PEGA 10-Q Quarter ended June 30, 2014

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2014

or

For the transition period from to

Commission File Number: 1-11859

PEGASYSTEMS INC.

(Exact name of Registrant as specified in its charter)

(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 x 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 x No ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 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 x

There were 76,308,501 shares of the Registrant’s common stock, $.01 par value per share, outstanding on July 25, 2014.

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PEGASYSTEMS INC.

Index to Form 10-Q

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PEGASYSTEMS INC.

(in thousands)

(1) The number of common shares outstanding for all prior periods has been retroactively restated to reflect the Company’s two-for-one common stock split effected in the form of a common stock dividend distributed on April 1, 2014

See notes to unaudited condensed consolidated financial statements.

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PEGASYSTEMS INC.

(in thousands, except per share amounts)

(1) The number of common shares and per share amounts have been retroactively restated for all prior periods presented to reflect the Company’s two-for-one common stock split effected in the form of a common stock dividend distributed on April 1, 2014.

See notes to unaudited condensed consolidated financial statements.

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PEGASYSTEMS INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

See notes to unaudited condensed consolidated financial statements.

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PEGASYSTEMS INC.

(in thousands)

See notes to unaudited condensed consolidated financial statements.

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PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.    ACCOUNTING POLICIES

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, 2013.

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 2014.

On March 6, 2014, the Company’s Board of Directors approved a two-for-one stock split of the Company’s common stock, effected in the form of a stock dividend. On April 1, 2014, each stockholder of record at the close of business on March 20, 2014 (the “Record Date”) received as a dividend, one additional share of common stock, par value $.01, for each share of common stock held on the Record Date. All shares of common stock and per share amounts in the Company’s unaudited condensed consolidated financial statements and in the accompanying notes for all periods presented have been restated to reflect the stock split, except for the number of authorized shares of common stock.

At the Company’s 2014 Annual Meeting of Stockholders, held on May 20, 2014, the stockholders approved an amendment to the Company’s Restated Articles of Organization increasing the number of authorized shares of common stock from 100,000,000 to 200,000,000.

On May 27, 2014, the Company announced an increase in its quarterly cash dividend from $0.015 to $0.03 per share. As a result, it is the Company’s 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.

During the second quarter of 2014, the Company recorded $3.5 million in adjustments to the purchase price allocation of its acquisition of Antenna Software, Inc. (together with its subsidiaries, “Antenna”) on October 9, 2013. As required by applicable business combination accounting rules, these adjustments were applied retrospectively. Therefore, short-term and long-term deferred income tax assets, goodwill, accrued expenses, and income taxes payable have been revised as of December 31, 2013 to reflect these adjustments. These revisions did not have any impact on the Company’s previously reported results of operations or cash flows. See Note 7 “Acquisitions” and Note 8 “Goodwill and Other Intangible Assets” for further discussion of these adjustments.

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2.    NEW ACCOUNTING PRONOUNCEMENTS

Revenue from Contracts with Customers: In May 2014, the Financial Accounting Standard Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers (Topic 606)”. This ASU amends the guidance for revenue recognition to replace numerous, industry-specific requirements and converges areas under this topic with those of the International Financial Reporting Standards. This ASU implements a five-step process for customer contract revenue recognition that focuses on transfer of control, as opposed to transfer of risk and rewards. This ASU also requires enhanced disclosures regarding the nature, amount, timing and uncertainty of revenues and cash flows from contracts with customers. Other major provisions include ensuring the time value of money is considered in the transaction price, and allowing estimates of variable consideration to be recognized before contingencies are resolved in certain circumstances. The amendments in this ASU are effective for reporting periods beginning after December 15, 2016, and early adoption is not permitted. Entities can transition to the standard either retrospectively or as a cumulative-effect adjustment as of the date of adoption. This ASU will be effective for the Company January 1, 2017. Management is currently assessing the impact the adoption of this ASU will have on the Company’s consolidated financial statements.

3. MARKETABLE SECURITIES

The Company considers debt securities with maturities of three months or less from the purchase date to be cash equivalents. Interest is recorded when earned. All of the Company’s investments are classified as available-for-sale and are carried at fair value with unrealized gains and losses recorded as a component of accumulated other comprehensive income, net of related income taxes.

As of June 30, 2014, remaining maturities of marketable debt securities ranged from July 2014 to July 2016, with a weighted-average remaining maturity of approximately 13 months.

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4.    DERIVATIVE INSTRUMENTS

The Company has historically used foreign currency forward contracts (“forward contracts”) to manage its exposure to changes in foreign currency denominated accounts receivable, intercompany payables and cash primarily held by the U.S. operating company. The Company has been primarily exposed to the fluctuation in the British pound and Euro relative to the U.S. dollar. More recently, the Company has experienced increased levels of exposure to the Australian dollar and Indian rupee.

