Pegasystems - Q1 2023

Transcript

Operator (participant)

Greetings, and welcome to the Pegasystems first quarter 2023 earnings results. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Ken Stillwell. Please go ahead.

Ken Stillwell (COO and CFO)

Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems Q1 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, targets, strategies, projects, forecasts, guidance, likely, and usually, or variations of such words or other similar expressions identify forward-looking statements, which speak only as of the date the statement was made that are based on current expectations and assumptions. Such statements deal with future events, they are subject to various risks and uncertainties. Actual results for fiscal year 2023 and beyond may differ materially from the company's current expectations.

Factors that could cause the company's results to differ materially from those expressed in the forward-looking statements are contained in the company's press release announcing its Q1 2023 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, 2022, and other recent filings with the SEC. Investors are cautioned not to place undue reliance on such forward-looking statements, 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 the result of new information, future events, or otherwise.

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

Alan Trefler (Founder and CEO)

Thank you, Ken, and to everyone who is joining today's call, we had a terrific start in 2023. Our team executed our strategy well, leveraging our strengths and remaining resilient in an environment that we expect will remain uncertain for some time. In Q1, we achieved ACV growth of 15%, driven primarily by increasing our footprint in our existing clients and through strength in Pega Cloud. This is exactly what we said we had tremendous opportunity and where we would focus our sales and marketing efforts. We also saw select new logos, though that's not our focus for this year. Clients are responding positively to our architecture, our model, our focus on deep engagement. Pega Cloud is driving growth, and cloud margins continue to scale.

It's great to see us continuing to make solid progress towards becoming a Rule of 40 company, balancing growth with fiscal discipline and generating significant cash flow. Overall, our results reinforce the effectiveness of our strategy, and we see tremendous opportunity for growth. Ken will discuss our financial results in more detail in a moment. Now, I'm spending a lot of time with our clients, both at our Cambridge-based executive briefing center, which continues to be solidly booked, and on the road, including a trip to Europe I've just returned from. I continue to hear the same themes. Last week, I was in Germany, Italy, and Sweden visiting clients. Despite the anxieties in Europe, the conversations I had were optimistic, and clients continue to be deeply interested in building relationships with Pega.

Digital transformation remains a driving force as organizations are looking for solutions to better deliver personalized engagement and optimize business processes. You know, Citi just published a spending survey that noted that digital transformation was one of the top investment priorities for CIOs in 2023. Pega has a long history of helping clients improve efficiency and effectiveness, as well as to improve their customers' experiences. Clients are also very interested in, and in some ways concerned about, the use of AI, especially with the newest generative technologies. They want to know how to leverage AI in responsible ways to drive automation without compromising enterprise governance or losing control of outcomes. Our approach to digital transformation and to AI is perfectly aligned to both address these concerns and meet these needs.

Now to talk about our approach, our viewpoint in developing software has always been about building technology that serves business people. We provide the most powerful and scalable low-code platform for AI-powered decisioning and workflow automation. We make it simpler for enterprises to work smarter, unify experiences, and adapt quickly. We ensure that organizations can empower their employees without compromising enterprise IT integrity. We're combining AI and automation to enable organizations to become autonomous enterprises that self-optimize towards business goals without sacrificing control. As you've no doubt seen, there's an elevated interest in AI and lots of excitement and hype. Just as a reminder, since our founding four decades ago, Pega has helped enterprise clients use our AI-powered solutions to automate complex business processes, improve customer experience, and drive operational efficiency.

We've been evolving our capabilities as the technology and our clients' needs have evolved, and we're in a unique position to lean on this heritage of harnessing, understanding, and leveraging AI to be able to provide unique capabilities to our clients. When we announced our generative AI plans last month, we stayed true to our approach with an offering that will allow clients to use the generative AI technology of their choice with enterprise governance to make generative AI truly enterprise-ready. We focus on building out use cases that maximize value and minimize risk. For example, we use generative AI to create better performing marketing copy or to generate prototype applications from just a simple sentence. Our approach incorporates auditing and human approval that are the hallmarks of Pega's platform. This managed architectural foundation provides organizations with safety, security, and reliability suitable for the enterprise.

IT managers will be able to integrate their own specific generative AI APIs into Pega Infinity and centrally manage licenses and controls to give clients flexibility to add existing or emerging generative AI APIs. A great example of our generative AI strategy coming to life is our recent inclusion in Amazon's announcement of Bedrock, a new AWS cloud service that allows developers to build and scale generative AI applications in the cloud. Because of our approach, we can easily integrate Bedrock into our platform and have use cases that can make it available to clients. At the same time, we can continue to support other cloud providers and other generative AI solutions based on our clients' preferences.

We've been at the forefront of providing responsible AI for years and are committed to putting the controls straight into our software to make sure that the fairness, the transparency, and robustness all exist. We believe the rapid generation generative AI developments will make lower-end low-code providers a commodity. On the other hand, the higher-end enterprise-grade solutions like Pega are going to benefit. We're excited about the opportunity to create additional value by augmenting our solutions for organizations. We've also rolled out new Pega Cloud enhancements supported by an enhanced global operations center that improves speed, scalability, agility, reliability, and security. These improvements help organizations maximize their technology investments and deliver better experiences for staff and clients.

