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spk15: Greetings and welcome to the PegaSystems second quarter 2023 earnings conference call. 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, Peter Welburn, Vice President of Corporate Development and Investor Relations. Thank you, sir. You may begin.
spk10: Good morning, everyone, and welcome to Pegasystem's Q2 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, wills, could, should, estimates, may, forecasts and guidance, or variations of such words and other similar expressions, identify forward-looking statements which speak only as of the date the statement was made and are based on current expectations and assumptions. Because such statements deal with future events, they are subject to various risks and uncertainties. Actual results for fiscal year 2023 and beyond could differ materially from the company's current expectations. Factors that could cause the company's results to differ materially from those expressed in forward-looking statements are contained in the company's press release announcing its Q2 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 31st, 2022, and in other recent filings with the SEC. Investors are cautioned not to place undue reliance on such forward-looking statements, and there are no assurances that the matters contained in such statements will be achieved. Although subsequent events may cause our views 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. And with that, I will turn the call over to Alan Treffler, founder and CEO of Pegasystems.
spk01: Thank you, Peter, and to everyone who has joined today's call, especially those of you who have gotten up pretty early to do so. I wanted to just reinforce that at Pega World last month, I had the opportunity to spend time with many of our clients and have very meaningful conversations. And in virtually every discussion, not just the ones I had, but in meeting with other Pega execs, our clients want to talk about the future of AI. and specifically about the impact of generative AI and how they should be thinking about it, how we are approaching it, and how they can leverage AI responsibly and safely. Clients are seeing that this technology will change their business in fundamental ways and are excited about the potential. At the same time, there is so much information in the market and so many conflicting opinions, they are eager to learn more and separate out the marketing hype from the reality. it's clear this technology is going to drive massive shifts in how we get work done. And in Pega's world, how applications are designed, built, evolved, and supported. We believe Pega is uniquely positioned to leverage this technology, bring it to our clients in a safe and secure way, and take advantage of this massive opportunity. Now, for those who attended Pega World, you saw this firsthand on the main stage as well as during our investor session. We believe the generative AI will accelerate the adoption of Pega, making it easier, faster, and cheaper to deploy it, improving the client experience, and driving expansion of existing relationships. And that will translate into helping our clients leverage Gen AI in their organizations to improve efficiency, save money, and enhance employee and customer satisfaction. Now, nonetheless, there are concerns about the overall economic environment. And clients are being conservative in their decision-making, even as they engage in these very positive conversations more deeply. Now, taking client feedback in and evaluating the impact of this new technology, it's become clear to us that we have further opportunities to streamline how we engage with our clients. During this quarter, we will be working with our teams on ways to get even closer to our customers. Now, because AI is so important, I want to take a minute to be able to reiterate why Pega is uniquely positioned to leverage generative AI and why this will bring special benefits to our clients. Now, Pega has been integrating and innovating the use of artificial intelligence and automation since I founded the company. And we've gone through many evolutions. I think this is as exciting one as I've ever seen. I believe we understand what clients need and we can find value and acceleration from generative AI while preserving the scale and scope that enterprises demand. And a big piece of this that is unique to Pega is we've built an architecture that is perfectly suited to tap into the disruptive power of generative AI, both today and well into the future. And we know how to monetize it. Most companies are thinking about generative AI as a code generator of one form or another. But that will really only get them so far. Going directly from prompts to code doesn't really provide the structure and enterprise needs to create an enterprise class system that can evolve. In contrast, Pega has always been based on the concept of a business model at the center. that creates a structure and a system that can evolve as the industry and customer needs change. Our architecture is built on what we call the situational layer cake. And you're going to hear me talk about the layer cake a lot, not just now, but in coming quarters, as it helps to really power this revolution. It's a proprietary capability that organizes all of an enterprise's processes, rules, data models, and UI, into layers, so it supports building and reusing. Now, this layer cake is the perfect place to plug in Gen AI. It creates a place that after the Gen AI contributes, people can see the model, touch it, understand it, and regenerate as needed. And it is this layer cake, this architecture, that is what Pega is uniquely able to provide our clients. a proprietary structural advantage at the heart of our products. Now, it's not something that can be easily copied or reproduced, and it allows us to develop an integrative generative AI rapidly and seamlessly. So we have been at the forefront of using AI in responsible ways and developing responsible AI frameworks that are trusted by our clients, and they will be critical as they build their own AI models. And the layer cake helps us there, too, by helping create visibility for what comes from Pega versus what a customer might build or develop independently on top of it. Now, this combination of architecture, experience, and capabilities, I believe, will make us more successful than our competitors because it will help our clients