PEGA 10-Q Quarter ended June 30, 2018

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2018

OR

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 78,645,411 shares of the Registrant’s common stock, $0.01 par value per share, outstanding on August 1, 2018.

Table of Contents

PEGASYSTEMS INC.

QUARTERLY REPORT ON FORM 10-Q

TABLE OF CONTENTS

2

Table of Contents

PEGASYSTEMS INC.

(in thousands)

See notes to unaudited condensed consolidated financial statements.

3

Table of Contents

PEGASYSTEMS INC.

(in thousands, except per share amounts)

See notes to unaudited condensed consolidated financial statements.

4

Table of Contents

PEGASYSTEMS INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS)/INCOME ⁽¹⁾

(in thousands)

See notes to unaudited condensed consolidated financial statements.

5

Table of Contents

PEGASYSTEMS INC.

(in thousands)

See notes to unaudited condensed consolidated financial statements.

6

Table of Contents

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, 2017.

On January 1, 2018 the Company adopted Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers (Topic 606)” using the full retrospective method which required each prior reporting period presented be adjusted to reflect the application of this ASU. See Note 2. “New Accounting Pronouncements” for additional information.

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 2018.

2. NEW ACCOUNTING PRONOUNCEMENTS

Financial Instruments

In June 2016, the Financial Accounting Standards Board (“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 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.

ASC 606 and ASC 340-40

On January 1, 2018 the Company adopted the ASC 606 revenue recognition standard and has adjusted prior periods to conform.

The most significant impacts of adopting ASC 606 and ASC 340-40 were as follows:

7

Table of Contents

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

For additional information on the Company’s accounting policies as a result of the adoption of ASC 606 and ASC 340-40 see Note 4. “Receivables, Contract Assets, and Deferred Revenue”, Note 5. “Deferred Contract Costs”, and Note 9. “Revenue”.

The impact of the adoption ASC 606 and ASC 340-40 on the Company’s unaudited condensed consolidated balance sheet and unaudited condensed consolidated statement of operations is:

8

Table of Contents

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Adoption of ASC 606 and ASC 340-40 had no impact on total cash from or used in operating, financing, or investing activities in the Company’s unaudited condensed consolidated statements of cash flows for the six months ended June 30, 2017.

3. MARKETABLE SECURITIES

9

Table of Contents

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

As of June 30, 2018, the Company did not hold any investments with unrealized losses that are considered to be other-than-temporary.

As of June 30, 2018, remaining maturities of marketable securities ranged from July 2018 to August 2021, with a weighted-average remaining maturity of approximately 1.5 years.

4. RECEIVABLES, CONTRACT ASSETS, AND DEFERRED REVENUE

Receivables

Unbilled receivables is the amount due from clients where the only condition on the right of payment is the passage of time. The Company regularly assesses receivables for collectability. As of June 30, 2018 and December 31, 2017, the allowance for doubtful accounts was not material.

Unbilled receivables are expected to be billed in the future as follows:

Contract assets and deferred revenue

⁽¹⁾ Included in other current assets in the unaudited condensed consolidated balance sheets.

⁽²⁾ Included in other long-term assets in the unaudited condensed consolidated balance sheets.

⁽³⁾ Included in other long-term liabilities in the unaudited condensed consolidated balance sheets.

Contract assets and deferred revenue are presented net at the contract level for each reporting period. Contract assets are amounts under client contracts where revenue recognized exceeds the amount billed to the client and the right to payment is subject to conditions other than the passage of time, such as the completion of a related performance obligation. Deferred revenue consists of billings and payments received in advance of revenue recognition.

10

Table of Contents

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

The change in deferred revenue in the six months ended June 30, 2018, was primarily due to new billings in advance of revenue recognition and $168.2 million of revenue recognized, excluding the impact of the netting of contract assets and deferred revenue, during the period that was included in deferred revenue at December 31, 2017.

Major clients

No client represented 10% or more of the Company’s total receivables as of June 30, 2018 or December 31, 2017.

5. DEFERRED CONTRACT COSTS

Sales incentives paid by the Company are considered incremental and recoverable costs of obtaining a contract with a client. These costs are deferred, as a long-term asset, and then amortized using the straight-line method over the period of benefit which is on average five years. The Company determined the period of benefit by taking into consideration client contracts, the Company’s technology, and other factors. The Company utilizes a practical expedient available under ASC 606 to expense costs to obtain a contract as incurred when the original amortization period is one year or less.

⁽¹⁾ Included in other long-term assets in the unaudited condensed consolidated balance sheets.

Amortization of deferred contract costs was as follows:

⁽¹⁾ Included in selling and marketing expenses in the unaudited condensed consolidated statement of operations.

During the six months ended June 30, 2018 and 2017, impairment of deferred contract costs was not material.

6. GOODWILL AND OTHER INTANGIBLE ASSETS

The change in the carrying amount of goodwill was as follows:

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

⁽¹⁾ Included in other long-term assets in the unaudited condensed consolidated balance sheets.

11

Table of Contents

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

⁽¹⁾ Included in other long-term assets in the unaudited condensed consolidated balance sheets.

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

7. ACCRUED EXPENSES

8. FAIR VALUE MEASUREMENTS

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The Company records its cash equivalents, marketable securities, and investments in privately-held companies 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:

The Company’s cash equivalents are composed of money market funds and time deposits which are classified as Level 1 and Level 2, respectively, in the fair value hierarchy. The Company’s marketable securities, which are 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 investments in privately-held companies are classified within Level 3 of the fair value hierarchy and are valued using model-based techniques, including option pricing models and discounted cash flow models.