We're continuing to make progress with Pega Launchpad, which we announced last year as our new cloud-based low-code application development platform that empowers software providers to build and commercialize workload-centric business-to-business SaaS apps. We're excited to be working with a select group of amazing early adopters whose Pega Launchpad-powered apps are being built to address the needs of new markets that they will be pursuing. We're coming up on PegaWorld iNspire, our annual trade show, and it's going to be fabulous. We'll be showcasing our new AI capabilities, announcing several new offerings, and demonstrating solutions at more than 40 partner booths and featuring over 200 demos in 100,000 sq ft of pure ingenuity.

We'll also be highlighting the success stories from more than 40 clients, including outstanding keynote presentations from Aflac, who will talk about how they are using Pega to reduce roadblocks and bottlenecks and manage staffing fluctuations and market pressures to continually deliver transformational outcomes. Citibank, one of our very first Pega clients who went live originally, obviously on very different technology, in 1984, is using Pega to deliver on its mission of being a trusted financial services partner, leveraging decision science to drive omni-channel customer-centric experiences. Rabobank from the Netherlands, who will demonstrate how they are revolutionizing customer experiences using our low-code and AI capabilities. Virgin Media, who will describe their journey to become a fully digital business, leveraging Pega's customer service, case management, and AI-based decisioning.

If you haven't yet, please check out the PegaWorld website, register, and join us to hear and see all of this in person, and especially feel free to join us for the investor session on Monday, June 12th. In summary, I'm pleased with our strong start to 2023 and our ongoing progress to be a Rule of 40 best company. Our results continue to be driven by ongoing demand from large global enterprises and for digital transformation solutions that drive automation and leverage AI. Our strategy to focus our effort on meaningful clients is proving effective and candidly is making us feel really good about how we're doing in the market as well as obviously winning business. We expect to face macroeconomic challenges in 2023, think we are well-prepared and experienced with executing in challenging times.

I feel confident that we are in the right space with the right capabilities and the right team, and our strategy is absolutely the right one to leverage the significant opportunity in front of us. To provide more color on our financial results, let me now turn it over to our COO and CFO, Ken Stillwell.

Ken Stillwell (COO and CFO)

Thanks, Alan. Given an uncertain economic environment, it is great to see our team deliver such a strong start to 2023. The three most important metrics to measure the success of our business are annual contract value, ACV, cash flow, and backlog. I'm going to focus my initial comments today on how we're progressing against these three critically important metrics. ACV grew 15% in constant currency year-over-year in Q1. Annual contract value growth has been and continues to be the most important metric for us. This strong result was powered by Pega Cloud ACV growth, which increased 24% in constant currency year-over-year. Pega Cloud represented approximately 67% of the $45 million of net new ACV added in the quarter in constant currency. Pega Cloud ACV continues to be the largest ACV component and the fastest-growing.

Our ACV growth was bolstered by our decision to realign our go-to-market strategy and focus our resources on deepening our relationships with our marquee customers. Our first quarter results provide clear evidence this strategy is working. Our ACV growth was broad-based, and in addition, we are attracting new logos, although that is not our primary focus for 2023. Moving to cash flow. In Q1, we generated $68 million in operating cash flow and produced $75 million in our free cash flow metric, which is a great start to 2023. We still have a lot of work to do for the year, though. When we started our subscription transition in late 2017, our vision was to transform Pega's economic model and build a successful business for the long term while delivering tremendous value for our clients.

Our strong ACV growth, coupled with our strong free cash flow generation, is the result of many years of hard work by our team to sharpen our growth strategy and efficiency. We're now running the business as a subscription business. We're really happy with the success we've had anchoring the concept of efficient growth. As you can see, some of the results are starting to show as we progress through the first quarter numbers. We expanded Pega Cloud gross margin to 72%, and we're increasing our operating leverage, and we believe there's more upside to our Pega Cloud's gross margin in the future. Moving on to backlog. Total backlog increased by 14% year-over-year in constant currency to $1.34 billion, driven by growth in Pega Cloud backlog.

Revenue had 2/3 of our net new ACV add from Pega Cloud in Q1, and that combined with a lower number of term license renewals, we obviously would recognize less revenue in the quarter than we did last year in the first quarter. That's because the majority of revenue from term license deals is recognized upfront and upon renewal. In contrast, Pega Cloud revenue is recognized ratably over time. Given these dynamics, revenue and non-GAAP EPS in an individual quarter can be highly variable and sometimes is not representative of the underlying fundamentals of what's happening in the business. For example, Total revenue in Q1 was down 14% year-over-year, driven by this 39% drop in term license revenue. We discussed this back in February.

Our term license backlog was unusually high at $172 million in the fourth quarter of 2021, you saw that backlog significantly impact revenue in the first quarter of 2022. Given that our term license backlog balance at the end of 2022 was significantly less than the prior year, we expected term license revenue in Q1 of 2023 to decline significantly year-over-year. We also repurchased $33 million of our $600 million Convertible Notes at approximately a 10% discount. This transaction was not part of a formal repurchase policy. Rather, as we generate cash, we will look to opportunistically retire our convertible debt. Similarly to last quarter, given an uncertain economic environment, we thought it would be helpful to provide some thoughts on modeling our business.

Our practice is to provide annual guidance at the start of the year and not to update guidance unless we've done a material acquisition or something else materially happens in the business like we mentioned last year. We do not provide quarterly guidance. Given our focus on increasing cash flow, we added a new metric this year, free cash flow. Our commitment to generating free cash flow is strong. As a company, we understand the value, especially in an uncertain growth environment, of delivering both consistent free cash flow generation and free cash flow improvement as we scale. That way, when we actually see these periods that are less certain in our, in the growth environment, when the economic climate is not as welcoming, we establish a solid free cash flow-based business.

As we expect our sales and marketing expenses to be higher in the first half of 2023 compared to the second half, that's driven by our PegaWorld conference being live in 2023, as we've mentioned, as Alan mentioned earlier, for the first time since 2019. I'm very excited that our investor session will once again be held in person in Las Vegas after a four-year virtual sessions. Monday, June 12th, at PegaWorld, we will host investors to discuss our long-term model and our long-term strategy. If you're interested in registering for the investor session, please email [email protected]. The agenda will include updates on our go-to-market strategy, our product innovation, and also our financial model. We will also include time on the agenda as usual for questions and discussion.

In closing, our team executed very well in the first quarter of 2023. Of course, we're still facing with all of our other participants in the software market, an uncertain economic environment. We're gonna continue focusing on those three most important metrics, as I mentioned: ACV, cash flow, and backlog. Operator, please open the line for questions.

Operator (participant)

Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Your first question comes from Kevin Kumar with Goldman Sachs. Please go ahead.

Kevin Kumar (VP)

Thanks for taking my question. Ken, the guidance you provided last quarter for 2023, I believe, factored in some softness in the macro environment. Have you seen anything materialize in terms of lengthening of deal sales cycles or changes to close rates? Or have those held up relatively well?

Ken Stillwell (COO and CFO)

Yeah. Great, great question, Kevin. There's a couple aspects to that. The first one is, in terms of our team executing against our sales campaigns and our pipeline, you know, I wouldn't say there was any deterioration that we saw in Q1. I think we executed well. I think our clients are still engaging. They're very committed to their digital transformation initiatives. That said, you know, you can definitely sense that, you know, there's some level of, you know, of economic concern out there, as there was last year. I think our execution against our pipeline was solid.

I think there's two pieces to that, right? Our execution was good, but, you know, you can feel the You know, you can feel the uncertainty or the, you know, the kind of the, the timidity that's out there in the marketplace. But we haven't seen that translate into, and actually, like, statistical deterioration of our closing metrics.

Kevin Kumar (VP)

Yep. That's helpful. Curious on the comment on logo adds. I know the focus has been more on expansion within existing customers, there's been some changes in the sales organization to focus on that. Was that kind of through the natural course of the sales process? I'm just curious if, you know, those were meaningful contributors to ACV. Thanks.

Alan Trefler (Founder and CEO)

Well, this is Alan. We do get inbound customers, meaningful organizations, that either have somebody who's worked with us somewhere else or, you know, see what, you know, leading companies are doing in the various industries. Those have been the basis of how we are and will in the future be adding new logos, you know, because, well, that's very consistent with our strategy. I will tell you that by giving ourselves the capacity to spend a lot more time with the several hundred customers that are critical to us and we have significant relationships with, we have absolutely uncovered the opportunity types that we had expected working with those companies, you know, and see both the upside and candidly are really, I think, building and continuing to improve great relationships with very important organizations.

You know, the strategy feels really good, particularly in a year that may be a little tougher.

Ken Stillwell (COO and CFO)

I would also add one other point to that, which is the. You know, I wanted to be very clear because I think that there are some people that heard the message of our strategy that we were not entertaining new logos or that somehow new clients were not important to Pega. That is not true. It's just not where the majority of our focus is because we think the opportunity is with our existing clients. But as Alan said, there are lots of companies out there that look just like our clients that are not current clients of Pega. Sometimes we find them, sometimes they find us. I think that that's that will continue to happen. I just wanted to make sure that that was, that nuance was clear.

Kevin Kumar (VP)

Great. Thank you both.

Ken Stillwell (COO and CFO)

Thank you.

Operator (participant)

Next question, Rishi Jaluria with RBC Capital Markets, please go ahead.

Richard Poland (Assistant VP of Equity Research)

Hi, this is Richard Poland for Rishi Jaluria. Thanks for taking my question. I guess the first one is just a two-part question around generative AI and kind of what you're doing on that lane. It's a really exciting opportunity. Just kinda, if you could, just elaborate a little bit on how you're differentiating against the other generative AI-type solutions out there. Just a follow-up on that is just how you think about the monetization opportunity long term? Thanks.

