UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2017
OR
For the transition period from to
Commission File Number: 1-11859
PEGASYSTEMS INC.
(Exact name of Registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(IRS Employer
Identification No.)
(617) 374-9600
(Registrant’s telephone number including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-acceleratedfiler, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company,” in Rule 12b-2 of the Exchange Act.
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒
There were 77,859,958 shares of the Registrant’s common stock, $.01 par value per share, outstanding on October 27, 2017.
Index to Form 10-Q
PART I—FINANCIAL INFORMATION
Item 1. Unaudited Condensed Consolidated Financial Statements
Unaudited Condensed Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016
Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2017 and 2016
Unaudited Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2017 and 2016
Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2017 and 2016
Notes to Unaudited Condensed Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II—OTHER INFORMATION
Item 1A. Risk Factors
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 6. Exhibits
Signature
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UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
Assets
Current assets:
Cash and cash equivalents
Marketable securities
Total cash, cash equivalents, and marketable securities
Trade accounts receivable, net of allowance of $6,189 and $4,126
Income taxes receivable
Other current assets
Total current assets
Property and equipment, net
Deferred income taxes
Long-term other assets
Intangible assets, net
Goodwill
Total assets
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable
Accrued expenses
Accrued compensation and related expenses
Deferred revenue
Total current liabilities
Income taxes payable
Long-term deferred revenue
Other long-term liabilities
Total liabilities
Stockholders’ equity:
Preferred stock, 1,000 shares authorized; no shares issued and outstanding
Common stock, 200,000 shares authorized; 77,839 shares and 76,591 shares issued and outstanding
Additional paid-in capital
Retained earnings
Accumulated other comprehensive loss
Total stockholders’ equity
Total liabilities and stockholders’ equity
See notes to unaudited condensed consolidated financial statements.
2
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
Revenue:
Software license
Maintenance
Services
Total revenue
Cost of revenue:
Total cost of revenue
Gross profit
Operating expenses:
Selling and marketing
Research and development
General and administrative
Acquisition-related
Total operating expenses
(Loss)/income from operations
Foreign currency transaction (loss)/gain
Interest income, net
Other income/(expense), net
(Loss)/income before (benefit)/provision for income taxes
(Benefit)/provision for income taxes
Net (loss)/income
(Loss)/earnings per share:
Basic
Diluted
Weighted-average number of common shares outstanding:
Cash dividends declared per share
3
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Other comprehensive income/(loss), net of tax
Unrealized gain/(loss) onavailable-for-sale marketable securities, net of tax
Foreign currency translation adjustments
Total other comprehensive income/(loss), net of tax
Comprehensive (loss)/income
4
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Operating activities:
Net income
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation and amortization
Stock-based compensation expense
Foreign currency transaction loss/(gain)
Other non-cash
Change in operating assets and liabilities:
Trade accounts receivable
Income taxes receivable and other current assets
Accounts payable and accrued expenses
Other long-term assets and liabilities
Cash provided by operating activities
Investing activities:
Purchases of marketable securities
Proceeds from maturities and called marketable securities
Sales of marketable securities
Payments for acquisitions, net of cash acquired
Investment in property and equipment
Cash used in investing activities
Financing activities:
Dividend payments to shareholders
Common stock repurchases for tax withholdings for net settlement of equity awards
Common stock repurchases under share repurchase programs
Cash used in financing activities
Effect of exchange rates on cash and cash equivalents
Net increase/(decrease) in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
Pegasystems Inc. (together with its subsidiaries, “the Company”) has prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“U.S.”) for complete financial statements and should be read in conjunction with the Company’s audited financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2016.
In the opinion of management, the Company has prepared the accompanying unaudited condensed consolidated financial statements on the same basis as its audited financial statements, and these financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results of the interim periods presented. The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year 2017.
2. NEW ACCOUNTING PRONOUNCEMENTS
Stock-Based Compensation
In May 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-09 “Stock Compensation (Topic 718), Scope of Modification Accounting” to clarify when to account for a change to the terms or conditions of a share-based payment award as a modification. Under the new guidance, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. The effective date for the Company will be January 1, 2018. The Company does not expect the adoption of this standard to have a material effect on its financial position or results of operations.