12

Table of Contents

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 levels during the six months ended June 30, 2018.

The Company’s assets and liabilities measured at fair value on a recurring basis were as follows:

⁽¹⁾ Included in other long-term assets in the unaudited condensed consolidated balance sheets.

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, including property and equipment and intangible assets, are recognized at fair value when they are impaired. During the six months ended June 30, 2018 and 2017, the Company did not recognize any impairments of its assets recorded at fair value on a nonrecurring basis.

9. REVENUE

Revenue policy

The Company’s revenue is primarily derived from:

Contracts with multiple performance obligations

The Company’s license and cloud arrangements often contain multiple performance obligations, including maintenance, consulting, and training. For contracts with multiple performance obligations, the Company accounts for individual performance obligations separately if they are distinct. The transaction price is allocated to the separate performance obligations on a relative stand-alone selling price basis. If the transaction price contains discounts or the Company expects to provide a future price concession, these elements are considered when determining the transaction price prior to allocation. Variable fees within the transaction price are estimated and recognized in revenue as the Company satisfies each performance obligation to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable fee is resolved. If the contract grants the client the option to acquire additional products or services, the Company assesses whether or not any discount on the included products and services is in excess of levels normally available to similar clients and, if so, accounts for that discount as an additional performance obligation.

13

Table of Contents

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Software licenses

The Company has concluded that its software licenses are distinct performance obligations as the client can benefit from the software on its own. Software license revenue is typically recognized at a point in time when control is transferred to the client, which is defined as the point in time when the client can use and benefit from the license. The software license is delivered before related services are provided and is functional without services, updates, and technical support. Stand-alone selling price for software licenses is determined using the residual approach. The Company utilizes the residual approach as license performance obligations are sold for a broad range of amounts (the selling price is highly variable) and a stand-alone selling price is not discernible from past transactions or other observable evidence. Periodically, the Company evaluates whether the residual approach is appropriate for its license and cloud performance obligations when sold with other performance obligations. As a result, if the standalone selling price analysis illustrates that the license and cloud performance obligations are no longer highly variable, the Company will utilize the relative allocation method for such arrangements.

Term license fees are usually payable in advance on a monthly, quarterly, or annual basis over the term of the license agreement, which is typically three to five years and may be renewed for additional terms at the client’s option. Perpetual license fees are usually payable when the contract is executed.

Maintenance

Software maintenance contracts entitle clients to receive technical support and software updates, on a when and if available basis, during the term of the maintenance contract. Technical support and software updates are considered distinct services but accounted for as a single performance obligation as they each constitute a series of distinct services that are substantially the same and have the same pattern of transfer to the client. Software maintenance revenue is recognized over time on a straight-line basis over the contract period. Maintenance fees are usually payable in advance on a monthly, quarterly, or annual basis over the term of the agreement.

Each of the performance obligations included in maintenance are priced as a percentage of the selling price of the related software license, which is highly variable. The Company determined the standalone selling price of each performance obligation included in maintenance based on this pricing relationship, which has remained constant within a narrow range, and observable data from standalone sales of maintenance, along with all other observable data.

Services

The Company’s services revenue is comprised of consulting and training, including software license implementations, training, reimbursable expenses, and cloud which is derived from sales of the Company’s hosted Pega Platform and software application environments. The Company has concluded that most services are distinct performance obligations. Consulting may be provided on a stand-alone basis or bundled with license and software maintenance services.

The stand-alone selling price for consulting in time and materials contracts is determined by observable prices in similar transactions without multiple performance obligations and recognized as revenue as the services are performed. Fees for time and materials consulting contracts are usually payable shortly after the service is provided.

The Company estimates the stand-alone selling price for fixed price services based on the estimated hours versus actual hours in similar geographies and for similar contract sizes. Revenue for fixed price services is recognized over time as the services are provided. Fees for fixed price services consulting contracts are usually payable as contract milestones are achieved.

The stand-alone selling price of cloud sales of production environments is determined based on the residual approach when sold with services and is recognized over the term of the service. The Company utilizes the residual approach as cloud performance obligations are sold for a broad range of amounts (the selling price is highly variable) and a stand-alone selling price is not discernible from past transactions or other observable evidence. The stand-alone selling price for cloud sales of development and testing environments is developed using observable prices in similar transactions without multiple performance obligations and is recognized over time over the term of the service. Cloud fees are usually payable in advance on a monthly, quarterly, or annual basis over the term of the service.

Contract modifications

The Company sometimes enters into amendments to previously executed contracts which constitute contract modifications. The Company assesses each of these contract modifications to determine:

14

Table of Contents

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

A contract modification meeting both criteria is accounted for as a separate contract. A contract modification not meeting both criteria is considered a change to the original contract and is accounted for on either:

Geographic revenue

Major products and services

During the six months ended June 30, 2018 and 2017, there were no material changes in the Company’s estimate of variable fees.

Committed not yet recognized revenue

Committed not recognized revenue represents contracted revenue that has not yet been recognized in revenue. Committed not recognized revenue is expected to be recognized in the future as follows:

For reporting periods prior to January 1, 2018, the date of initial adoption of ASC 606, the Company has elected the practical expedient and not compiled and disclosed the amount of the transaction price allocated to the remaining performance obligations.

15

Table of Contents

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Major clients

Clients accounting for 10% or more of the Company’s total revenue were as follows:

*Client accounted for less than 10% of total revenue.

10. STOCK-BASED COMPENSATION

Expense