be more successful and being able to let them quickly adapt and build for change. By the way, I think Gen AI is going to be devastating to most of the low-code companies that haven't taken this kind of approach. As a result, you already see some players starting to talk less about using low-code, and I think a lot of low-code players are going to get wiped out. But at Pega, we're still talking about low-code because we've always used low-code to build the layer case. We've always used low-code in a way that provides the structure that was really almost presciently designed for the introduction of concepts like generative AI. So, we can implement generative AI as a strength. Now, I expect that we will monetize generative AI in three ways. First, clients will create more Pega apps and process more work on our platform. You know, most of our licenses are already work quantity-based. Years ago, we began moving away from seat licenses because, frankly, seats are going to go down. Or if the industry does the right thing, they should go down a lot. And, you know, we saw this coming a long, long time ago. So you can think of most of our licenses as being consumption and capacity-based, which is exactly, I believe, the type of license you want in this sort of environment. I think it's good for the client and good for us. Secondly, I do think we're going to see that the fact that we're doing this generative AI work in PegaCloud and leading with PegaCloud for generative AI will serve as a catalyst for more clients to move from existing term or maintenance contracts to PegaCloud subscription agreements. And third, we will offer specific GenAI-powered add-on features for which there will be an additional charge. Now, we recently announced and showed at PegaWorld 20 generative AI boosters that will be available with Pega Infinity 23 this summer. And we've just gotten started. In fact, our engineering team began this year with a Gen AI token hackathon that resulted in more than 100 new prototypes and capabilities. Many made it into Infinity 23, and there's much more to come in subsequent releases. We have clients who are signing up to be early adopters already, and they are engaged and excited about these capabilities. And we're excited about working with them and seeing what we can accomplish together. Before I move on, I want to take just a few minutes and provide some additional color on Pegaworld, because it was so spectacular. This was the first time we came together in person since 2019, and the energy and excitement was palpable. If you couldn't join the sessions or would just like to see all the replays that are available on Pega.com, just search on Pega World Replays. We have more than 3,500 attendees from around the world representing over 47 countries. And we have inspiring keynotes from clients like Virgin Media, Rabobank, Citi, and Aflac who are all using Pega to drive their business. We have more than 80 deep dive breakout sessions with additional clients sharing their stories from companies including BT, Google, Santander, Siemens, T-Mobile, United Healthcare, Verizon, and Wells Fargo. But one of my favorite breakouts was from Lease Plan, who talked about their transition to a fully digital business model. They're leveraging Pega in their center of excellence in pursuit of their vision to becoming a car as a service organization with a strong focus on service efficiency and digital channels. This will help them optimize costs and capture market growth. And they're leveraging our state-of-the-art Constellation open user experience technology and our prescriptive design system to give their clients and their staff exceptional experiences. You can find a replay of this excellent session on PEGA.com. Just go to PEGA World under Events and search on Lease Plan. One word. I heard there very often how much clients value being able to connect with peers from other companies and learn from the Pega journeys of others. And they told me that attending in person, they were able to get down in just a few days what might have taken weeks or months in terms of discovery, getting questions answered, experiencing the technology, and ultimately understanding the value Pega can provide. I also heard positive feedback about our client-first target org model. And the value we are, I think, mutually achieving, providing a more focused and dedicated engagement team to stay close to our clients. And they're excited about the new capabilities, and they're really looking forward to seeing how we continue to approach generative AI in the future. Finding ways to accelerate development and improve the function of business users without the needs for, well, traditional, longer ways to do it. So I came away feeling incredibly energized and more convinced than ever that we have the right client engagement style, the right technology, and a team that can drive success for our clients and for Pega. Our partners were there in force, and they also, I think, got a both enormous value, and I saw tremendous engagement between them and our clients. So as we move into the second half of the year, we're going to be looking to continue to double down and push on this strategy to improve operating effectiveness with additional improvements to our go-to-market alignment that will help maintain and bring even greater attention to that focus. So, in summary, we are focused on building a successful company for the long term and having our clients successfully navigate what is currently, candidly, a challenging selling environment that we think may persist for some time. Let's face it, right now the world is uncertain and rapidly changing. But I believe we have the right strategy to succeed in this environment while building for the future. We're focusing on our client base with solutions that drive efficiency and cost savings. And we're helping our clients navigate this same set of macroeconomic conditions. We see that Gen AI will rapidly change the landscape of how work gets done. Massively. And we have a unique advantage that we can leverage and that I believe will be sustainable. And we are making good progress as we pursue the goal of trying to be a rule of 40 company as we exit next year, balancing growth with fiscal discipline. And I'm happy to point out, generating very, very significant cash flow. Now, to provide more color on financial results, Let me turn it over to our CFO and COO, Ken Stilwell.
spk14: Thanks, Alan. Our first half results demonstrate our ability to generate increasing amounts of free cash flow while maintaining a double-digit growth rate. The most important metric to measure the success of our business continues to be the growth in annual contract value, or ACV. At the midpoint in 2023, ACV grew 13% year over year. Our ACB growth was driven by the continued momentum of Pega Cloud ACB, which reached $499 million at the end of the second quarter. I'm excited that our Pega Cloud SaaS business continues to be the largest and fastest growing ACB component. And Pega Cloud backlog grew by 23%, or $164 million year over year. Pega Cloud now represents more than two-thirds of total backlog. This growth is further evidence of the underlying strength and momentum of our subscription transition. Another key metric to measure the success of our business is cash flow. In the first half of 2023, Pega generated $114 million of cash flow from operations and $123 million of free cash flow, a fantastic achievement. $123 million is the highest level of free cash flow dollars generated in the first half of a year in the history of the company. There are several reasons we delivered this result. First, in late 2017, we started the subscription transition to move from a company that sold perpetual software licenses to now a company that sells primarily subscription offerings. We embraced the subscription-based business model in response to demand from our clients who were looking for a fully managed offering as a modern way to access our technology. We also liked the fact that recurring billings and thus cash collections are more durable and predictable. We knew and discussed publicly that cash flow would improve as we exited the subscription transition. Seeing Pega generate record-free cash flow in the first half of the year is a great step forward in realizing the vision we articulated more than five years ago. Second, as part of the completion of the subscription model transition, we placed a greater emphasis across the organization on driving free cash flow. Whether it being more disciplined on hiring or more selective with third-party spend, I'm seeing numerous examples of our team members making meaningful steps to focus on improving profitability. Third, we're doing a better job aligning our spending with our ACV growth drivers. In other words, we're instilling better operational rigor than we have in the past. For example, we believe that more than 90% of our ACV growth this year will originate from existing clients through our high client retention rates and our cross-sell and up-sell activity. It's far more efficient to sell into existing clients and new logos, especially in times of greater economic uncertainty that I think we'd all agree we're experiencing today. One reminder, in a subscription-based business like ours, which generates significant term license revenue, there can be a mismatch between billings and revenue. Under ASC 606, the majority of term license software revenue is recognized up front. However, billings and cash collections occur primarily one year in advance in equal installments over the life of the contract. This dynamic means that we can deliver strong cash flow even as reported revenue in any given quarter fluctuates up or down. As a reminder, we do not provide quarterly revenue guidance. Collectively, our mid-year results show that we continue to make progress on managing the company with and toward a Rule of 40 mindset. As a reminder, we define Rule of 40 as the combination of ACV growth and free cash flow margin. Achieving the Rule of 40 milestone is a very important one for all of us at Pega. Reaching this goal will provide us with another reason to be proud of the business we're running. Generating strong free cash flow provides the fuel for Pega to invest in our business and to provide outstanding support to our clients. And it gives us the financial strength and flexibility to navigate through any uncertain economic environment. For example, in the first half of 2023, our cash and marketable security balance grew, providing us with the ability to spend about $90 million on repurchases of our convertible debt at a discount. At the end of Q2, our outstanding convertible debt balance was approximately $500 million. As we outlined in our investor session during Pega World in June, we see three major levers to achieve the free cash flow margin necessary to attain the Rule 40. The first is expanding total gross margin, which is a function of Pega Cloud gross margin, term maintenance gross margin, and our professional services gross margin. Improving Pega Cloud gross margin will be the biggest driver of total gross margin improvement. We expect to improve Pega Cloud gross margin by continuing to scale Pega Cloud, increasing automation, and implementing multi-tenancy in Kubernetes. On a trailing 12-month basis, Pega Cloud revenue is now $423 million, up from about $50 million just a few years ago. In the first half of 2023, Pega Cloud gross margin improved from 68% to 73% year over year. The second major lever that will drive operating leverage is in the area of sales and marketing. This is certainly the most difficult of the three to tackle. We continue to balance our need to invest in sales and marketing to drive ACB growth with our need to improve sales efficiency. We certainly have a lot of work to do. In the last few months, we've received feedback from our clients, partners, and employees on ways to further simplify client engagement to drive greater success. We're evaluating all of these suggestions to improve our go-to-market effectiveness, and we plan to implement changes in the second half of the year to continue driving improvement in our go-to-market productivity. The third and final major lever that will improve our operating leverage is in the area of research and development in G&A. The approach here is simple. We plan to increase R&D and G&A spending at a slower rate than we expect to grow the company, delivering best-in-class innovation to our clients continues to be critical to our success. We will continue to invest heavily in R&D. However, we believe we can do so in a manner that still improves our efficiency. As you can tell, we're very focused on growth, expanding gross margin, improving sales efficiency, and increasing operating leverage. The companies that are successful in navigating uncertain economic times, like the environment we're in today, typically are ones that focus on growth, expense management, and generating free cash flow. It's very reassuring to our clients that Pega maintains the financial strength to continue providing outstanding customer support and product innovation. Before I wrap up, I've been asked to offer a few thoughts on modeling our business in the second half of 2023. As a reminder, the third quarter of the year is typically one of the lightest term license revenue quarters of the year due to seasonality. That's because we often book far fewer renewals of term license agreements in that period. In contrast, the final quarter of the year is typically a relatively stronger term license revenue quarter because we, like most enterprise software companies, experience a higher level of contract renewals in the last quarter of the fiscal year. In conclusion, it was great seeing so many of you in person during our investor session in June at Pega World in Las Vegas, and I'm looking forward to seeing all of you as we get back on the road in August and September. Operator, at this time, please open the line for questions.