Financial Instruments
In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments,” which requires measurement and recognition of expected credit losses for financial assets measured at amortized cost, including trade accounts receivable, upon initial recognition of that financial asset using a forward-looking expected loss model, rather than an incurred loss model for credit losses. Credit losses relating to available-for-sale debt securities should be recorded through an allowance for credit losses when the fair value is below the amortized cost of the asset, removing the concept of “other-than-temporary” impairments. The effective date for the Company will be January 1, 2020, with early adoption permitted. The Company is currently evaluating the effect this ASU will have on its consolidated financial statements and related disclosures.
Leases
In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842),” which requires lessees to record most leases on their balance sheets, recognizing a lease liability for the obligation to make lease payments and a right-of-use asset for the right to use the underlying asset for the lease term. The effective date for the Company will be January 1, 2019, with early adoption permitted. The Company expects that most of its operating lease commitments will be subject to this ASU and recognized as operating lease liabilities and right-of-useassets upon adoption with no material impact to its results of operations and cash flows.
Revenue
In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606)”. This ASU amends the guidance for revenue recognition, creating the new Accounting Standards Codification Topic 606 (“ASC 606”). ASC 606 requires entities to apportion consideration from contracts to performance obligations on a relative standalone selling price basis, based on a five-step model. Under ASC 606, revenue is recognized when a customer obtains control of a promised good or service and is recognized in an amount that reflects the consideration which the entity expects to receive in exchange for the good or service. In addition, ASC 606 requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.
The Company has elected the full retrospective adoption model, effective January 1, 2018. The Company’s quarterly results beginning with the quarter ending March 31, 2018 and comparative prior periods will be compliant with ASC 606. The Company’s Annual Report on Form 10-K for the year ended December 31, 2018 will be the Company’s first Annual Report that will be issued in compliance with ASC 606.
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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
The Company has made significant progress on quantifying the impact of its adoption and identifying necessary changes to our policies, processes, systems, and controls.
The Company expects the following impacts:
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3. MARKETABLE SECURITIES
The Company’s marketable securities are as follows:
September 30, 2017
Municipal bonds
Corporate bonds
December 31, 2016
As of September 30, 2017, the Company did not hold any investments with unrealized losses that are considered to be other-than-temporary.
As of September 30, 2017, remaining maturities of marketable debt securities ranged from October 2017 to September 2020, with a weighted-average remaining maturity of approximately 14 months.
4. DERIVATIVE INSTRUMENTS
In May 2017, the Company discontinued its forward contracts program; however, it will continue to evaluate periodically its foreign exchange exposures and may re-initiate this program if it is deemed necessary.
The Company has historically used foreign currency forward contracts (“forward contracts”) to hedge its exposure to fluctuations in foreign currency exchange rates associated with its foreign currency denominated cash, accounts receivable, and intercompany receivables and payables held primarily by the U.S. parent company and its United Kingdom (“U.K.”) subsidiary.
At December 31, 2016, the total notional value of the Company’s outstanding forward contracts was $128.4 million.
The fair value of the Company’s outstanding forward contracts was as follows:
Asset Derivatives
Foreign currency forward contracts
Liability Derivatives
As of September 30, 2017, the Company did not have any forward contracts outstanding.
The Company had forward contracts outstanding with total notional values as of September 30, 2016 as follows:
Euro
British pound
Australian dollar
United States dollar
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The income statement impact of the Company’s outstanding forward contracts and foreign currency transactions was as follows:
Gain (loss) from the change in the fair value of forward contracts included in other income (expense), net
Foreign currency transaction (loss) gain from the remeasurement of foreign currency assets and liabilities
5. FAIR VALUE MEASUREMENTS
Assets and Liabilities Measured at Fair Value on a Recurring Basis
The Company records its money market funds, marketable securities, and forward contracts at fair value on a recurring basis. Fair value is an exit price, representing the amount that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants based on assumptions that market participants would use in pricing an asset or liability. As a basis for classifying the fair value measurements, a three-tier fair value hierarchy, which classifies the fair value measurements based on the inputs used in measuring fair value, was established as follows: (Level 1) observable inputs such as quoted prices in active markets for identical assets or liabilities; (Level 2) significant other inputs that are observable either directly or indirectly; and (Level 3) significant unobservable inputs on which there is little or no market data, which require the Company to develop its own assumptions. This hierarchy requires the Company to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value.