Alan Trefler (Founder and CEO)

Oh, sure. You know, I think we've got a structural advantage compared to lots of other companies because Pega has always been a model-driven company. What that means is you create a model of how you want your business to run, and from that model, our system actually writes the software. We're using the generative technology to basically inform the model. For instance, you can say, "Hey, I want to define a process for a home equity loan." Generative AI will do a terrific job of identifying what are the stages you would go through? What would a schema, a data schema look like that would capture the information that you would need? What would, for example, sample data look like that you might use to be able to test it? All of those are components that go into our model.

This gives you such an amazing opportunity to really jump-start but also simplify a lot of things about how you apply technology to your business. Those are the types of examples, things that really leverage an architecture that I think is extremely well-suited. Candidly, a lot of the companies have been talking about low-code, I think are in enormous trouble because, you know, low-code apps that don't fit a real enterprise standard and don't have the right structures, I think in many cases, just gonna be replaced by people using generative AI to write the code. There's a huge market for things that are a little more sophisticated, need to be updated routinely.

You know, you don't just do it once and use it, but you wanna be able to update and update it again, update it six months later. Those are the types of things that I think we have a structural advantage for, or towards when we do it. Monetizing it, I think this is absolutely gonna drive additional demand for Pega in a variety of use cases. With our clients in general, when they use our software more, it gives us a chance to get paid more. You know, that's good for them, and it's good for us. I think that this has candidly a lot of appropriate excitement, you know, in addition to the hype we see, which is nonstop. We're not affected by that.

You know, it's part of I think having a pretty mature understanding of what AI is about. We were on this technology long before it broke in the mainstream media.

Richard Poland (Assistant VP of Equity Research)

Thank you, Alan. That's super insightful. Maybe one for Ken. Just as we think about the pace of Pega Cloud gross margin expansion, it's been really solid in the past, you know, recent years. How should we think about that kind of going forward? I know one of the previous targets, I think, was in the mid-to-high 70% range by 2025. Is that kind of the track we should still think about Pega Cloud gross margins? Thanks.

Ken Stillwell (COO and CFO)

Sure. Maybe interesting to paint the picture. You know, when we first started Pega Cloud, the first couple of years, our gross margin was 35%, then it was 45%, then it was 50%. When it was about 50%, we set a target of 70%. Now that we've surpassed 70%, we moved the target to 75% a couple of years ago. We kinda said, "Well, you know, maybe we could do high 70s." You know, naturally, that can't go on forever, of course, right? At some point, you do hit a point where the efficiency has got to stabilize. I think best-in-class SaaS companies would strive to have gross margins that begin with an eight, right?

We wanna be best in class, and we're starting to get some good scale. I think, you know, I think, you know, 75% to high 70s is, you know, maybe a mile marker on that journey to being a best-in-class SaaS company from a gross margin standpoint. Maybe that's the way I'll frame it.

Alan Trefler (Founder and CEO)

Yeah. I would just throw in that the way this has been achieved, has been through excellent collaborative work of the team, both in terms of putting extensive automation into our cloud operations that both save money, but also make the system more reliable and more effective for our clients. You know, being able to rework. You may have heard me talk about Project fnx, actually about five years ago is when we talked about that. Being able to rework the system to be a cloud-oriented and microservices-oriented architecture. There's a, there's a lot of what I would describe as non-financially related improvements that go beyond just what we would get from scale.

That's what makes me excited and, you know, think that, you know, we can't raise the bar forever, but we do have a little more we can go.

Richard Poland (Assistant VP of Equity Research)

Thank you. Very helpful, guys.

Operator (participant)

Next question, Steve Enders with Citi. Please go ahead.

Steve Enders (Equity Research Analyst)

All right, great. Thanks for, thanks for taking the question here. I guess maybe just following up on the AI discussion. I guess how do you think about where you have, like, a right to win and will be kind of focusing on your AI initiatives and embedding that in the product versus, you know, maybe looking at the rest of the technology ecosystem and partnering with other technology vendors or third parties, to embed some of that functionality into your, into your product set?

Alan Trefler (Founder and CEO)

Well, we're definitely building our generative capabilities to be able to partner. We talked about the partnership with AWS. Partnership with the other major AI providers also is central to how we're gonna go to market. We see being able to use the super rapidly emerging large language model capabilities that are gonna continue to evolve as something that needs to be part of our open architecture there.

We, of course, also have some of our own AI capabilities when it comes to what we call the Customer Decision Hub and what we call Process AI, which is not really a generative technology, but is also very powerful from both a benefit and a cost savings and a customer service perspective. I, you know, I feel really well equipped to be able to be a significant player. Not that we're gonna come up with something super general, right? 'Cause I think that's gonna be an insanely competitive space.

