2023-10-19 09:42:56 ET
Summary
- Pegasystems is a strong player in the technology industry, offering an AI-enhanced process automation platform for digital transformation.
- Q2 2023 earnings showed a decline in ACV growth but strong cash flow, and the company plans to capitalize on Generative AI for future growth.
- Several downside risks linger, including execution risks tied to customer retention, competitive pressures from tech giants, and vulnerabilities due to international operations and regulations.
- As Pega approaches Q3 2023, optimism and caution pervade, spotlighting ACV trajectories, cash flow, and Generative AI integrations.
Pegasystems ( PEGA ) has emerged as a strong player in the technology industry centralized around an AI-enhanced process automation platform. Its innovative suite of business process management and customer relationship management products is pivotal in the digital transformation of business operations.
Pega's platform is a sanctuary of empowerment, enabling individuals without a traditional coding background to take the wheel of process automation projects confidently and proficiently. In an era where the speed of innovation is paramount, Pega facilitates expedited software development cycles, fostering an environment where clients can accelerate the journey from concept to market, maintaining relevance in an evolving business ecosystem.
As Pega prepares to report on Q3 2023 earnings next week, this article highlights key areas investors should monitor.
Business Model Overview
Pegasystems generates revenue by selling access to its premier enterprise software platform, which specializes in customer engagement and process automation. Its revenues can be categorized into two segments: Recurring Revenues, which consist of on-premise software licenses (including perpetual and term), and maintenance fees. Non-recurring revenues include perpetual licenses and consulting fees. Recurring revenues account for 80% of total revenues as of Q2 2023.
Pega's transition to the cloud began in 2017 when recurring revenues accounted for 56% of total revenues. Over the past few years, Pega has been navigating through different transitions into its business model, which include a focus on recurring revenue from perpetual and a migration to a cloud-based model. Since 2017, Pega has witnessed consistent and exponential growth from this strategic shift.
The solutions Pega offers are pertinent to most business verticals, such as financial services, healthcare, insurance, government, etc. In addition, strategic partnerships with system integrators and technology consulting firms complement its software and services with domain expertise and implementation to its clients. Major partnerships include Accenture (ACN), Amazon (AMZN), Capgemini SE (CAPMF) (CGEMY), and Google (GOOG) (GOOGL). Its customers are some of the largest enterprises in the world as they focus on only global 3,000 companies.
Financial Overview
Due to the recurring subscription model, the Annual Contract Value growth rate is the most important key performance indicator for Pega. ACV represents the annualized value of active contracts, standing as the beacon of the company's financial health.
During its Q2 2023 earnings, Pega reported total ACV growth of 13% year-on-year, with Pega-Cloud driving results at 22%. However, total ACV growth declined sequentially, which is unusual for the company. Net-New ACV declined $10M, excluding the impact of FC rates, marking the lowest sequential growth since its transition to a cloud-based model.
Management responded to analysts' concerns on the ACV growth, noting that the muted performance was a culmination of a strong build in the first quarter, timing of renewals, and some deal dynamics. It was expressed that the erratic nature of term licenses, influenced by deal timings and upfront revenue recognition, also played a role in this decline.
Another key metric to the company's success is cash flow. In the first half of 2023, Pega generated $114 million of cash flow from operations and $123 million of free cash flow, the highest in the company's history. This was undoubtedly the biggest highlight of the quarter. The continued strength in cash flow is driven by a heightened focus on aligning the business with ACV growth drivers and a disciplined focus on cost management.
Management has a policy of not updating guidance intra-year despite the strong first half of the year. Pega initially guided for $150 million of free cash flow during 2023, which was nearly achieved through the first half of the year.
During the earnings call, management expressed a lot of enthusiasm around Generative AI, with the phrase said 22 times, and its potential to accelerate adoption, making it easier and cheaper for Pega to deploy, thus driving the customer experience.
Pega plans to capitalize on Generative AI in three ways. First, they intend to encourage the creation of more applications and processing of a higher volume of work on their platform, aligning with their consumption and capacity-based licensing framework. Secondly, by integrating Generative AI with Pega Cloud, they aim to enhance its appeal, motivating clients to transition from traditional contracts to Pega Cloud subscription agreements. Third, Pega will introduce specialized, premium, Generative AI-powered features, allowing clients to tailor their experience through additional, value-added services, ensuring continued innovation and adaptability in their offerings.
Heading into Q3 2023, Pegasystems faces both opportunities and challenges. The Q2 results brought mixed feelings for investors, with a decline in the ACV growth rate yet a record achievement in cash flow. Despite the ACV decline observed in Q2, Pega's management attributed it to deal timings, term license dynamics, and a robust Q1 performance, suggesting it might be an isolated occurrence rather than a trend.
Downside Risks
One substantial risk shadowing Pega pertains to execution. As they navigate through the final phases of their subscription transition, executing a continuous growth trajectory regarding ACV growth and robust cash flows hinges fundamentally on customer retention and successful renewal strategies. Failing to achieve these strategic milestones could cause periods of volatility in the stock price.
The competitive landscape in which Pega operates is crowded with tech giants like Salesforce (CRM) and Microsoft (MSFT). Increased competition for market share can put pressure on Pega to reduce prices. Additionally, Pega seeks to provide complex solutions for its customers; thus, less sophisticated solutions make Pega too costly and unnecessary.
Furthermore, Pega faces international risks stemming from its operations outside the United States, accounting for 42% of its revenue over the past three years. Key risks involve compliance with governmental regulations, including employment, tax, privacy, and data protection. Laws and business practices that favor local competitors and the challenges posed by increased tariffs and other trade barriers also pose significant risks. Because of its international presence, Pega is susceptible to fluctuations in foreign currency exchange rates, which could adversely affect its financial results and cash flows.
Valuation
The table below compares Pega with its peer group of public application software companies of similar scale. The peers include Blackbaud ( BLKB ), BlackLine ( BL ), nCino ( NCNO ), EngageSmart ( ESMT ), Vertex ( VERX ), and Box ( BOX ). The median forward P/E multiple for the peer group stands at 45.86x, with a median LTM gross margin of 68.2%. PEGA's NTM EPS is $1.93, and its Forward P/E Multiple is 21.01x, and an LTM Gross Margin of 70.6%.
PEGA's current share price is $40.55. When benchmarking Pega's NTM EPS with the peer group's median Forward P/E Multiple, its implied share price is $88.50, indicating it's trading at a discount of approximately 118% relative to its peers.
Final Thoughts
Pegasystems' remarkable free cash flow achievement in the first half of 2023 cannot be overlooked. However, the management's conservative approach to guidance raises some concerns. Their decision has muddied the waters, introducing an element of uncertainty as investors commonly seek reliability and consistency in company projections and outlooks.
The absence of quarterly guidance from Pega further complicates the scenario. It leads to broader variances in analysts' estimates, reducing the dependability of these external projections and making investment decisions somewhat murkier.
As we pivot towards Pega's Q3 2023 earnings, investors are met with a blend of optimism intertwined with a hint of caution. The focus should primarily be on monitoring the trajectory of ACV growth, observing cash flow consistency, and Generative AI strategies and implementations.
Navigating through the second half of 2023, Pega's narrative will inevitably unfold stories of its adaptability, operational resilience, and strategic foresight. A watchful eye on these elements will be essential for investors to accurately gauge the company's potential and future direction.
For further details see:
Pegasystems: A Deep Dive Ahead Of Q3 2023 Earnings