Pegasystems Inc

NASDAQ:PEGA

Earnings Call Transcript 2018-Q4

[Operator]

Good day and welcome to the Pegasystems Fourth Quarter and Full Year 2018 Earnings Results Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ken Stillwell, Chief Financial Officer, Chief Administrative Officer and Senior Vice President. Please go ahead, sir.

[Ken Stillwell]

Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems Q4 2018 earnings call. Before we begin, I'd like to read our Safe Harbor statement.

Certain statements contained in this presentation may be construed as forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. The words expects, anticipates, intends, plans, believes could, should, estimates, may, targets, strategies, intends to, projects, forecasts, guidance, likely and usually or variations of such words and other similar expressions identify forward-looking statements, which speak only as of the date of 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 2019 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 Q4 2018 earnings and in the company's filings with the Securities and Exchange Commission including its annual report on Form 10-K for the year ended December 31, 2018 and other recent filings with the SEC.

Investors are cautioned not to place undue reliance on such forward-looking statements and there are no assurances that the matters contained in such statements will be achieved. Although, subsequent events may cause our view to change, except as required by applicable law, we do not undertake and specifically disclaim any obligation to publicly update or revise these forward-looking statements whether as a result of new information, future events or otherwise.

And with that, I'll turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

[Alan Trefler, Founder & Chief Executive Officer]

Thank you, Ken. Q4 was strong capping off a terrific year and I'm pleased with how our strategy is playing out. And we're more convinced than ever that we have the right solutions and vision for what the market needs. As we discussed, our goals are to accelerate growth, while we move to a more recurring model and our year-end results demonstrate the progress we're making. A lot of this is continuation of the trends we've discussed over the year. We're seeing an acceleration in our move to the cloud and other recurring arrangements and our trademarked Cloud Choice message is resonating. And really all of our client deals are being deployed with Cloud Choice as an important factor.

And in 2018 amazingly Pega Cloud, where we are actually the full-service cloud provider, represented half of all new deals compared to that being in the low 20%s in 2017. This is a very positive development in terms of driving recurring revenue and cash flow over the longer term. Now we started talking very much about ACV, well over a year ago, and our strong underlying business trends are reflected in license and cloud annual contract value, that's ACV, growing 40% year-over-year. And total ACV, which includes maintenance, grew at a very healthy 23% from a year ago to $570 million.

As we've discussed over the past several quarters, ACV is the measure we are most focused on because we think it most closely reflects our underlying business trends, while we work through our transition to being a cloud and as-a-service company. But as we've also said, it's important to look at current performance, as well as future obligation and our commitments from clients, to really understand the health of the business and Ken will go into more detail of that when he picks up in a moment.

Q4 showed us with an annual run rate of $1 billion for each of billings and collections, which is very exciting. And I'm especially pleased this year to see a strong Q4, following a strong Q2 and Q3. I think this is a result of greater consistency in our sales team performance, of course, with significant wins as well throughout 2018, all of which confirms that our strategy is working and that we're doing a good job of on-boarding our new staff over the last couple of years.

Though really pleased with our financial results, we believe there's even more we can do to capture a improved proportion of the immense opportunity before us, which is why our strategy is critical to continually and working to accelerate our growth. So in terms of strategy and differentiators that Pega has, throughout 2018 we focused our efforts on continuing to deliver the best solutions for client engagement formally known as CRM and digital process automation formally known as workflow. This strategy culminated in the launch of Pega Infinity, our future-proof digital transformation platform, powered by six key differentiators at the core of our competitive advantage.

We do deep analysis of our deals and we are finding that we are winning business because of the differentiation of the solutions we provide and the way it lets our customers think about their future. These differentiators include: Real-time omni-channel AI to deliver the right next best action and insight at every client interaction. End-to-end automation and robotics that drives process optimization and productivity across our clients' organizations. Journey-centric rapid delivery that gets our clients to quick value by transforming one customer journey at a time. Our Situational Layer Cake that drives reusability differentiation and specialization at enterprise scale and software that writes itself, the industry's first and most comprehensive no-code platform that automatically generates tunes and documents the software that powers our clients' enterprise application.

This enables us to offer this Cloud Choice capability that allows our customers to run on Pega Cloud as a fully managed service, choose in their future to move to Microsoft Azure, bring it on a private cloud with Pivotal or run on the Google Cloud platform, an unprecedented set of choices in a world where choice is increasingly important.

Now, as I referenced earlier, we made a dramatic product announcement at PegaWorld last year with Pega Infinity, which we see as the industry's most complete digital transformation suite. And I've been delighted with the ongoing positive response we are getting for it. Not just from clients and prospects, but also from the industry by way of continued leadership ratings from top two analyst firms like Gartner, Forrester, Chartis and Ovum.

Earlier this month, we were recognized as the clear leader in Gartner's Intelligent Business Process Management Magic Quadrant for the 12th time, an accomplishment we're very proud of but never take for granted. It's an absolutely gorgeous picture that you should check out on our website. And you can expect to see more of a rhythm of continuous improvement in our product with enhancements moving forward as we continue to build on the differentiators I described earlier to improve client engagement and also to drive operational efficiency.

Now that said, we've got some exciting announcements planned for PegaWorld this year and we've already have about 100 important speakers signed up, presenting from organizations like British Airways, Ford, Google, HSBC, Rolls-Royce, Scotia, Sirius Radio, UNUM and UnitedHealthcare. We'll be in Las Vegas once again on June 3 and 4, and I hope to see you there.

Of course this momentum is being driven by our growing number of talented staff and throughout 2018, I highlighted some of the terrific very senior hires we made. They've been building on the functions and developing highly productive and innovative teams in our organization. And recently, we announced the addition of Ron Hovsepian to our Board, who brings more than 30 years of deep B2B leadership experience to Pega, including as a President and CEO of Novell where he led the company through the critical shift to Linux with extensive follow-up work at leading SaaS companies.

Pega is has now more than 4,600 global staff strong and we expect to actively hire through 2019 to further support our growth goals and take advantage of this tremendous set of opportunities.

This complements the great progress we have made in expanding our ecosystem, which is critical also to our strategy. It's exciting to see the company continue to grow and scale and see the terrific work being recognized by customers, prospects and analysts.

So in summary, I'm very happy with our 2018 performance and particularly pleased to see good continued acceleration in license and cloud ACV. We will continue to invest prudently and appropriately in marketing and sales to ensure we can reach ambitious goals and I continue to be positive about how our software is being adopted and the massive level of our long-term growth opportunities.

To provide more color on the financial results let me turn this over to our CFO, Ken Stillwell.

[Ken Stillwell]

Great stuff Alan, thanks. Before going into some of the details, I'd like to reinforce a few things. We're in the midst of a pretty significant shift of our client contractual commitments from perpetual to cloud, which is just a terrific outcome of our strategy. This shift to cloud creates a negative short-term impact on reported revenue and margins.

As Alan mentioned in 2018, Pega Cloud commitments represented half of all new business. If we maintain our new business commitments of Pega Cloud at approximately 50%, 2018 and 2019 represent the years most impacted by the cloud shift.

During this transition and even after the transition, Annual Contract Value, ACV and Remaining Performance Obligation, RPO or backlog are two key metrics we use to measure the growth of our business.

Annual Contract Value is the most important measure because it reflects the growth and recurring cash flow commitments from our clients. Remaining Performance Obligation, which many people refer to as backlog, represents the total client commitments that have not been taken to revenue. When assessing the performance of the business, we believe the combination of ACV, RPO backlog and revenue can provide valuable information to help interpret the results.

For example, if revenue grew but ACV and RPO backlog declined that would likely not be judged as favorably as if revenue was flat, but ACV and RPO backlog grew significantly. The key is the CR business growing and producing predictable future cash flows, which is why we are laser-focused on ACV.

Now let me remind everyone of several key goals we set out to achieve in 2018 and beyond; first, we set a goal to accelerate growth. This is because our market opportunity is huge and we've been strengthening our position in the CRM market which Gartner said was the largest enterprise software segment in 2017 and which is projected to be the fastest-growing segment for years to come.

Demand for digital process automation otherwise known as DPM and robotics has accelerated over the past couple of years as clients seek digital transformation to innovate around both their client-facing applications and their operational systems.

Pega's products continue to be recognized by clients and by industry analysts as some of the best in the market. We also believe the shift to recurring cloud deals can assist with accelerating growth in new client commitments because it encourages smaller faster deals and also shorter sales cycle so clients can buy and expand over time and we saw evidence of this in 2018.

Second, we set a goal of moving our business to an increasingly recurring model. We believe this move not only drives value for shareholders, but also provides velocity in adding -- and achieving value for our clients and provides a flexible and more predictable investment model for them.

Third, we set a goal to offer Cloud Choice to our clients. We believe our Cloud Choice promise to our clients can make our cloud solutions more attractive and drive higher adoption of Pega Cloud.

And fourth, we set a goal to build a business that could sustain both improvement and profitability as we scale and achieve better visibility to future recurring cash flow. We set off to accomplish these goals while continuing to run the business under our Rule of 40 longer term targets of balancing growth and margin and continuing to invest in sales and marketing to capture the market opportunity.

With these goals in mind, let's dive into our key -- let's dive into our Q results. What an exciting 2018. The fourth quarter capped a very solid year on many fronts. Q4 2018 showed double-digit growth and new client commitments over Q4 2017 which as many of you might recall was a tremendous quarter.

The strong Q4 execution helped drive year-over-year growth in new client commitments to over 35% for the full year of 2018. And ACV growth accelerated as well. License and cloud subscription ACV grew 40% year-over-year and total ACV accelerated to 23% year-over-year.

At the same time, we exceeded our expectations for accelerating to a more recurring model with approximately 90% of new client commitments being recurring in 2018. While we significantly accelerated the move to Pega Cloud with approximately 50% of new client commitments in 2018 being Pega Cloud versus the 30% we originally expected for 2018. Our Cloud Choice message is resonating with clients.

And even through the significant transition to cloud, as Alan mentioned earlier, our Q4 annual run rate was $1 billion for each of billings and client cash collections for the first time in Pega's history which is a tremendous milestone.

Given these solid results, we believe we're building a business that can grow profitably as we scale and achieve better visibility to future recurring cash flow in line with our longer term Rule of 40 targets.

So, now let's talk more about the impact of the cloud transition on our reported results. It's worth reminding everyone that our movement to recurring cloud commitments although desired and strategic results in a delay of revenue recognition compared to the timing of when the commitment is recorded.

Our movement to the cloud at this pace had the largest short-term reduction on reported revenue and margins during 2018 as it will have again in 2019. We expect improved revenue growth as we cross the cloud transition midpoint in early 2020.

Presuming Pega Cloud continues to be half of total new commitments, we should complete our transition sometime in early 2022. Although revenue will still lag billings as is common for SaaS business.

For 2018, we expected 30% of our new commitments to be Pega Cloud understanding that each 1% movement away from that mix would result in at least $3 million of short-term revenue headwind. Given that we transitioned faster than anticipated for 2018, we estimate the impact of reduced revenue by at least $60 million to our 2018 results, but we love the positive impact of future cash flow.

To help investors evaluate our performance through the ASC 606 and cloud transitions, we began disclosing ACV in early 2017, which we said is critical to how we look at the business. Notably our term and cloud ACV grew by 40% year-over-year, which highlights the growth in predictable future cash flows from term license subscription and increasingly cloud.

Including maintenance, we ended the year with $570 million of total ACV, which is up 23% from a year ago and accelerating from last quarter. Total ACV now equals 63% of our trailing 12-month revenue, which is up from less than 50% of trailing 12 months revenue just a few years back.

Turning to Remaining Performance Obligation backlog. Our $631 million of Remaining Performance Obligations backlog from clients not taken to revenue as of December 31, 2018 includes perpetual term cloud maintenance and consulting. This increase of 20% over just last quarter is another highlight of how strong Q4 2018 was.

You also note that $400 million of that $631 million of RPO representing 63% of these commitments are projected to convert to revenue in the next 12 months. The absolute number may fluctuate over time depending on the timing of future commitments, the growth of the business and the average duration of our contracts that are in our backlog.

We've seen the average contract duration of our client commitments decline slightly from historical levels down to approximately 3.5 years. This is almost exactly what we expected would occur with the movement to cloud and a push for faster-deal velocity. Looking at the detailed lines of revenue, our fastest growth is cloud at 62% year-over-year.

Our slowest is perpetual license, a decline of 17% year-over-year. Also consulting was flat. These three items highlight progress against our strategy, which is to shift our business from perpetual licenses to Pega Cloud while getting clients faster value and production and to share more of our implementation work with our strategic partners.

So now turning to investment areas and margin. We have consciously continued our strategic investments in go-to-market and in fact, we're investing to capture a larger share of the growth opportunity. In 2018, our sales and marketing investments closely correlated with our growth in new client commitments, which are largely recurring commitments. We're pleased to see our term and cloud ACV grow by almost twice our growth in sales and marketing expense.

Given the multibillion-dollar market opportunity in front of us, we believe that continued prudent investment will drive larger scale and ultimately a more profitable firm. We are focused on driving efficiency in our go-to-market operation as we drive higher growth rates and we believe both objectives are achievable and will drive tremendous value creation for shareholders over time.

A recent example of improving efficiency. Pega Cloud gross margin increased by six percentage points in 2018 to 55%. This is consistent with our strategy to drive operating leverage in our cloud business and expand our gross margins as we scale. From a cash flow perspective for the full year 2018, we produced over $100 million of operating cash flow and finished the period with total cash and marketable securities of over $200 million. As we transition to cloud, continue our strategic investments in sales and marketing and create long-term recurring cash flows for -- from our clients, during this transition there will of course be lower upfront cash flow compared to a traditional perpetual model.

Once we're through the transition, we expect operating cash flow to align closely to our operating margins. In 2018, we returned over $100 million to shareholders through dividends, net settlements of equity and share buybacks. This was approximately twice the level of what we returned in 2017.

Turning to our fiscal year 2019 guidance, assuming Pega Cloud continues as approximately half of new client commitments, we expect $965 million of revenue and $0.50 of non-GAAP EPS. We believe revenue will be slightly back-end loaded in 2019 as we benefit from the progress in our cloud transition.

Costs should follow a similar trend as they did in 2018 as their timing is less affected by the cloud transition. Just as it was in 2018, the impact of the cloud shift will be significant to revenue and margins in 2019. So continuing to drive significant ACV growth is a priority and is the ultimate measure investors tell us is most important. This is such an exciting time at Pega.

Before opening the call for questions, I'd like to remind you that we hosted Investor Day which will be held on Monday, June 3 during our Annual Conference PegaWorld at the MGM Grand in Las Vegas. If you're interested in attending please send an e-mail to [e-mail]. For those who cannot join in person, we'll hold a webcast of the event accessible on our IR website. You could also reach out to me or to ICR if you want to register for PegaWorld.

And with that operator we will open the call to questions.

[Operator]

[Operator Instructions] We'll go first to Rishi Jaluria with D.A. Davidson.

[Rishi Jaluria, D.A. Davidson]

Hey Alan and Ken. Thanks for taking my questions. Good to see the underlying business continue to accelerate. Ken let me start with your comment that your guidance for next year is assuming that cloud is still going to be kind of relatively flat at about 50% of new sales for 2019. Why is that number not increasing?

And I understand Cloud Choice, but I would -- I guess expect given the cloud transition you're going through for that number to at least tick-up. Is that kind of specific to 2019 relative to the fact that 2018 was well ahead of your expectations? And then -- and maybe how should we be thinking about that number beyond 2019?

[Ken Stillwell]

So, good question Rishi. So, we've had four quarters now where that percentage has consistently stayed around the 50% number. And when we thought about our guidance for next year, we felt that 50% was a reasonable target given that customers do have choice. And there are situations where customers want to use the Pega solutions inside their own cloud environment for instance Google Cloud, Azure etcetera.

Could that percentage be larger than 50%? Of course, it could. And I think that we've given some kind of -- some framework on how to think about the impact to revenue in the past when the percentage varies off to 50%. I think we felt that it would be a little bit aggressive to pick a number much higher than 50%, given that we haven't seen that trend be higher than 50%. And so that's the reason why we built the model under that framework.

[Alan Trefler, Founder & Chief Executive Officer]

And you need to remember that a Cloud Choice client may still choose to have Pega run it for them on our cloud. That can be one of their choices. That's what's happened actually with some of our perpetual license. We don't really get much Pega Cloud revenue when they do that, it ends up hitting another one of the revenue line. So there's no question that the practical and visceral shift to cloud is happening in a very, very profound way. I think that we don't have a better estimate to give you than what we've seen in the last couple of quarters going into this year.

[Rishi Jaluria, D.A. Davidson]

Got it. That's helpful guys. And then if I look at perpetual license this quarter, where are those -- where is that perpetual license coming from? I mean it's not all rolling off RPO? Is that mainly existing perpetual license customers that are may be expanding usage or Alan to your point is it people buying perpetual licenses and then deploying it in their own environment? How should we be thinking about that line?

[Alan Trefler, Founder & Chief Executive Officer]

So it's interesting. There were certain industries and Telco for example where they spend so much on capital expenditures that they are kind of almost ignored by investors. And some of those folks who are doing purchases actually prefer to be able to show it on the capital expenditure line and they have a bias towards perpetual. On the other hand, we're really seeing that more and more companies who you would've thought of as capital purchases have just been caught up in this as-a-service trend, so it is decreasing. But our philosophy is as long as we're getting fair prices from clients, we should sell things to them in ways that make it easier for them to buy and that's what drives that.

[Rishi Jaluria, D.A. Davidson]

All right, got it. And if we look at the consulting pretty steep decline year-over-year, was that primarily the result of offloading more services to your partner ecosystem? Selling more out-of-the-box applications that maybe have lower services attach rate or something else?

[Ken Stillwell]

Yes. Yes and yes. So our strategy was to drive more value of our solutions with less implementation required. So certainly, we would want that attach as you might call it to reduce over time. But really important to us is our ecosystem as implementation partners because that would -- we don't scale that. It really makes it challenging to try to take on the majority of the work our self. And so for sure both of those two strategies, you're seeing really kind of in the results of keeping our services growth more subdued. And that -- and we view that as a successful outcome of our strategy.

[Rishi Jaluria, D.A. Davidson]

All right, got it. And last one, I'll jump off. But Ken, as we think about our models for next year, how should we be thinking about that sales and marketing line? I mean should sales and marketing expenses be growing at a similar rate for maybe forward ACV growth given the investments that you're making and obviously the sales comp incentivizing ACV? Or is there a better way to think about that?

[Ken Stillwell]

I think it's very fair to think that our sales and marketing expense investment should grow less than our license and cloud ACV growth, because we want to get efficiency out of our sales and distribution.

But we grew that number somewhere in the mid-20s in terms of percentage range for 2018 and our model, if you kind of unpack it, is probably going to see something similar to that in 2019. But that would still show some level of operating leverage from sales and marketing given that assumption in the ACV growth.

[Rishi Jaluria, D.A. Davidson]

Got it. That’s helpful. All right. Thank you so much, Alan and Ken.

[Ken Stillwell]

Thanks, Rishi

[Alan Trefler, Founder & Chief Executive Officer]

Thanks.

[Operator]

We'll now take a question from Peter Lowry with JMP Securities.

[Peter Lowry, JMP Securities]

Great. Thank you. First, how much of your business is U.S. federal and does the U.S. government shutdown have any impact on your business?

[Alan Trefler, Founder & Chief Executive Officer]

So it obviously is discouraging when government shuts down, but I would say that we won't see any material impact from our business as a result of the shutdown.

