News Column

PEGASYSTEMS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

May 6, 2014

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains or incorporates forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, but are not limited to, statements about our future financial performance and business plans, the adequacy of our liquidity and capital resources, the continued payment of quarterly dividends by the Company, and the timing of recognizing revenue under existing term license agreements. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which we operate and management's beliefs and assumptions. In addition, other written or oral statements that constitute forward-looking statements may be made by us or on our behalf. Words such as "expect," "anticipate," "intend," "plan," "believe," "could," "estimate," "may," "target," "project," or variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Important factors that could cause actual future activities and results to differ include, among others, variation in demand for our products and services and the difficulty in predicting the completion of product acceptance and other factors affecting the timing of license revenue recognition, the ongoing uncertainty and volatility in the global financial markets, the ongoing consolidation in the financial services and healthcare markets, reliance on third party relationships, the potential loss of vendor specific objective evidence for our consulting services, and management of the Company's growth. These risks are described more completely in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2013. We do not intend to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.



Business overview

We develop, market, license, and support Better Business Software® solutions that help clients improve their business results by giving them the power to engage customers, simplify their operations, and adapt to change. Our unified software platform enables our clients to build, deploy, and change enterprise applications easily and quickly, by directly capturing business objectives, automating programming, and automating work. We also provide consulting services, maintenance, and training related to our software.



We focus our sales efforts primarily on target accounts, which are large companies or divisions within companies and typically leaders in their industry. Our strategy is to sell a series of licenses that are focused on a specific purpose or area of operations.

Our license revenue is primarily derived from sales of our Pega Build for Change® platform (PegaRULES Process Commander ("PRPC")) and related business solutions. PRPC is a comprehensive platform for building and managing Business Process Management ("BPM") applications that unifies business rules and business processes. Our solutions, built on the capabilities of PRPC, are purpose or industry-specific collections of best practice functionality, which allow organizations to quickly implement new customer-facing practices and processes, bring new offerings to market, and provide customized or specialized processing. Our products are simpler, easier to use and often result in shorter implementation periods than competitive enterprise software products. PRPC and related business solutions can be used by a broad range of clients across markets including financial services, insurance, healthcare, communications and media, life sciences, manufacturing and high technology, and government markets. Our business solution products include Customer Relationship Management ("CRM") software, which enables unified predictive decisioning and analytics and optimizes the overall customer experience. Our decision management products and capabilities are designed to manage processes so that actions optimize the process outcomes based on business objectives. We continue to invest in the development of new products and intend to remain a leader in BPM, CRM, and decision management.



We also offer Pega Cloud®, a service offering that allows our clients to immediately build, test, and deploy their applications in a secure cloud environment, while minimizing their infrastructure and hardware costs. Revenue from our Pega Cloud offering is included in services revenue.

19



--------------------------------------------------------------------------------

Table of Contents

Our acquisition of Antenna Software, Inc. and its subsidiaries ("Antenna") on October 9, 2013 expanded our Application Mobility Platform, which provides clients with a mobile application development platform to build, manage, and deploy mobile applications as part of a seamless omnichannel experience. Enterprises can manage the complex elements of the mobile application lifecycle including security, integration, testing, and management of mobile applications and devices. Pega's mobile application development solutions help businesses to significantly reduce their development time, deployment costs, and the complexity associated with run-the-business mobile applications. The operations of Antenna are included in our operating results from the date of acquisition. Total revenue and earnings attributable to Antenna included in our consolidated statements of operations in the first quarter of 2014 was approximately $4.7 million and a net loss of approximately $2.2 million, respectively. Due to the rapid integration of the products, sales force, and operations of Antenna, other than the maintenance and hosting revenue attributable to the recognition of the fair value of acquired deferred maintenance and hosting revenue, it may not be feasible for us to identify revenue from new arrangements attributable to Antenna. We offer training for our staff, clients, and partners at our regional training facilities, at third party facilities, and at client sites. Our online training through PegaACADEMY provides an alternative way to learn our software in a virtual environment quickly and easily. We believe that this online training will continue to expand the number of trained experts at a faster pace.



