid-year results show that we continue to make progress on managing the company with and toward a Rule of 40 mindset. As a reminder; we define Rule of 40 as the combination of ACV growth and free cash flow margin. Achieving the Rule of 40 milestone is a very important one for all of us at Pega. Reaching this goal will provide us with another reason to be proud of the business we're running.
Generating strong free cash flow provides the fuel for Pega to invest in our business and to provide outstanding support to our clients. And it gives us the financial strength and flexibility to navigate through any uncertain economic environment. For example, in the first half of 2023, our cash and marketable security balance grew, providing us with the ability to spend about $90 million on repurchases of our convertible debt at a discount. At the end of Q2, our outstanding convertible debt balance was approximately $500 million.
As we outlined in our investor session during PegaWorld in June, we see 3 major levers to achieve the free cash flow margin necessary to attain the Rule of 40. The first is expanding total gross margin, which is a function of Pega Cloud gross margin, term maintenance gross margin and our professional services gross margin. Improving Pega Cloud gross margin will be the biggest driver of total gross margin improvement.
We expect to improve Pega Cloud gross margin by continuing to scale Pega Cloud, increasing automation and implementing multi tenancy in Kubernetes. On a trailing 12-month basis, Pega Cloud revenue is now $423 million, up from about $50 million just a few years ago. In the first half of 2023, Pega Cloud gross margin improved from 68% to 73% year-over-year.
The second major lever that will drive operating leverage is in the area of sales and marketing. This is certainly the most difficult of the three to tackle. We continue to balance our need to invest in sales and marketing to drive ACV growth with our need to improve sales efficiency. We certainly have a lot of work to do.
In the last few months, we've received feedback from our clients, partners and employees on ways to further simplify client engagement to drive greater success. We're evaluating all of these suggestions to improve our go-to-market effectiveness, and we plan to implement changes in the second half of the year to continue driving improvement in our go-to-market productivity. The third and final major lever that will improve our operating leverage is in the area of research and development and G&A. The approach here is simple.
We plan to increase R&D and G&A spending at a slower rate than we expect to grow the company. Delivering best-in-class innovation to our clients continues to be critical to our success. We will continue to invest heavily in R&D. However, we believe we can do so in a manner that still improves our efficiency. As you can tell, we're very focused on growth, expanding gross margin, improving sales efficiency and increasing operating leverage. The companies that are successful in navigating uncertain economic times like the environment we're in today typically are ones that focus on growth, expense management and generating free cash flow. It's very reassuring to our clients that Pega maintains the financial strength to continue providing outstanding customer support and product innovation.
Before I wrap up. I've been asked to offer a few thoughts on modeling our business in the second half of 2023. As a reminder, the third quarter of the year is typically one of the lightest term license revenue quarters of the year due to seasonality. That's because we often book far fewer renewals of term license agreements in that period. In contrast, the final quarter of the year is typically a relatively stronger term license revenue quarter because we, like most enterprise software companies, experience a higher level of contract renewals in the last quarter of the fiscal year.
In conclusion, it was great seeing so many of you in person during our investor session in June, at PegaWorld in Las Vegas. And I'm looking forward to seeing all of you as we get back on the road in August and September.
Operator, at this time, please open the line for questions.
Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from Steve Enders with Citi. Please proceed with your question.
Okay, great. Thanks for taking the question this morning. I guess, I just want to ask first on kind of what you are seeing out there in the macro situation and some of the uncertainty with customer budget and, I guess, how that relates into the sequential decline that we saw here on the ACV line in the quarter.
So let me -- hi, Steve, it's Ken. Let me hit on the second part of your question. And then I'll hand over to Alan to give a perspective on the market landscape. So it is unusual to have a decline in ACV sequentially in a quarter. It's not unheard of, especially in a situation where we had such a strong build in the first quarter. There's a lot of anomalies that pop up in a quarter around renewals and we do have some churn in clients. It doesn't always happen linear.