The Company’s money market funds are classified within Level 1 of the fair value hierarchy. The Company’s marketable securities classified within Level 2 of the fair value hierarchy are valued based on a market approach using quoted prices, when available, or matrix pricing compiled by third party pricing vendors, using observable market inputs such as interest rates, yield curves, and credit risk. The Company’s foreign currency forward contracts, which were all classified within Level 2 of the fair value hierarchy, are valued based on the notional amounts and rates under the contracts and observable market inputs such as currency exchange rates and credit risk. If applicable, the Company will recognize transfers into and out of levels within the fair value hierarchy at the end of the reporting period in which the actual event or change in circumstance occurs. There were no transfers between Level 1 and Level 2 during the nine months ended September 30, 2017.
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The Company’s assets and liabilities measured at fair value on a recurring basis consisted of the following:
Fair Value Assets:
Money market funds
Marketable securities:
Fair Value Liabilities:
For certain other financial instruments, including accounts receivable and accounts payable, the carrying value approximates their fair value due to the relatively short maturity of these items.
Assets Measured at Fair Value on a Nonrecurring Basis
Assets recorded at fair value on a nonrecurring basis, such as property and equipment and intangible assets, are recognized at fair value when they are impaired. During the nine months ended September 30, 2017 and 2016, the Company did not recognize any impairments of its assets recorded at fair value on a nonrecurring basis.
6. TRADE ACCOUNTS RECEIVABLE, NET OF ALLOWANCE
Unbilled trade accounts receivable
Total trade accounts receivable
Allowance for sales credit memos
Unbilled trade accounts receivable primarily relate to services earned under time and materials arrangements and to license, maintenance, and cloud arrangements that have commenced or been delivered in excess of scheduled invoicing.
7. GOODWILL AND OTHER INTANGIBLE ASSETS
The changes in the carrying amount of goodwill for the nine months ended September 30, 2017 as follows:
Balance as of January 1,
Purchase price adjustments to goodwill
Currency translation adjustments
Balance as of September 30,
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Intangible assets are recorded at cost and are amortized using the straight-line method over their estimated useful lives as follows:
Customer related intangibles
Technology
Other intangibles
Amortization expense of intangibles assets is reflected in the Company’s unaudited condensed consolidated statements of operations as follows:
Cost of revenue
Future estimated amortization expense related to intangible assets as of September 30, 2017 is as follows:
Remainder of 2017
2018
2019
2020
2021
2022 and thereafter
8. ACCRUED EXPENSES
Outside professional services
Income and other taxes
Marketing and sales program expenses
Dividends payable
Employee related expenses
Other
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9. DEFERRED REVENUE
Term license
Perpetual license
Cloud
Professional Services
Current deferred revenue
10. STOCK-BASED COMPENSATION
Stock-based compensation expense is reflected in the Company’s unaudited condensed consolidated statements of operations as follows:
Cost of revenues
Total stock-based compensation before tax
Income tax benefit
During the nine months ended September 30, 2017, the Company issued approximately 1,299,000 shares of common stock to its employees and 18,000 shares of common stock to its non-employee directors under the Company’s stock-based compensation plans.
During the nine months ended September 30, 2017, the Company granted approximately 1,052,000 restricted stock units (“RSUs”) and 1,520,000 non-qualified stock options to its employees with total fair values of approximately $47.5 million and $20.6 million, respectively. This includes approximately 175,000 RSUs which were granted in connection with the election by employees to receive 50% of their 2017 target incentive compensation under the Company’s Corporate Incentive Compensation Plan in the form of RSUs instead of cash. Stock-based compensation of approximately $7.7 million associated with this RSU grant will be recognized over a one-year period beginning on the grant date.
The Company recognizes stock based compensation on the accelerated recognition method, treating each vesting tranche as if it were an individual grant. As of September 30, 2017, the Company had approximately $56.8 million of unrecognized stock-based compensation expense, net of estimated forfeitures, related to all unvested RSUs and unvested stock options that is expected to be recognized over a weighted-average period of 2.1 years.
11. EARNINGS PER SHARE
Basic earnings per share is computed using the weighted-average number of common shares outstanding during the applicable period. Diluted earnings per share is computed using the weighted-average number of common shares outstanding during the applicable period, plus the dilutive effect of outstanding options and RSUs, using the treasury stock method. Certain shares related to some of the Company’s outstanding stock options and RSUs were excluded from the computation of diluted earnings per share because they were anti-dilutive in the periods presented, but could be dilutive in the future.
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The calculation of the Company’s basic and diluted earnings per share is as follows:
Weighted-average common shares outstanding
(Loss)/earnings per share, basic
Weighted-average effect of dilutive securities:
Stock options
RSUs
Effect of assumed exercise of stock options and RSUs
Weighted-average common shares outstanding, assuming dilution
(Loss)/earnings per share, diluted
Outstanding stock options and RSUs excluded as impact would be anti-dilutive
In periods of loss, all equity awards are excluded, as the inclusion of any equity awards would be anti-dilutive.
12. GEOGRAPHIC INFORMATION AND MAJOR CLIENTS
Geographic Information
Operating segments are defined as components of an enterprise, about which separate financial information is available that is evaluated regularly by the chief operating decision maker (“CODM”) in deciding how to allocate resources and in assessing performance.
The Company develops and licenses software applications for customer engagement and its Pega®Platform, and provides consulting services, maintenance, and training related to its offerings. The Company derives substantially all of its revenue from the sale and support of one group of similar products and services—software that provides case management, business process management, and real-time decisioning solutions to improve customer engagement and operational excellence in the enterprise applications market. To assess performance, the Company’s CODM, who is the chief executive officer, reviews financial information on a consolidated basis. Therefore, the Company determined it has one reportable segment—Customer Engagement Solutions and one reporting unit.
The Company’s international revenue, based upon the clients’ location, is as follows:
U.S.
Other Americas
U.K.
Other EMEA(1)
Asia Pacific
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Major Clients
Clients accounting for 10% or more of the Company’s total revenue were as follows:
Client A
Clients accounting for 10% or more of the Company’s total trade accounts receivable were as follows:
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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 revenue recognition under license and cloud arrangements and are described more completely in Part I of our Annual Report on Form 10-K for the year ended December 31, 2016.
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,” “strategy,” “is intended to,” “project,” “guidance,” “likely,” “usually,” 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 materially from those expressed in such forward-looking statements 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; reliance on third party relationships; the potential loss of vendor specific objective evidence for our consulting services; the inherent risks associated with international operations and the continued uncertainties in international economies; the Company’s continued effort to market and sell both domestically and internationally; foreign currency exchange rates; the financial impact of any future acquisitions; the potential legal and financial liabilities and reputation damage due to cyber-attacks and security breaches; and management of the Company’s growth. These risks, and other factors that could cause actual results to differ materially from those expressed in such forward-looking statements, are described more completely in Part I of the Company’s Annual Report on Form10-K for the year ended December 31, 2016 as well as other filings we make with the Securities and Exchange Commission
We have no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or risks. New information, future events or risks may cause the forward-looking events we discuss in this report not to occur or to materially change.
Business overview
We develop, market, license, and support software applications for marketing, sales, service, and operations. In addition, we license our Pega® Platform for clients that wish to build and extend their own applications. The Pega Platform assists our clients in building, deploying, and evolving enterprise applications, creating an environment in which business and IT can collaborate to manage back office operations, front office sales, marketing, and/or customer service needs. We also provide consulting services, maintenance, and training for our software. Our software applications and Pega Platform can be deployed on Pega, partner, or customer-managed cloud architectures.
Our clients include Global 3000 companies and government agencies that seek to manage complex enterprise systems and customer service issues with greater agility and cost-effectiveness. Our strategy is to sell a client a series of licenses, each focused on a specific purpose or area of operations in support of longer term enterprise-wide digital transformation initiatives.
Our license revenue is primarily derived from sales of our applications and our Pega Platform. Our cloud revenue is derived from the licensing of our hosted Pega Platform and software application environments. Our consulting services revenue is primarily related to new license implementations.
Financial and Performance Metrics
Management evaluates our financial performance, based a number of select financial and performance metrics. The performance metrics are periodically reviewed and revised to reflect any changes in our business. Historically, Recurring Revenue and License and Cloud Backlog have been our primary performance metrics. However, due to the change in the revenue recognition patterns of term license arrangements as a result of the expected implementation of the new revenue accounting standard (See Note 2) in the first quarter of 2018, we have started tracking Annual Contract Value (“ACV”), a new performance measure.
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Select Financial Metrics
(Dollars in thousands,
except per share amounts)
Operating margin
Diluted (loss)/earnings per share
Cash flow provided by operating activities
Select Performance Metrics
Annual Contract Value (“ACV”)
The change in ACV measures the growth and predictability of future cash flows from committed term license, cloud, and maintenance arrangements as of the end of the particular reporting period.
ACV is the sum of the following two components:
Term License and Cloud ACV
Maintenance ACV
Term License, Cloud and Maintenance ACV
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Recurring Revenue
A measure of the predictability and repeatability of our revenue.
Recurring revenue
Total recurring revenue
Recurring revenue as a percent of total revenue
License and Cloud Backlog
A measure of the continued growth of our business as a result of future contractual commitments by our clients.
License and Cloud Backlog is the sum of the following two components:
License and cloud backlog may vary in any given period depending on the amount and timing of when the arrangements are executed, as well as the mix between perpetual, term, and cloud license arrangements, which may depend on our clients’ deployment preferences. A change in the mix may cause our revenues to vary materially from period to period. A higher proportion of term and cloud license arrangements executed will generally result in revenue being recognized over longer periods.
Deferred license and cloud revenue on the balance sheet
Term license and cloud
Total deferred license and cloud revenue
License and cloud contractual commitments not on the balance sheet
Total license and cloud commitments
Total license (term and perpetual) and cloud backlog
Total term license and cloud backlog
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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 U.S. 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 the related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions, and expectations 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, 2016. For more information regarding our critical accounting policies, we encourage you to read the discussion contained in Item 7 under the heading “Critical Accounting Estimates and Significant Judgments” 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, 2016.
Results of Operations
Software license revenue
Total license revenue
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The mix between perpetual and term license arrangements executed in a particular period varies based on clients’ deployment preferences. A change in the mix may cause our revenues to vary materially from period to period. A higher proportion of term license arrangements executed will generally result in license revenue being recognized over longer periods. Additionally, some of our perpetual license arrangements include extended payment terms or additional rights of use, which may also result in the recognition of revenue over longer periods.
The decrease in perpetual license revenue in the three months ended September 30, 2017 was primarily due to a decrease in the average value of perpetual arrangements executed and a lower percentage of perpetual arrangements executed and recognized in revenue in the current period. The decrease in perpetual license revenue in the nine months ended September 30, 2017 was primarily due to a lower percentage of perpetual arrangements executed and recognized in revenue.
The decrease in term license revenue in the three months ended September 30, 2017 was primarily due to a large term license renewal for which the second year of the term was recognized as revenue in the three months ended September 30, 2016. If the second year of this term license arrangement was not paid in advance in the three months ended September 30, 2016, term license revenue would have decreased 2%. The increase in term license revenue in the nine months ended September 30, 2017 was primarily due to broad based growth amongst new and existing customers offset by a large term license arrangement which was prepaid and recognized in revenue in the three months ended March 31, 2016. If this term license arrangement was not prepaid and recognized in revenue in the three months ended March 31, 2016 term license revenue would have increased 26%.
The aggregate value of future revenue expected to be recognized during the remainder of the year under existing noncancellable perpetual arrangements not reflected in deferred revenue was $13.3 million as of September 30, 2017 compared to $3.9 million as of September 30, 2016.
The aggregate value of future revenue expected to be recognized during the remainder of the year under existing noncancellable term and cloud arrangements not reflected in deferred revenue was $37.7 million as of September 30, 2017 compared to $26.7 million as of September 30, 2016. For additional information see “Future Cash Receipts from Committed License and Cloud Arrangements” which can be found in “Liquidity and Capital Resources.”
Maintenance revenue
The increases were primarily due to the continued growth in the aggregate value of the installed base of our software and strong renewal rates significantly in excess of 90%.
Services revenue
Consulting services
Training
Total services
Consulting services revenue is primarily generated from new license implementations. Our consulting services revenue may fluctuate in future periods depending on the mix of new implementation projects we perform as compared to those performed by our enabled clients or led by our partners.
The increases in consulting services revenue were primarily due to higher billable hours during the three and nine months ended September 30, 2017 driven by a large project which began in the second half of 2016.
Cloud revenue represents revenue from our Pega Cloud offerings. The increases in cloud revenue were primarily due to continued growth of our cloud client base.
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Total gross profit
Software license gross profit %
Maintenance gross profit %
Services gross profit %
Total gross profit %
The decrease in total gross profit in the three months ended September 30, 2017 was primarily due to a shift in the mix of license arrangements executed from perpetual to term licenses and an increase in lower margin services revenue.
The increase in total gross profit in the nine months ended September 30, 2017 was primarily due to increased total revenue.
