Pegasystems Inc

NASDAQ:PEGA

Earnings Call Analysis

Pega Reports Record Year and Optimistic Outlook

Pega ended the year on a high note with an 800% increase in free cash flow and 11% year-over-year growth in Annual Contract Value (ACV). Notably, Q4 saw the highest ever Pega Cloud ACV added, $58 million, leading to a 21% growth in that segment. Total revenue reached $1.43 billion, buoyed by more term renewals and extended license contracts than anticipated. Pega Cloud margins improved from 70% to about 75%, and operating expenses were leveraged for gains across the board. For the first time, non-GAAP EPS surpassed $2 per share. Achieving the Rule of 30, Pega combines double-digit ACV growth and free cash flow margin, reflecting increased operational discipline. Looking ahead to 2024, Pega anticipates 11% ACV growth and forecasts total revenue of about $1.5 billion.

Pega's New Financial Frontier: Strong Cash Flow and Cloud Growth

Pega Systems has witnessed an exceptional year, characterized by a significant leap in free cash flow and robust reacceleration of Pega Cloud Annual Contract Value (ACV). Entering a new financial era, Pega now enjoys improved visibility into its subscription business model, enabling better operational efficiency and superior cash generation.

Reinvigorated Cloud Services Driving ACV Growth

An 11% year-over-year growth in ACV, particularly in the fourth quarter, signals the effectiveness of Pega's new go-to-market strategy. This acceleration in growth is especially evident in Pega Cloud, which ballooned by 21% year-over-year, with a record-setting $58 million in new ACV during Q4 alone.

Total Revenue and Operational Results

Pega's total revenue reached $1.43 billion, influenced by a larger number of term renewals and some clients opting for longer duration licenses. The year saw an eye-catching increase in operations cash flow to $218 million, which is more than an 800% uptick from the previous year's $22 million. Full year GAAP earnings per share (EPS) was $0.73, while non-GAAP EPS was at $2.48.

Looking Forward: Financial Guidance for 2024

For 2024, Pega anticipates ACV growth of 11% and envisions revenues approximating $1.5 billion. Predictions for profitability include a cash flow from operations around $365 million and a notable surge in free cash flow, which is expected to jump by about 75% to $350 million. GAAP EPS is projected to be $1.18 per share, with non-GAAP EPS climbing to $2.75 per share.

Strategic Focus on Client-Centric Growth

Pega's focus remains steadfast on client-centric growth and expansion. With more than 50% of their ACV now from Pega Cloud, the company is reducing variability risks and setting a pathway for tight alignment between operating margins and free cash flow in the coming years. Free cash flow is identified as the more representative metric of normal business operations for 2024, with revenue being more distributed due to increased Pega Cloud opportunities.

Investment Priorities for Sustainable Expansion

Pega anticipates operating leverage across all sectors, with cloud gross margins on the rise and other operating expenses (OpEx) becoming more leveraged. Spearheading the list of investment priorities is the go-to-market transformation, an initiative shaped by a deep commitment to client focus.

Earnings Call Transcript 2023-Q4

[Operator]

Good morning. My name is Jeannie, and I will be your conference operator today. I would like to welcome everyone to the Pegasystems Q4 and Fiscal Year 2023 Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to Peter Welburn, VP, Corporate Development and Investor Relations. You may begin your conference.

[Peter Welburn, executive]

Thank you, Jeannie. Good morning, everyone, and welcome to Pegasystems Q4 and Full Year 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, and actual results for fiscal year 2024 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 2023, and full year earnings, and in the company's filings with the Securities and Exchange Commission, including its annual report on Form 10-K for the year ended December 31, 2023, and in other recent filings with the Securities and Exchange Commission.

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 change 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 turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

[Alan Trefler, executive]

Thank you, Peter, and to everyone who's joining today's call. It's terrific to see how well the team performed in 2023. The organization responded to our new go-to-market strategy, and we finished the year with a very strong Q4. We continue to deepen and expand our client relationships.

We've been doing a terrific job, I think, of applying GenAI to introduce innovative industry-changing technology, and we generated a good mix of growth and cash flow, which Ken will discuss in more detail in a few minutes.

Now this year continued the important themes we've been talking about, and I'm more convinced than ever, there's still amazing opportunity for growth within our client base. And I'm confident in our org-focused deep engagement model.

I continue to engage with our most senior clients most recently in Davos for the World Economic Forum Annual Meeting. I talked to dozens of C-suite clients and partners about how they're responding to change, their business opportunities, the challenges and plans for 2024 and beyond.

AI is still central to almost every client conversation as they continue to try to understand and explore where and how to leverage AI effectively and safely in their organizations. And we're showing them how Pega can help.

These conversations reinforce to me that what we have is unique and perfectly suited to enterprise needs. I couldn't be more excited about the incredible opportunity to leverage GenAI and revolutionize the way clients use our technology to drive success in 2024 and beyond.

Let me tell you why Pega is perfectly positioned to help clients deliver on the GenAI opportunity. Since I founded, we've been incorporating the principles of AI, generally, statistical as well as now generative, into our offerings and really focused on building products designed for the needs of the sophisticated enterprise.