[Ken Stillwell]

And we don't -- just, Peter, though the one thing that maybe worthwhile is, we actually disclose any customer that's greater than 10% in our financials for the year and you'll notice that we didn't have one this year.

And so that -- and we would view the federal government as one customer. So that gives you an idea that even all federal government clients don't add up to 10% of our business. So that's helpful, just to give you like a sensitivity.

[Peter Lowry, JMP Securities]

Okay, great. Thanks. And then, it sounds pretty good, but can you elaborate on how you feel about your current sales force productivity and where you're focused on with your sales and marketing investments?

[Alan Trefler, Founder & Chief Executive Officer]

Yes. I think, we've done a very good job, particularly, over the last six months at establishing really good patterns to help us manage the existing sales force and set a standard for being able to onboard additional people. So that's really the key, is to try to have what we call good effectiveness and good productivity, as we onboard large groups.

What I'm excited about is that the overall productivity levels of the company actually increased in 2018 despite what we would consider to be quite material increases in the selling force. So I'm actually very -- you won't find I'm satisfied by much and I'm certainly not yet satisfied with selling productivity, but in terms of the progress, very impressive.

[Peter Lowry, JMP Securities]

Okay. Thank you.

[Ken Stillwell]

Thanks, Pete.

[Operator]

We'll now take a question from Steven Koenig with Wedbush Securities.

[Ahmad Khalil, Wedbush Securities]

Hey, guys. This is Ahmad Khalil on for Steve. Thanks for taking my question and congrats on the quarter. First off, what would you say Pega's view on the demand -- in demand environment of today compared to say maybe six to nine months ago?

[Alan Trefler, Founder & Chief Executive Officer]

I would say that it's unchanged. I think, the demand environment was strong six to nine months ago and the demand environment today is also, I would say, extremely strong. There are a couple of geographies that are a little shakier. I think the whole Brexit and France confusion makes some of those countries a little more different and difficult to project.

But we now have a substantial footprint that -- I think, which is benefiting with the fact everybody really is worried about how they improve their operational productivity, whether it's the large banks that are announcing -- Corbat and Citi announced how they are expecting to literally reduce thousands to tens of thousands of the staff in the coming decade. So to improve your efficiencies and make them more competitive digitally.

We are perfect acknowledging to be able to bring customers more closely engaged with the institution and help them gain efficiency by eliminating loss of sort of extraneous work.

So I see a lot of demand driven by efficiency gains and a lot of demand driven by companies, just wanting to try to secure a better relationship with their customer. So I view both of those as an important levers.

And relative what happened in the various economies, we've always been pretty good at responding to macroeconomic shifts, if you look at our history, and being able to have both the revenue potential and customer engagement and the savings potential of the operational efficiency makes us feel comfortable continuing to do the investment and believing we'll get that return

[Ken Stillwell]

One additional point to kind of add some color to that. We've had -- we had -- 2018 was an incredibly strong year for us and that was not on the backs of a small number of deals from just one vertical. So I think just thinking about cross vertical, you see a lot of strength in a lot of places, which we've -- for us we've kind of capitalized on.

So I think that's an important thing to see the strength be more distributed across different industries than just focused on one or two. So that's been kind of a positive observation we've seen in 2018 and into 2019.

[Ahmad Khalil, Wedbush Securities]

Great. Thanks. That's really helpful color. And then just one follow-up. It seems like your investments and focus on shortening your sales cycles is working to bring your contract durations come down a little bit. I guess, looking to next year, how would -- how do you expect your duration to trend? And what kind of impact would you say that would have on ACV growth?

[Ken Stillwell]

So we would expect the contract durations to slightly come down -- continue to come down. We don't think we're going to be moving to one year contract. I mean, sometimes will do a one year contract, when it strategically makes sense for a new customer, for instance. But it will come down, we believe from 3.5 years and probably come down kind of somewhere closer to the three years to 3.25 years. So, not a massive shift down.

We believe that's critical for our flexibility so that we can actually not have additional objections when customers want to buy Pega. Cloud Choice is certainly a great differentiator, so is our ability to be flexible in the contracting structure, and we view that as a differentiator as well.