The increases in service gross profit percent in the three and nine months ended September 30, 2017 was driven by a large project which began in the second half of 2016 and several additional large projects for which costs were recognized in 2016 but whose associated revenue was not recognized until after September 30, 2016.
Operating expenses
As a percent of total revenue
Selling and marketing headcount, end of period
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 the three months ended September 30, 2017 was primarily due to an increase in compensation and benefits of $1.8 million, driven by increased headcount and equity compensation, partially offset by a decrease in sales commissions associated with the lower value of new license arrangements executed during the three months ended September 30, 2017.
The increase in the nine months ended September 30, 2017 was primarily due to an increase in compensation and benefits of $12.7 million, respectively, driven by increased headcount and equity compensation, and an increase in employee travel and entertainment, partially offset by a decrease in brand marketing program expenses of $2.2 million.
The increase in headcount reflects our efforts to increase our sales capacity to target new accounts in existing industries, as well as to expand coverage in new industries and geographies and to increase the number of sales opportunities.
Research and Development headcount, end of period
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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 design changes to existing products and integration of acquired technologies.
The increases in the three and nine months ended September 30, 2017 were primarily due to increases in compensation and benefits of $2.9 million and $12.6 million, respectively, attributable to increased headcount and equity compensation.
General and administrative headcount, end of period
General and administrative expenses include compensation, benefits, and other headcount-related expenses associated with finance, legal, corporate governance, and other administrative headcount. They also include accounting, legal, and other professional consulting and administrative fees. The general and administrative headcount includes employees in human resources, information technology, and corporate services departments, whose costs are partially allocated to other operating expense areas.
The increases in the three and nine months ended September 30, 2017 were primarily due to increases in compensation and benefits of $0.4 million and $4 million, respectively, attributable to increased headcount and equity compensation. The increase in the nine months ended September 30, 2017 was partially offset by a decrease of $1.5 million in legal fees.
Stock-based compensation
The increases were primarily due to the increased value of our annual periodic equity awards granted in March 2016 and 2017. These awards generally have a five-year vesting schedule.
Amortization of intangibles
The decreases in amortization of intangibles in the three and nine months ended September 30, 2017 were due to the amortization in full of certain intangibles acquired through past acquisitions.
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Non-operating (expense)/income, net
Other (expense)/income, net
n/m - not meaningful
In May 2017, we discontinued our forward contracts program; however, we will continue to evaluate periodically our foreign exchange exposures and may re-initiate this program if it is deemed necessary.
Historically, we have used foreign currency forward contracts (“forward contracts”) to hedge our exposure to fluctuations in foreign currency exchange rates associated with our foreign currency denominated cash, accounts receivable, and intercompany receivables and payables held primarily by the U.S. parent company and its United Kingdom (“U.K.”) subsidiary. See Note 4 “Derivative Instruments” of this Quarterly Report on Form 10-Q for additional information.
The total change in the fair value of our foreign currency forward contracts recorded in other income (expense), net, during the three months ended September 30, 2016 was a loss of $1.2 million. The total change in the fair value of our foreign currency forward contracts recorded in other (expense)/income, net, during the nine months ended September 30, 2017 and 2016 was a gain of $0.3 million and a loss of $5 million, respectively.
Effective income tax rate
The (benefit)/provision for income taxes represents current and future amounts for federal, state, and foreign taxes.
The increase in the effective income tax rate in the three months ended September 30, 2017 is primarily due to the significant increase of $3.5 million in excess tax benefits generated by our stock compensation plans on significantly lower income before (benefit)/provision for income taxes, which decreased by $20.2 million.
The decrease in the effective income tax rate in the nine months ended September 30, 2017 is primarily due to the significant increase of $19.1 million in excess tax benefits generated by our stock compensation plans, on significantly lower income before (benefit)/provision for income taxes, which decreased by $5.8 million.
The inclusion of excess tax benefits as a component of the provision for income taxes may increase volatility in the effective tax rates of future periods as the amount of excess tax benefits from share-based compensation awards varies depending on our future stock price in relation to the fair value of awards, the timing of RSU vesting and exercise behavior of our stock option holders, and the total value of future grants of share-based compensation awards.
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Liquidity and capital resources
Cash provided by (used in):
Operating activities
Investing activities
Financing activities
Effect of exchange rate on cash
We believe that our current cash, cash equivalents, marketable securities, 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.
As of September 30, 2017, approximately $61.1 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 may be required to pay upon repatriation due to the complexity of the foreign tax credit calculations. 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.
The primary drivers during the nine months ended September 30, 2017 were net income of $36.6 million and $80.6 million from trade accounts receivable, largely due to increased cash collections and the timing of billings.
The primary driver during the nine months ended September 30, 2016 was net income of $18.2 million.
Future Cash Receipts from Committed License and Cloud Arrangements
As of September 30, 2017, none of the amounts shown in the table below had been billed and no revenue had been recognized.
The below amounts for 2018 and subsequent periods may not be recognized in the periods shown below as a result of the adoption of the new revenue recognition standard (ASC 606). (See Note 2. New Accounting Pronouncements contained elsewhere in this Quarterly Report on Form 10-Q for additional information)
Total
Total contractual future cash receipts due from our existing license and cloud arrangements were approximately $376.3 million as of September 30, 2016.
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During the nine months ended September 30, 2017, we purchased $25.7 million of marketable debt securities and made investments of $9.1 million in property and equipment, partially offset by proceeds received from maturities of marketable debt securities (including called marketable debt securities) of $23.1 million.
During the nine months ended September 30, 2016, we acquired OpenSpan for $48.8 million, net of cash acquired, and invested $15.3 million primarily in internally developed software and leasehold improvements at our corporate headquarters, partially offset by proceeds received from the sales of marketable debt securities of $62.3 million.
We used cash primarily for repurchases of our common stock, share repurchases for tax withholdings for the net settlement of our equity awards, and the payment of our quarterly dividend.
Since 2004, our Board of Directors has approved annual stock repurchase programs that have authorized the repurchase in the aggregate of up to $195 million of our common stock. Purchases under these programs have been made on the open market.
The following table is a summary of our repurchase activity:
Authorizations
Repurchase for net settlement of tax under stock-based compensation
Repurchases paid under authorized share repurchase program
Repurchases unsettled
Activity in Period
In addition to the share repurchases made under our repurchase programs, we net settled the majority of our employee stock option exercises and RSU vestings, which resulted in the withholding of shares to cover the option exercise price and the minimum statutory tax withholding obligations.
During the nine months ended September 30, 2017 and 2016, option and RSU holders net settled a total of 2.4 million shares and 1.6 million shares, respectively, of which only 1.3 million shares and 0.8 million shares, respectively, were issued to the option and RSU holders. The balance of the shares were surrendered to us to pay for the exercise price with respect to options and the applicable taxes for both options and RSUs. During the nine months ended September 30, 2017 and 2016, instead of receiving cash from the equity holders, we withheld shares with a value of $23.7 million and $10.1 million, respectively, for the exercise price of options.
Dividends
Dividends Declared
Dividends Paid
It is our current intention to pay a quarterly cash dividend of $0.03 per share, however, the Board of Directors may terminate or modify this dividend program at any time without notice.
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Market risk represents the risk of loss that may affect us due to adverse changes in financial market prices and rates. Our market risk exposure is primarily related to fluctuations in foreign exchange rates.
As of September 30, 2017, we did not have any forward contracts outstanding. See Note 4 “Derivative Instruments” of this Quarterly Report on Form 10-Q for further discussion.
Other than the item discussed above, there were no significant changes to our quantitative and qualitative disclosures about market risk during the first nine months ended September 30, 2017. See Part II, Item 7A. Quantitative and Qualitative Disclosures about Market Risk included in our Annual Report on Form 10-K for the year ended December 31, 2016 for a more complete discussion of our market risk exposure.
(a) Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act) as of September 30, 2017. In designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and our management necessarily applied its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of September 30, 2017.
(b) Changes in Internal Control over Financial Reporting
There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act) during the quarter ended September 30, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
We encourage you to carefully consider the risk factors identified in Part I, Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2016. These risk factors could materially affect our business, financial condition, and future results and could cause our actual business and financial results to differ materially from those contained in forward-looking statements made in this Quarterly Report on Form10-Q or elsewhere by management from time to time. There have been no material changes during the nine months ended September 30, 2017 to the risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2016.
The following table sets forth information regarding our repurchases of our common stock during the three months ended September 30, 2017:
Period
July 1, 2017 - July 31, 2017
August 1, 2017 - August 31, 2017
September 1, 2017 - September 30, 2017
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The following exhibits are filed or furnished, as the case may be, as part of this report.
EXHIBIT INDEX
Exhibit No.
Description
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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