Description

Business Description:

Pegasystems provides customer engagement and business process automation solutions through an enterprise software platform.  The Customer Engagement suite provides solutions for marketing, sales automation, and customer service.  These primarily target B2C companies and compete with Salesforce and Microsoft Dynamics.  The Business Process Management (BPM) suite handles back-end corporate processes such as case management, contact center processes such as chat, and other industry-specific processes.  The Company has continued to focus on capturing a larger portion of the customer journey for clients by integrating the front- and back-end processes.  Additionally, PEGA has sought to augment these solutions through the integration of robotic process automation (RPA).  This began with the acquisition of OpenSpan in April 2016 for approximately $50M and has been augmented though a series of smaller, tuck-in acquisitions of chat and natural language processing technologies.  The Company recognizes revenue through five reporting segments:

• Term License ($336M of CY21 Revenue / 28% of Total Revenue):  Reflects revenue associated with the Pega Platform that is run on the cloud architecture of the customer’s choice.  The customer manages the deployment of the solution themselves under this structure, and the Company refers to this as “Client Cloud”.

• Maintenance ($320M of CY21 Revenue / 26% of Total Revenue):  Reflects revenue associated with maintenance and support of Pega Platform under Term License and legacy Perpetual License agreements such as software upgrades, telephone support and bug fixes or patches.  Maintenance renewal rates are over 90%.

• Pega Cloud ($301M of CY21 Revenue / 25% of Total Revenue):  Platform allows clients to develop, test and deploy applications within the Pega Platform utilizing Pegasystems’ hosted cloud infrastructure and applications. 

• Consulting ($222M of CY21 Revenue / 18% of Total Revenue):  Revenue associated with new software license implementations, training and reimbursable costs.

• Perpetual License ($32M of CY21 Revenue / 3% of Total Revenue):  Revenue associated with the Pega Platform delivered on-premises for a customer and a one-time license payment.  The Company’s salesforce no longer sells Perpetual License contracts, and any new agreements must be approved by the CFO.

Investment Thesis:

• Mission-Critical Software Tethered to Digital Transformation Theme:  Prior to COVID, enterprise clients were already utilizing PEGA for their digital transformation strategies, and this underpinned much of the Company’s recent SaaS transition as existing on-premises customers pivoted to cloud offerings.  However, in a post-COVID world, digital transformation strategies became more critical for enterprises to maintain functionality with distributed workforces, and implementation timelines have accelerated.  The Company’s solution has been deemed mission-critical by customers and has retention rates above 95%.  At the PegaWorld Conference held every June, customers actually get onstage and rave about the product.  This is highly unusual for a few reasons. First, many customers adhere to confidentiality and may not want to reveal their use of PEGA. Second, this theoretically makes subsequent negotiations with PEGA more difficult if the Company knows how much a customer loves and values the product.  However, customers from Coca-Cola to Google still present their PEGA use cases to a packed auditorium.  The Company is the leader within its core enterprise BPM market with approximately 30% share versus competitors such as legacy share-donor IBM and newer low-code upstart Appian.  Furthermore, numerous customer checks indicate that a “rip-and-replace” of PEGA from their organizations would be extremely disruptive, disastrous, and comparable to the IT version of “getting gum out of your hair”.  The solution is extremely sticky because it was largely sold through an enterprise’s IT organization, resulting in PEGA becoming much of the underlying process management “fabric” throughout the business.  As newer low-code solutions are increasingly being sold to non-IT personnel such as marketing departments, PEGA is still highly entrenched at existing customers and difficult to supplant.

• Cloud Transition Has Created a More Stable, Recurring Financial Model:  Historically, PEGA was a large-deal-driven, old-school, perpetual-license software company.  The CEO often referenced “whale deals” on earnings calls, which represented deals worth over $10M of bookings.  If one or more deals slipped into the subsequent quarter, the stock could have been down (15%) to (20%) on the earnings print.  After bringing in a new CFO in June 2016 from a Thoma Bravo software portfolio company, CEO Alan Trefler focused on driving a SaaS transition.  The Company realigned incentives for the salesforce to sell subscription revenue and received positive customer feedback and adoption of the new platforms under a Cloud or Term License structure.  As of 4Q22, LTM Perpetual License revenue only represented 3% of total revenue versus 22% when the CFO took over.  Currently, the Company has ceased selling Perpetual License contracts outside of rare exception that require direct approval from the CFO.  Additionally, LTM Recurring Revenue, characterized as Cloud, Term License and Maintenance, now represents 79% of total revenue versus 52% in 3Q16.  With a more predictable revenue base and less volatile earnings results versus expectations, the stock warrants an expanded multiple exiting the SaaS transition.  Historically, the stock traded for EV / NTM Annual Contract Value (ACV) of 6.9x between 2017 and 2019 versus the current 5.9x.  This is a more apples-to-apples metric comparing PEGA’s valuation over historical periods, since the SaaS transition skewed the reported revenue and growth rate.  Lastly, PEGA has reinvigorated its presence with channel partners to drive revenue growth and is ceding more service works to these partners.  Over time, the current Consulting revenue of 18% of total will shrink over time and create a more favorable mixshift of high-margin, recurring software revenue while simultaneously providing an enhanced financial incentive for integration partners to recommend the Pega Platform. 