spk15: Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate that your line is in the question queue. You may press star 2 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. One moment, please, while we poll for questions. Our first question comes from Steve Enders with Citi. Please proceed with your question.
spk04: Okay, great. Thanks for taking the questions this morning. I guess I just want to ask first on, you know, kind of what you are seeing out there in the macro situation and some of the uncertainty with customer budgets. And I guess, you know, how that relates into the sequential decline that we saw here on the ACV line in the quarter.
spk14: So let me – hey, Steve, it's Ken. Let me hit on the second part of your question, and then I'll hand over to Alan to give a perspective on the market landscape. So it is unusual to have a decline in ACV sequentially in a quarter. It's not unheard of. especially in a situation where we had such a strong build in the first quarter. There's a lot of anomalies that pop up in a quarter around renewals. And we do have some churn in clients. It doesn't always happen linear. We actually have consumption agreements that reset at different points in the way we calculate ACV. So we tend to not look at things in such a small, discrete period as a quarter and think about things over a trailing 12 months kind of view. So like I said, it is unusual to see that happen, but it is not something that we believe is systemic and we don't think it impacts our ability to drive toward our four-year results. So I'll hand back to Alan on his view of the market.
spk01: Yeah, so I think the market is definitely being conservative. We're seeing more approvals sometimes popping in at the last moment, you know, having some things that you would have expected would have just closed in the matter of course, and some would have since closed, but that just took longer. I think that in the companies that are our clients, there's just an extra level of scrutiny that is going on, which, you know, I've seen before and in other times when there was uncertainty, and I think we know how to deal with it, But I do know that I'm expecting that this is going to be true for a lot of other companies, and it's going to be true possibly for the next quarter or two. I don't think it affects our long-term prospects in any way.
spk04: Okay. That's helpful context there, and I appreciate the comments around that. I guess, you know, kind of given the budget situation that we're talking about here and, you know, the excitement around AI, how are you thinking about the path to monetization for all the new functionality that you, you know, talked about and released at PegaWorld last month and how customers are kind of feeling about those investments in PegaAI going forward?
spk01: Well, you know, look, customers are being bombarded with every company they talk to and even ones I'm sure they're trying to avoid coming and offering AI miracles to them. The hype cycle here is actually, I think it might be unprecedented. The reality, though, is we have a lot of credibility with our clients, particularly when we can show them the real types of things that we were able to show at PegaWorld, and that you can see in some of the videos that we posted. So there was a tremendous amount of of interest. And I think we have a lot of confidence from our clients that the way we're going to do it is going to be a way that really works. You know, we are seeing, as we've seen in the past, a lot of customers doing their own experimentation. A lot of customers, as you would expect, are putting their toes, dipping their toes in a lot of ponds. We're seeing the same with analytics too, that there's just a lot of, oh my God, how do I figure out how to get the value out of my data, how do I drive expense out, how do I do everything from create better end-to-end automation to be able to have the AI do summarization that otherwise a human would have to do. So there's just so much activity and interest. I think we're doing well, and I've been in a lot of meetings in which we've had this discussion, explaining why the Pega approach differentiated why it's architecturally superior and I know customers are taking that very very seriously and I expect it will lead to you know as I said in the three ways we think of monetizing this I think it will lead you to greater usage and we're already primed for that greater usage to lead to better better outcomes for them and good outcomes for us
spk02: Okay, perfect. Thanks for taking the questions.
spk15: Our next question comes from Kevin Kumar with Goldman Sachs. Please proceed with your question.
spk07: Thanks for taking my question. I had one on cash flow, which was very strong in the first half of the year. And I know you updated guidance during investor day to $180 million for the year. It feels like you're tracking ahead of that number, particularly given 4Q tends to be a strong quarter. Is that still the right way to think about that? Anything else you would call out in terms of kind of the cadence of cash flow for the year?
spk14: Hey, Kevin, thanks for your question. So it would be silly for me to suggest that being where we are at the midway point doesn't you know, is it a good thing in terms of us achieving our cash flow for the year? And I certainly don't think that, you know, 150 or 180 or whatever number we have is something where we'll just stop and say, oh, we've achieved that, we're good for the year. So we're going to try to generate as much cash flow as we can, because we know that the more cash flow that we generate this year just means that our structure is set up to generate cash flow in future years. So I would say we're not updating or adjusting guidance, but I would say we're very pleased with where we are, and we think it bodes well for the future of increasing cash flow for Pega.
spk01: I'll also say that the mood of the company has really, I believe, come a long, long way in adopting a culture of balance, of trying to head towards rule of 40 this year, rule of 40 next year. And so it wasn't like the cash just fell out of the sky. It's that people are doing the right things. You're thinking about being more economical, but also how to be candid, bump up that critical component of being a ruler of 30 and 40 companies. It's part of everybody's complex. So it's one of those things that a little extra attention
spk02: It helps a lot. That's great.
spk07: Thanks for the context there. I had one on Europe. Looking at the segment revenue details, it implies, I think, Europe accelerated revenue growth in the first half. Is that maybe just catch-up? Is there anything you'd call out in terms of potential recovering in some of those different regions and anything you're hearing from your customer base? Thank you.