We actually have consumption agreements that reset at different points in the way we calculate ACV, so we tend to not look at things in such a small discrete period as a quarter and think about things over a trailing 12 months kind of view. So like I said, it is unusual to see that happen, but it is not something that we believe is systemic. And we don't think it impacts our ability for -- to drive toward our full year results. So I'll hand back to Alan on the view -- on his view of the market.
Yes. So I think the market is definitely being conservative. We're seeing more approvals sometimes popping in at the last moment, having some things that you would have expected would have just closed in the matter for course, and some of which have since closed, but that just took longer. I think that, in the companies that are our clients, there is definitely an extra level of scrutiny that is going on, which I've seen before and in other times when there was uncertainty.
And I think we know how to deal with it -- well, I know we know how to deal with it, but I do know that -- I'm expecting that this is going to be true for a lot of other companies and it's going to be true possibly for the next quarter or two. I don't think it affects our long-term prospects in any way, though.
Okay. No, that's helpful context there and I appreciate the comments around that. I guess, kind of given the budget situation that we're talking about here and the excitement around AI, how are you thinking about the path to monetization for all of the new functionality that you've talked about and released at PegaWorld last month and how customers are kind of feeling about those investments in PEG AI going forward?
Well, look. Customers are being bombarded with every company they talk to, even ones that I'm sure they're trying to avoid, coming and offering AI miracles to them. I -- the hype cycle here is -- actually I think it might be unprecedented, to tell you the truth. The reality, though, is we have a lot of credibility with our clients, particularly when we can show them the real types of things that we were able to show at PegaWorld and that you can see in some of the videos that we posted, so there is a tremendous amount of interest. And I think we have a lot of confidence from our clients that the way we're going to do it is going to be a way that really works. We are seeing, as we've seen in the past, a lot of customers doing their own experimentation. A lot of customers, as you would expect, are putting their toes, dipping their toes in a lot of ponds, all right?
We're seeing the same with analytics too, that there's just a lot of, "Oh, my god. How do I figure out how to get the value out of my data? How do I drive expense out? How do I do everything from -- create better end-to-end automation to be able to have the AI do summarization that otherwise the human would have to do? So there's so much activity and interest. I think we're doing well. And I've been in a lot of meetings in which we've had discussion explaining why the Pega approach is differentiated, why it's architecturally superior.
And I know customers are taking that very, very seriously. And I expect it will lead to -- as I said, in the three ways we think of monetizing this, I think it will lead to greater usage. And we're already primed for that greater usage. It will lead to better outcomes for them and good outcomes for us.
Okay. Perfect. Thanks for taking the questions.
Our next question comes from Kevin Kumar with Goldman Sachs. Please proceed with your question.
Thanks for taking my question. I had ones on cash flow which was very strong in the first half of the year. Ken, I know you updated guidance during Investor Day, the $180 million for the year. It feels like you're tracking ahead of that number, particularly given 4Q tends to be a strong quarter. Is that still the right way to think about that? Anything else you would call out in terms of kind of the cadence of cash flow for the year?
Hey, Kevin, thanks for your question. So it would be silly for me to suggest that being where we are at the midway point doesn't -- isn't a good thing in terms of us achieving our cash flow for the year. And I certainly don't think that $150 million or $180 million or whatever number we have is something where we'll just stop and say, We've achieved that. We're good for the year. So we're going to try to generate as much cash flow as we can because we know that the more cash flow that we generate this year just means that our structure is set up to generate cash flow in future years. So I would say we're not updating or adjusting guidance, but I would say we're very pleased with where we are. And we think it bodes well for the future of increasing cash flow for Pega.
I'll also say that the mood at the company is -- has really, I believe, come a long, long way in adopting a culture of balance of trying to head towards Rule of 30 this year, Rule of 40 next year. And so it's -- it wasn't like the cash just fell out of the sky. It's that people are doing the right things. You're thinking about both being more economical but also how to, to be candid, bump up that critical component being a Rule of 30 and 40 company. It's part of everybody's complex, so it's one of those things that a little extra attention helps a lot.
