PEGA 10-Q Quarter ended June 30, 2017

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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, 2017

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  ☒    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-accelerated filer, 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 77,624,615 shares of the Registrant’s common stock, $.01 par value per share, outstanding on July 28, 2017.

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PEGASYSTEMS INC.

Index to Form 10-Q

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PEGASYSTEMS INC.

(in thousands)

See notes to unaudited condensed consolidated financial statements.

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PEGASYSTEMS INC.

(in thousands, except per share amounts)

See notes to unaudited condensed consolidated financial statements.

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PEGASYSTEMS INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(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. 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-use assets 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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PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

The Company is still in the process of quantifying the implications of the adoption of ASC 606. However the Company expects the following impacts:

3. MARKETABLE SECURITIES

The Company’s marketable securities are as follows:

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PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

As of June 30, 2017, the Company did not hold any investments with unrealized losses that are considered to be other-than-temporary.

As of June 30, 2017, remaining maturities of marketable debt securities ranged from July 2017 to September 2020, with a weighted-average remaining maturity of approximately 15 months.

4. DERIVATIVE INSTRUMENTS

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.

The Company is primarily exposed to foreign currency exchange rate fluctuations in the Euro relative to the U.S. dollar for the U.S. parent and in the U.S. dollar, the Euro, and the Australian dollar relative to the British pound for the Company’s U.K. subsidiary. The forward contracts are not designated as hedging instruments. As a result, the Company records the fair value of these contracts at the end of each reporting period in the accompanying unaudited condensed consolidated balance sheets 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 expense, net, in the accompanying unaudited condensed consolidated statements of operations. The cash flows related to these forward contracts are classified as operating activities in the accompanying unaudited condensed consolidated statements of cash flows. The Company does not enter into any forward contracts for trading or speculative purposes.

In May 2017, the Company discontinued its forward contracts program, however, it will continue to periodically evaluate its foreign exchange exposures and may re-initiate this program if it is deemed necessary. 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:

As of June 30, 2017, the Company did not have any forward contracts outstanding.

The Company had forward contracts outstanding with total notional values as of June 30, 2016 as follows:

The income statement impact of the Company’s outstanding forward contracts and foreign currency transactions was as follows:

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PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 six months ended June 30, 2017.

The Company’s assets and liabilities measured at fair value on a recurring basis consisted of the following:

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PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 six months ended June 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 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 are:

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

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PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

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

Future estimated amortization expense related to intangible assets as of June 30, 2017 is as follows:

8. ACCRUED EXPENSES

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PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

9. DEFERRED REVENUE

10. STOCK-BASED COMPENSATION

Stock-based compensation expense is reflected in the Company’s unaudited condensed consolidated statements of operations as follows:

During the six months ended June 30, 2017, the Company issued approximately 1,068,000 shares of common stock to its employees and 13,000 shares of common stock to its non-employee directors under the Company’s stock-based compensation plans.

During the six months ended June 30, 2017, the Company granted approximately 954,000 restricted stock units (“RSUs”) and 1,441,000 non-qualified stock options to its employees with total fair values of approximately $41.9 million and $19.2 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 June 30, 2017, the Company had approximately $64.7 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.

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PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

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.

The calculation of the Company’s basic and diluted earnings per share is as follows:

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.

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

The Company’s international revenue is from clients based outside of the U.S. The Company derived its revenue from the following geographic areas:

Major Clients

No client accounted for 10% or more of the Company’s total revenue during the three and six months ended June 30, 2017 or 2016.

No client accounted for 10% or more of the Company’s total outstanding trade receivables as of June 30, 2017 or December 31, 2016.

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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 existing 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; the ongoing consolidation in the financial services, insurance, healthcare, and communications markets; 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; foreign currency exchange rates; the financial impact of the Company’s past acquisitions and 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 Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2016. 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

To provide additional insight into how management evaluates our financial performance, we have used a number of performance metrics to supplement our selected financial metrics. These performance metrics are periodically revisited 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 (ASC 606 “Revenue from Contracts with Customers”) in the first quarter of 2018, we have started tracking the performance measure Annualized 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. Additional information about our future adoption of the new revenue standard and its impact can be found in Note 2. “New Accounting Pronouncements” contained elsewhere in this Quarterly Report on Form 10-Q.

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Selected Financial Metrics

Recurring Revenue

A measure of the predictability and repeatability of our revenue.

The increase in recurring revenue was primarily driven by increased term license revenue recognized from term backlog and a large term license renewal for which the first year of the term was prepaid and recognized as revenue in the three months ended June 30, 2017. The increase in term revenue would have been greater if not for a large term deal greater than $10 million for which the license fee for the full license term was recognized in the first quarter of 2016.

License and Cloud Backlog

A measure of the continued growth of our business as a result of future contractual commitments by our clients.

It is computed by adding deferred license and cloud revenue recorded on the balance sheet (See Note 9 “Deferred Revenue”) and client license and cloud contractual commitments, which are not recorded on our balance sheet because we have not yet invoiced our clients, nor have we recognized the associated revenues (See “Future Cash Receipts from Committed License and Cloud Arrangements” which can be found in “Liquidity and Capital Resources” contained elsewhere in this Quarterly Report on Form 10-Q for additional information). 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.

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Annualized 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: