2023-11-21 20:18:49 ET
Summary
- Pegasystems achieved strong revenue growth in Q3, driven by strength in term licenses.
- The company's profitability and free cash flow generation were strong in 3Q23.
- Pegasystems' focus on aligning spending with growth drivers and cost discipline positions it for margin expansion.
Investment action
I recommended a buy rating for Pegasystems ( PEGA ) when I wrote about it the last time , as I expected PEGA to achieve its FY23 revenue guide given the momentum in its cloud business. The key thesis point was that PEGA should be able to continue generating strong, sustainable FCF moving forward. Based on my current outlook and analysis of PEGA, I recommend a buy rating. I expect valuation to further improve from here as the market gradually takes into account PEGA’s strong FCF performance from here onwards.
Review
PEGA did really well in the 3Q23 quarter . Total revenue grew 24% y/y, primarily driven by strength in term licenses (grew 139%). The strength seen in 3Q23 was a very encouraging one, as 3Q is typically the weaker quarter relative to 1Q and 4Q. Furthermore, management stated that the strong performance was not due to a concentration of just one or two deals, which means the strength was more broad-based. Pega Cloud revenue experienced a slight slowdown, growing only 21% compared to 2Q23's 23% growth. As for profitability, pro-forma [PF] EBIT margin increased by 267 basis points to 12.3%. Consequently, PF EPS reached 44c.
My focus on 3Q23 was the strong profitability and FCF generation performance, as I believe the market is still strongly focused on them. Indeed, the stock price and valuation (now trading at 3.14x forward revenue) started to recover from the recent weakness (share price dropped from $50 to $30+ in late October) when the 3Q23 report came out. While the slowdown in annual contract value [ACV] and backlog growth are concerning, PEGA's strong FCF generation was the highlight, especially when the quarter typically saw weaker seasonality. If we look at PEGA's historical EBIT margin performance, 3Q was always weaker than 1Q. However, this time round, 3Q was much stronger than 1Q. The other trend is that 4Q is always better than 3Q, which means there is a good chance that 4Q23 will see a stronger EBIT margin (i.e., further margin expansion sequentially).
The same trend can be seen in the FCF movements. Historically, 3Q FCF tends to be weaker than 4Q (except FY19), as it is not a strong quarter for FCF generation. PEGA's strong FCF performance in 3Q has surprised the market, as this means that 4Q FCF is likely to be at least 3Q23 levels ($23.8 million). This implies that FY23 FCF should total at least ~$150 million (suppose 4Q23 generates the same FCF as 3Q23). In the call, management mentioned that they should be able to achieve $200 million of FCF in 2023. This implies 4Q FCF will come in at $77 million. I believe this is possible as historically (except FY19), 4Q FCF has outpaced 3Q FCF by an average of ~$44 million. If 4Q23 were to outperform by the same level, the implied FY23 FCF could easily reach $191.5 million. The remaining $8 million could easily come from further margin improvement, as PEGA is still a growing company. As such, I see the $200 million target as very possible. The more important implication here is that this means FY24 FCF will be much higher than $200 million. Management is now guiding for FY24 FCF margin to be in the range of mid-to-high 20s%. This is a major outperformance in expectations, as consensus was only expecting a high-teen FCF margin for FY24. Another important point to note is that the $200 million target is GAAP FCF, which means there are no one-off adjustments that skew the metric.
am excited that our team is in a position to deliver the highest annual cash flow in the history of the Company, and Q4 is typically our strongest cash flow generation quarter of the year. 3Q23 call
In my opinion, aligning spending with the ACV growth drivers and focusing on general cost discipline puts PEGA on the right track to continue expanding margins. This discipline, along with Pega Cloud's gross margin expansion and increased sales effectiveness brought about by adjustments to PEGA's sales approach, should lead to higher margins. As a result, the FCF margin should further improve as well.
The last lever is really just to -- as we improve our free cash flows to enhance our operating leverage by growing total other costs like general administrative and R&D to make sure that those spend at a slower pace than our ACV growth. 3Q23 call
Fortunately, PEGA's macro situation remains stable. Despite the longer sales cycles caused by increased scrutiny of deals, management noted that the situation has not worsened. On the bright side, demand is on the rise in a few EMEA countries, so things are looking up there. I cannot comment much on the macro situation given that I am not an expert here. However, for PEGA, I am very encouraged by the robust FCF improvement in the business. I remain bullish at the current share price.
Valuation
Author's work
My growth assumptions for PEGA remain the same as in my previous model. The update here is that I expect PEGA valuation to improve to 3.5x. The reason for the increase is that PEGA profitability and FCF performance are moving in the right direction. Note that I previously mentioned that the key reason why PEGA is trading at a discount to peers is because it is not growing as fast and generating meaningful profits. With 3Q23, I believe the market is gradually taking into account PEGA’s improving profitability and FCF margin; hence, valuation should improve relative to peers.
Risk and final thoughts
The macro condition is still hard for PEGA. In 3Q23, ACV saw growth of 10%, falling short of the 11–13% target management had initially expected for FY23. The elongated sales cycles are likely to persist in the near term, which should continue to weigh on ACV growth, thereby possibly putting some form of pressure on valuation expansion. In conclusion, I reiterate my buy rating for PEGA given its strong FCF performance. Moreover, management's focus on aligning spending with ACV growth drivers and cost discipline positions PEGA for margin expansion.
For further details see:
Pegasystems: FCF Performance Was Solid