spk14: yeah that i will i will um i would say don't please be careful with how much you look into segment uh reporting for re for regions on revenue because remember a lot of our revenue still is term license revenue under asc 606 and so the the mix and the timing can can somewhat just be just happens to be the you know the way the revenue flowed between the geos. I would say that said, we have not seen a noticeable change in the theaters in the first half of the year in terms of positive or negative. I just think sometimes the revenue flow is different, Kevin, so it's more that than it is actual economic changes.
spk02: Understood. Thanks for taking my questions. Yep.
spk15: Our next question comes from Rishi Jalura with RBC Capital Markets. Please proceed with your question.
spk03: Oh, wonderful. Thanks, Alan and Kat, for taking my questions. First, I wanted to kind of drill a little bit back into the consumption element of the business. At the analyst day, you had said that part of the goal of generative AI is driving more consumption. Maybe can you give us a little bit of a reminder for... today, how much of your business is actually consumption? And as we think about the actual adoption of generative AI solutions, how that impacts the mix of consumption versus subscription, you know, and maybe what does that do to some of the leading metrics like ACB and RPO that we're all still looking at? And then I've got to follow up.
spk14: So let me start with that, and then Alan can fill in the gaps. So Just a reminder for us, when we say consumption, we don't mean a contract that is paid by the drink with no commitments from the clients. What we mean is that the contract is based on a usage or a consumption metric, and that that increase in that metric allows a sharing of value between our clients getting more value from using the solution and us achieving more value from those commitments. When you think about our contract consumption, meaning a model that our contracts are based on a consumption or usage metric, it's well above 50% of our contracts are actually using a usage-type metric or a consumption-type metric. In terms of the amount of our ACD or revenue that is driven by variances from... contractually committed arrangements with our clients, meaning overages or variances, it's still a relatively small part of our business that comes from clients going over their contractual. Normally what happens with clients is when they get to that point, we recontract with them with new commitments.
spk01: So most of the agreements, and I think just to clarify what Ken is saying there, because I think it's a really interesting and important point, we did... We did some things several years ago when we began wanting to move to a more non-seat-based model, to a model that was based on the quantity of work to converge the concepts of subscription and consumption. So what we found is that clients really don't like it when the amount they have to pay bounces around too much. from one quarter to another. It makes it hard for them to budget. You know, it can feel unpredictable, particularly if it ends up being driven by some external circumstance, you know, that suddenly something calls a lot more items or a lot more exceptions or a lot more calls in the call center. So the quarter-to-quarter variation was something we wanted to avoid. But on the other hand, we wanted to accommodate customers whose business was increasing even as their seats were decreasing. So what we basically typically do, as Ken said, to avoid having it bounce too much for a customer from order to order, is instead of doing overage charges, we use the increased level of use, the increased consumption, to reset a new subscription price so that it reflects itself in the go-forward ACV. And it becomes something that, candidly, is a lot easier for the customer to budget and understand. I think it's actually easier for us to administer, but I don't believe that was the ultimate motivation. Does that make sense, Richie?
spk03: Yeah, that's a very, very thorough answer. Really appreciate it, guys. I want to thank Richie.
spk14: I'm going to answer one part of your question that we didn't answer, backlog, RPO. When you move to more consumption or usage-based models, there is a chance that applying a contract duration would come down slightly. And so that could actually be a headwind to RPO growth slightly, not materially, but slightly. So that's the one part of your question there, just to clarify that. And the reason why that is, is we want... faster iterations of measuring our client's usage to be able to grow ACV. Longer durations tend to lock in usage for longer periods of time. So that's the RPO answer.
spk03: Okay, great. And just to clarify, that shouldn't have an impact on CRPO or RPO with one year under, correct?
spk14: No, no. It would be highly unlikely to impact current RPO. Yep.
spk03: Okay, really helpful. Thanks. And then one other piece of feedback we got when we were talking to partners at Pekka World is that generative AI can really help speed up time to value. Maybe based on your customer conversations, how do we think about the potential for this to reduce implementation times, reduce sales cycles, and kind of lead to maybe over time, you know, better net new business, you know, showing up in the model. Maybe help us understand how you're thinking about that. Thanks.
spk01: I think it's going to be huge. You know, when I did my closing at Pegaworld, and the video is still up there, I talked about four things that I expected to come back to that audience with the following year. And I want you to know that the company is galvanized around working as hard as we can to make sure we deliver on these things. The first was what we call peg at your fingertips. So using the power of generative AI, including some of the things that are going to be in 23, to be able to make it so the system is giving people building the software advice. It's also going to be able to give end users who are using the software advice and even do work for them. So that was the first of the four. The second was we expect to double developer productivity as a direct result of the implementation of these features. And relative to what you were asking about, I think this is unquestionably going to increase the velocity of sales cycles, and it's going to make it easier for customers to get a lot more done with the same dollars. And so we're working to get our partners excited about how this will let them do more amount, which should improve their sales cycles as well. And the final two, as you may remember, were the concepts of Launchpad and the Autonomous Enterprise.
spk02: All right, perfect. Thank you, guys.
spk15: Our next question comes from with JP Morgan. Please proceed with your question.
spk11: Great. Hey, guys. Thanks for taking the questions. I wanted to ask you one thing that you were talking in the script about more opportunity to further streamline sales, additional improvements to go to market. Is there any way to kind of tease that out? What other things are you thinking that you can apply?
spk01: Yeah, we've just begun sharing that with the company and are going to spend some time today talking with the company as a whole about what we're doing. But in principle – We're going to make it so a couple of the roles and functions that historically have been kind of segmented out are going to become less siloed in the front office of the go-to-market. The work of people that we call success managers and people we call account executives and other sorts of roles and functions that are in there that were specialists in certain areas. We're going to work to bring them under a common organizational and management structure. So that, I believe, is once again going to continue to make us more effective. Certainly gotten feedback from our clients that it will be easier for them to deal with more focused teams. And I think of it as just really a continuation of some of the things we started in January. I do believe it will improve sales efficiency, but that is not the primary driver here.
spk11: Got it. Understood. And Ken, going back to kind of the sequential decline in ACV, was the macro sequentially worse in Q2 versus Q1? Anything to note there?
spk14: I don't believe the macro was worse. I think our performance in Q1 was better than our performance in Q2, and naturally that contributes. But that, you know, that actually happens in a business like ours where we have smaller numbers of deals where the deals are larger value, you tend to not get kind of like, it's not like a statistical kind of trend in terms of the booking. So that's not that unusual to see in our business.
spk02: Understood. Thank you.
spk15: Our next question comes from Jake Roberge with William Blair. Please proceed with your question.
spk05: Hey guys, thanks for taking my questions. Just wanted to dig deeper into your comments that generative AI can monetize just those lower end use cases in low code. Could you just talk more about why your platform positioning helps you take advantage of AI? And then just from a timing perspective, when do you think we can actually start seeing AI layer into the model? Is that something that's more Q4 or do you think that's more of a 2024 story?
spk01: Could you repeat the second question? I'm sorry. You said when can we start seeing?
spk05: Yeah, it was just really around the timing of when we could start seeing AI layer into the model. Is that something that starts generating revenue in Q4, or is that more of a 2024 story?
spk01: So a couple of different things there, all of which I think are terrific, actually. So the reality is a lot of what you see are people building Systems using AI by you know using them as an accelerator for traditional coding You know think about think about co-pilot of using using it to even generate in the low code area Entire systems the trouble with the system that's generated like that is it's it's really hard to change It doesn't have a structure that makes it easy for you to go in and say oh Italy wants to do something differently. How do I go change this set of things for Italy? Because, candidly, when the generated stuff happens, it tends to kind of get generated in clubs or in a way that's not necessarily organized for change. The layer cake in Pega lets you organize the key dimensions of change. We find that in businesses, in enterprise businesses, change typically happens for one of three reasons. You generally get a general way you want to do a process or make a set of decisions, and they will vary based on a product variation or a customer variation or a jurisdictional variation, a locational variation. And we have built those dimensions into this layer cake. So when you want to make a change or how something works for Italy or how you handle a particular high-value set of clients, you've got a place to go. You've got a place to go in the layer cake that you can regenerate those pieces as opposed to having to deal with something that looks a lot more like soup. Now, the soup doesn't matter as much in small systems. So I think it's going to be used extensively there. But in anything that you'd think of as an enterprise solution, really important to have that structure. And this will be hitting the streets this year. So this is going to be something that our customers, when 23 ships this summer, This is going to be in the hands of customers.
spk05: Okay, helpful. And then just we're obviously hearing a lot about platform consolidation, just given the uncertain macro. Have you seen any changes to the competitive environment or even with your GSI partnerships, just as some of the larger software platforms like Microsoft and ServiceNow invest more in the space? And then on the other end, Have you started to benefit at all, just as customers may look to consolidate like a point solution RPA or process mining vendor onto your broader platform?
spk01: Yeah, we're seeing actual some real benefits from platform consolidation in the pipeline and actually in real implemented systems where some of our clients are using us to do more of their workflows. And I think that's actually a larger source of benefit for us than the consolidation across different product families, like, you know, process mining versus, you know, versus work automation. But, yeah, I do think we are going to see some consolidation. And I would expect, based on where our history has been when this sort of thing has happened, that that is beneficial for us.
spk02: Thanks for taking my questions.
spk15: Our next question comes from Vinod Desrarathan from Barclays. Please proceed with your question.
spk06: Hi, guys. Thanks for taking my questions. I just want to follow up on some of the macro and Gen AI questions you've talked about. So far, it seems like you're seeing some offsetting demand factors between Gen AI starting to help, but macro still being kind of more of a negative factor. When do you expect this tug of war to kind of start to favor Gen AI over macro and kind of start to show up in a stronger pipeline and then really start to show up in net new ACV growth?