The forward contracts utilized by the Company are not designated as hedging instruments and as a result, the Company records the fair value of these contracts at the end of each reporting period in its consolidated balance sheet as other current assets for unrealized gains and accrued expenses for unrealized losses, with any fluctuations in the value of these contracts recognized in other income (expense), net, in its consolidated statement of operations. These forward contracts have terms of 90 days or less.

As of June 30, 2014 and December 31, 2013, the Company did not have any forward contracts outstanding.

During the second quarter of 2014, the Company did not enter into any forward contracts. The Company is in the process of reassessing its hedging strategy.

During the first six months of 2014 and 2013, the Company entered into forward contracts with notional values as follows:

During the first six months of 2014 and 2013, the total change in the fair value of the Company’s forward contracts recorded in other income (expense), net, was as follows:

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5.    FAIR VALUE MEASUREMENTS

Assets Measured 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 observable inputs that are observable either directly or indirectly; and (Level 3) significant unobservable inputs in which there is little or no market data, which requires 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. On a recurring basis, the Company records its marketable securities at fair value.

The Company’s investments are all classified within Level 1 and Level 2 of the fair value hierarchy. The Company’s investments classified within Level 1 of the fair value hierarchy are valued using quoted market prices. The Company’s investments classified within Level 2 of the fair value hierarchy are valued based on matrix pricing compiled by third party pricing vendors, using observable market inputs such as interest rates, yield curves, and credit risk.

The fair value hierarchy of the Company’s cash equivalents and marketable securities at fair value is as follows:

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 first six months of 2014 and 2013, the Company did not recognize any impairments on its assets measured at fair value on a nonrecurring basis.

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6.    TRADE ACCOUNTS RECEIVABLE, NET OF ALLOWANCE

Unbilled trade accounts receivable relate to services revenue earned under time and material arrangements, and maintenance and license arrangements that had not been invoiced as of June 30, 2014 and December 31, 2013, respectively.

7.    ACQUISITIONS

MeshLabs

On April 28, 2014, the Company acquired MeshLabs Software Private Limited (“MeshLabs”), a provider of advanced text analytics and social engagement solutions based in Bangalore, India, for $0.8 million in cash consideration.

Antenna

On October 9, 2013, the Company acquired Antenna, a leading provider of mobile application development platforms. The Company acquired all of the outstanding capital stock of Antenna in a cash merger for $27.1 million, including the final working capital adjustment to the purchase price, which was paid by the Company in the first quarter of 2014. The total purchase price of $27.1 million included $4.2 million, which was deposited in escrow to secure the selling stockholders’ indemnification obligations to the Company. Under the merger agreement, this amount may be due to the former shareholders of Antenna in or before April 2015 less any amounts presented and approved for payment against the escrow. During the second quarter and first six months of 2014, the Company incurred and recorded direct and incremental expenses associated with the transaction of $0.1 million and $0.3 million, respectively, which were primarily professional fees.

The operations of Antenna are included in the Company’s operating results from the date of acquisition. For the three and six months ended June 30, 2014, revenue of approximately $4.1 million and $8.7 million, respectively, and a net loss of approximately $2.8 million and $5.2 million, respectively, was attributable to Antenna and included in the Company’s unaudited condensed consolidated statements of operations. Due to the rapid integration of the products, sales force, and operations of Antenna, other than the maintenance and hosting revenue attributable to the recognition of the fair value of acquired deferred maintenance and hosting revenue, it may not be feasible for the Company to identify revenue from new arrangements solely attributable to Antenna.

The Company is in the process of investigating the facts and circumstances existing as of the acquisition date in order to finalize the allocation of the purchase price to the fair value of assets acquired and liabilities assumed and establish the related tax basis. In the first quarter of 2014, the Company paid $0.8 million of the remaining merger consideration related to the final working capital adjustment, resulting in a $0.6 million purchase price adjustment to goodwill. In the second quarter of 2014, the Company recorded a $3.5 million purchase price adjustment related to taxes. These purchase price adjustments are also reflected retrospectively as of December 31, 2013 in the accompanying unaudited condensed consolidated balance sheet. The Company expects to finalize remaining purchase accounting adjustments during the third quarter of 2014.

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As of June 30, 2014, as a result of the preliminary purchase price allocation, the Company recognized $19.9 million of goodwill, which is primarily due to the expected synergies of the combined entities and the workforce in place. The goodwill created by the transaction is nondeductible for tax purposes. The Company recorded $36.9 million of deferred tax assets, a $24.2 million valuation allowance related to the Company’s preliminary determination it will not be able to utilize all of the acquired Antenna federal and foreign net operating losses due to various limitations and restrictions, and a $6.8 million deferred tax liability associated with the acquired intangibles, for a net deferred tax asset of $5.9 million. A summary of the preliminary purchase price allocation for the acquisition of Antenna is as follows:

The valuation of the assumed deferred revenue was based on the Company’s contractual commitment to provide post-contract customer support to Antenna clients and future contractual performance obligations under existing hosting arrangements. The fair value of this assumed liability was based on the estimated cost plus a reasonable margin to fulfill these service obligations. The majority of the deferred revenue will be recognized in the 12 months following the acquisition.

The valuation of the acquired intangible assets is inherently subjective and relies on significant unobservable inputs. The Company used an income approach to value the acquired customer related, technology and trade name intangible assets. The non-compete assets were valued using the with-and-without method, a form of the income approach which considers the cash flow differentials under multiple scenarios with or without key executives. The valuation for each of these intangible assets was based on estimated projections of expected cash flows to be generated by the assets, discounted to the present value at discount rates commensurate with perceived risk. The valuation assumptions take into consideration the Company’s estimates of contract renewal, technology attrition and revenue growth projections.

The estimated fair values for specifically identifiable intangible assets acquired, by major asset class, are as follows:

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Pro forma Information

The following pro forma financial information presents the combined results of operations of the Company and Antenna as if the acquisition had occurred on January 1, 2012 after giving effect to certain pro forma adjustments. The pro forma adjustments reflected herein include only those adjustments that are directly attributable to the Antenna acquisition, factually supportable, and expected to have a continuing impact on the Company. These pro forma adjustments include a net increase in amortization expense to eliminate historical amortization of Antenna intangible assets and to record amortization expense for the $10.4 million of acquired identifiable intangibles, a decrease in interest income as a result of the cash paid for the acquisition, and a decrease in interest expense as a result of the repayment of all Antenna outstanding debt in connection with the acquisition. The pro forma financial information does not reflect any adjustments for anticipated synergies resulting from the acquisition and is not necessarily indicative of the operating results that would have actually occurred had the transaction been consummated on January 1, 2012.

8.    GOODWILL AND OTHER INTANGIBLE ASSETS

The following table presents the changes in the carrying amount of goodwill:

(1) The purchase price adjustments identified during the first six months of 2014 have been retroactively applied as of December 31, 2013.

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Intangible assets are recorded at cost and are amortized using the straight-line method over their estimated useful lives.

Amortization of intangibles was reflected in the Company’s unaudited condensed consolidated statements of operations as follows:

Amortization of intangibles is estimated to be recorded over their remaining useful lives as follows:

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9.    ACCRUED EXPENSES

10.    DEFERRED REVENUE

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11.    ACCRUED RESTRUCTURING COSTS

During the fourth quarter of 2013, in connection with the Company’s evaluation of its combined facilities with Antenna, the Company approved a plan to eliminate space within one facility. The Company ceased use of this space during the fourth quarter of 2013 and recognized $1.7 million of restructuring expenses, representing future lease payments and demising costs, net of estimated sublease income for this space. The lease expires in 2021.

A summary of the restructuring activity is as follows:

12.    STOCK-BASED COMPENSATION

For the second quarter and first six months of 2014 and 2013, stock-based compensation expense was reflected in the Company’s unaudited condensed consolidated statements of operations as follows:

On April 1, 2014, the Company effected a two-for-one stock split of the Company’s common stock in the form of a stock dividend. All shares of common stock and per share amounts in the Company’s unaudited condensed consolidated financial statements and in the accompanying notes for all prior periods presented have been restated to reflect the stock split, except for the number of authorized shares of common stock. See Note 1 “Accounting Policies” for further discussion.

During the first six months of 2014, the Company issued approximately 422,000 shares to its employees and 22,000 shares to its non-employee directors under the Company’s share-based compensation plans.

During the first six months of 2014, the Company granted approximately 1,049,000 restricted stock units (“RSUs”) and 1,070,000 non-qualified stock options to its employees with total fair values of approximately $20.7 million and $8.2 million, respectively. Approximately 100,000 RSUs were issued in connection with the election by employees to receive 50% of their 2014 target incentive compensation under the Company’s Corporate Incentive Compensation Plan (the “CICP”) in the form of RSUs instead of cash. Stock-based compensation of approximately $2 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, while treating each vesting tranche as if it were an individual grant. As of June 30, 2014, the Company had approximately $25.6 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 2.2 years.

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13.    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, RSUs, and warrants, using the treasury stock method and the average market price of the Company’s common stock during the applicable period. 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 antidilutive in the periods presented, but could be dilutive in the future.