2023-10-19 18:22:21 ET
Summary
- Pegasystems Inc. demonstrates robust revenue streams, particularly in its Pega Cloud and Subscription Services segments, with a 13% YoY growth in Annual Contract Value and an 8.7% increase in total revenue.
- The company's financial health is unstable, indicated by a high Debt to Equity Ratio of 7.2x and a declining asset base.
- The valuation suggests a 'Hold' position for investors with a balanced risk profile and a long-term horizon, as the stock seems fairly priced with limited upside potential in the near term.
Investment Thesis
Pegasystems Inc. ( PEGA ) presents a mixed bag for investors, a company teetering between strategic growth and financial vulnerabilities. With a 13% YoY growth in Annual Contract Value and an 8.7% increase in total revenue, it demonstrates robust revenue streams, particularly in its Pega Cloud and Subscription Services segments. However, the company's financial health is unstable, indicated by a high Debt to Equity Ratio of 7.2x and a declining asset base, shrinking 12.2% from $1,357.7 million to $1,192.4 million in just six months. A negative Net Working Capital of -$22 million further raises liquidity concerns.
Its valuation, based on both LTM and projected EBIT multiples, sets the fair value range between $39.21 and $43.66 per share, aligning closely with the current market price of $42.37. While the company is poised for revenue growth in booming sectors like cloud computing and AI, it also faces significant risks, including high leverage, declining assets, and an uncertain economic environment exacerbated by factors like inflation and geopolitical tensions. Therefore, for an investor with a balanced risk profile and a long-term horizon, the current valuation suggests a 'Hold' position, as the stock seems fairly priced with limited upside potential in the near term but offers opportunities for long-term gains if the company successfully navigates its financial and operational challenges.
Overview
Pegasystems Inc. is strategically positioning itself to excel in the enterprise software industry by focusing on several key areas. The company is laying off about 4% of its workforce, incurring a $16 million charge in the process. This workforce realignment isn't just a cost-cutting measure; it's aimed at optimizing operational efficiency, making the company leaner and more adaptable to market changes. Alongside this, Pega Cloud, a significant part of their offerings, accounts for 40% of their Annual Contract Value ((ACV)). The ACV has grown by 13% year-over-year, signaling robust revenue growth and financial stability. The company's transition to a subscription-based model has also been successful, contributing to this stability by ensuring a more predictable and recurring revenue stream.
The company's focus on cloud computing is relevant, given that this sector is booming, with companies rapidly migrating for better scalability and cost-effectiveness. Pegasystems offers services like rapid migration, modernization, and platform refresh to ease this transition for their clients. They are also investing in generative Artificial Intelligence to enhance their platform's efficiency and capabilities. This aligns well with industry trends, as AI integration is becoming more prevalent for automation, analytics, and customer service. While the company faces competition from low-code and other enterprise software providers, its strategic investments in AI, particularly generative AI, give it a competitive edge.
Pegasystems is also focused on client engagement. They are revamping how they interact with clients based on feedback and reviews, which is a differentiator that can potentially lead to high customer retention rates. This is vital in an industry where client relations can make or break a company.
Financially, they are targeting the Rule of 40, a business heuristic used to balance growth and profitability, aiming to achieve this balance by next year. Pegasystems's latest twelve-month rule of 40 is 13.6%, calculated by adding levered free cash flow margin (8%) and revenue growth (5.5%).
However, Pegasystems acknowledges the current uncertain economic environment, which is making clients cautious about making big commitments. This could be due to various factors like inflation, geopolitical tensions, or market volatility, and it adds a level of risk to the company's sales and growth projections. To mitigate this, the company is being conservative in their decision-making, perhaps signaling a risk-mitigated approach to their business planning. Given the fast-paced nature of the tech industry, they also face the challenge of staying ahead of competitors with similar or more innovative solutions. However, their ongoing efforts in Research and Development (R&D), along with efficient spending on General & Administrative Expenses (G&A), indicate a focus on innovation and operational effectiveness.
In summary, Pegasystems Inc. is making calculated moves to secure its future. It is focusing on technological advancements in cloud computing and AI, operational efficiency through workforce realignment, and a client-centric approach to business.
Revenue Analysis
Starting with Pega Cloud, this segment has 21.3% year-over-year growth , moving from $183.8 million to $222.9 million between the first halves of 2022 and 2023. If this rate holds, the segment could generate approximately $270.4 million by the first half of 2024. This aligns well with the growing cloud market, reinforcing that Pega Cloud could become the company's main revenue source.
The Maintenance segment slightly grew by 2.3%, increasing from $158 million to $161.7 million year-over-year. If this stays the course, we could see a revenue of $165.5 million by mid-2024. The steady growth suggests it's a reliable segment that adds stability to the company's financials.