For the types of customers that we know we can serve, that have enterprise needs that actually fit perfectly with the types of things we're considering and doing, yeah, we're getting great feedback from the early clients we've shown this to, that, we're absolutely on the right track and gonna be delivering things this year that they would be excited to use.

Steve Enders (Equity Research Analyst)

Okay. Understood, appreciate the thoughts there. I guess maybe for Ken, you know, really good cash flow in the quarter. I mean, I think it kind of accounted for half of the initial guide that you put out for the year there. Was there anything, you know, one time in nature that maybe got pulled in, into the end of the quarter or anything that we should be thinking about it as we think about, you know, cash, the pace of cash flow throughout the rest of the year here going forward?

Ken Stillwell (COO and CFO)

Yeah, sure. Steve, just a reminder that typically our billings are higher in Q4 and Q1, which would mean that our, you know, our collections would be typically higher in Q4 and Q1. That said, we do have a lot of cash outlays in Q1 because like, for example, we have our annual CICP payment that goes out. It's a higher payment of a commission quarter typically, because Q4s are typically higher in bookings. There were some offsets to that, but I would say Q4 and Q1 are typically stronger free cash flow quarters, and Q2 and Q3 are typically less strong just because of the nature of our bookings and billings. That said, Q1 was very strong in terms of free cash flow.

Steve Enders (Equity Research Analyst)

Okay. Appreciate the answer there. Thanks again for taking the questions.

Ken Stillwell (COO and CFO)

Sure.

Operator (participant)

Next question, Jake Roberge with William Blair. Please go ahead.

Jake Roberge (Software Equity Research Analyst)

Hey, thanks for taking my questions. Alan, just wanted to dig deeper into your comment that generative AI could commoditize lower-end low-code use cases. Could you just talk a little bit more about why Pega's history in the AI world and its positioning in more mission-critical workflows help you really take advantage of the opportunities from the AI theme moving forward?

Alan Trefler (Founder and CEO)

Well, sure. I also can, you know, just explain why I think our positioning and our technology provides a moat that is consistent with our enterprise approach. You know, when Pega goes into a customer, the types of things we talk about with a "low-code customer," is we talk about building a low-code app factory. What does that mean? Well, that means they're able to build apps quickly, but it also means the apps have a structure that lets them be hooked together, that doesn't have them be really isolated things, and that also lets them leverage, you know, the other enterprise assets like the interfaces, like some of the controls, the other types of things that are gonna be either consistent or related across apps.

This ability to have what we call a Layer Cake, where certain things go across the entire customer enterprise and other things might vary with, you know, say, different divisions of a bank or of an insurance company, or that might vary with types of work or applications. Those all fit into a cake. They run in a way that really is complementary to each other. I think that really lends itself to being super distinguished from companies that have just a bunch of little apps running around.

You know, any company that's been betting their future on generating low-code apps that do kind of simple things or that run on a mobile device, you know, we've experimented with generating little mobile apps that are actually really quite remarkable in some ways that look exactly like the demos from some of our competitors. I think that you're gonna find the market is really gonna end up really shaking out the market because I think the low end's just gonna go away.

Jake Roberge (Software Equity Research Analyst)

Very helpful. Thanks for that color. Then, Ken, how do you feel about the pace of your subscription transition at the start of this year? Have you seen any impact to the migration as a result of the macro? Do you feel like Pega's still on track to complete the transition this year and be a Rule of 40 business as you exit 2024?

Ken Stillwell (COO and CFO)

Those are good questions. I'm gonna tease a couple of them out. First, the subscription transition pace, I think is. I'm very happy with. There's been some, maybe it took a little longer to get through the kind of financial transformation of the subscription, probably by six months to a year than what I had originally kind of envisioned in my mind. I thought it would take four to five years. It took more like five to six years. You know, in general, close enough. I think that went well. Not every client is gonna want Pega Cloud. That's an important point. It really ties to our cloud choice.

Now, we want every client to have Pega Cloud, but the reality is not everyone has the use case or may choose to wanna manage it themselves, depending on lots of things that might be decided within their environment. That's okay. I think such a significant amount of our clients will. In terms of clients who've chose to move workloads onto Pega Cloud, I mean, we have not pushed clients or in some cases, forced clients like other companies have done to say, "You have no choice, you must move." Because we understand that our clients and our relationship is different than the typical software company, and we need to be respectful of how mission-critical the Pega applications are and how hard it might be to just shift over to another, to another environment.

That said, we do have clients every kind of year, every quarter, you know, having those conversations, and some have begun to move and some have moved new workloads. The most important thing for us, I think, though, is that 2/3 of our clients have seen Pega Cloud. Meaning they may not have all of their estate on Pega Cloud, but they have something there. I think that they know the value and over time, that migration, as you mentioned, will happen with to the extent that the clients kind of want to. In terms of the economic kind of maybe if you have headwind in the economy, does that mean people move or not move to Pega Cloud? I think is kind of like the maybe the punchline of your question.