Critical accounting policies

Management's Discussion and Analysis of Financial Condition and Results of Operations is based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") and the rules and regulations of the SEC for interim financial reporting. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions, and beliefs of what could occur in the future given available information. There have been no changes in our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2013. For more information regarding our critical accounting policies, we encourage you to read the discussion contained in Item 7 under the heading "Critical Accounting Policies, Significant Judgments, and Estimates" and Note 2 "Significant Accounting Policies" included in the notes to the Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2013. Results of Operations Three Months Ended Increase March 31, (Dollars in thousands) 2014 2013 Total revenue $ 140,464$ 116,246$ 24,218 21 % Gross profit $ 94,551$ 78,593$ 15,958 20 % Total operating expenses $ 79,924$ 65,642$ 14,282 22 % Income from operations $ 14,627$ 12,951$ 1,676 13 %



Income before provision for income taxes $ 14,541$ 12,018

$ 2,523 21 % 20



--------------------------------------------------------------------------------

Table of Contents Revenue Three Months Ended Increase March 31, (Decrease) (Dollars in thousands) 2014 2013 License revenue Perpetual licenses $ 23,385 44 % $ 26,360 61 % $ (2,975) Term licenses 26,826 51 % 15,680 36 % 11,146 Subscription 2,403 5 % 1,169 3 % 1,234 Total license revenue $ 52,614 100 % $ 43,209 100 % $ 9,405 22 % The aggregate value of new license arrangements executed during the first quarter of 2014 significantly increased compared to the first quarter of 2013 due to a higher number and higher value of license arrangements executed in the first quarter of 2014. The aggregate value of new license arrangements executed fluctuates quarter to quarter. During the first quarter of 2014 and 2013, approximately 74% and 44%, respectively, of the value of new license arrangements were executed with existing clients. The mix between perpetual and term license arrangements executed in a particular period varies based on client needs. A change in the mix between perpetual and term license arrangements executed may cause our revenues to vary materially from period to period. A higher proportion of term license arrangements executed would result in more license revenue being recognized over longer periods as payments become due or earlier if prepaid. Some of our perpetual license arrangements include extended payment terms or additional rights of use, which also result in the recognition of revenue over longer periods. While there was a significant increase in the value of perpetual license arrangements executed during the first quarter of 2014 compared to the first quarter of 2013, perpetual license revenue decreased because the revenue recognition criteria was not met for a larger amount of perpetual arrangements signed in the first quarter of 2014 as compared to the first quarter of 2013. The increase in term license revenue was primarily due to revenue recognized on term license arrangements executed in 2013 and a $1.5 million prepayment of a customer arrangement in the first quarter of 2014. The aggregate value of payments due under noncancellable term licenses and our Pega Cloud arrangements grew to $234.1 million as of March 31, 2014 compared to $214.7 million as of March 31, 2013. We expect to recognize $53 million of the $234.1 million as revenue during the remainder of 2014 in addition to new term license and Pega Cloud agreements we may complete or prepayments we may receive from existing term license agreements. See the table of future cash receipts on page 27. Subscription revenue primarily consists of the ratable recognition of license, maintenance and bundled services revenue on perpetual license arrangements that include a right to unspecified future products. Subscription revenue does not include revenue from our Pega Cloud offerings, which is included in services. The timing of scheduled payments under client arrangements may limit the amount of revenue recognized in a reporting period. Consequently, our subscription revenue may vary quarter to quarter. The increase in subscription revenue was primarily due to the timing of a payment for a customer arrangement. Three Months Ended Increase March 31, (Dollars in thousands) 2014 2013 Maintenance revenue Maintenance $ 44,881$ 36,322$ 8,559 24% 21



--------------------------------------------------------------------------------

Table of Contents

The increase in maintenance revenue was primarily due to the growth in the aggregate value of the installed base of our software. Maintenance revenue primarily attributable to recognition of the fair value of the acquired Antenna deferred maintenance revenue was $0.8 million in the first quarter of 2014.

Three Months Ended Increase March 31, (Decrease) 2014 2013 (Dollars in thousands) Services revenue Consulting services $ 38,076 89 % $ 33,183 90 % $ 4,893 15 % Cloud 3,858 9 % 1,858 5 % 2,000 108 % Training 1,035 2 % 1,674 5 % (639 ) (38 ) % Total services $ 42,969 100 % $ 36,715 100 % $ 6,254 17 % Consulting services primarily relate to new license implementations. Our consulting services revenue in the first quarter of 2013 was unusually low primarily because many of our large fourth quarter 2012 license arrangements were for the purchase of additional usage, which do not require implementation services. Cloud represents revenue from our Pega Cloud offerings. The increase in cloud revenue was primarily due to a $1.3 million increase of revenue attributable to Antenna. The decrease in our training revenue during was primarily due to the increased adoption of our PegaACADEMY self-service online training by our partners, which has a significantly lower average price per student as compared to our traditional instructor-led training. Gross profit Three Months Ended Increase (Decrease) March 31, (Dollars in thousands) 2014 2013 Gross Profit Software license $ 51,035$ 41,626$ 9,409 23 % Maintenance 40,217 32,587 7,630 23 % Services 3,299 4,380 (1,081) (25)% Total gross profit $ 94,551$ 78,593$ 15,958 20 % Total gross profit % 67 % 68 % Software license gross profit % 97 % 96 % Maintenance gross profit % 90 % 90 % Services gross profit % 8 % 12 %



The increase in total gross profit was primarily due to increases in license and maintenance revenue.