Our clients come to us because they want to transform their businesses to become more efficient, more profitable or improve loyalty, creating better experiences for their customers and employees. And our enterprise AI decisioning and workflow automation platform enables clients to unlock business transforming outcomes with real-time optimization and continuous improvement.

You can find great case studies on our website that explain how our clients are using the software to want and improve customer engagement by customizing conversations real-time in its scale. For instance, Wells Fargo describes how they are using our Customer Decision Hub to provide targeted and relevant responses to the billions of interactions they receive monthly from customers.

Secondly, to enhance client service through AI-powered guidance that delivers amazing experiences for customers and employees, boosting loyalty, supporting retention and driving down costs. Aflac describes on the website how we're simplifying and automating the processing of thousands of e-mails per week in tech to resolution, improving customer and employee satisfaction.

And finally, what we've always done is streamlining operations by automating operations with intelligence. This is what Lloyd's talks about, automating their business processes to resolve fraud and dispute cases faster and more effectively even while on the phone with the client.

These results are what matter to our clients. They are looking to transform their businesses, not simply crank out more code. So when we apply GenAI, we're not using it to generate code. We're using it to optimize the business concepts adhering to best practices, for example, suggesting the most efficient and effective way to process a mortgage or insurance client, or how to create the best offer and marketing treatment for a client.

We have a unique structure built around business concept and enterprise process, rules, data models, UI, all of those are organized into layers so they can be built on, reused and specialized to support the needs of different product lines, customer segments or geographical jurisdictions that an enterprise might need to manage.

This layered architecture is the perfect architecture for GenAI, and what I believe gives Pega a unique advantage. Because we use the GenAI not to write code, but to directly offer and control and influence the business concepts themselves.

This unique layer cake architecture has enabled us to develop, integrate and deliver new GenAI capabilities and services very quickly. And it's based on a patented architecture that we've studied and evolved for decades and can't readily be copied or reproduced. I think this gives us a clear competitive advantage.

So in terms of our strategy for this year and next, there are 4 major areas we believe our approach to GenAI will drive a massive impact for our clients and for Pega. First, we're looking to double developer productivity in Pega with Pega skills always at their fingertips. Second, we're looking to ignite enterprise innovation by being able to bring together industry expertise, Pega technology, the wisdom of the Internet and our clients' insights.

Third, we're looking to try to maximize revenue and efficiencies for our clients by giving them real-time optimization and personalization of customer interactions and making it so that they can continually optimize. And finally, being able to streamline work processes and customer experiences by giving the right people instant access to the right real-time systems and capabilities so they can literally get the work done.

Let me tell you how we're delivering on the strategy today, and what to expect in the future. Now we started by introducing 20 GenAI boosters as part of Pega Infinity '23 in the fourth quarter, supporting our goal of improving development, productivity, and showing our clients how these tools can be used safely and responsibly. We launched an interactive demo on our website that lets clients immediately experience the power of our GenAI capability.

Then under the description of a business process you want to optimize, and Pega GenAI helps design the optimal processes, the stages, the steps, the data model, the user personas, all in seconds. It's available to any of you. Since its launch, thousands of visitors have experienced the demo, entering workflows from client onboarding to 5G network rollout, and we're hearing terrific things. Do get on and try it yourself.

And in the last few weeks, we announced 2 new powerful offerings that I think are going to be game changing. The Pega AI -- GenAI Knowledge Buddy and the Pega GenAI Blueprint. The Knowledge Buddy is an enterprise-grade generative AI-powered knowledge assistant to quickly and easily help customers and employees get specific answers based on our company's own content, but synthesized by generative AI. So employees don't have to search across siloed and scattered knowledge basis.

Now there are a lot of GenAI-based assistants in the market that ingests content or answer questions. But when we looked at them, we think that they're generally not built for true enterprise needs. So we've designed a product that is fortified with enterprise-grade integration, auditing and controls.

It puts organizational knowledge on employees and customers' fingertips, allowing them to ask questions through simple conversational interfaces and get specific, accurate and concise responses with transparent attribution to where the source content is coming from.

We're using Knowledge Buddy to embed all the Pega's documentation and support library into our design environment so developers can easily find answers about how Pega can make them more productive and operate faster and with less training. This powerful combination of our innovative AI architecture with security features means that our clients can use this latest technology and feel confident and safe knowing they're adhering to high standards of trust and responsibility.

And just a few days ago, we announced something I think is going to be truly remarkable as it develops. It's the Pega GenAI Blueprint. This is a collaborative SaaS application that automates enterprise-grade workflow application designs to catalyze enterprise innovation and significantly increase developer productivity.

I'm going to ask Kerim Akgonul, our Chief Product Officer, to tell you about this groundbreaking product. Kerim?

[Kerim Akgonul, executive]

All right. Thank you, Alan. Our GenAI Blueprint is very, very exciting. And it really stems from the fact that we all know that traditional design processes are often unsuccessful and are always very time-consuming, mostly because they don't really stimulate design thinking, they don't drive a vision, they don't really drive stakeholder alignment.

In these days, most generative AI approaches focus solely on churning out software code. They're not focused on organizing outcomes or driving business alignment. But Pega GenAI Blueprint is entirely focused on driving incredible outcomes with amazing speed for enterprise applications.

It combines Pega's robust library of industry expertise and process templates with general Internet knowledge. It uses generative AI to synthesize all of that information and automatically recommends best practice workflows, data models and more, all just from an application name and brief description.

We even get to layer in a client's best practices to ensure effectiveness in reuse. And there is absolutely nothing else like this in the market today. Business leaders across every industry can rapidly capture their vision and even rethink their business processes to drive innovation in their organizations, sparking brand new ideas that they wouldn't have thought of on their own.

This interactive application, Blueprint's, it's generates are easily understood and collaborated on by all stakeholders to drive alignment. They can take Blueprint's suggestions and alter them to meet their needs. And once agreed to, they are ingested into Pega to generate the enterprise-grade cloud architected applications. And this is how we can leverage GenAI to actually drive transformation in an enterprise.

And when you get a chance to see this product, you'll be astonished at the speed of innovation and how widely applicable it is across every industry and geography. The response from our early adopter clients and partners has been incredibly positive for their specific use cases. And what's important is that Pega GenAI Knowledge Buddy and Pega GenAI Blueprint will help our clients and partners more quickly and easily learn how to build Pega applications.

And since Pega has always been known as one of the most powerful platforms from creating applications, and we're now significantly reducing the barrier to entry and speed to value by making it much more accessible. And we think we've just really -- just scratched the surface of what GenAI can do. These newest products are the start of a series of exciting offerings that we'll be offering between now and PegaWorld on June 9 that will continue to deliver on our strategy.

I'll turn it back over to Alan.

[Alan Trefler, executive]

Thanks, Kerim. It's very exciting. And we're very excited to be going back to Las Vegas again this year for PegaWorld from June 9 to June 11. Please mark your calendars. We have an exciting lineup of clients who are presenting. For example, National Australia Bank will be featuring its groundbreaking initiatives using the customer decision up to drive value for the bank and its customers, developed and into production in under 6 months.

And Verizon will be talking about how we permeated selling into all its customer-facing teams and delighted customers by leveraging deep intelligence about the client, marketing science and real-time signals. So check out the agenda on pega.com to see the dozens of other great client stories you'll be able to hear about in person and talk to the customers directly.

And of course, we'll be talking about and showing our newest innovations and what to expect for the rest of the year. Now we've scheduled our investor session on Monday, the 10th at noon local time. And we hope to see you then, if not before. I'll be joining Ken to meet with some investors here well on the road visiting clients. So keep an eye on for an invite and be sure to register. It is going to be tremendous.

So in summary, we're delivering transformative innovation to truly change the way the world builds software. I'm pleased that our go-to-market strategy and org-focused model is working and our focus on balancing growth and profitability is evident in our results. I believe we have competitive advantage to our architecture, and we're going to be able to leverage GenAI to bring significant value to clients in a way our competitors can't easily match. And I think there is a tremendous opportunity for that in 2024 and beyond.

To provide more color on our financial results, let me now turn it over to Ken Stillwell, our COO and CFO.

[Kenneth Stillwell, executive]

Thanks, Alan. Pega has truly entered a new financial frontier. We finished the year with extremely strong growth in free cash flow and a nice reacceleration of Pega Cloud ACV. In the 40-year history of Pega, we've never seen the level of cash flow generation we experienced in 2023. And quite frankly, we're just getting started.

The shift to a new subscription business model provides us with improved visibility, which allows us to better manage the operating efficiency of the firm and drive superior cash generation. That dynamic, coupled with our strong go-to-market execution in the fourth quarter of 2023, resulted in impressive results in a challenging market.

Annual contract value, or ACV, continues to be the most important metric to measure the success of our business. The ACV growth in constant currency accelerated in Q4, growing by 11% year-over-year. Our double-digit ACV growth was powered by an extremely strong net new ACV added in the fourth quarter. In fact, our sales team booked more net new ACV in Q4 of 2023 than it did in Q4 of 2022, a clear indication that our new go-to-market strategy is working.

The surge in net new ACV was a result of an extremely strong growth in Pega Cloud. We added $58 million in Pega Cloud ACV in the fourth quarter alone, the highest of any quarter ever. As a result, Pega Cloud ACV growth reaccelerated in Q4 to 21% year-over-year. It's just awesome to see.

Pega Cloud is now our primary offering that clients are demanding as it enables our clients to focus on developing innovative business applications on the Pega platform, without having to manage an underlying cloud infrastructure. It also helps keep our clients current on the latest and greatest Pega technology, which is also a tremendous benefit.

Moving on to revenue. We achieved total revenue of $1.43 billion. Revenue growth was driven by 2 key factors. First, 2023 had a larger number of term renewals than in 2022. And second, we had a handful of clients in Q4 who chose to renew term license contracts for longer durations than we forecast. Under ASC 606, as many of you are aware, the significant portion of multiyear term license bookings are recognized as subscription license revenue in the quarter that the deals are booked.

Moving to cash flow. Cash flow from operations was $218 million, an increase of over 800% from the prior year's total of $22 million. Free cash flow surged year-over-year to $201 million, once again, the highest free cash flow in the history of the company. This strong increase demonstrates the core strength and completion of our subscription transition and the team's success in managing operating costs. We achieved this amazing number, even though we had over $50 million in items like restructuring and legal costs.

We expanded non-GAAP Pega Cloud margin from 70% to approximately 75%. We also improved operating leverage across all 3 operating expense lines. We reduced non-GAAP sales and marketing expense as a percentage of total revenue from 43% to 35%, making the very difficult decision to execute the 2 reductions in force in 2023.

These 2 actions brought together our sales and client success teams reduced operational silos and focused on teams -- focus our teams on cross-selling and upselling into the existing clients. Capital expense also normalized since we had completed the build-out of our Waltham, Massachusetts office.

Moving on to earnings per share. Full year GAAP EPS came in at $0.73, and non-GAAP EPS was $2.48. Non-GAAP EPS exceeded $2 per share for the first time in the company's history. Many of the same factors that powered our strong cash flow growth were key drivers in our year-over-year improvement in EPS as well. I'm really happy with our double-digit ACV growth and our robust increase in free cash flow.

We wanted to exit 2023 as a Rule of 30 company, which we've done. We define the Rule of 30 the same way we define the Rule of 40, as a combination of our ACV growth plus our free cash flow margin adjusted for any items like restructuring, legal fees, interest expense, taxes, essentially making it an EBITDA-like equivalent measure.

Achieving the Rule of 30 demonstrates progress we have made instilling much greater operational rigor and performance transparency in our business.

Moving to our guidance for 2024. As a reminder, we provide annual guidance at the beginning of the year, and we do not typically update annual guidance unless we do a material acquisition. We do not provide quarterly guidance.

Starting with our growth metrics for 2024, we expect ACV to grow 11%. We expect total revenue of approximately $1.5 billion. Revenue growth will be slower than ACV growth in 2024 because we have a slightly lower mix of multiyear term license renewals, and we're modeling an uptick in cloud-based bookings as clients continue to buy Pega Cloud as the primary offering.

Moving to our profitability metrics. We're guiding cash flow from operations to $365 million. We're forecasting free cash flow to increase about 75% year-over-year to $350 million. We expect GAAP EPS of $1.18 per share, and non-GAAP EPS of $2.75 per share. I've received feedback that it's helpful when we share thoughts on modeling our business, so I'll continue to offer a few suggestions, starting with ACV growth.

We expect ACV growth to once again be back-end loaded in 2024. As we experienced in 2023, many of our existing client contracts are up for renewal at the end of the year. And since we plan to focus our go-to-market motion on cross-selling and upselling into our existing clients, we expect to see a significant portion of our net new ACV that gets added in the final quarter of the year.

This is very common for enterprise technology companies. And quite frankly, in the environment that we've seen in 2023 and we predicted 2024, we will continue to see a significant amount of transactions that tend to happen toward the end of a buying cycle or a fiscal year.

Given that we've added such unusually high amount of net new ACV in Q1 of 2023, we face a very tough ACV compare in the first quarter of 2024. As a result, you would expect that our ACV growth rate would slow a little in the first quarter and then bounce back at the later part of the year.

Moving to term license revenue. We expect total term license revenue to decrease year-over-year in 2024 as existing clients and new clients choose Pega Cloud. We also have a slightly lower number of multiyear renewals coming due in 2024 than we did in 2023. We also expect to book shorter duration term license contracts as more of our clients value the consumptive nature of their growth.

Under ASC 606, a shorter duration term license contract results in less term license revenue booked upfront than a traditionally longer duration contract. However, more frequent contract renewals provides us with a greater opportunity to cross-sell, upsell and support and assist our clients as they move to Pega Cloud and also initiate new workloads and new use cases on Pega Cloud.

Next, I want to remind you that PegaWorld, our annual client and partner event, as Alan mentioned, will be held from Sunday, June 9 through Tuesday, June 11 at the MGM Grand in Las Vegas. Please mark your calendars. We'd love to have you join us in person as you have in previous years. Our annual investor session is planned for Monday, June 10, during the PegaWorld session. In addition, we'll be on the road at several sell-side conferences in March as well as a few NDRs. We look forward to catching up with you all of you soon.

In conclusion, we've focused on providing outstanding experiences and value to our clients and believe that well-managed firms drive responsible levels of free cash flow for their shareholders. As we've demonstrated in 2023, we're very focused on balancing growth and profitability and made outstanding progress on both of these metrics. We've set the course for achieving the Rule of 40 as we exit 2024, with double-digit ACV growth and robust free cash flow.

Operator, please open the call for questions.

[Operator]

[Operator Instructions] Your first question comes from the line of Steve Enders with Citi.

[Steven Enders, analyst]

Okay. Great. I guess maybe just to start is, it would great to hear on what you are seeing out there in the macro landscape, it sounds like it's still a pretty challenging environment, but pretty good results here on the ACV. So -- Yes, maybe just to get an update on how things are trending, and how you're thinking about the macro setup for '24 here?

[Alan Trefler, executive]

Sure. Well, I think it's a challenging environment. There's a lot of uncertainty out there. But we're seeing great receptivity to our approach to the use of AI, and how we're looking to weave it in to our product lines, which, as I said, I think we have a really unique architecture with this layer cake you heard me talk about, which is at the heart of our model to an architecture that is just different than the way other people look and candidly really fits beautifully with how to incorporate the GenAI.

So as we get our customers to see that, we're seeing a lot of enthusiasm. In reality, all this stuff is really new. And people are just sort of trying to understand what it's going to mean for them. There is so much hype around this stuff that I think customers are appropriately a little skeptical. And we actually welcome that because we think by exploring what's really there, they're going to be able to tell the difference between the stuff that's going to leave them hydrated and disappointed and what we think we're going to be able to do.

But I'll tell you the level of enthusiasm for not just what we're talking about, but how we're doing it, I think, is very high.

[Kenneth Stillwell, executive]

I'll add 1 other piece of -- 1 other perspective on that, Steve. Given that we have a war going on in Eastern Europe, certainly a war going on in the Middle East, inflation rates still kind of bouncing around in the global economy, our clients have been pretty resilient through that, right? Their buying patterns, their investment in technology has actually stayed pretty strong.

So although I think there is still some -- we are still watching the macro backdrop, it's actually been pretty resilient in 2023 and into 2024. So we think we're pretty optimistic about the economic landscape going forward, but there are a lot of things out there that are risks as a couple of the ones I just mentioned that we just have to watch.

[Steven Enders, analyst]

Okay. Great. That's helpful. And then, Alan, you were talking quite a bit about GenAI and how clients are thinking about it. And I guess, how do you kind of cut through the noise out there to position Pega to be one of the first calls that people will make as they look to implement GenAI? And I guess maybe for Ken, how are you kind of thinking about modeling adoption through the year and the impact to the model here?

[Alan Trefler, executive]

So look, we are not just positioning, but implementing GenAI as core to our product lineup. So this is in some stand-alone SKU that's off to the side. This is something that's going to empower our entire product line in the way that our customers work generally.

And what I'll tell you is that if you go look at the Pega Generative AI demo that we've had on our website since November, or if you go look at Blueprint, which was announced at the beginning of this week, and I believe it's just another game-changing evolution of what we showed in November.

I think you'll be able to see our clients realize this doesn't just let them like vomit it up more code faster. So this lets them rethink their business in an organized, structured and, most importantly, extensible way. And I think that will become very clear if you take a look at it. Certainly, the demos we've been giving to clients and partners over the last 2 weeks have gotten a brilliant response. So we're feeling good about that.

[Operator]

Your next question comes from the line of Rishi Jaluria with RBC Capital Markets.

[Rishi Jaluria, analyst]

I wanted to stick first on the topic of generative AI. Ken, I remember at the Analyst Day last year, you talked a lot about how ultimately this is going to manifest itself in driving consumption rather than discretely pricing for a distinct SKU. Mick, can you help us understand, #1, what are adoption rates look like of a lot of your GenAI capabilities today? And how can that adoption rate trend maybe over the next 1, 2, 3 years?

And alongside that, let's assume that we're going to get no real AI revenue this year. But at a certain point, how do you start to measure that this usage is actually translating to revenue on the consumption line above typical trends? Maybe help us understand your framework for that. And then I've got a quick follow-up.

[Kenneth Stillwell, executive]

Sure. So let me take a piece of that, and then Alan can chime in. So you're correct, and we still believe that the primary value that GenAI and the application like Blueprint, for example, what it really does is it helps to reduce the barrier to clients being able to leverage Pega to automate parts of their business. So that is -- we believe that strongly. And when you see it, and you will see it soon. You will see it -- you'll understand that you'll be able to real time be able to exceed that experience as we have, as our clients and the partners have.

The second part of that is, so what does that reducing that barrier that we do. Well, given that we believe that Pega is the leader in workflow automation, we see that as an opportunity to expand the use cases, the number of companies, the speed at which those companies deploy those applications.

So generative AI, for us, is not a $30 add-on of a feature that a user can use in an environment because we think that is a very limited value in terms of the company. It's a price that will ultimately get commoditized over time. We believe generative AI will allow our clients to allow Pega to be much more pervasive into their application landscape to allow them to power their businesses.

In terms of the measurement, the measurement is quite clear. It's the growth in our ACV accelerating through the use of generative AI tools like Blueprint with our clients. And I think that, that's -- I know that the question that you're really asking is will we be able to see a line in the actual financial statements that says AI? I would say we won't say no because you never know how pricing and packaging may evolve over time, but the primary value for us is to allow clients to get value from enterprise-grade applications like ours faster. And we think that is a powerful differentiator.

[Alan Trefler, executive]

I mean I would say that unlike the way some people are going at this, this is actually at the -- we've actually incorporated GenAI at the very heart of everything that we're doing. And what that means is that it's going to power the engine for -- it should power the engine for faster adoption and faster growth, and that's where you'll see it.

And, by the way, I think that's a much better and more appropriate way to apply a technology that's dramatic than having it be sort of an add-on individual set of SKUs. Doesn't mean there won't be some SKUs off to the side, but the real meaningful change is what this does to the heart of our entire business.

[Kenneth Stillwell, executive]

What I would say there is maybe 1 exception that you will actually see us have a SKU that will more -- potentially have some transactional value to, which is our Buddies. right? Where we would actually sell our Knowledge Buddy capabilities or embed them and that you may actually see us have that be something that is worth talking about future. I say may, because we have to decide whether that's appropriate or not. But I would say that's kind of how we're thinking about GenAI in our business.

[Alan Trefler, executive]

Yes. But the Buddy represents a tiny fraction of how GenAI is changing this product. So hope that helps.

[Rishi Jaluria, analyst]

Yes. Wonderful. That's super helpful color. Then just a quick follow-up. I know Cloud Choice has always been at the heart of Pega and part of your value proposition. As you think about GenAI adoption, especially given resource intensity of GenAI workloads that can be 10x more resource intensive than traditional workloads.

Can you maybe talk about how does GenAI play into now the whole Cloud Choice? Does it maybe push customers more towards adopting Pega Cloud in a soft manner because some of these GenAI services can be cloud-only services. Maybe help us understand how that all works out.

[Alan Trefler, executive]

Sure. I'm going to try to avoid drifting too technical, but we're glad to go as deep as anybody wants subsequently. So to be able to operate and use GenAI effectively, we do need to be in a cloud environment. And we are seeing clients say, hey, we'd like to be on Pega Cloud. GenAI is just another reason why that's an advantage in addition to the other advantages Ken mentioned during his script.

But we've also introduced a new capability we call [indiscernible], which allows an on-premise Pega customer to create an effective digital twin of the AI capability on Pega Cloud. So they can keep their main system in their environment, but bridge from their premise to Pega Cloud for the use cases of generative Al. That way, we get to do GenAI at the speed of cloud and continue that moving along fast.

But for some of our customers who are candidly though increasingly more open to being 100% cloud, some of our customers do want to keep some things on-premise. And I think Cloud Choice keeps everyone honest. So from a value system point of view, I kind of like it that it's not creating captive customers. And this is a way we kind of think, support the best of all worlds.

[Operator]

Your next question comes from the line of Jake Roberge with William Blair.

[Jacob Roberge, analyst]

Ken, if you just take a step back and look at the model and how that's shaping up, do you think this is the last year that we should see the gap between revenue and ACV growth so that heading into next year, those metrics could actually start to converge a bit more?

[Kenneth Stillwell, executive]

Yes, it's a great question, Jake. Certainly, the variances will continue to shrink. We have -- we're going to have over 50% of our ACV Pega Cloud, but we still do have a significant percent that's not Pega Cloud. So to the extent that, that percentage continues to go down and really it's not the maintenance line, it's, of course, the term license line, as soon as -- because that continues to go down as a percentage of our business, you'll have less risk of variability.

And so I do think that you are correct in that when you go into '25, '26, '27, the gap, the difference between, say, would you look at like our operating margin and you look at our free cash flow, those 2, you would think that they would be very close together. That's the point you're on. But they do vary based on term revenue. That will continue to become more muted over time.

[Alan Trefler, executive]

We didn't have the 606 [indiscernible] where you have to present value, some revenue, even though it comes in on an annual basis. I think it would all be beautifully more consistent. The reality is because of that, especially, I think we get a lumpiness from time to time. But if you look over a year, that should also be less and less.

[Kenneth Stillwell, executive]

And let me just touch on 1 thing that could be a question behind your question, Jake, or what other investors might be thinking about. If you look at our business for 2024 and you say, which is the more representative normalization of the business, free cash flow or your operating profit? In 2024, it's free cash flow. There is nothing unusual happening with free cash flow.

But with revenue, when you have more Pega Cloud opportunities, you do have the revenue being spread out a little more. So that may be a question that other investors have us to be very clear with that. Free cash flow is the normalization of the business. Sometimes revenue and EPS are a little bit off from that, either slightly higher or slightly lower.

[Jacob Roberge, analyst]

Okay. Very helpful. And then it feels like the macro started to stabilize a little in Q4. And then you're also seeing some nice demand trends for AI heading into 2024. As you constructed the guide for this year, did you take those trends into account? Or would you say that you're still factoring in just some potential macro uncertainty that's out there?

[Kenneth Stillwell, executive]

We're still factoring in some amount of macro question about interest rates and election, et cetera, those are all things that we'd factor into how we think about guidance. Okay. Very helpful. Congrats again on the great results.

[Operator]

Your next question comes from the line of Kevin Kumar with Goldman Sachs.

[Kevin Kumar, analyst]

I wanted to ask about investment priorities for the year. I guess guidance shows a pretty nice uptick in free cash flow. So Ken, can you talk about where you're seeing opportunities for leverage? Obviously, cloud gross margins continue to expand. But how are you thinking about maybe the other OpEx categories? And maybe just touch on kind of key investment priorities for the year.

[Kenneth Stillwell, executive]

So you will still -- in 2024, we're still going to see operating leverage in pretty much every line, right? And I should say pretty much every line, right? You're going to see gross margin expand. You're going to see sales and marketing become more leverage. You're going to see R&D, G&A. So you'll see contributions from everything, Kevin.

In terms of the investment priorities, I think the -- our go-to-market transformation, we really love where we are in terms of the focus on our clients. And so the decision -- the strategic decision we need to start making is how do we want to think about introducing new logos or new expansion and how -- and at what pace do we want to do that? And we want to make sure that's really thoughtful so that we can leverage the model that we have, which is a peak client engagement model.

In terms of R&D, you see a lot of investment in GenAI, right? And it's -- we really feel like with the combination of GenAI and the power of our platform, it's just -- it really is just mind-blowing in terms of the opportunity we have in front of us. So it's going to be there, including investment -- continued investment in Launchpad, right, as we actually scale Launchpad. So we see efficiency though, across all of the lines because our costs will grow less than our ACV does.

[Alan Trefler, executive]

And we're going to have to probably hold to 1 question per party for the rest because it looks like it's a pretty good size queue. So...

[Operator]

Your next question comes from the line of Pinjalim Bora with JPMorgan.

[Pinjalim Bora, analyst]

Ken, 1 quick one for you. You talked about shorter contract duration. Can you help me understand what has changed in the business because your consumption-based nature of the business has always been there. So what has changed for customers to kind of drive towards shorter contracts?

[Kenneth Stillwell, executive]

So Pinjalim, we -- what we're really talking about is as clients have opportunities to leverage scaling up the Pega usage within their contract, the commitment or the reset periods tend to be shorter than a 3-year or a 5-year type fixed commitment. And so that -- there's a connection there between more and more larger clients actually enjoying that consumptive growth nature and actually the durations coming down a little bit. So those 2 things are connected.

[Operator]

Your next question comes from the line of Austin Cole with Citizens JMP.

[Unknown Analyst]

Though it sounds like there's -- obviously, you guys have a lot going on with generative AI. I'm wondering -- and with Blueprint, specifically, how is this helping you land more customers and stay competitive?

[Alan Trefler, executive]

Sure. So I think actually, if you go look at it, it will speak for itself. The reaction I had from a couple of C-suite executives who I was just on the call, and we were actually demoing and showing this to them is they were kind of stunned because what it let's you do is it lets you from a couple of paragraphs of a description of something you want to do with your business, really stimulate new thinking, and not just do that, but actually go from this sort of design thinking approach of what you're trying to achieve.

Because, let's face it, we live in businesses where -- they're all workflows. They're all doing work. They're all posting transactions. They're all engaging with clients. Being able to bring generative AI to both help you understand what workflows do you need for your business, and then what should each of those workflows look like? Who are the participants in those workflows? What channels do they come in on? And what data will those workflows either consume from your back-end systems or will you need to acquire or you want to post back to your back-end systems when that workflow is done.

All of those concepts are now in a position where literally in a couple of minutes, you get something that is awesome. It's just a terrific point that you can edit and you can evolve and you can make yours, but you're not starting from a white board. You're starting from something that, historically, would have taken us 2, 3, 4 weeks to get to. And that now is literally 2, 3, 4 minutes, completely changes the game.

Now this is very new. It's evolving. Our real target for a lot of this stuff fully hitting its stride because we've sort of set our team up internally at PegaWorld being the place where this all comes to fruition while all of you were there. But we're showing it now and it's going to be available now, and it's going to be available in a way that existing Pega '23 and '24 customers will be able to use.

And the reaction is just -- it's actually very, very gratifying. So it's on our website. Check it out, if there's something you can say. By the way, about questions, we're not hiding from questions. We're going to do questions after this call. We just have a company call immediately after this. If you have a second question, just get back in queue again and we'll get to you if we can. Thank you.

[Operator]

Your next question comes from the line of Dan Ives with Wedbush.

[Daniel Ives, analyst]

To that last question and your point, I mean, does it really feel that it's starting to become just a more strategic conversation for Pega with existing as well as new logos? I mean is that from your perspective?

[Alan Trefler, executive]

Yes, I would say that's very much my perspective. In fact, we've had this conversation with many, including long-standing customers in which we say, look, you've historically thought of us in a certain way, as a way that we can do certain type of exceptions and disputes for you, a way that we can help you sell certain things in a certain area.

We like to talk now about what this looks like at a much more strategic level. And we have several clients where we've completely changed that conversation. We were talking to senior people before, but they were thinking of us as being more of an area solution.

Now we're really being thought of at a number of key clients as a way that they want to do business. And I think that's very, very gratifying. It was part of the goal of moving to the org focused, deep engagement strategy. And I think it's also something we're going to be able to scale up to additional organizations as we get our legs here under us with this new GenAI capability.

I'll say 1 more thing about GenAI. Historically, everyone thought Pega was very powerful. But candor the wrap on us was that it could be a little harder to use and maybe the resources weren't as prevalent. We've gone directly at those things with GenAI. And we have all of the power -- we have more of the power than we ever had. But boy, I think that those traditional long-standing challenges are going to look completely different this year.

[Operator]

Your next question comes from the line of Fred Havemeyer with Macquarie.

[Frederick Havemeyer, analyst]

Congratulations on the results here. I wanted to ask regarding another GenAI question, sorry to be a little bit not original here, but I've been seeing a lot of interesting work coming out, for example, like Bret Taylor's new startup Sierra.

Coming out from customer service agents and client-facing agents that are taking on more like generative AI-powered agenetic characteristics, I'm curious -- I know that Pega has a deep expertise in building out client-facing bus and service portals and so forth. Just generally, how do you think about agents, like autonomous agents powered by GenAI as part of the overall product road map at Pega?

[Alan Trefler, executive]

So 2 stops there. One, we introduced recently this concept of what we call the autonomous enterprise, which is how do you not just think of agents as little one-off things. But how do you think about structuring your entire enterprise so it's not built for "users," but it's built around the work itself you want to achieve so that you build it for autonomy, but when it's appropriate, you let people put their hands on the wheel and take over.

So we've actually designed into this whole new blueprint way of thinking, this whole idea of an autonomous enterprise, what we sometimes call a center-out enterprise, which doesn't focus on either the front-end UI or the back-end systems, but really lets you focus on what is the very work that defines your institution? And how do you build that in so it can run with automation and autonomy?

That naturally lends itself to agents and automation, as do workflows. Also for call center agents, to the extent that a little bit of your question, I think at that, we just rolled out in Q4 really exciting voice AI capabilities, which you can read about on pega.com also. Where we are listening to the conversation, actually filling in fields on the screen, allowing the operator to validate them, and then using that information in the wrap-up and in the other sort of elements summarization. And we now have that in production at initial clients. So a very, very exciting time with that.

[Operator]

Your next question comes from the line of Blair Abernethy with Rosenblat Securities.

[Blair Abernethy, analyst]

Great quarter, guys. Just as you have discussed AI, GenAI becoming more strategic to your customers and to how you're going to market, what is the impact? Or how are you looking at your consulting and channel partners in -- over the next couple of years? Is this an area you will be investing more in? Or do you think this is -- you're going to be taking more of this back into your control because obviously, you guys will be the experts in this area?

[Alan Trefler, executive]

Sure. So we're -- we will only be successful if our application of AI makes everyone more expert. This whole idea of reducing the barriers to entry is also going to be very helpful, not just for our clients, and not just for our own staff, but our partners. I do not see that Pega is going to be taking over the work from our partners. In fact, to the contrary, Kerim over the last 2 weeks has done what he probably more than dozen...

[Kerim Akgonul, executive]

[indiscernible].

[Alan Trefler, executive]

With exclusively partners, to give them a head start on Blueprint. And one of the most exciting things is that he's building in the ability for our partners to create their own blueprints, which when they go to a customer, they'll be able to bring their best practice blueprint on a particular topic to the client. We'll then add in what our practices are, the best practices from the Internet. GenAI pulls that all together and give you a consolidated blueprint that I think is going to be really good for partners to come in with more packaged IP.

So yes, I think this is going to be terrific for partners. It's also going to make it easier for them to learn. But let's face it, GenAI is going to change all the businesses that we're in. And that's true for our partner businesses as well.

[Operator]

Your next question comes from the line of Mark Schappel with Loop Capital Markets.

[Mark Schappel, analyst]

A nice finish to the year. Alan, just a question for you. There's a little discussion or not much discussion about Launchpad in your prepared remarks this quarter. I was wondering if you could just give us a quick update on the solution and mainly around the status of your early adopter program.

[Alan Trefler, executive]

Absolutely. So I'm very excited about Launchpad, but we have a massive business here to run and to grow, and I want to make sure that people know we're taking care of that, and we're spending money wisely on that, and we're growing that business. So Launchpad, I'm thrilled to say that in Q4, we got our initial couple of clients live. And it's going well.

This interest, we're working with partners, in particular, to get them to capture their IP because that seems to be something that our partners are very, very interested in to use Launchpad as a way to bring their intellectual property and their practices to market. And I'm hoping we'll have some nice exciting things to talk about by the time we get to PegaWorld when it comes to Launchpad as well.

So you're also going to see that we're updating those pages on our website, and it's going to make it a lot easier for people to see, understand and get involved in Launchpad as the year goes along. So I think that's -- it's going to be a terrific augmentation to our business and very good for our progress as well.

[Operator]

Your next question comes from the line of Anthony Hong with KeyBanc Capital Markets.

[Anthony Hong, analyst]

I just want to ask, provided an improving free cash flow position and a strengthening balance sheet. Could you provide an update on Pega's view regarding its debt, including debt retirement or refinancing given the current interest rate environment?

[Kenneth Stillwell, executive]

Sure. So as you can see with the cash that we have on the balance sheet and the free cash flow we're going to generate in 2024, we'll be in a net positive cash position very soon, certainly well before the end of the year. And with the -- with our convert coming due in the first quarter of 2025, we'll have more than enough cash on the balance sheet to fully satisfy that convert retirement if we so choose to do so.

So I would say; Point 1, we certainly have no concern about being able to retire the convert as scheduled. Second point is that, that provides lots of flexibility in terms of how we want to think about capital allocation and the leverage of things like convertible or traditional debt on the balance sheet. So I would say we're evaluating how we want to think about that as we now are becoming a multi-hundred million dollar consistent and predictable free cash flow generator.

But right now, with respect to the existing convert, we'll have plenty of cash to satisfy that if we do -- if we choose to do so.

[Operator]

There are no further questions at this time. I will now turn the call back over to Alan Trefler, Founder and CEO of Pegasystems for closing remarks.

[Alan Trefler, executive]

Thank you very much, everyone, who joined the call, especially those of you who got up early on the West Coast, we definitely do appreciate that. We want you to know that we're excited about where we are. The folks in the team are working extremely hard. And I think everyone who can, should come to PegaWorld because I think what you see there is going to be really eye-opening. So thank you very much, all of you, and I look forward to talking to you again next quarter.

[Operator]

This concludes today's call. You may now disconnect.