• COVID-Recovery Story:  Unlike the typical COVID-reopening story such as retailers, online-travel agencies, or out-of-home entertainment, PEGA represents a slightly different variant.  Through customer and partner channel checks, PEGA’s solution is typically more expensive versus customers, but it is justified given the robustness of the platform.  Contracts are typically three years in length and can reach a total value in the millions of dollars.  Many of these enterprises are less willing to agree to deals with such large terms without an in-person discussion or balancing the need for digital transformation with waiting for COVID restrictions to lessen and business travel to resume.  One integration partner also suggested that the PEGA sales team is very impressive in person.  “There is definitely a charm from PEGA, and the Company totally wows you.  A reopening of business travel would certainly make things better for PEGA.”  Per another integration partner, PEGA took advantage of the pandemic by helping their existing customers address remote work solutions and addressing the need for customer engagement where people filled those gaps pre-COVID.  PEGA’s corporate policy has allowed client travel since May 1, 2021 under the expectation that a return to office for many clients would have normalized by July 2021.  However, the combination of the Delta and Omicron variants delayed office returns for many clients.  As business travel and in-person meetings become more acceptable for new and existing customers, PEGA should be able to add new logos and continue to increase spend with current customers.  Lastly, customers also stated that PEGA receives meaningful sales momentum from the partner channel and customers engaging with one another to share use cases.  The inability to hold in-person user conferences has also contributed to the subdued sales momentum for PEGA.  As there is an incremental lifting of restrictions at the government and corporate level, PEGA could be a coiled spring of sales momentum in 2022 / 2023.

• Levered Play on Robotic Process Automation (RPA):  Robotic Process Automation allows business users to configure a “bot” to automate processes that reduce the need for human-directed actions.  Within RPA, there are two types of bots, attended and unattended.  Unattended bots are generally considered “scraping tools” that are effective at functions such as automatically moving data between platforms such as data repositories and Excel spreadsheets.  These bots direct back-office tasks without human interaction and can be scheduled to run automatically.  Well-known solutions providers such as UiPath and Blue Prism are focused on this segment of the market.  Conversely, PEGA is focused on attended bots, which it believes augments the core BPM and CRM solutions.  The Company believes that RPA can create a more intelligent front- and back-office software fabric for organizations, but unattended bots and their use cases have limitations.  The automated bots streamline workflows to reduce human input, suggest subsequent actions and can automatically detect and fix damaged bots without human interaction.  PEGA entered the RPA vertical via its acquisition of OpenSpan in April 2016 for approximately $50M, and as of 2021, approximately 10% of total revenue (~$120M) is comprised of RPA solutions.  This revenue is almost entirely comingled with revenue from customers paying for the Pega Platform given less than 1% of total revenue is derived from “one-off” RPA bot revenue.  PEGA believes the future of RPA is delivering a more complete digital process automation solution for large enterprises versus UiPath’s vision.  For perspective, UiPath had $608M of total revenue for the fiscal year ended January 31, 2021.  Based upon 7,969 customers, this translates to $76k of revenue per customer.  However, UiPath has heavy customer concentration of revenue with 1% of customers spending over $1M representing 35% of revenue and 13% of customers spending over $100k representing 75% of revenue.  The bull thesis on UiPath is their ability to increase customer spend to over $1M across the client base, but per checks, the enterprises spending over $1M are exceptionally behind the digital transformation curve such as Japanese banks transitioning a substantial volume of legacy software.  The notion that there is a long-tail of customers requiring over $1M of unattended-RPA spend to muscle up the digital process automation curve this aggressively appears challenged.   Excluding the top-1% of UiPath’s customers, the business only averages $50k of annual revenue per customer.  This is well-below PEGA’s average annual customer spend of closer to $1M.  Company RPA is growing faster than total revenue given slower growth within Consulting Services and the more mature BPM streams; however, simply assuming RPA revenue remains at 10% of total for CY22 implies growth of 22%.  This is obviously below UiPath’s growth of over 30%, but PATH also trades for 15.4x CY22 revenue.  