spk01: Yeah, I think the net new ACV, I think the tug of war is won by real things in the hands of real customers. You know, if you look at what's out there, there's a lot of stuff happening. including ours, which hasn't fully hit the street yet. And I think as that hits the street, we're going to see it do a much harder tug in that direction. I also think some of the macro just represents greater conservatism, just extra layers of approvals or running by the CFO at the end twice that was not candidly present as much. as we entered the year, but isn't it all shocking, you know, given the uncertainty and that everybody's trying to save money, you know, in this environment. So, you know, I'm very excited. We need to be able to achieve our Rule of 40 ambitions for next year. We need a good breath record, and we're still psyched to be able to do that.
spk06: Understood. And then just maybe on the Rule of 40, you know, your progression and scaling of Pega Cloud and gross margins. You know, at PegaWorld, I saw you guys were, you know, hoping to adopt externalized services for microservices, I think, by Infinity 24 with a more full deployment by the year after that. How should we think about kind of modeling Pega Cloud gross margin as you kind of hit those milestones?
spk14: Yeah, so we wanted to get – the way I would frame it is – Way back when, when we started this like five years ago, we said we want to get Pegacloud gross margin 70%. A couple years ago, we said we're going to change that number to 75%. We're now pretty close to 75%, and we've talked about that there's no reason why that number can't go and approach 80, you know, in the coming years. So I would model it kind of in a more linear fashion. That is probably one part of our business that actually does have linearity in terms of the scaling. So I would probably think about it that way.
spk01: And we're putting improvements online every quarter.
spk02: Got it. Thanks. Appreciate it. Yep.
spk15: Our next question comes from Fred Habermeyer with Macquarie. Please proceed with your question.
spk12: Thank you very much. Good to speak, Alan. Good to speak, Ken. I think I was coming in with more technical-focused questions, but something here kind of tickled my fancy. So I wanted to ask, I think maybe for Alan, as we think about the opportunity here to potentially improve how customer service, sales, et cetera, are done with the aid of generative AI, I mean, you have all of the pieces in place to do things like autonomous agents for enterprise and the like, but just I wanted to ask you, what do you think about the opportunities to kind of like augment or improve how customer service is done more efficiently with generative AI?
spk01: I think it's enormous. I think it's enormous in an assisted sense. And I also think that it's going to really fundamentally change the way self-service works as well, which is why I'm glad we're not tied to SeatCats because let's face it, one of the big cost savings that people are achieving and want to achieve is, is, you know, the reduction of labor that they have trouble finding anyway. And so, you know, I think it's going to be a really perfect storm in that direction. And I do think that we do have a terrific collection of the parts to deliver on that for our clients. I think it will be great.
spk12: I'm looking forward to seeing what you'll be doing there. I guess the next one is – Just with respect to your partners as well, how are they approaching their strategies and recommendations at the moment related to just no-code, low-code and generative AI to their clients? Are they kind of also in a place where they're experimenting with or helping their clients experiment with new technology? And is there any sort of a headwind that this experimentation is doing to platform it up like low-code, no-code platform adoption?
spk01: I think there is a lot of experimentation going on throughout the entire business system because, candidly, people are trying to figure out what's real and what's hype. The partner engagement I've had, though, has been extremely enthusiastic about what we're doing. I'm not sure that they're as enthusiastic about everybody, but I'm sure the partners
spk02: Thank you.
spk15: Our next question comes from Mark Sheffel with Loop Capital Markets. Please proceed with your question.
spk09: Hi, thanks for taking my question. On Launchpad, you discussed the offering in more detail at the recent investor day. I was wondering if you'd just bring us up to date on the status of your early adopter program for Launchpad, and maybe just talk a little bit about some of the parts and capabilities of the offering that your partners are most excited about.
spk01: So I'm thrilled, actually, with the feedback from our early adopters. The early adopter program is oversubscribed, and the partners are showing enormous enthusiasm. Just so folks know, if you haven't to launch pad. Launch pad is a way of bringing the way we've historically thought about work-driven systems to partners who want to capture their own IP and offer their own IP to subscribers powered by Pega. And it was built specifically for this, and I think it's really unique in the market in being able to do that, and that is the feedback we've gotten from the the organizations that we've done the early work with. So, you know, we've been reluctant to make any projections for this year because it is a nascent technology. But I'm expecting that I will be able to talk about Launchpad's contribution to the financial strength of the business next year because I think it's going really well.
spk02: Great. Thank you. Our next question comes from Tom Blakey with KeyBank Capital Markets.
spk15: Please proceed with your question.
spk13: Hey, Alan and Ken. Thanks for squeezing me in here. Great stuff here. I'm trying to balance out these two moving parts on the macro. It seems to have gotten incrementally a little more head windy, and AI. which you seem more bullish on, Alan, in terms of the $1.4 billion calendar 23 guide. It seems like maybe AI could be incremental here, but just trying to understand kind of where we are, like when the guidance was set and where we are now in terms of balancing these two points out. And I have a follow-up on free cash flow.