The decrease in services gross profit percent was primarily due to costs incurred on several consulting projects in the first quarter of 2014 for which the corresponding revenue will be recognized in future periods as revenue recognition criteria had not been met and lower gross margin associated with Antenna projects. 22



--------------------------------------------------------------------------------

Table of Contents Operating expenses Three Months Ended (Dollars in thousands) March 31, Increase 2014 2013



Amortization of intangibles:

Cost of revenue $ 1,840$ 1,541$ 299 19 % Selling and marketing 1,496 1,232 264 21 % General and administrative 420 4 416 n/m $ 3,756$ 2,777$ 979 35 % n/m - not meaningful



The increase in amortization expense was due to the amortization associated with $10.4 million of intangibles acquired from Antenna in October 2013.

Three Months Ended Increase March 31, (Dollars in thousands) 2014 2013 Selling and marketing Selling and marketing $ 45,807$ 39,270$ 6,537 17 % As a percent of total revenue 33 % 34 % Selling and marketing headcount at March 31, 608 512 96 19 % Selling and marketing expenses include compensation, benefits, and other headcount-related expenses associated with our selling and marketing personnel as well as advertising, promotions, trade shows, seminars, and other programs. Selling and marketing expenses also include the amortization of customer related intangibles. The increase in selling and marketing expenses was primarily due to a $3 million increase in compensation and benefit expenses associated with higher headcount, a $0.7 million increase in commission expense associated with the higher value of new license arrangements executed during the first quarter of 2014 compared to the first quarter of 2013, a $0.8 million increase in marketing and sales program expenses and a $0.3 million increase in amortization expense related to our Antenna customer-related intangible assets. Effective January 1, 2014, we realigned the organizational structure of our product management and design team. As a result of this change, we changed the classification of this team's expenses from selling and marketing to research and development as the roles of the members of this team are now aligned with our research and development efforts. The decrease caused by this realignment partially offset the increase in headcount as well as the overall increase in selling and marketing expenses during the first quarter of 2014 compared to the same period in 2013. Three Months Ended Increase March 31, (Dollars in thousands) 2014 2013 Research and development Research and development $ 24,609$ 19,576



$ 5,033 26 %

As a percent of total revenue 18 % 17 % Research and development headcount at March 31, 924 754 170 23 % Research and development expenses include compensation, benefits, contracted services, and other headcount-related expenses associated with the creation and development of our products as well as enhancements and engineering changes to existing products. 23



--------------------------------------------------------------------------------

Table of Contents

The realignment of the organizational structure of our product management and design team as discussed above contributed to the increase in headcount as well as the overall increase in research and development expense during the first quarter of 2014 compared to the same period in 2013. The increase in headcount also reflects the impact of Antenna and the growth in our India research facility as we have been replacing contractors with employees. The increase in offshore headcount lowered our average compensation expense per employee. The increase in research and development expenses was primarily due to a $3.6 million increase in compensation and benefit expenses associated with higher headcount inclusive of the $1.8 million compensation and benefit expenses associated with our product management and design group now included in research and development and a $0.5 million increase in expensed equipment. Three Months Ended Increase March 31, (Dollars in thousands) 2014 2013 General and administrative General and administrative $ 9,302$ 6,796$ 2,506 37 % As a percent of total revenue 7 % 6 % General and administrative headcount at March 31, 276 245 31 13 % General and administrative expenses include compensation, benefits, and other headcount-related expenses associated with finance, legal, corporate governance, and other administrative headcount. It also includes accounting, legal, and other administrative fees. The general and administrative headcount includes employees in human resources, information technology and corporate services departments whose costs are allocated to our other functional departments. The increase in general and administrative expenses was primarily due to a $1 million increase in professional fees, a $1.2 million increase in compensation and benefits associated with higher headcount, and a $0.4 million increase in amortization associated with the Antenna trademark intangible asset.



Stock-based compensation

The following table summarizes stock-based compensation expense included in our unaudited condensed consolidated statements of operations:

Three Months Ended Increase (Decrease) March 31, (Dollars in thousands) 2014 2013 Cost of services $ 1,011$ 1,173$ (162) (14)% Operating expenses 2,284 2,259 25 1 %



Total stock-based compensation before tax 3,295 3,432

(137) (4)% Income tax benefit (991) (1,103) The decrease in stock-based compensation expense was primarily due to the timing of the 2013 and 2012 annual periodic equity grants, which occurred in March 2014 and December 2012, respectively. 24



--------------------------------------------------------------------------------

Table of Contents

Non-operating income and expenses, net

Three Months Ended March 31, Change (Dollars in thousands) 2014 2013



Foreign currency transaction gain (loss) $ 322$ (1,890)

$ 2,212 (117)% Interest income, net 124 118 6 5 % Other (expense) income, net (532) 839 (1,371) (163)% Non-operating loss $ (86)$ (933)$ 847 (91)% We use foreign currency forward contracts ("forward contracts") to manage our exposure to changes in foreign currency denominated accounts receivable, intercompany payables, and cash primarily held by our U.S. operating company. We have not designated these forward contracts as hedging instruments and as a result, we record the fair value of the outstanding contracts at the end of the reporting period in our consolidated balance sheet, with any fluctuations in the value of these contracts recognized in other (expense) income, net. The fluctuations in the value of these forward contracts recorded in other (expense) income, net, partially offset in net income, the gains and losses from the remeasurement or settlement of the foreign currency denominated accounts receivable, intercompany payables, and cash held by the U.S. operating company recorded in foreign currency transaction gain (loss). We have been primarily exposed to the fluctuation in the British pound and Euro relative to the U.S. dollar. More recently, we have experienced increased levels of exposure to the Australian dollar and Indian rupee. See Note 3 "Derivative Instruments" in the notes to the accompanying unaudited condensed consolidated financial statements for discussion of our use of forward contracts. The total change in the fair value of our forward contracts recorded in other (expense) income, net, during the first quarter of 2014 and 2013 was a loss of $0.5 million and a gain of $0.8 million, respectively.



Provision for income taxes

We account for income taxes at each interim period using our estimated annual effective tax rate and adjust for discrete tax items recorded in the same period. The provision for income taxes represents current and future amounts owed for federal, state, and foreign taxes. During the first quarter of 2014 and 2013, we recorded a tax provision of $4.8 million and $2.9 million, respectively, which resulted in an effective tax rate of 32.8% and 24.5%, respectively. Our effective tax rate for first quarter of 2013 was below the statutory rate primarily due to a $0.8 million tax benefit related to our 2012 research and experimentation credit recognized in the first quarter of 2013 as a result of the American Taxpayer Relief Act of 2012 that was signed into law in January 2013. Our effective tax rate for the first quarter of 2014 was higher than in the first quarter of 2013 primarily because the research and experimentation credit has not yet been extended to 2014. 25



--------------------------------------------------------------------------------

Table of Contents

Liquidity and capital resources

Three Months Ended March 31, (in thousands) 2014 2013 Cash provided by (used in): Operating activities $ 72,858$ 66,046 Investing activities (2,630) (13,224) Financing activities (6,587) (4,127) Effect of exchange rate on cash 458 (2,489) Net increase in cash and cash equivalents $ 64,099$ 46,206 As of As of December 31, March 31, 2014 2013



Total cash, cash equivalents, and marketable securities $ 220,964

$ 156,692

The increase in cash and cash equivalents was primarily due to the significant increase in cash provided by operating activities associated with our strong accounts receivable collections during the first three months of 2014, which were generated from our significant arrangements executed in the fourth quarter of 2013. We believe that our current cash, cash equivalents, and cash flow from operations will be sufficient to fund our operations, our dividend payments and our share repurchase program for at least the next 12 months. We evaluate acquisition opportunities from time to time, which if pursued, could require use of our funds. On October 9, 2013, we acquired Antenna for $26.3 million in cash. During the first quarter of 2014, we paid $0.8 million of the remaining merger consideration related to the final working capital adjustment for Antenna and we incurred direct and incremental expenses associated with the transaction of $0.2 million. As of March 31, 2014, approximately $63.6 million of our cash and cash equivalents was held in our foreign subsidiaries. If it becomes necessary to repatriate these funds, we may be required to pay U.S. tax, net of any applicable foreign tax credits, upon repatriation. We consider the earnings of our foreign subsidiaries to be permanently reinvested and, as a result, U.S. taxes on such earnings are not provided. It is impractical to estimate the amount of U.S. tax we could have to pay upon repatriation due to the complexity of the foreign tax credit calculations and because we consider our earnings permanently reinvested. There can be no assurance that changes in our plans or other events affecting our operations will not result in materially accelerated or unexpected expenditures.



Cash provided by operating activities

The primary drivers of cash provided by operating activities during the first three months of 2014 were net income of $9.8 million, a $57.3 million decrease in accounts receivable due to our significant collections, and a $18.3 million increase in deferred revenue primarily due to the timing of our annual billings. The primary drivers of cash provided by operating activities during the first three months of 2013 were net income of $9.1 million, a $61.7 million decrease in account receivable due to higher collections, and a $6.8 million increase in deferred revenue. 26



--------------------------------------------------------------------------------

Table of Contents


For more stories on investments and markets, please see HispanicBusiness' Finance Channel



Source: Edgar Glimpses


Story Tools






HispanicBusiness.com Facebook Linkedin Twitter RSS Feed Email Alerts & Newsletters