I would say that really depends on whether the client views a movement to a vendor cloud like Pega Cloud is going to solve some other financial inefficiency that they may have or some optimization that they may have inside their organization. That is absolutely true for some of our clients. For other clients, they may not be ready to move because, you know, they may not have, they may not want to use some of those resources in the short term to make that move. I would say that last part, it really depends. I would say overall, the economic environment probably is a little bit helpful to have clients think about Pega Cloud when it's a tougher environment. But that's not a universal point.

Alan Trefler (Founder and CEO)

Yeah. It, it's also beneficial, you know, if customers are under pressure in terms of retaining some of the right skilled staff. You know, once again, obviously, it's super easy when we're operating and running it. Just to make it a little more tangible for folks, you know, we've got some customers, very large customers, where we have systems that literally do tens of millions of cases a month, that are so woven into their business that they're actually connected to, you know, dozens of their systems with, you know, sometimes hundreds of interfaces that are used, that really are doing a lot of heavy duty, a combination of automation and driving decisions.

If a customer like that has made the strategic decision that they wanna move to an Amazon or a Google Cloud, and they wanna basically pick up their data center and move their data center in total, including apps that may not run on the cloud, that, you know, might be billing and accounting systems that would have to run in a, you know, in a non-vendor cloud, we think that's an entirely reasonable thing for them to do, and that it's very empowering to our customers to give them that sort of cloud choice.

A lot of times it has to do with whether their strategy is to, you know, cloudify if they want to, as it were, by sort of doing a best-of-breed, we're gonna go out to the vendors who know how to do it best, or whether they wanna do it by picking up their data center and/or data centers and moving them en masse. There's some of each.

Jake Roberge (Software Equity Research Analyst)

Sounds great. Thanks for taking my questions.

Ken Stillwell (COO and CFO)

Thank you.

Operator (participant)

Next question, Pinjalim Bora with JPMorgan. Please go ahead.

Pinjalim Bora (Executive Director of Enterprise Software Equity Research)

Hey, thanks for taking the questions. Ken, I'll try one more time on the FCF performance. Seems pretty strong. Seems like the change in working capital was positive, after a long time in a Q1. It seems like the SBC jumped a little bit. I wanna make sure there's not a one-time thing that's driving this, just thinking through what should we expect for the year on free cash flow?

Ken Stillwell (COO and CFO)

Sorry, Pinjal. I heard the, I heard the free cash flow point, but did you say SBC for the second point?

Pinjalim Bora (Executive Director of Enterprise Software Equity Research)

The stock-based comp seems jumped a little bit and seems like.

Ken Stillwell (COO and CFO)

Okay. Yeah.

Pinjalim Bora (Executive Director of Enterprise Software Equity Research)

Go ahead.

Ken Stillwell (COO and CFO)

Yeah, I'll explain, I'll explain. You were a little bit faint on the volume, that's why I asked. Okay. Free cash flow, if you think about maybe the way to think about free cash flow is to think about billings, and billings connected a little bit to the revenue cycle. If you think about the revenue cycle through the year, our largest quarters for revenue are typically Q1 and Q4. Our softest quarters for revenue are Q2 and Q3. Our billings are not materially different than that across the year, which means our billings would be higher in Q1 and Q4, and a little bit lesser in Q2 and Q3. Our costs are relatively consistent across the year.

If you now take billings and cost, and you translate that into cash flow, our cash flow would typically be stronger in Q1 and Q4 and less strong in Q2 and Q3. Hopefully that's helpful to give a little bit of color on the cash flow. On stock-based comp, one of the biggest, that there is a, there is an adjustment, I should say adjustment. There is a higher stock-based comp in the beginning and through 2023, because of two factors. Primarily one, we actually adjusted our vesting period from five to four years. For stock-based compensation, which will, you know, play in a little bit into the kind of near-term acceleration, but not, you know, I would kind of call that a one-time thing.

The second one is that we actually did an equity grant that was out of cycle in the second half of 2022, that is in the calculation for 2023. That certainly would not be something that would repeat. There's a little bit. There is some one-time pressure up on that that is not a structural change to our stock-based compensation strategy.

Pinjalim Bora (Executive Director of Enterprise Software Equity Research)

Yep, understood. Very clear. One for Alan. Obviously, we have heard a lot of AI in this call, and you're doing a lot of things around AI. I want to ask you about, you know, how do you think about kind of the potential to capture incremental value from the efficiency that customers will gain from using AI capabilities versus kind of the potential pressure on seats that those efficiencies might actually drive?

Alan Trefler (Founder and CEO)

I think for a lot of folks, the automation that occurs is gonna put you know, pressure on seats because candidly, if you can do things in automated channels or self-service becomes better or the chatbots become better, that obviously affects, for example, the number of contact center seats you have. To the extent that it's being run through us and, you know, we are the tooling that I think companies find is best to use to manage those client interactions, including the automated ones, we've really moved away from user-based pricing to basically work-based pricing.

From our point of view, we don't see a revenue bleed from a customer who's got a couple of seats ending up automating those because, you know, candidly, it's better for the customer, and it's fine for us. I think we're pretty insulated based on the outcome-based pricing that we've really tended to do for the last five years.