spk14: So let me take that one on the revenue side. So, Tom, I think this has happened to us in a few years where when they're PegaCloud momentum, you know, creates a little bit of variability on the accounting revenue piece of it, right? So if you look at where we started the year, the revenue number can move around because of that mix of PegaCloud. I think when you think about our ACV and our billings, which are kind of, those are very integrally connected. I'd say that's kind of where the macro discussion comes in. I just want to separate revenue from ACV a little bit. So I think revenue is definitely a little bit more of a wild card depending on the mix of the contracts. So that's an unfortunate reality for our business. But setting that up in terms of the ACV and the billings, I think maybe I'll leave you, Alan, to think about how you think about the macro now versus maybe when we started the year.
spk01: Yeah, look, on a macro basis, the economic uncertainty and the fact that we have seen like some more approvals come into the mix is obviously a challenge, one we've seen before. But I will tell you from a macro point of view, Gen AI is a huge, and not short-term factor here. And I think it's going to – this is going to fundamentally change our business and a number of other businesses in a very, very big way over the next 12 to 24 months. So I'm very, very bullish. I'd love to be able to put out a quarter where there wasn't some bit of mixed results. Do you have a question you said about cash flow?
spk13: Yeah, I did. And before I get to that, Alan, just while I have you there, on the huge comment on Gen AI, there's been some fellow vendors and big titans out here talking about monetization there. Do you want to offer up maybe some visibility very early on here that you see in terms of possible like for like uplift in terms of... pricing or monetization per client, given that 90% of ACV is going to come from existing clients?
spk01: Yeah, I think the biggest aspect of monetization is going to be because we're going to accelerate our clients' use of the technology so that they're going to use it more. I think some of the vendors you're referring to are stuck with more of a seat model, and they're going to have to figure out how to fix it. We don't have that problem. So we're really in a good place that as customers get excited about this and want to use it, it's going to lead to greater volumes, and that will lead directly to monetization. We will have some add-on things that are separately priced, but I don't expect that we're going to do something onerous to our clients like I think some customers are worried about from other vendors. I've heard some numbers brought forward on seat pricing that I think are going to be anxiety-producing to their customer base. We don't have to do that with our customer base to turn this into money. Okay.
spk13: Yeah, I guess you know what I was referring to, Alan. Thank you. That's very clear. And on the impressive free cash flow here, I'm just wondering, you know, you're still trading, I think, at an 8% or 9% discount here, Ken. Not calling out anything specifically, but I'd like to know what your updated thinking is there. I know things are probably a little bit more, for lack of a better word, happy for you here, Ken. So, but, you know, just an update on capital structure. uh, capital return and also how it kind of like maybe possibly impacts that rule of 40, um, as you, as you move things around here with a much, uh, you know, potentially better balance sheet going forward. That'd be helpful.
spk14: Thank you. I think, I think that we were never, um, we were never, uh, aggressively in the market to buy back the converts we were offered. Those were opportunistic, uh, where, where, you know, some investors, you know, what we're looking to, um, you know, to get out of their positions. And we felt like there was an interesting IRR to do so. And actually, if the stock price goes up and as we get closer to maturity, that becomes less arbitrage, so to speak, on that versus what we can get at overnight rates. So I would say we're still, you know, we'll consider opportunities when they come in, but we're not aggressively going out, nor did we on the other transactions. I think it's more just a sign that you know, we have a lot of confidence in the durability of the business and the cash flow of the business, and we felt like we're very comfortable, you know, taking that $100 million out of the convert.
spk13: And then just from a longer-term perspective, so just letting, from a strategic perspective then, just letting the cash build?
spk14: Yeah, I mean, we have, naturally from a capital allocation standpoint, we have a near-term event if we wanted to have, which is to basically take out the converts and not to re-up them or to refinance them. So naturally, that's something that's out there that we want as much flexibility as we can with our options.
spk01: We're at time, but I see there are a couple more people in the queue. We'll very quickly take two more questions. Thanks, guys. Thank you.
spk15: Our next question comes from Patrick Walt Ravens with Citizens JMP. Please proceed with your question.
spk08: Oh, great. Thank you. So, Alan, my question is, do you have enough sort of PhD-level AI talent to do what you want to do? I mean, you have Peter Van Der Poeten, and then you added Christian, right? But how much do you need?
spk01: I have Rob Walker, too, who's a pretty good PhD and has been with us. He was on the main stage at Pegaworld and We have a couple of others who aren't PhDs but easily could have been who are sprinkled in. So, yeah, I feel really good about our talent base.
spk08: Oh, and then can I ask, as long as – can we get an update on the lawsuit? There's probably not a lot you can say, but whatever you can say.
spk01: You know, we're in the appeal waiting process, and I'm looking forward to getting that in front of the judges. I'll just say that.
spk08: All right, great. Thank you.
spk01: Thank you. And I think we are at time, so we will have to call it. Let me just tell everyone, thank you very much. We're working hard for you. We're actually generating cash. I know Ken and I are both very excited about it. And we will continue to keep you all updated. Take care, everyone. Bye-bye.
spk15: This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.
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