That's great. Thanks for the context there. I had one on -- just on Europe. Looking at the segment revenue details, it implies, I think, Europe accelerated revenue growth in the first half. Is that maybe just catch-up? And is there anything you'd call out in terms of potential recovery in some of those different regions? And anything you're hearing from your customer base?
Yes. That -- I will say, don't -- please be careful with how much you look into segment reporting for regions, on revenue, because -- remember a lot of our revenue still is term license revenue under ASC 606. And so the mix and the timing can somewhat just be -- just happens to be the way the revenue flowed between the geos. I would say, that said, we have not seen a noticeable change in the theaters in the first half of the year in terms of positive or negative. I just think sometimes the revenue flow is different, Kevin. So that, I -- it's more that than it is actual economic changes.
Understood. Thanks for taking my questions.
Yes.
Our next question comes from Rishi Jaluria with RBC Capital Markets. Please proceed with your question.
Wonderful. Thanks a lot for taking my questions. First, I wanted to kind of drill a little bit back into the consumption element of the business. At the Analyst Day, you had said that part of the goal of generative AI is driving more consumption. Maybe can you give us a little bit of a reminder for today how much of your business is actually consumption? And as we think about the actual adoption of generative AI solutions, how that impacts the mix of consumption versus subscription. And maybe what does that do to some of the leading metrics like ACV and RPO that we're all still looking at? And then I've got a follow-up.
So let me start with that, and then Alan can fill in the gaps. So just a reminder for us: And it -- when we say consumption, we don't mean a contract that is paid by the drink with no commitments from the clients. What we mean is that a contract is based on a usage or a consumption metric; and that, that increase in that metric allows a sharing of value between our clients getting more value from using the solution and us achieving more value from those commitments.
If -- when you think about our contract consumption, meaning a model that our contracts are based on a consumption or usage metric, it's well above 50% of our contracts are actually using a usage-type metric or a consumption-type metric. In terms of the amount of our ACV or revenue that is driven by variances from contractually committed arrangements with our clients, meaning overages or averages, it's -- variances, it's still a relatively small part of our business that comes from clients going over their contractual. That -- normally what happens with clients is, when they get to that point, we re-contract with them with new commitments.
So most of the agreements -- and I think -- just to clarify what Ken is saying there. Because I think it's a really interesting and important point. We did some things several years ago, when we began wanting to move to a more non-seat-based model to a model that was based on the quantity of work, to converge the concepts of subscription and consumption. So what we found is that clients really don't like it when the amount they have to pay bounces around too much from one quarter to another. It makes it hard for them to budget. It can feel unpredictable, particularly if it ends up being driven by some external circumstance that suddenly something falls, a lot more items or a lot more exceptions on the calls to the call center, so the quarter-to-quarter variation was something we wanted to avoid, but on the other hand, we want to accommodate customers whose business was increasing even as their seats was -- were decreasing.
So what we basically typically do, as Ken said, to avoid having it bounce too much for a customer from quarter to quarter is, instead of doing overage charges, we use the increased level of use, the increased consumption, to reset a new subscription price so that it reflects itself in the go-forward ACV. And it becomes something that candidly is a lot easier for the customer to budget and understand. And I think it's actually easier for us to administer, but I don't believe that was ultimate the motivation of it. Does that make sense, Rishi?
Yes. That's a very thorough answer. I really appreciate it, guys. And then…
I want to -- Rishi, I'm going to answer one part of your question that we didn't answer, backlog, RPO. When you move to more consumption- or usage-based models, there is a chance that a contract duration would come down slightly. And so that could actually be a headwind to RPO growth slightly, not materially but slightly. So that's your second -- one part of your question there, just to clarify that. And the reason why that is, is we want faster iterations of measuring our clients' usage to be able to grow ACV. Longer durations tend to lock-in usage for longer periods of time. So that's the RPO answer.
Okay. Great. And just to clarify: That shouldn't have an impact on CRPO or RPO with one year or under, correct?