So we do think it will come down slightly, and we think that that is a tool that we use to help keep our growth accelerating.

[Alan Trefler, Founder & Chief Executive Officer]

So it's interesting one of the things that I'm proud of the company because when you make enormous shifts like this, it can be a problem and obviously it wasn't in 2018. We moved from a company that was 100% TCV, total contract value, where there was an enormous incentive to sign five-year deals to a company that was 100% ACV with a little bit of sweetener for line.

And I think we did that without missing a beat. We're there as a firm. And I don't imagine that in the foreseeable future, you'd ever see the duration go under three on average that's just not the discussion in the buying mentality. Sometimes when you're dealing with a client, who's not really sure, if he's going to be able to do a one, but boy, that's really the exception.

[Ahmad Khalil, Wedbush Securities]

Great. Thanks so much. Thanks, Alan. Thanks, Ken.

[Alan Trefler, Founder & Chief Executive Officer]

Thanks, Ahmad.

[Operator]

[Operator Instructions] We'll take our next question from Mark Schappel with Benchmark.

[Mark Schappel, Benchmark]

Hey, guys. Let me start off by saying that nice job on the quarter. A couple of questions. So, Alan, with respect to your two principal product lines BPM and CRM, did any particular one of those drive the revenue upside in the quarter, or did any particular one of those drive the business in the quarter?

[Alan Trefler, Founder & Chief Executive Officer]

It's pretty balanced. The reality is that the front office has become an increasingly important place for us, that's sometimes in the guys of marketing where one of the world's largest banks, for instance, shows us on Pega Cloud to drive every contact and customer engagement across the channels it's amazing Pega Cloud win against our competitors as you would expect. And that sort of thing is happening very exciting. But also people want efficiency and being able to tie that customer engagement all the way through to being able to operationalize it, that middle out story we told at PegaWorld it's resonating. And I'd say, it's quite balanced which gives us a lot of comfort as we go forward.

[Ken Stillwell]

I would add one small piece of color to that, Mark, which is earlier in the year I was at an Investors Conference -- earlier in 2018, I was at an Investor Conference and an investor came up to me and said, hey, the most common thing we're hearing is digital transformation, that was in like January of 2018 and I remember hearing that thinking that's interesting. And so, I think what you've seen in 2018 is digital transformation or the operational efficiency has been -- has really kept pace with the front office or the CRM part of the business which over the last few years has not been the case. CRM has been actually growing faster. So, I do think that that's a -- that's really great for us given that we do so well on both sides of that.

[Mark Schappel, Benchmark]

Great. And then with respect to the BPM business, I know that it's accelerated this year beyond the normal, say 6% to 8% growth rate. I was wondering if that acceleration carried into the December quarter.

[Ken Stillwell]

It did. Yes.

[Mark Schappel, Benchmark]

Good. And then I guess just as a follow-up to the prior questions on the sales force, besides just adding headcount, what are some of the other initiatives that you're planning that to focus on in the coming year with respect to the sales force?

[Alan Trefler, Founder & Chief Executive Officer]

Yeah, we've been looking to get our enablement and what we call validation up to another level of sophistication. So, we've implemented formal video recordings, independent grading of salespeople being able to really show that they've mastered the key messages. We've tied this into what we call integrated selling programs where we really try to get the materials and the content on the website and the messages that people would use in engaging in clients to be very well integrated and part of this sort of more validated effort.

And we've really, I think, done an improved job of concentrating our forces and making better choices about where the sales teams should spend their time. That came out of a lot of work earlier in the year, really beefing up the operations area and the analysis functions, which I'm very excited will continue to help us, as we grow the sales force.

Normally, you expect the performance of -- as you increase the sales force, you typically expect average performance to decline. I mean, that's just normal and sensible, because sensibly there are newer people and you've got them assigned to, obviously not the absolute optimal clients because your first people would be assigned there. But I know I think we with these tools have the ability to maintain and even improve productivity as we grow. So, that's something we feel good about.

