Pegasystems Inc. — FY 2018 Form 10-K
Reporting period: Fiscal year ended December 31, 2018. The filing also reports unaudited fourth-quarter results. FY 2017 and 2016 comparisons were retrospectively adjusted for adoption of ASC 606.
Business context
Pegasystems develops enterprise software for customer engagement and digital process automation, including its Pega Platform, applications using AI and robotic automation, cloud hosting, maintenance, and consulting. It sells primarily to large organizations and government agencies; the company reports one operating segment.
Financial performance and liquidity
| Metric | FY 2018 | FY 2017 | Change |
|---|---|---|---|
| Revenue | $891.6 million | $888.5 million | Flat |
| Gross profit / margin | $589.8 million / 66% | $608.8 million / 69% | Gross profit down 3% |
| Operating income (loss) | ($17.0 million) | $93.2 million | Turned to loss |
| Net income | $10.6 million | $98.5 million | Down 89% |
| Diluted EPS | $0.13 | $1.19 | Down 89% |
| Operating cash flow | $104.4 million | $158.2 million | Down 34% |
| Cash, equivalents and marketable securities | $207.4 million | $223.7 million | Down $16.3 million |
Revenue mix: subscription revenue (term license, cloud and maintenance) was $524.8 million, up 5% and 59% of revenue. Cloud revenue grew 62% to $82.6 million; maintenance rose 9% to $263.9 million. Term license revenue fell 14% to $178.3 million and perpetual license revenue fell 17% to $109.9 million. Consulting revenue was essentially flat at $257.0 million.
Total annual contract value was $570.0 million, up 23%; term and cloud ACV increased 40% to $300.3 million, while maintenance ACV rose 8% to $269.7 million. Remaining performance obligations were approximately $631.0 million, of which 63% was expected to be recognized within one year; timing depends on satisfying contract conditions.
FY 2018 fourth-quarter revenue was $256.4 million versus $254.6 million in Q4 2017. Q4 operating income was $15.5 million and net income was $16.4 million, compared with $38.5 million and $40.6 million, respectively, in Q4 2017.
Current assets were $610.6 million and current liabilities $331.8 million at year-end. The filing reports no borrowings in the presented balance sheet; it does report $67.4 million of future operating lease payments. Management said existing cash, marketable securities and operating cash flow should fund operations, dividends and repurchases for at least 12 months. Operating cash flow fell despite positive net income; cash uses included $101.5 million in financing activities, mainly repurchases and dividends. The company paid a $0.03 quarterly dividend and repurchased $55.3 million of stock under its program.
Material changes and drivers
- Revenue was nearly unchanged, while gross profit declined and the company recorded an operating loss. Selling and marketing expense increased 24% to $373.5 million and R&D expense rose 12% to $181.7 million, reflecting increased investment and staffing.
- The shift from upfront license sales toward cloud subscriptions supported cloud and ACV growth, but reduced near-term recognized revenue and pressured gross margin and cash-flow growth. Cloud has lower margins than license revenue and cash is generally collected over the service period.
- Net income was supported by a $22.2 million income tax benefit despite a $11.5 million pretax loss. The reported effective tax rate was 192%, reflecting, among other items, tax credits and share-based compensation tax benefits; FY 2017 also included a $14.2 million tax benefit related to U.S. tax reform.
- ASC 606 adoption materially changed the timing of license revenue recognition and increased unbilled receivables. The company used full retrospective adoption; FY 2017 revenue was adjusted upward by $47.9 million and FY 2016 by $12.0 million.
Outlook, risks and contingencies
No specific numerical revenue or earnings guidance is provided. Management expects revenue mix to continue shifting toward cloud, which could slow total revenue growth and gross-profit growth in the near term. It also cautions that cloud growth may slow operating cash-flow growth because collections occur over the service period. Maintenance renewal rates historically exceeded 90%, but cloud clients have no obligation to renew.
- Key risks include intense competition from larger software providers, variable timing and mix of license and cloud transactions, execution of sales and product-development plans, and the ability to scale implementation, training and support capacity.
- Other disclosed risks include cybersecurity or service outages, data privacy and regulatory compliance (including GDPR), foreign exchange exposure, international operations and tax uncertainty, dependence on partners and hosting providers, and attracting and retaining skilled personnel.
- Approximately $63.9 million of cash and equivalents was held in foreign subsidiaries and treated as permanently reinvested; repatriation could create additional taxes.
- The company reported no separate legal proceedings. It is involved in ordinary-course contractual disputes and potential claims, which management did not expect to materially harm financial position or results. Foreign tax audits were ongoing; management did not expect a material effect. Unrecognized tax benefits were $18.2 million.
- Management and the auditor reported effective internal control over financial reporting. The auditor issued an unqualified opinion on the financial statements and controls.
Most important facts for investors to verify
- Whether cloud growth and rising ACV convert into durable recognized revenue, cash generation and improved cloud margins.
- Drivers of the sharp FY 2018 earnings decline, including elevated selling and marketing and R&D costs, and the extent to which tax benefits affected reported net income.
- Collection and billing trends in the large unbilled receivables balance, and the timing and conditions for recognizing the $631.0 million of remaining performance obligations.
- Renewal and retention rates for cloud and maintenance clients, plus the capacity of Pega and its partners to deliver implementations and support.
- Potential effects of tax audits, foreign cash repatriation, cybersecurity/privacy events, foreign exchange movements and lease commitments.