The company's Subscription Services segment is showing robust growth, registering a revenue of $197.1 million in Q2 2023, up from $171.8 million in the same quarter the previous year. This marks an impressive 14.7% growth, indicative of strong demand for these services. This trend holds up in the half-yearly comparison as well, where revenue jumped from $341.9 million to $384.6 million, a rise of 12.5%. On the flip side, the Subscription License stream exhibited a contraction, slipping from $41.6 million to $41.2 million, a 1% decrease. This decline becomes more concerning in the half-yearly view, where the revenue plummeted from $179.1 million to $125.7 million, a 29.8% dip. This could be attributed to competitive pressures and a shift in business strategy. If this trend persists, the segment might shrink to $88.3 million by the first half of 2024. This sharp decline suggests the company should urgently reassess its strategy for this segment.
Consulting services slipped by 7.1%, dropping from $119.9 million to $111.4 million. Projecting this decline, we could be looking at $103.5 million by mid-2024. While the decline isn't as critical as the Subscription License segment, it still requires some focused attention.
Lastly, the Perpetual License segment declined by 79.6% from $9.7 million to just $2 million. If this trend continues, this segment could decline to $0.4 million by the first half of 2024. Given this downturn, the company might want to consider either revamping or phasing out this segment.
The total revenue for the company increased from $274.3 million in Q2 2022 to $298.3 million in Q2 2023, marking an 8.7% growth. The company relies heavily on its Subscription Services, which constituted 66% of the total revenue for Q2 2023. While this indicates the strength of this segment, it also poses a risk of revenue concentration, making the company vulnerable to industry-wide challenges in this area.
The cost of revenue saw a marginal uptick from $95.1 million in Q2 2022 to $96.1 million in Q2 2023, a 1% increase. While this is not alarming, it could be indicative of creeping inefficiencies that need to be addressed. The company's financial health seems to be improving, as evidenced by the reduction in net loss from $286.3 million in Q2 2022 to $46.8 million in Q2 2023. This suggests a move towards operational efficiency and, possibly, profitability.
The U.S. market still dominates with 54% of total revenue, albeit a slight dip from 55% in the previous year. If this slight decline continues, the U.S. might contribute around 53% of total revenue by H1 2024. Other Americas decreased from 10% to 6%, suggesting a declining influence. The U.K. remained steady at 11%, while Europe (excluding the U.K.), Middle East, and Africa saw an increase from 15% to 17%. The Asia-Pacific region also grew its share from 11% to 12%. These trends suggest that the company's market penetration strategies are working well in Europe and Asia-Pacific.
In summary, the total projected revenue for the first half of 2024 could be 270.4 + 165.5 + 88.3 + 103.5 + 0.4 = $628.1 million. This indicates a slight increase from $623.7 million in H1 2023.
To summarize, Pega Cloud is set to continue its good performance, while Subscription License needs a serious strategy rethink. Meanwhile, geographical diversification is showing promising growth outside the U.S., particularly in Europe and Asia-Pacific. The company's heavy reliance on Subscription Services could be a significant risk, and the decline in revenue from the Subscription License and Perpetual License segments could escalate into financial vulnerabilities if not swiftly addressed.
Balance Sheet Analysis
Starting with liquidity, the company has a Current Ratio of 1.6x. This ratio above 1 is a good indicator, suggesting that the company can meet its short-term obligations. Now, pivoting to the capital structure, the Debt to Equity Ratio stands at 7.2x. This ratio tells us that the company is heavily financed by debt, which could spell trouble if revenue streams dry up. Adding another layer, the company holds Convertible Senior Notes valued at $498.1 million. In a best-case scenario, these notes could convert to equity, easing the debt burden. However, this conversion would dilute the ownership stake of current shareholders. It's crucial to know the terms of these notes to understand at what price levels they would convert and how that would affect the stock price.
Between December 2022 and June 2023, the company's total assets decreased by 12.2% from $1,357.7 million to $1,192.4 million. This shrinkage is concerning, especially when paired with high leverage. High leverage, indicated by the Debt to Equity Ratio, brings along both opportunity and risk. The high ratio might reflect an aggressive growth strategy, but it also adds layers of financial risk, especially given the shrinking asset base. In the coming year, this could mean that a significant portion of revenue might have to be earmarked for debt repayment, constraining the company's ability to invest in growth initiatives. Also, the existence of Convertible Senior Notes poses the risk of equity dilution in the near future, which would decrease the value of existing shares. Consequently, the company needs to concentrate on asset turnover to improve its Return on Investment ((ROI)).
In summary, Pega Systems appears to be in a risky position due to its high leverage, increasing liabilities, and decreasing assets. While it shows short-term financial health, these red flags could potentially develop into significant financial risks in the long term.
Free Cash Flow Analysis
The total current assets have declined by 18.9% from $910 million in 2021 to $738 million in 2023. This decrease indicates that the company has less money readily available for its operations. On top of that, Net Working Capital (NWC) has plummeted from $82 million in 2021 to -$22 million in 2023. This negative NWC is a major red flag that suggests the company might struggle to pay off its short-term debts.
Both EBIT and NOPAT are still in the negative, with EBIT improving slightly from -$65 million in 2021 to -$81 million in 2023 and NOPAT going from -$44 million to -$54 million. This means the company's core business isn't profitable yet. However, revenue has risen from $1,164 million in 2021 to $1,291 million in 2023, showing a growth of 10.9%.
Looking ahead, if this 18.9% decline in total current assets continues, we could see them shrink to around $598 million, which is not a good sign for the company's liquidity. On the flip side, if the 10.9% revenue growth sustains, we could expect revenues to reach about $1,432 million. However, this growth needs to be balanced against the backdrop of negative NWC and NOPAT, which could pose liquidity and solvency risks.
Forward-looking analysis: If the trend of declining NWC persists, we're looking at severe liquidity issues. For 2024, our projections indicate that the Unlevered Free Cash Flow could deteriorate further to -$61.95 million, adding to liquidity concerns. In addition, if we factor in interest payments on the company's total liabilities, which stood at $1,047 million in 2023, the Levered Free Cash Flow could plummet to -$114.3 million. This suggests the company will have an even tougher time fulfilling its debt obligations, signaling more financial risks.
To sum it up, the company shows promise in revenue growth but raises significant concerns about liquidity and operational efficiency.
Shareholder Yield
The dividend yield is 0.29% based on common dividends paid of $9.9 million and a market cap of $3,379.9 million. This positive yield suggests that the company is returning value to its shareholders, and if the dividend policy remains unchanged, we could expect a similar return next year. Conversely, the buyback yield is at -0.17%, calculated using net stock buybacks of -$5.8 million and the same market cap. This negative yield is a red flag; it means the company is issuing more shares than it is buying back, which could dilute the value for existing shareholders.
The debt paydown yield is 2.84%, with a change in total debt being $95.9 million. This high percentage indicates the company is reducing its debt, which generally shows good solvency and long-term sustainability. However, the actual increase in debt by $95.9 million is a concern that needs close monitoring, as it could put the company at financial risk, especially if there are revenue shortfalls. These yields together give us a total shareholder yield of 2.96%.
For the one-year forecast, if the company maintains its current dividend policy and rate of debt reduction, the dividend yield is expected to remain at 0.29% and the debt paydown yield around 2.84%. The buyback yield is predicted to stay negative at -0.17%, given the current trend. In terms of performance indicators, the negative buyback yield is a significant red flag. It could indicate potential dilution for shareholders and signify that the company might be facing liquidity issues.
Valuation
I have conducted a comparative analysis utilizing the EV/EBITDA multiple to arrive at a fair value of Pegasystems Inc. I chose SAP SE, IBM, Verint Systems, Guidewire Software, and Fair Isaac Corporation as benchmark companies. These firms were selected due to their similar business models, market presence, and financial metrics, which ensures a robust comparison.
LTM EBIT Multiple Analysis
Pegasystems has a negative LTM EBIT multiple of -62.3x. This is a stark deviation from the selected benchmark companies like IBM, which has a multiple of 13.2x, and Fair Isaac Corporation, which is at a considerably higher 39.4x.
The negative multiple for Pegasystems is a red flag because it suggests the company is not generating positive EBIT, potentially indicating operational issues. Additionally, the negative EBIT multiple makes Pegasystems an outlier when compared to peers, as none of the benchmark companies have negative multiples. Therefore, this could signify higher operational risks and aggressive growth strategies that have not yet translated to profitability.
Projected EBIT Multiple Analysis
The "Projected EBIT Multiple" gives us a forward-looking view based on expected earnings. Pegasystems stands out with a forward multiple of 22.5x. This is higher than IBM's 11.2x but lower than Fair Isaac's 31.6x, indicating some level of market confidence in Pegasystems' future performance. Given the company's negative LTM EBIT, a positive forward multiple might suggest market expectations of a turnaround in profitability and operational efficiency.
When we look at the projected EBIT growth, Pegasystems shows a remarkable 53% growth forecast for 2025, which is substantially higher than IBM's 6.5%. This indicates strong market confidence in Pegasystems' ability to improve its operational performance, possibly turning its negative EBIT to a positive figure in the coming fiscal years.
Fair Value Range
The implied enterprise value for Pegasystems, based on selected EV / LTM EBIT, ranges from $2,867 million to $3,169 million. After accounting for non-shareholder claims, the implied equity value ranges between $2,608 million to $2,910 million. When broken down per share, the implied value ranges from $31.32 to $34.95. On the other hand, based on projected EBIT, the implied equity value ranges from $3,920 million to $4,360 million, translating to a per-share value range of $47.09 to $52.38.
Investment Recommendation
After taking both the LTM and projected multiples into account, the fair value for Pegasystems' stock appears to lie between $39.21 and $43.66. This range is calculated by averaging the low and high implied stock prices derived from both LTM and projected EBITDA multiples. Since the current market price of $42.37 falls within this range, the recommended action is to 'Hold' the stock.
The 'Hold' status means that the stock is fairly valued at current levels, and there's no compelling case for immediate buy or sell actions. Therefore, investors should continue to monitor Pegasystems' operational performance, debt levels, and market conditions for future investment decisions.
For further details see:
Pegasystems: A Mixed Opportunity In A Transforming Landscape