[Mark Schappel, Benchmark]

Okay, great. And then finally is it fair to assume that the company is still committed to the 2022 targets of 15% to 17% revenue growth and operating margins of 23% to 25%?

[Ken Stillwell]

Let me reframe that 2022 target. We are committed to Rule of 40. We would -- we actually believe there is more value if we can get there on a 25% revenue growth and 15% operating margin. But certainly 17% revenue growth and 23% wouldn't be a terrible outcome either, but we are striving to accelerate our growth. So, I think -- think about the commitment being the Rule of 40 and the balance of the two which is in that -- which is kind of the way I framed it and I think that's -- and yes, the answer is yes to that.

[Mark Schappel, Benchmark]

Great. Thank you. That's all.

[Ken Stillwell]

Thanks Mark.

[Operator]

We'll now take a question from Stephen Bersey with MUFG.

[Stephen Bersey, MUFG]

Hey, guys. Just wondering how we should think about your implementation times for cloud versus a traditional rollout? And specifically is there any differences really on the planning side?

[Alan Trefler, Founder & Chief Executive Officer]

Yes, the cloud rollouts are faster. The simple reality is not having to depend on the client to provision. For a large client that can take 60 days, sometimes even a little more out of the schedule. So, in terms of really trying to get value to customers in 90 days which has been something we've been really talking about and promoting.

The cloud has facilitated that and we have dozens of instances during the year where customers achieve that with what I would describe as meaningful obligation. We're not talking about little BFFs with some of the stuff that's out there focuses on, we're talking about things that are generally going to be intrinsic to the business.

[Stephen Bersey, MUFG]

Got it. And any standout verticals or modules that were either introduced or you think have more to go that you'd like to highlight?

[Alan Trefler, Founder & Chief Executive Officer]

Well, I think that one of our journey at a time CRM which is whether that's in terms of doing some of the next best action or being able to fulfillment of something that people want to be able to do across a couple of channels and do that what we call micro journey or journey at a time where you don't have to go rip out a whole channel to really insinuate this into a channel.

I was recently visiting one of our great clients in Europe Rabobank and they were using our technology for both what they call real-time relevance which is how they describe decisioning and 8, 10-Ks management. And they were in a position where they were simultaneously rolling out new client capabilities in a true omni-channel way as opposed to the old fashion way people have historically done things where you end up having to get the people in the channel to build the stuff out of channel of all the time. So it's really exciting I would say to see a lot of the customer engagement CRM-type capabilities getting taken off in that way.

[Stephen Bersey, MUFG]

Thanks. And maybe on the second half business momentum, you skewed towards the second half. I know you're not guiding for the year after but does that roll into Q1 that strength in Q2? Or do you think there's a similar mix next year?

[Ken Stillwell]

So that's a great question, Steve. So what you should see is if you think about where we are in the cloud transition, the first year is where you take a big hit. You take a big hit the second year largely because the first part of the second year, you still are in a heavy transition. As you get towards the back end of 2019, you start to come out of that. And that doesn't then go away in the first half of 2020, meaning you don't start to come out of the transition positively then revert back, it's a continual coming out.

So 2020 as a year should actually be much more subdued in terms of the cloud transitioning effects, 2021 will even be less than 2020. And when you get to 2022 there really is no impact anymore. So I don't think there's a significant shift in the linearity or the seasonality of when revenue hits in the quarters. I think what you're seeing in 2019 is a more back-end loaded because that we're still earlier in the cloud transition.

[Stephen Bersey, MUFG]

Hey, that’s great. Thanks for taking my questions.

[Ken Stillwell]

Thanks, Steve.

[Operator]

And it appears there are no further questions at this time. I'd like to turn the conference back to Alan Trefler for any additional or closing remarks.

[Alan Trefler, Founder & Chief Executive Officer]

Thank you very much. We're excited about where we are. We love the potential of this market and what we can do with it and we're working hard. And I know Ken would love to see all the investors at PegaWorld on June 3rd. Thank you very much everyone.

[Operator]

This concludes today's call. Thank you for your participation. You may now disconnect.