Pinjalim Bora (Executive Director of Enterprise Software Equity Research)

Got it. Thank you.

Ken Stillwell (COO and CFO)

Thanks, Pinjal.

Operator (participant)

Next question, Steve Koenig with SMBC Nikko. Please go ahead.

Steve Koenig (Managing Director)

Hi, gentlemen. Thanks for taking my questions. Congratulations on a great start to the year. Just maybe a housekeeping question or two for Ken, and then a question for Alan. Ken, you mentioned that 67%, I think it was, of net new ACV is cloud. Just so I'm clear, you know, you guide based on an assumption on cloud percentage of new client commitments, and that guide, I think, was 60%-70% for the year. Is that the same definition that you're using as this net new ACV being cloud or like what was the percent of new client commitments? Was it the same definitionally?

Ken Stillwell (COO and CFO)

Yeah. Yeah, Steve, it's, we're trying to be very consistent with that metric to what our reported metric is because it can sometimes get confusing when we use a metric that may be across one or two quarters versus one quarter. That was the reason. Yes, it's essentially the same measure. We just felt like it would be much easier to talk about that metric because that's what translates into revenue. That will translate into billings, into backlog, et cetera.

Steve Koenig (Managing Director)

Got it. Yeah, that makes sense, and we can calculate that from the, from the financials, so that's great. You're on track with your guide so far, you know, in terms of your cloud assumption, is my takeaway there. You know, we also noticed the, you know, the cloud ACV and RPO was very good in the quarter, better than we expected, and cloud was especially good. The cloud ACV was a bit higher than we would have predicted based on the revenue results, cloud revenue. I'm wondering, were there some back-end loaded cloud deals that should help cloud revenue next quarter? On the same lines, as, you know, you had an outlook that subscription licenses would be relatively level for Q1 through Q3. Is that still kind of your thinking here? One last one for Alan, if you don't mind.

Ken Stillwell (COO and CFO)

Revenue lags ACV for sure. When we book deals, they typically don't have really any revenue impact in the quarter. I'm generalizing. There's definitely a lagging effect there. And yes, we think that for our term license revenue for 2023, that would be more back-end loaded because that's when the renewals are happening. That is a correct statement as well. If you wanna hit Alan with his question.

Steve Koenig (Managing Director)

Got it. Great. Thanks. Super. Moving, you know, yet another question on generative AI, but very relevant here, I think. Alan, you know, one of the kind of, knocks on Pega, I guess, over the years is that there's not as many Pega developers as there are Java developers, you know? Kinda hard, you know, that's a hard, you know, one to overcome that. You got a, you know, more and more Pega-trained developers, a lot of partners. You've grown your ecosystem very well and really focused on that. This generative AI capability, do you know, to build models even or to help build the model that you talked about, earlier, is that, you know?

Does that fundamentally make the current Pega-trained developers more productive or can that be used to democratize development of a model? Then along the same lines, like, does the model even need to be transparent to users if this AI gets good enough? You know? Like, why not have the AI, you know, from the language model build the process model and then have the whole thing turn that have Pega turn that into code, you know, soup to nuts. Anyway, just some random questions for you. Hopefully, that's coherent.

Alan Trefler (Founder and CEO)

I think they're good questions, and they're certainly top of mind. You know, Pega historically, and, you know, in addition to perhaps there being, you know, fewer developers than Java, which is, can be a high bar to jump over. You know, we've also at times been, you know, criticized for being a little hard to use or requiring a learning curve, which we've been working to improve, but, you know, it's one of the things that takes work. I think that the advent of generative AI takes a massive change to both of those.

It will make existing developers very much more productive, but it really opens up the use of the technology to a much more, to use your word, democratized group of citizen developers, where we can leverage the structure we have. Because a lot of the citizen developer stuff has the risk of not really providing the right guidance for an enterprise. We can provide that guidance and control with, like, our Layer Cake, but still make it so that the instructions don't require any sort of deep Pega knowledge, but can be interpreted from language. Relative to your question of why go into the model at all, you know, the real challenge when you look at demos and think about this stuff is not just how do you create a little app.

You know, certainly for customers who have more than a, what I would describe as a single small app need. If you need to create a system that does a number of things and talks to a number of back ends, you need some structure that captures how that system works. When you wanna go make changes to that system, you need to be able to go to a structure to make the changes. You don't wanna go around regenerating things all the time. That would be super unreliable, really easy to introduce bugs. Because we have this model that's the center of our architecture, I think we're uniquely qualified to not just be able to capture like a little process flow, but to be able to capture the really robust things you need to build an app.

How you edit and validate data, how you actually send it out to different backend systems, how you decide what the right controls are. If the thing's gonna post a transaction, who needs to approve it? All of those types of things are in our model, and they're visible. They actually can make sense to business people. Now our models will be able to be constructed in this really exciting and staggeringly, I think, well, you know, staggeringly powerful way. That's why we're really excited about what this does for us. It's not just gonna be one turn of the crank. This is gonna really influence, I think, you know, the business that we're in quite a bit for years.