No, no. It would be -- it would highly unlikely to impact current RPO, yes.
Okay. Really helpful. Thanks. And then one other piece of feedback we got when we were talking to partners at PegaWorld is that generative AI can really help speed up time to value. Maybe based on your customer conversations, how do we think about the potential for this to reduce implementation times; reduce sales cycles; and kind of lead to, maybe over time, better net new business showing up in the model? Maybe help us understand how you're thinking about that. Thanks.
I think it's going to be huge. When I did my closing at PegaWorld, and the video is still up there, I talked about 4 things that I expected to come back to that audience with the following year. And I want you to know that the company is galvanized around working as hard as we can to make sure we deliver on these things.
The first was what we call Pega at your fingertips, so using the power of generative AI, including some of the things that are going to be in 2023, to be able to make it so the system is giving people building the software advice. It's also going to be able to give end users who are using the software advice and even do work for them. So that was the first of the four.
The second was we expect to double developer productivity as a direct result of the implementation of these features. And relative to what you were asking about, I think this is unquestionably going to increase the velocity of sales cycles and it's going to make it easier for customers to get a lot more done with the same dollars. And so we're working to get our partners excited about how this will let them do more for the same amount, which should improve their sales cycles as well, so -- and the final two, as you may remember, were the concepts of Launchpad and the autonomous enterprise.
Got it. Perfect. Thank you guys.
Our next question comes from Pinjalim Bora with JPMorgan. Please proceed with your question.
Great. Hey, guys, thanks for taking the question. I wanted to ask you one thing that you were talking in the script about more opportunity to further streamline sales, additional improvements to go-to-market. Is there any way to kind of tease that out? What other things are you thinking that you can apply?
Yes. We've just begun sharing that with the company. And I'm going to spend some time today talking with the company as a whole about what we're doing, but in principle, we're going to make it so in -- a couple of the roles and functions that historically have been kind of segmented out are going to become less siloed in the front office and the go-to-market, the work of people that we call success managers and people we call account executives and other sorts of roles and functions that are in there that were specialists in certain areas.
We're going to work to bring them under a common organizational and management structure. So that, I believe, is once again going to continue to make us more effective. We've certainly gotten feedback from our clients that it will be easier for them to deal with more focused teams. And I think of it as just really a continuation of some of the things we started in January. I do believe it will improve sales efficiency, but that is not the primary driver here.
Got it. Understood. And Ken, going back to kind of the sequential decline in ACV: Was the macro sequentially worse in Q2 versus Q1? Anything to note there?
I don't believe the macro was worse. I think our performance in Q1 was better than our performance in Q2. And naturally that contributes, but that -- Pinjalim, that actually happens in a business like ours where we have smaller numbers of deals. Where the deals are larger value, you tend to not get kind of like the -- like it's not like a statistical like kind of trend in terms of the bookings. So that's not that unusual to see in our business.
Understood. Thank you.
Our next question comes from Jake Roberge with William Blair. Please proceed with your question.
Hey, guys. Thanks for taking my question. Just wanted to dig deeper into your comments that generative AI can commoditize -- monetize just those lower-end use cases in low code. Can you just talk more about why your platform's positioning helps you take advantage of AI? And then just from a timing perspective, when do you think we can actually start seeing AI layer into the model? Is that something that's more Q4, or do you think that's more of a 2024 story?
Could you repeat the second question? I'm sorry. You said, when can we start seeing...
Q - Jacob Roberge
Yes. It was just really around the timing of when we can start seeing AI layer into the model. Is that something that starts generating revenue in Q4, or is that more of a 2024 story?
So a couple of different things there, all of which I think are terrific actually. So the reality is a lot of what you see are people building systems using AI by using them as an accelerator for traditional coding. Think about copilot, using it to even generate in the low-code area and tie your systems. The trouble with a system that's generated like that is it's really hard to change.
It doesn't have a structure that makes it easy for you to go in and say, "Oh, Italy wants to do something differently. How do I go change this set of things for Italy?" Because candidly, when the generated stuff happens, it tends to kind of get generated in cloud server in a way it is not necessarily organized to change. The layer cake in Pega lets you organize the key dimensions of change. We find that in businesses and enterprises, change typically happens for 1 of 3 reasons.
You generally get a general way you want to do a process and make a set of decisions, and they will vary based on a product variation or a customer variation or a jurisdictional variation or locational variation. And we have built those dimensions into this layer cake. So when you want to make a change or how something works for Italy or how you handle particularly a high-value set of clients, you've got a place to go. You've got a place to go in the layer cake that you can -- we generate those pieces, as opposed to having to deal with something that looks a lot more like soup.
Now, the soup doesn't matter as much in small systems. So I think it's going to be used extensively there, but in anything that you'd think of as an enterprise solution, really important to have that structure. And this will be hitting the streets this year. So this is going to be something that our customers -- when '23 ships this summer, this is going to be in the hands of customers.
Okay, helpful. And then just we're obviously hearing a lot about platform consolidation, just given the uncertain macro. Have you seen any changes to the competitive environment or even with your GSI partnerships just as some of the larger software platforms like Microsoft and ServiceNow invest more in the space? And then on the other end, have you started to benefit at all just as customers may look to consolidate like a point solution RPA or process mining vendor onto your broader platform?
Yes. We're seeing actually some real benefits from platform consolidation in the pipeline and actually in real implemented systems where some of our clients are using us to do more of their workflows. And I think that's actually a larger source of benefit for us than the consolidation across different product families like process mining versus robotic automation. But yes, I do think we are going to see some consolidation. And I would expect, based on where our history has been when this sort of thing has happened, that, that is beneficial for us.
Helpful. Thanks for taking my questions.
Our next question comes from Vinod Srinivasaraghavan from Barclays. Please proceed with your question.
Hi, guys. Thanks for taking my question. I just want to follow up on some of the macro and GenAI questions you've talked about. And so far, it seems like you're seeing some offsetting demand factors between GenAI starting to help but macro still being kind of more of a negative factor. When do you expect this tug-of-war to kind of start to favor GenAI over macro and kind of start to show up in a stronger pipeline and then really start to show up in net new ACV growth?
Yes, I think that net new ACV -- I think the tug-of-war is won by real things in the hands of real customers. If you look at what's out there, a lot of -- there's a lot of stuff including ours, which hasn't fully hit the street yet. And I think, as that hits the street, we're going to see it do a much harder tug in that direction.
I also think some of the macro just represents greater conservatism, just extra layers of approvals or run it by the CFO at the end twice, that was not candidly present as much as we entered the year, but isn't at all shocking given the uncertainty and everybody is trying to save money in this environment. So I'm very excited. We need to -- to be able to achieve our Rule of 40 ambitions for next year, we need a good road rally and we're still psyched to be able to do that.
Understood. And then just maybe on the Rule of 40, your progression and scaling of Pega Cloud and gross margins. At PegaWorld, I saw you guys were hoping to adopt externalized services for micro services, I think, by Infinity '24, with a more full deployment by the year after that. How should we think about kind of modeling Pega Cloud gross margin as you kind of hit those milestones?
Yes. So we wanted to get -- the way I would frame it is, way back when, when we started this, like, five years ago, we said we want to get Pega Cloud gross margin to 70%. A couple of years ago, we said we're going to change that number to 75%. We're now pretty close to 75% and we've talked about that there's no reason why that number can't go and approach 80% in the coming years. So I would model it kind of in a more linear fashion. That is probably one part of our business that actually does have linearity in terms of the scaling. So I would probably think about it that way.
And we're putting improvements online every quarter.
Got it. Thanks. Appreciate.
Our next question comes from Fred Havemeyer with Macquarie. Please proceed with your question.
Thank you very much. Good to speak to Alan, Ken. I think I was coming in with more technical-focused questions, but something kind of tickled my fancy. So I wanted to ask, I think, maybe for Alan. As we think about the opportunity here to potentially improve how customer service, sales, et cetera are done with the aid of Generative AI. I mean, you have all of the pieces in place to do things like autonomous agents for enterprise and the likes, but just wanted to ask you, what do you think about the opportunities to kind of like augment or improve how customer service is done more efficiently with Generative AI?
I think it's enormous. I think it's enormous in an assisted sense and I also think that it's going to really fundamentally change the way self-service works as well, which is why I'm glad we're not tied to seat counts. Because -- let's face it. One of the big cost savings that people are achieving and want to achieve is the reduction of labor that they have trouble finding, anyway. And so I think it's going to be a really perfect storm in that direction. And I do think that we do have a terrific collection of the parts to deliver on that frontline. So, things would be great.
Looking forward to seeing what you'll be doing there. I guess the next one is just with respect to your partners as well. How are they approaching their strategies and recommendations at the moment related to just no code, low code and generative AI to their clients? Are they kind of also in a place where they're experimenting with or helping their clients experiment with new technology? And is there any sort of a headwind that this experimentation is doing to platform -- like low-code, no-code platform adoption?
I think there is a lot of experimentation going on throughout the entire business system because, candidly, people are trying to figure out what's real and what's hype. The partner engagement I've had, though, has been extremely enthusiastic about what we're doing. I'm not sure that they're as enthusiastic about everybody, but I'm sure the partners will find a way to monetize it themselves, without a doubt.
Thank you.
Our next question comes from Mark Schappel with Loop Capital Markets. Please proceed.
Thanks for taking my question. Alan, on Launchpad. You discussed the offering in more detail at the recent Investor Day. I was wondering if you could just bring us up to date on the status of your early adopter program for Launchpad. And maybe just talk a little bit about the -- some of the parts and capabilities of the offering that your partners are most excited about?
Yes. So I'm thrilled actually with the feedback from our early adopters. The early adopter program is oversubscribed and the partners are showing enormous enthusiasm. Just so folks know, if you haven't plugged into Launchpad, Launchpad is a way of bringing the way we've historically thought about work-driven systems to partners who want to capture their own IP and offer their own IP to subscribers powered by Pega and it was built specifically for this. And I think it's really unique in the market in being able to do that, and that is the feedback we've gotten from the organizations that we've done the early work with.
So we've been reluctant to make any projections for this year because it is a nascent technology, but I'm expecting that I will be able to talk about Launchpad's contribution to the financial strength of the business next year, because I think it's going really well.
Great. Thank you.
Our next question comes from Tom Blakey with KeyBanc Capital Markets. Please proceed with your question.
Hey, Alan and Ken. Thanks for squeezing me in here. Great stuff here. I'm trying to balance out these two moving parts on the macro. It seems to have gotten incrementally a little more headwindy, and AI which you seem more bullish on, Alan. In terms of the $1.4 billion calendar '23 guide, it seems like maybe AI could be incremental here. But just trying to understand kind of where we are, like when the guidance was set and where we are now in terms of balancing these two points out. And I have a follow-up on free cash flow.
So let me take that one, on the revenue side. So Tom, I think it is -- this has happened to us in a few years where when there -- the Pega Cloud momentum creates a little bit of variability on the accounting revenue piece of it, all right? So if you look at where we started the year, the revenue number can move around because of that mix of Pega Cloud. I think, when you think about our ACV and our billings, which are kind of -- those are very integrally connected, I'd say that's kind of where the macro discussion comes in.
I just want to separate revenue from ACV a little bit. So I think revenue is definitely a little bit more of a wildcard depending on the mix of the contracts. So that's an unfortunate reality for our business, but setting that up in terms of the ACV and the billings, I think maybe I'll leave you, Alan, to think about how you think about the macro now versus maybe when we started the year.
Yes. Look. On a macro basis, the economic uncertainty and the fact that we have seen like some more approvals come into the mix is obviously a challenge and one we've seen before. But I will tell you, from a macro point of view, GenAI is a huge and not short-term factor here. And I think it's going to -- this is going to fundamentally change our business and a number of other businesses in a very, very big way over the next 12 to 24 months.
So I'm very, very bullish. I'd love to be able to put out a quarter where there wasn't some bit of mixed results, but we're working towards that. Cash flow was very positive. I will return to that. You had a question, is that about cash flow?
Yes, I did. And before I get to that, Alan, just while I have you there on the huge comment on GenAI. There's been some of fellow vendors and big titans out there talking about monetization there. Do you want to offer up maybe some visibility very early on here that you see in terms of possible like-for-like uplift in terms of pricing or monetization per client given that 90% of ACV is going to come from existing clients?
Yes. I think the biggest aspect of monetization is going to be because we're going to accelerate our clients' use of the technology, so that they're going to use it more. I think some of the vendors you're referring to are stuck with more of a seat model. They're going to have to figure out how to fix it. We don't have that problem. So we're really in a good place that, as customers get excited about this and want to use it, it's going to lead to greater volumes and that will lead directly to monetization.
We will have some add-on things that are separately priced, but I don't expect that we're going to do something onerous to our clients, like, I think some customers are worried about from other vendors. I've heard some numbers brought forward on seat pricing that I think are going to be anxiety producing to their customer banks. We don't have to do that with our consumer base to trying to set their mind.
Yes. I guess you know what I was referring to, Alan. That's very clear. And on the impressive free cash flow here, I'm just wondering, your converts are still trading, I think, at a 8% or 9% discount here, Ken. Not calling out anything specifically, but I'd like to know what your updated thinking is there. I know things are probably a little bit more, for the lack of a better word, happy for you here, Ken
So -- but just an update on capital structure, capital return and also how it kind of like maybe possibly impacts that Rule of 40 as you move things around here with a much -- potentially better balance sheet going forward? That would be helpful. Thank you.
Well, I think that we were never aggressively in the market to buy back the converts. We were -- those were opportunistic where some investors were looking to get out of their positions and we felt like there was an interesting IRR to do so. And actually if the stock's price goes up and as we get closer to maturity, that becomes less arbitrage, so to speak, on that versus what we can get at overnight rate.
So I would say we're still -- we'll consider opportunities when they come in, but we're not aggressively going out nor did we on the other transactions. I think it's more just a sign that we have a lot of confidence in the durability of the business and the cash flow of the business and we felt like we're very comfortable taking that $100 million out of the convert.
And then just from -- and from a longer-term perspective, so just letting -- from a strategic perspective then, just letting the cash build?
Yes. I mean we have -- naturally, from a capital allocation standpoint, we have a near-term event if we wanted to have, which is to basically not -- to basically take out the converts and not to re-up them or to refinance them. So naturally that's something that's out there that we want as much flexibility as we can with our options.
We're at time, but I see there are a couple of more people in the queue. We'll very quickly take two more questions.
Thanks, Alan.
Thank you.
Our next question comes from Patrick Walravens with JMP. Please proceed with your question.
Great. So Alan, my question is do you have enough sort of PhD-level AI talent to do what you want to do. I mean you have Peter van der Putten and then you added Christian, right, but how much you need...
I have Rob Walker too, who is a pretty good PhD and has been with us on the main stage at PegaWorld. And I -- and we have a couple of others who aren't PhDs but easily could have been who are sprinkled in. So yes, I feel really good about our talent base in this environment.
And then can I ask -- can we get an update on the lawsuit? There's probably not a lot you can say, but whatever you can say?
We're in the appeal-waiting process, and I am looking forward to getting that in front of the judges. I'll just say that.
All right. Great. Thank you.
Thank you. And I think we are at time. So we will have to call it. Let me just tell everyone, thank you very much. We're working hard for you. We're actually generating cash, which I know Ken and I are very excited about. And we will continue to keep you all updated. Take care, everyone. Bye-bye.
This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.