A potential catalyst could be if PEGA Management were to quantify how much robotics revenue is generated on an earnings call, since it could potentially serve as a positive surprise to investors given there are few ways to play RPA in the public markets after the acquisition of Blue Prism by SS&C, especially at PEGA’s valuation.

• Compelling Valuation Given Growth / Margin Profile and Nature of Business:  PEGA currently trades for 4.8x CY22 revenue and 6.0x CY22 recurring revenue, representing a discount of approximately (40%) on both metrics to a series of sub-$10B market cap software comparables forecasted to grow at roughly a 20% CAGR through 2023 with a recurring a revenue base of ~80%.  PEGA arguably warrants some discount due to the unlikelihood of being an acquisition target given CEO Alan Trefler owns nearly 50% of shares, but the current valuation gap is still excessive.  Since PEGA’s RPA business is less defined and growing slower than UiPath, ~7.5x seems reasonable at a (50%) discount to PATH and in line with the PRSM take-out multiple for a business growing less than 20%, increasingly becoming a share donor, and the same scale as PEGA’s RPA Revenue.  However, using a more reasonable (25%) discount to the software comparables (~7.2x revenue) for the Non-RPA Software Revenue yields 30% upside on CY22 numbers.  This also assumes the 15-20% of Consulting revenue is valued at 1.0x revenue.

Current Implied SOTP Valuation:

Revised SOTP Valuation:

Assuming PEGA continues growing revenue at a 21% CAGR through 2025 and reaches approximately 23% EBITDA margin as scale is created after ramps in salesforce hiring in 2018 / 2019, there is ~85% upside, reflecting a 25% IRR, conservatively assuming no expansion of the current EV / Revenue multiple and actually (7%) compression in the EV / Recurring Revenue multiple as the mix of recurring increases.  Using a more reasonable multiple of ~7.0x EV / Recurring Revenue (still a 25% discount to peers) implies ~130% upside in the stock and a 35% IRR.

Risks & Mitigants:

• Departure of Hayden Stafford (President, Global Field Operations) Could Jeopardize Sales Execution and Indicate PEGA Sales Momentum Waning:  Left in March 2022 to take a position as President and Chief Revenue Officer of Seismic (private), a marketing and sales enablement software platform headquartered in San Diego.

• Stafford appears to have departed for a more attractive opportunity.  Seismic has raised over $425M of capital in six rounds with the most recent round of $170M in August 2021 at a $3B valuation.  Notable investors include Permira, JMI Equity and Lightspeed Venture Partners.

• PEGA has largely completed the SaaS transition, so revenue and ACV are more closely aligned on an annual basis.  The Company only provides annual revenue guidance at the beginning of the year, and CY22 guidance implies 20% to 23% growth (proxy for ACV), which seems healthy versus the 20% floor that investors and sell-side analysts have set for the stock.  Guidance was also issued after the news of Stafford’s departure was already known to Management and suggests the annual go-to-market plan accounted for the departure and would inherently be derisked versus the guide coming prior to his departure and being a surprise.

• Recent channel checks with integration partners indicate their PEGA practices are performing above plan YTD as of late March 2022.

• Lack of Salesforce Momentum is Unrelated to COVID Headwinds:  Speaking with industry participants and integration partners has suggested that COVID was a headwind to COVID given the higher-touch nature of such a large sale.

• PEGA’s sales team was mentioned as having a “wow factor” in person. 

• User conferences and partner meetings aid in PEGA implementations given many users share use cases with each other.

• One integration partner mentioned that PEGA “got better” during the pandemic in terms of focusing on existing partners with ways enhance their use cases and could also be a coiled spring to chase new logos as reopening continues with back-to-office and travel.

• Technology Valuation Multiples Compress Further in Rising Rate Environment:  PEGA’s current EV / Revenue multiple of 4.8x is below the five-year average after compressing (36%) since mid-November 2021.  Furthermore, to correct for the business model transition where the valuation was suppressed as a largely perpetual license model or SaaS revenue not yet being recognized, another valuable metric is EV / ACV.  Looking back at the valuation from CY17 through CY19, the stock traded for an annualized average EV / NTM ACV of 6.9x with a low of 6.4x in CY19.  CY20 and CY21 were excluded at 8.6x and 11.5x, respectively.  Assuming PEGA meets CY22 ACV expectations and the only risk is multiple compression, using the average and low imply the Company is already trading at a discount of (15%) and (9%) to those metrics at 5.9x.

Catalyst

See write up above