Steve Koenig (Managing Director)

Got it. Hey, thanks a lot. Congrats again.

Ken Stillwell (COO and CFO)

Thanks Steve.

Operator (participant)

Next question, Joe Meares with Truist Securities. Please go ahead.

Joe Meares (VP of Equity Research)

Thanks so much, guys. Just have one question. Thinking about the white space within the current customer base, I think in the past you've spoken to it being quite large. I'm just curious if you could remind us of the size there, and then maybe just qualitatively how that fits into different buckets, whether it's, you know, selling into different geographies or, you know, new product cases. Then maybe just how task mining with Everflow might help kind of even broaden that opportunity? Thanks so much.

Ken Stillwell (COO and CFO)

I'll take the first part, then Alan, you can take maybe the process mining part. We often think about this, and naturally, you know, Joe, you can never get this perfect, right? Because you're speculating on how big the market is. You know, we can use market data from third-party companies that do this for a living. We know what our spend is, and we kinda have a directional idea of what we think, you know, would be a reasonable target. When you look across our client base, you know, we are well below 10% penetrated. Single digits, kind of mid-single digits penetration.

When you go out and say, "Well, what would that look like after three to four years of growth with this client?" We maybe approach 10%. I think even in our largest clients, you know, we've talked about maybe we're 25%-30% penetrated in some of our largest clients in terms of what we might be able to get from them. I think the number is almost ridiculously high to, you know, to talk about how much we could tackle that hundred-dollar-billion market that we have out there. I think it's, you know, we've been in business for a long time, you know, our 40-year anniversary, actually, this month, as a company.

I don't think we should mistake that and the relationship with we have for our clients to think that we are deeply penetrated in those clients in terms of the opportunity set. Alan, you wanna maybe talk about Everflow and?

Alan Trefler (Founder and CEO)

Yeah. You know, that's absolutely correct. You know, when I go talk to, you know, the government of Bavaria, like I did last week when I was in Germany, you know, we have such a tiny fraction of what we're able to do for, you know, the governments and same for the commercial enterprises as well, where there's, you know, really in all but a few cases, staggering upside. You know, candidly, the customers like the attention, and they deserve the attention. I think this is gonna be win-win for everybody. Everflow is just a wonderful tool to help people just get a better understanding of what's going on with their processes. I think it's less that Everflow itself, you know, generates large amounts of ACV.

I think it's more that the use of Everflow is part of the discovery of how you can do better automation and how you can apply the Pega Platform technology to be able to handle, you know, the things that, you know, Pega Workflows are good at.

Joe Meares (VP of Equity Research)

Awesome. Thank you so much, guys.

Operator (participant)

Next question, Vinod Srinivasaraghavan with Barclays, please go ahead.

Vinod Srinivasaraghavan (VP of Software Equity Research)

Hi. Thank you for taking my question. Just one for me. You've talked about usage-based buying before, and you've talked about it a little bit earlier. Can you talk about, you know, how did usage patterns with customers purchasing the product in this way trend throughout the quarter?

Ken Stillwell (COO and CFO)

Just to be clear, when we think about the usage-based contracts, what we're really talking about is the ability for our clients to bring on new use cases, new workloads, to expand their footprint of Pega in a frictionless way. As they do that, naturally, the volume that they use, where they see value from that, we, you know, we get, you know, a small fraction of that value that is created by the client. In terms of usage, across the year, some clients have it very consistent because it's a very predictable and repeatable process. Some have peaks and troughs through the year because of the nature of the business. Like, loan originations might be bigger in the spring than it might be in other parts of the year, for example.

In terms of the quarter, there weren't, you know, I wouldn't say that there's trends that we're tracking on usage. What I would say is that the majority of our engagement with clients, we're engaging in this way, so that we can actually help our clients have a frictionless way to adopt and not have to go back in kind of the traditional, you know, perpetual world, if you go back many years, where they had to actually go through a, you know, sizing it up and a purchasing process and trying to identify the need and go through a very rigorous and overhead-heavy internal process. We want our clients to be able to get value from Pega in a frictionless way, that's really a very important part of the usage-based model.

Alan Trefler (Founder and CEO)

We'll often calculate the usage based on a trailing 12-month average so that, you know, individual quarters won't bounce up and down, and usage won't vary month-to-month. You know, customers and both customers and us, I think, are happier when that's a little smoother. So that's how we've gathered to do this.

Vinod Srinivasaraghavan (VP of Software Equity Research)

Got it. Thank you. Appreciate it.

Alan Trefler (Founder and CEO)

With that, let me thank everybody for attending. We're excited about where we are. We're working hard, and I want you guys to know, particularly the ones who wanna see brilliant generative AI capabilities, that PegaWorld is gonna be, I think, enormously exciting this year. It's at the MGM Grand. It's June 11th through 13th, Investor Day on the 12th, and look forward to seeing you in Las Vegas. Thank you very much.

Operator (participant)

This concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation.