Pegasystems [PEGA] Conference call transcript for 2023 q3
2023-10-26 15:18:02
Fiscal: 2023 q3
Operator: Greetings, and welcome to the Pegasystems Third Quarter 2023 Earnings Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Peter Welburn, Vice President, Corporate Development and IR for Pegasystems. Please go ahead.
Peter Welburn: Thank you, Priscilla, and good morning, everyone, and welcome to Pegasystems Q3 2023 Earnings Call. Before we begin, I would like to read our safe harbor statement. Certain statements contained in this presentation may be construed as forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. The words expects, anticipates, intends, plans, believes, will, could, should, estimates, may, forecasts and guidance, or variations of such words and other similar expressions identify forward-looking statements, which speak only as of the date the statement was made and are based on current expectations and assumptions. Because such statements deal with future events, they are subject to various risks and uncertainties, actual results for fiscal 2023 and beyond could differ materially from the company's current expectations. Our press release announcing our Q3 2023 earnings and our SEC filings, including our most recent annual report, describe factors that could impact our results and cause them to materially differ from those expressed in forward-looking statements. Investors should not place undue reliance on forward-looking statements, matters contained forward-looking statements may not occur. Later events, new information or other factors may cause our views to change, but we will not publicly update or revise forward-looking statements unless required by law to do so. And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.
Alan Trefler: Thank you, Peter, and to everyone who's joined today's call. It's great to see us improve performance in an uncertain macroeconomic environment. Now more than ever, we are focused on running a business that balances growth and free cash flow. And it's especially good to see record cash flow as we come out of our subscription transition, and we're just getting started. Ken will go into more detail on our financial results in a moment. As I mentioned last quarter, we've been finding additional ways to engage effectively and efficiently with our clients. The transformation of our go-to-market model is delivering on our goal of deepening client relationships. This helps drive more meaningful engagement across multiple teams as those relationships strengthen. And I was excited to spend most of Q3 on the road, meeting with clients, prospects and partners globally. Coming off the tremendous momentum from PegaWorld and the launch of Infinity '23, it was terrific to spend this direct time with these constituencies. And we recently had around the world trip, and it was good to see folks I have not had a chance to see at PegaWorld. I met face-to-face with over 100 clients and partners and had terrific conversations across the board, across the U.S. with Amazon, Bank of America, UnitedHealth Group, and even to India with Verizon where they, like many of our clients, are establishing global competency centers, and we're having a chance to engage our Indian team directly with them. Going down to APAC with ANZ Bank, National Australia Bank, multiple government agencies across APJ, and in London with HSBC, Lloyds and Vodafone. As well as with the thousands of our partners around the world, including Accenture, Capgemini, Cognizant, EY and Infosys. So what I'll tell you also is our U.S. briefing center, continues to be extremely busy this year. We've had hundreds of meetings with clients like ING, Mondelez, Navy Federal Union and Scotiabank with their staff have really come in to deal with deep dive on topics ranging from Pega Strategy to Pega Cloud. We have many more plans for Q4. And in Q3, we kicked off a series of account-based marketing client events, to continue the momentum of PegaWorld with 75 regional and clients specifically as planned, and we're going to have even more before the end of the year. I'm really enjoying being back on the road in a significant way. And I'm terrifically excited about the level of engagement and dialogue we're having. And even though you can accomplish a lot remotely, meeting in-person provides a different type of opportunity to dig in and understand what's top of mind for our clients. Now, as I've done this, I have had a chance to really hear firsthand what the client interest and questions are about what Pega can do and does Pega have a unique advantage in this product environment. And what I'll tell you is that AI, no surprise, has become central to nearly every client conversation. And their questions are following into a few categories. First, what should their AI strategy be? And where does Pega fit? Second, how can they protect and govern their proprietary customer data? And third, how can they address the risks associated with GenAI, [indiscernible] hallucinations where the AI provides a response not backed up by data or best process. And this -- these places are where Pega technology experience gives us a unique competitive advantage in my view. Let me elaborate. First, in terms of strategy. We have decades of hands-on experience helping clients leverage AI, and we can use it to help them with their strategy. We have terrific insights into the most successful early use cases for GenAI, and those we believe will deliver the highest return on investment. And we're showing them to our clients and getting tremendous, tremendous positive feedback. One of the best things that actually any of you to try is this interactive demo on pega.com that shows how we have linked generative AI into the core thinking of how Pega workflow should work, and how it's going to help you create all the necessary elements using the knowledge of the Internet to be able to bring best practices into a business. You'll see within seconds, the workflows, the users, the data model and the other key elements identified. We launched it when Pega Infinity went live in mid-September. And in the first month, thousands of people from around the world accessed the demo and did over 6,000 workflow generations, from employee onboarding to a cricket score board generator. Now I would suggest that anybody interested in understanding how this can be done really practically, I would go find it try it free. It's on pega.com, just go to the site, either take the interactive tour that we have or just search for GenAI and check out the interactive demo, which is what I've just been talking about. Try building an app for your current firm or a business that you've been thinking about starting when you retire. And I think you'll be -- you'll share the excitement of how Pega is in a position to really bring this technology home in a very unique way. We had a lot of fun, and a lot of clients have gotten very jazz and interested in this. You can even try it on your mobile phone, and you can be building these sorts of things right from your mobile phone, and it's also quite a good demo there. So when customers see what we're able to do, see what we're shipping in Infinity '23, we get a very positive reaction in terms of how we can add powerful and pragmatic capabilities to their businesses. Now in terms of where Pega fits into their strategy, you need to remember that while most companies continue to think about GenAI as a cogenerator, Pega is core is based on the concept of a business model that brings a structure and system that could evolve as the client needs and the industry needs and the customer needs to evolve. Instead of code with our GenAI, we generate business launching into a model that organizes the business objectives and lets the AI be understood, let it be reviewed, adjusted, curated and approved. And the center of this is what you've heard me refer to as our unique situation layer cake. This is something that organizes the way a business runs into layers, with some elements operating across the business as a whole, some on the division, some perhaps in the department and some for different customer segments or different regions and geographies. This unique structure organizes all the enterprise assets, the processes, the rules, the data models and UI into these layers, which are designed for BUs. There are the perfect architecture for using GenAI with. And it's what gives Pega a unique, and I believe standing advantage because you'll plug GenAI in when the rules and workflows are defined and there'll be able to complement what already exists, they'll be able to let you change pieces of your business or workflow at a time, and they provide, I think, a power that's very, very different than a lot of the hype that's out there, because users are looking at our model versus looking at code. They can actually collaborate it, the business users of transparency working with IT. It provides that vehicle for governance when changes are introduced and makes them all manageable. So in short, it takes the output from the AI and organizes it in a way that really helps businesses build for change. And it's proprietary to Pega. I don't think it can be readily copied or reproduced, and we don't see anybody else taking this approach. We really feel good about what this means for us. So we've also created about 20 GenAI boosters with Pega Infinity that makes the GenAI practical, that makes it all real. And you can also see those described at pega.com. Now secondly, relative to data, we will be able to help clients protect and govern customer data through the powerful capabilities in our software. Pega's audit trail capabilities, which have been described as the best in the industry, are robust and comprehensive. And third, we addressed GenAI risks by leveraging a platform which is designed to help customers deploy all of their processes and their AI effectively and responsibly. [indiscernible] can see what's happening and help identify where AI is working in their models, and help them understand when the AI is doing something that makes sense and when it's generating nonsense. Our robot capabilities also help clients confirm that the data that powers AI decisioning is unbiased and comprehensive using our unique ethical bias check, which helps identify and eliminate biases hidden in the AI, are flagging possible discriminatory offers and messages generated by AI before they reach the customer. This unique capability helps clients pinpoint any offending elements and adjust the algorithms to ensure fair outcomes. Now the client response we're having to this is very, very exciting and inspiring. And it's wonderful to see our clients now beginning to work on this and taking it very, very much apart. I think as we move into 2024, we're going to complement what we've already released here in '23 with a great new pipeline of features that are going to very, very aggressively continue to extend the power of these game-changing capabilities but also leveraging our unique architecture. Before I wrap up, I also want to provide a quick update on Pega Launchpad, our new cloud-based low-code application development platform for building business-to-business SaaS applications that we announced last year. It's a gorgeous piece of software, and the team has done a tremendous job in staying focused and supporting our early adopters, and we now have our first handful of Launchpad clients. We're really excited to ramp this business up in 2024 and beyond. So in summary, we continue to improve our performance. And as we come out as a subscription transition, we see the cash improving despite the uncertain macro environment. The transformation of our go-to-market model is improving our sales efficiency and our engagement, focusing on really deepening the critical relationships that drive our business. And our unique technology architecture is a competitive advantage that lends itself to really leverage GenAI in a way that I don't see our competitors easily replicating it, is going to be a big and long-lasting distinction. So we continue to make good progress. We continue to make good progress in becoming a Rule of 40 company, balancing growth with fiscal discipline and to provide more color on the financial results. Let me now turn it over to our COO and CFO, Ken Stillwell. Ken?
Kenneth Stillwell: Thanks, Alan. Through the first 3 quarters of 2023, we've made meaningful progress improving our cash flow while maintaining double-digit ACV growth. We're managing the company with a Rule of 40 mindset, the principal in a well-run firm's growth rate and free cash flow margin should meet or exceed 40%. I've got some exciting news to share later on the call regarding our free cash flow. Now I'm going to start this morning with the most important metric to measure the success of our business. Growth in annual contract value, or ACV. This year, we've experienced a macroeconomic environment that's not noticeably worse than last year, but it's certainly not much better. Our clients are still buying, but they're scrutinizing things more closely. Sales cycles are a little longer than they've been for the last few years. Despite that, our sales team delivered a good Q3 with significant contributions from EMEA and from our financial services clients. Through the first 3 quarters of 2023, total contract value, TCV, bookings increased by about 20% year-over-year. And I think that's just an important measure to complement our ACV and backlog performance. Given the strong level of activity we experienced in Q3, our new go-to-market strategy is clearly leading to deeper engagement with our clients. As a result, ACV grew 12% year-over-year with currency helping our growth by around 2%. We like numerous other companies received an SEC comment letter related to standardizing our free cash flow measures. As you know, the more traditional way to calculate free cash flow is to take cash flow from operations and subtract capital expenditures. So going forward, this is the approach we will use. Going forward, we're not adding back onetime cash items such as restructuring charges to calculate and adjust free cash flow. However, we will continue disclosing in our earnings release cash items that we believe are not representative of our ongoing operating performance. As we enter 2024, we do not anticipate onetime cash items being a big part or a big item of interest for investors. Over the first 3 quarters of 2023, Pega generated $138 million of cash flow from operations and $124 million of free cash flow. In Q3 alone, we added $24 million of free cash flow. The $124 million is the highest amount of free cash flow dollars generated in the first 3 quarters of the year in the history of the company. We increased our cash and marketable securities by $60 million year-to-date, and that's given our almost $100 million of convert repurchase. As we outlined during the most recent investor session at PegaWorld in June, our multiyear plan to improve our free cash flow features 3 key levers. First, we need to expand total gross margin. We're confident we can continue to expand total gross margin by scaling our Pega Cloud business, increasing cloud automation, implementing Kubernetes and multi-tenancy. And our most recent results confirm that we're making progress. In Q3, on a trailing 12-month basis, non-GAAP total gross margin increased to just over 74%, a 129 basis point improvement year-over-year. Our key driver of our gross margin improvement is non-GAAP Pega Cloud gross margin, which increased 430 basis points from 69% to just under 73% on a trailing 12-month basis. Another lever to improve our free cash flow is to improve sales efficiency, which we view as the most important of the 3 levers. As you know, we made the difficult decision to reduce our headcount in the last year with the majority of those reductions coming from the sales and marketing organization. It's difficult to deliver double-digit growth while at the same time improving sales efficiency. We spend more than $0.5 billion annually on sales and marketing. That's a pretty big number, and we need to make sure that we're leveraging that to drive our growth. The last lever is really just to as we improve our free cash flow is to enhance our operating leverage by growing total other costs like general administrative and R&D to make sure that those spend at a slower pace than our ACV growth. At a company our size, we should definitely be able to exhibit operating leverage as we scale. Over the last year, we've taken action to simplify our go-to-market motion. For software companies like ours, the enemy of sales efficiency and effectiveness is often complexity. So we've eliminated layers of management, further clarify team roles, focused our sales team on cross-selling and up-selling into our existing clients, making sure that all of our teams are aligned. Taking together these actions are helping to improve our sales efficiency. And you can see the results in our financials. On a non-GAAP basis, total sales and marketing spend as a percentage of revenue declined from 47% and to 38% year-over-year in Q3 on a trailing 12-month basis. Our focused execution on balancing growth and profit is positively impacting our profitability, generating $124 million of free cash flow, as I mentioned, in the first 3 quarters of 2023, and it shows progress across all of our levers. The big change from the negative free cash flow of $36 million generated in the first 3 quarters of 2022. I've also got some good news to share regarding our free cash flow trajectory as we go forward. Based on where we are year-to-date that our global team's successful execution on our plan, I'm confident that we've got a shot to deliver more than $200 million of free cash flow in 2023. I'm excited that our team is in a position to deliver the highest annual cash flow in the history of the company, and Q4 is typically our strongest cash flow generation quarter of the year. To be clear, we do not update guidance quarterly, and I'm not creating any type of precedent or officially updating free cash flow guidance for 2023. I'm just sharing my current thoughts on our free cash flow trajectory as we approach the completion of 2023. In prior calls, we have shared some thoughts on modeling our business, and we've received feedback this practice is helpful. So I've decided to reinforce those again today. First, let me start with free cash flow. I know that making a change in how we present free cash flow might be considered somewhat unusual. So we've added a table in our earnings release to show the free cash flow quarterly, just to help with your modeling. The table also separately discloses items that affect our cash flow and are considered by management, not to be representative of the core business operations, such as restructuring costs. Second, our prior 2023 annual free cash flow guidance included these adjustments. So going forward, our free cash flow guidance will be consistent with a more conventional methodology. Lastly, we did close more term license deals in the quarter than is typical. Our term license bookings are strongest in the first and the final quarters of the year. So a strong term license booking result in Q3 is not typical. However, we view the growth in ACV as the most critical measure. And our clients sometimes decide to use client cloud versus Pega Cloud, and we will support them when they make that decision. This year, we continue to make progress on our journey to improve our cash flow, while at the same time maintaining a double-digit ACV growth rate in what continues to be a more uncertain selling environment. Our team is clearly embracing a Rule of 40 mindset and doing a much better job of managing the trade-offs between growth and profit. The world's greatest software companies do not only achieve the Rule of 40 in a single year, but they do it consistently and over sustained periods of time. That's our objective. To be the kind of company that balances growth and profit over the long term. And we look forward to closing out 2023 in the next few months. As I wrap up today, I wanted to announce that our annual investor session will be held on Monday, June 10, the MGM Hotel in Las Vegas, during PegaWorld. Please mark your calendars. I look forward to seeing you all on the road as we get out to meet current and potential investors in November and December. One last point. The date for our oral argument in our Virginia appeal is now scheduled for November 15. Although it will likely be months before we know the result, it's still great to have the appeal now scheduled and in front of us. With that, operator, please open the call for questions.
Operator: [Operator Instructions] And our first question comes from Steve Enders with Citi.
Steven Enders: Maybe to start, I just want to get a better understanding for -- when you talk about uncertain macro and that kind of continuing, what that actually looks like in terms of the deal environment that you're seeing out there? And maybe how are things maybe changed so far in October from the conversations and the deal environment that you're seeing today?
Alan Trefler: Yes. I would say that the mood in a lot of clients has -- for the last year, candidly, has been just more questioning again, it's entirely consistent with organizations really doing candidly, a better level of scrutiny than when money was free. People are acting now across the board like they're really respecting businesses that are in a position to deliver profitability. So you get more checking of types of deals and that can lead to slightly longer sales cycles. I will tell you, I'm not seeing anything that is troubling as we enter the fourth quarter. The reality is that customers also really, really want to set their businesses up for success in 2024. And I've had conversations with many clients that see us as being central to how they're going to gain the real efficiencies, which isn't around the cost of software, but it's really around the cost of their operations and their ability to engage. But I think I've said over the last year, we've been through lots of recessionary periods. And when things get a little tougher, even if we're not in a recession, I think people are kind of acting a little like we are. When that happens, we sort of aim the needle as it were how do we deliver really tangible things for clients as opposed to focusing on generating revenue, which are the things are happier, everybody who wants to spend time on that. Does that give you some color?
Steven Enders: No, definitely. There's helpful context there, especially for the 4Q view. So I definitely appreciate the commentary there. And then maybe shifting gears a little bit more to the sales and marketing changes and initiatives. I guess, as we think about what that means for closing out the year and the improvement in productivity and efficiency there, I guess, what has been the feedback from customers that you talked to in terms of the impact that could potentially have? And as we think about the free cash flow impact, both in the quarter moving forward, I guess how should we be thinking about the impact that those changes would be having to the cash flow specifically?
Kenneth Stillwell: So there's a couple of pieces to that question. So let me see if I can hit a couple of pieces, Steve. So the first is we made changes -- we made some organizational changes in the last few months. And those are never easy, and we have a lot of empathy for the people that were impacted. Those changes have not actually resulted in any improvement in free cash flow for the business, yes, as you might imagine, and they will have a very small, if any, impact even in Q4 that the actions taken. However, they'll have a full year impact in 2024. So that's just something that's almost kind of on the shelf for an improvement in 2024. I wanted to also clarify one thing. When I talked about achieving $200 million in free cash flow, I'm actually referring to the new more traditional measure. If you were to take into account onetime items, et cetera, naturally under the way that we were previously talking about, that number would be much higher. So just to clarify that because I know that was maybe a little vague in my script.
Alan Trefler: I'd also say that we worked very hard, and I think the team did a great job to take and make the changes so that we could enter Q4 with the changes behind us. And we've basically done that. So I'm not expecting that we would tell you next year the Q4 has been materially implemented by change. Right now, I would say we're at the heavy execution mode.
Operator: Our next question comes from Pinjalim Bora with JPMorgan.
Pinjalim Bora: Can I ask you about the term out performance? What drove that was federal part of it or anything else to kind of call out? Secondly, on cloud ACV growth, that seems to continue to decelerate. And I hear your point on overall ACV growth being more important. But as you launch Infinity '23, which adds kind of a lot of GenAI capabilities on the cloud side, I believe, should we expect cloud ACV growth to kind of trough at some point going forward?
Kenneth Stillwell: Yes. So great question. So when you see quarters -- so if you look at kind of newer organizations or even newer kind of activity that a client is doing, there is a higher amount of those that typically go Pega Cloud. That is kind of just because Pega Cloud -- when you have clients that may expand existing workflows, existing relationships, they may put -- bring on a new project and they already are managing Pega in a client cloud environment naturally, that's the way that they would purchase or expand their relationship with Pega. So when you see quarters where you typically have a higher percentage of kind of term versus SaaS, the primary driver for that is probably just a little bit outsized expansion with existing clients that may not -- now many of our clients have both. So it kind of depends on which application environment there or which set of use cases they're expanding. But that's typically -- it's really not -- it's not a change in strategy or a change in buying behavior. It just comes down not to like how -- kind of how you -- how the difference between the 2. And in terms of like a net new workload versus existing workload. So that's kind of why you might see the drop.
Alan Trefler: I would also say that based on just the vibrations in the market here as we enter Q4, I'd be surprised if we don't see a pickup in the cloud rates as we go into the next quarter or 2.
Kenneth Stillwell: Yes. I think that's -- I mean you -- Pinjalim, you know that the difference between a Q4 typically had a little bit more client cloud license. And that's typically because that tends to be a period where you have clients kind of look at increasing their spend with us during a renewal period. So just think about that kind of same activity can happen sometimes in other quarters.
Pinjalim Bora: Yes, understood. Just to be clear, for this quarter in term, were there any very large deals that swung kind of the number towards the positivity 1 or 2 large deals or just...
Kenneth Stillwell: No, it wasn't actually. No. We -- in our movement, that's a very fair question. But no, Q3 was not skewed by like 1 deal or 2 deals of that. And also as we move a little bit more towards as we refer to in a more consumption-based, you do actually have more repeatable growth and not as many very large kind of shock deals. Clients are increasing over time as opposed in our previous model, even in the perpetual model, they are tended to be kind of whales as we used to call them.
Operator: Our next question comes from Jake Roberge with William Blair.
Jake Roberge: Alan, when you're talking to customers, where the dollars per AI spend coming from? Are they coming from existing IT budgets and maybe crowding out other areas of spend? Are you seeing customers create net new budget dollars and potentially actually expand their overall IT spend to account for those investments?
Alan Trefler: So we're seeing both. And happily, we are seeing the innovation budgets starting to come forward. We've had with a client actually just yesterday announced they were putting another several hundred million dollars into their innovation budget, which is a great thing to hear from a client that we're currently selling to. So I think that it will affect some traditional spend for sure, but they're really looking to make sea changes in their business over the next couple of years, and they're all not wanting to fall behind.
Jake Roberge: Very helpful. Then Ken, do you still feel Pega is on track to complete the subscription transition this year? And then I know you put out those targets of being a Rule of 40 business as you exit 2024. Given constant currency ACV growth ticked down to 10% this quarter, how should we think about the balance between growth and margin as you look to reach those targets?
Kenneth Stillwell: So we do believe we'll be done with the subscription transition. In fact, I would even say it go as far as to say we're really done now. We've had a few years where our perpetual license revenue has been under 5% of our total book -- sorry, perpetual bookings have been under 5% for now, probably 4 years maybe. And so I think the business has normalized much more. Naturally, we'll have variability quarter-to-quarter, and you do have the unfortunate accounting of 606. But that said, take that aside, the billings, the consistency of billings, the predictability of billings, that is very much normalized in our business now, Jake. And then when you think about exiting 2024. I mean it certainly looks to us that 2024 would exit with a much higher contribution on the free cash flow than the growth, just even where we are now, naturally, as a Rule of 30-type company, cash flow is higher than our growth rate. And I think it's being realistic about where we thought we would land, we always kind of have this model of 15, 25 kind of company was kind of a very nice sustainable model. And so we have a little work to do on the growth side, but I think we're well on track to actually be kind of mid- to high 20s free cash flow company in 2024. That's our goal. Naturally, we're still another quarter away from thinking about our guidance for 2024, but we've been very transparent with that's our objective.
Operator: Our next question comes from Kevin Kumar with Goldman Sachs.
Kevin Kumar: Alan, you called out EMEA in the script. So just curious if you can expand on the health of the customer base in those regions and just the overall kind of macro environment there?
Alan Trefler: Yes. I would say that if you go back a couple of quarters, EMEA was looking a little tepid. I was very pleased with my last visit. And I'm actually coming back there in Q4 because we see things that are set to be done. So I'm seeing a return in most of the countries in EMEA, not all of them. Some of them are still a little tougher, I would say, Germany, for instance. But the U.K. there's a lot of political stuff going on there, but they're very interested in trying to figure out how to reframe those businesses to be more profitable.
Kevin Kumar: Great. And then maybe can you give an update on the government vertical, what use cases are you best positioned for? And just in general, the level of deal activity that you're seeing in that vertical?
Alan Trefler: Yes. We're seeing a lot of activity in that vertical. And we just hired Jen Pratt, a new senior executive who we announced, who is pushing forward to really, I think, help us be much more effective in that vertical. So I'm very excited, and I love the way she's coming up to speed, though she's only been here a couple of months now. What I've seen in that vertical is a lot of interest. Our bellwether clients like the IRS and the FBI and Department of Justice, there's a lot of stuff going on, and there are major needs in those businesses. The use cases we do is we handle serious workflows. But candidly, there are workflows that are kind of pushing tickets around. Those aren't the Pega workflow. The Pega workflows is where you actually take a meaningful piece of work that has typically a lot of data associated in it and with it that has to live over a long period of time, which is perfect for the government environment. And that needs a combination of automation, auditing and improve citizen engagement, which is now increasingly top of mind for organizations. So government, not just in the U.S., but when I take a look at what's going on with some major, major work we're doing in the U.K., when I look at work we're actually in Germany, the trip I just took to APAC. We have more than a dozen government systems running in Singapore, for instance. I'm seeing lots of things in every region that make me feel great about what Pega is doing.
Kenneth Stillwell: And just one additional comment on that. If you think about a vertical, so to speak, that is more prone to keep legacy applications plugged in, but be able to try to modernize kind of at the user layer like the -- which really feeds well into Pega orchestrating and being able to interact and interface with data set with systems that have maybe embedded in the government, I mean that is a very strong value proposition to be able to improve the customer experience, the applications, modernize, go to cloud, but yet still interact with some of these systems that they really just -- the government really just can't mothball.
Operator: Our next question comes from Rishi Jaluria with RBC.
Rishi Jaluria: Maybe I want to go back to better understanding the macro impact. And more specifically, think about what are customers and partners saying about large-scale digital transformations because as we've been hearing from partners that those are things that a lot of customers might be dragging their feet on given the uncertain macro. But simultaneously, I'd have to imagine as companies are contemplating their generative AI strategy, digital transformation to enable that and integrate workflows becomes more and more important. So maybe can you help us understand what you're seeing in terms of those and kind of weighing the puts and takes about both the near-term macro as well as how customers are kind of trying to position themselves long term to embrace generative AI and your role in enabling that? And then I've got a quick follow-up.
Alan Trefler: Sure. So it's a good question. I would say there are actually a couple of parallel threats to pull on here. So there's no question when the macro becomes a little more [indiscernible] that organizations want to make sure what they're really investing in is practical and pragmatic. So they want to make sure what they're going to see is going to have results. And Pega is very, very well equipped for that environment. We've switched ourselves away from the -- boy we help you really boost revenue much more to, hey, we're going to help you make decisions better. We're going to help you drive workforce better in ways that literally get their work done. So that's something that I think we're well suited for. There is a lot of buzz around generative AI. But there's also a lot of what I would describe as client gambling and experimentation. Customers are trying to figure it out. And so a lot of them are trying, they're buying, they're getting developers to build things, lots of little pots stirring, but they're also looking for the places in which GenAI can be used to really drive that previous category, the category of really differently approaching pragmatic results. And I've seen customers get really excited about what we can do. I was visiting with a client who put [indiscernible] to one of its call centers to be able to use what we call voice AI to be able to interpret and fill in screens and do a whole variety of things to massively improve productivity, which costs they're looking for but also significantly reduce their annual time and improves the customer experience. So I think it's going to be interesting for the investment community to try to delineate what action in the market is tied to the AI type and the experimentation, which in some cases, it's not going to persist and what's going to be tied to the real core systems evolutions, they're going to work now and going to work into future years. Does that help?
Rishi Jaluria: Yes, absolutely. Very helpful. And then, Ken, just a follow-up for you on the gross margin side. So you continue to show a pretty impressive cloud gross margin expansion. How should we be thinking about terminal gross margins on the cloud side, especially as you do have a little bit of multi-tenancy around the core, you are embracing Kubernetes. Is this something that over time could become an 80% cloud gross margin business? Or is there anything structure that might be holding you back from that?
Kenneth Stillwell: Yes, great question. So I will say this with a level of confidence, but also we have to get there. When we first started Pega Cloud, we were hoping to get to 70%. And then when we got close to 65%, we said, we should be 75%. And now we're approaching 75%, we're saying we should be 80%. And so I do see a path to 80%. I don't know how hard it will be to get much above 80%. It might be surprisingly easy. It might be terribly difficult. But I would say now that we're approaching 75%, we definitely see a path to 80%.
Operator: Our next question comes from Raimo Lenschow with Barclays.
Raimo Lenschow: This quarter, we obviously had the term was much better than cloud. And you kind of talked about some of the reasons there. If you think about the next steps for you guys now as we kind of maneuvering through the downturn. Is there any plans to kind of double-click more on the cloud side? Or is that -- do you think you will continue to stay on that. The customer has a choice there? And then one, Ken for you. Like if I think about the margin progression, obviously, very good progress this year. But as we get ready for more AI investments, potentially better times ahead. How do you think about that balance of growth versus investments for going forward?
Kenneth Stillwell: So I'll take the first one, and maybe, Alan, you can give your thoughts on AI, and how AI might help the margin profile of us and our clients. So the first piece, we are fully committed to Pega Cloud as being what we really are excited about our clients leveraging. That said, we understand clients are on a journey to get there, and we want to support them through that journey. And in some cases, that journey may take longer than we may hope that it would because they have unique operational needs. And quite frankly, they may not be ready to move to cloud at the pace that other companies will. So we are -- our commitment to Pega Cloud is unchanged, completely committed, completely committed to scale it and modernize and make the experience better for clients, always automate, et cetera, improved margins. But that said, we are not moving away from our ability to support our clients and client choice. So that's our stance. Alan, do you want to talk a little bit about AI and how that might fit into the margin profile?
Alan Trefler: Yes. So I think this is going to be really interesting as we go forward. And those of you who were there may recall, that in my closing presentation at PegaWorld, which was in June, I stood up and I said we're going to be using these new technologies, which -- many of which we've now released more are coming as soon as Q1. We're going to use these new technologies to do 4 things. And just to rehighlight the 2 that are relevant to your question. One is to put Pega at your fingertips. So to radically change the training and education and ease-of-use profile of Pega technology by using this to really help people build and guide faster. And the second is what we -- I actually said we were going to report in June, which is a little bit of a time, but it's come out in front of us that I expected that we have double productivity of people building in Pega, which should open up a major stream of new opportunities for our clients to get results faster and better. The other piece is we also have many -- through these sort of accelerators that we build on these GenAI capabilities, important new features that will also make the customers' operations more productive and improve their cost profile as well to the use of GenAI. So we have a lot that we are working on right now that I think is going to very, very much change the view as we enter '24 and as we go through '24.
Operator: Our next question comes from Mark Schappel with Loop Capital Markets.
Mark Schappel: Alan, starting with you, I appreciate your comments on generative AI in your prepared remarks. And look, I realize it's still early for that solution, but are you seeing the offering attract like a new type of customer to the company?
Alan Trefler: Yes, I am. I'm seeing the -- remember, we have a target organization structure. So it's really a new type of buyer inside the customer who -- if you want to really get filled for this, just go to that generative AI page on pega.com that I mentioned, which we sit with business buyers. You think of this as being, in many ways, a technical part of the sale, but we sit with business buyers, and we say, why don't you put in whatever workflows you worry about or whatever ways of doing business that you are concerned about. The most interesting I had at the Cyprus International Banking Conference a month ago. Obviously, we had a senior executive from a large U.K. bank, asked to see what should the process be for closing the account of a politically exposed person. If you read the news, you may note that the -- believe it was the CEO Koos was fired, because they had done that inappropriately. And what came out was mind-blowing. And it completely changes the whole way you think about how you want to operate and develop processes. So try it, and we've got a whole generation -- whole new area of buyers where we did use to have something like that, that had shown before. And now we've got thousands in their playing with it.
Mark Schappel: That's helpful. And then, Ken, on the go-to-market front, I believe you noted organizational changes to the sales team that coincided with the workforce reduction. I was wondering if you could just detail a little bit further what those or changes, where I assume you somewhat flatten the sales organization.
Kenneth Stillwell: Well, we're referring to the changes that we had previously disclosed and we talked about, Mark, which is to put a lot of the selling type resources closer to the client to put a lot of our technical both presales and post-sales resources kind of closer together so that we could actually have like kind of a continuous engagement from presales to post go live. We've looked at the kind of the state, the hierarchy of the organization in terms of the layers, the number of management layers. We've looked at bringing people kind of that did similar type roles into a unified mission. Those are the types of activities that we have that really were part of what I was referring to.
Alan Trefler: And it's good to have that all behind us.
Kenneth Stillwell: Yes.
Operator: Our next question comes from Joe Meares with Truist Securities.
Joe Meares: I had another question about the headcount reductions. Are you guys planning to rely more on partners now in light of reducing headcount in sales and marketing? And then just as far as -- it was helpful to hear that it's not going to add to free cash flow in 2023. And you're not asking you to guide to 2024, but just curious what the potential dollar impact from sales and marketing could be there? And the fact that you're going to be getting over $200 million in free cash flow potentially this year, does that bring that 3 to 5-year $500 million free cash flow target closer to the 3-year end of that range?
Kenneth Stillwell: I'll take the last part of your question. But -- so the -- we are very -- we feel great about the progress that the organization has made in the results. Naturally, some of the decisions we made are hard, and we -- but we had to make them. And -- when you think about an annual run rate impact of a change like that, a rule of thumb that I always use is what the restructuring charges times 4. That's just an easy rule of thumb. I would say most companies kind of have that type of situation. So if you look at our charge times 4, that's typically the run rate savings. You're probably talking $60 million to $70 million of kind of annual kind of run rate impact from the change that we made last quarter. And now when you talk about like us getting to $500 million, listen, we're thinking we're going to be above 2, $500 million still is a ways away. That said, I do think it shows us a path to get to that number and it's certainly within the range of what we talked about. If we can get there a year earlier, while that would be great, but right now, we're quite frankly, focused on Q4 of '23, as you can imagine. So I don't want to get too far ahead of ourselves. Sorry, I remind me the first part of the question again because I think that was Alan question.
Joe Meares: Yes. No, it was more just if you're planning to rely more so on partners given the you're reducing headcount in sales and marketing.
Alan Trefler: I don't think we're depending anymore on partners as a result of reducing headcount, but we are emphasizing the importance of partner engagement with our account teams. So partners are really critical. But it's not like we're going to have to replace the changes we've made. A lot of the changes we made, frankly, were a simplification of some of the management structures and reducing the number of power organizations that candidly, one of our clients would have to deal with as well as internally that we're creating silos. And I'm feeling really good about what we're able to do.
Joe Meares: Great. And then just as a follow-up around GenAI. Some of the customers we've spoken to over the last 3 or 4 months have noted that they don't even really know how GenAI can be applied to their businesses yet. So they don't feel that they're really in a position to make a purchase. And so I'm just curious if you're seeing somewhat of like a pause here in terms of actually signing contracts? And if that means that this could be a little bit more accretive to 2024 than maybe 2023? And do you think that you'll have any case studies by, say, the next Investor Day next year around this customer saw x savings from our GenAI solution. Just curious if you think things will be that far down the road by...
Alan Trefler: I'm quite confident we will have case studies for next PegaWorld. I think we could even start drafting them in Q1. It's not like they'll be waiting for Q2. The -- one of the things that I said was that I think a lot of clients are experimenting because they're not entirely sure where, how they should use it. And if there are risks, if there aren't risks. But when you take a look at, for example, if you do the GenAI demo I talked about, you'll see the clients see them and they say, "Oh my God, I've got a whole new way to think about my reengineering and transformation process. I can actually use a lot of collective wisdom to bring the best practices that at least stimulate my thinking. And I think it's an example of very practical and everyone that sees that as well. So we'll see what you say.
Operator: Our next question comes from Fred Havemeyer with Macquarie.
Fred Havemeyer: I wanted to ask on -- sorry if I'm beating a dead horse here, but a generative AI-related topic. Primarily I'm curious here, are you seeing any sort of change in priorities among your partners? Where they're investing or allocating into their practices as we've seen coding copilot become more robust and become more productionized.
Alan Trefler: So first of all, I would like to counsel you to not casually use horse metaphors. We never talk about dead horses in Pega. We're leading them to water or any of that or any of those sorts of things. But having said that -- keep it clean, that's all I'd say right? But -- and the horse is flying strong, so don't worry about that. The partners are trying to figure it out. There's a sense of an enormous opportunity. But boy, is this going to massively change how a lot of partners end up delivering their projects. It's going to be very, very large, and so. I think that by looking up with the partners on an innovation agenda, which is what we're working with, and being able to use and show them some of the tooling we have like the demo, we're able to get them excited about how they could reorient some of their efforts. Because frankly, we're in a period of a lot of discovery going on. There's no question in my mind that this is extremely real but there's also no question that the [indiscernible] some of the short-term tangible benefits. And everybody kind of knows that industry going it out. term tangible benefits. And everybody kind of noticed that and just figuring it out. But boy, this is going to so radically change our technology as we go through '24. Yes, it's actually enormously exciting.
Operator: Our next question comes from Blair Abernethy with Rosenblatt Securities.
Blair Abernethy: Ken, could you just comment on the renewal environment, given the consistent weakness in the macro or difficulty in the macro, just how did renewals trend in Q3? And what should we be expecting in Q4?
Kenneth Stillwell: We haven't seen any noticeable change in the likelihood of a client continuing to stay and invest and even grow in the applications that they have with Pega. So I mean, naturally, we do have clients that decide to go in a different direction. We do have clients that have transformational changes in their business. And unfortunately, Pega may not be part of that, that does happen. We're just -- it happens at every software company. But it's not something that there's been a noticeable change in 2023.
Alan Trefler: Yes. What I made comments about the macro environment, none of them are related to the renewal environment. Our customers really were fortunate in the set of the client base that we've really been focusing on are not the SMB type businesses that are more likely to try to squeeze out their vendors. Our customers are trying to squeeze that benefit.
Kenneth Stillwell: Historically, when we talk about the sales cycles, Blair, for anyone else still listening, it's really focused on net new workloads is where you -- existing applications, existing projects are not -- they might be leaning more into trying to push volume to automate.
Blair Abernethy: Okay. Great. And just, Alan, just following on your commentary to be in your prepared remarks about the AI risks. Can you maybe just expand on that a little bit? You've had Infinity '23 has been in the market for a month or so here. But just what sort of -- given the nature of your banks and insurance customers, what are they looking for in terms of managing these risks? And is that -- is it scalable, I guess, when I look at the issues from a risk perspective?
Alan Trefler: Well, I think we have a really good understanding of that. And I'll just tap off a couple of places that we're really working. One is to give the right people a chance to curate the output from AI before it actually gets used in a way that might be unpredictable. And we show examples of that and what we've already released. And for everything that we're going to be building over the next two release in '24 you're going to see more and more of that. The second is we understand how to really eliminate those hallucinations and being able to use both our best practices and client best practices to take the power of Generative AI, but to make it that would operate very controlled fashion. I'm not sure that everybody understands how to do that, but we definitely do. And that's a lot of what we're working on making sure we're building in, so that those knobs and dials are firmly in the clients' hands. And the third is, and we've talked about this for 2 years, the whole ethical AI and bias checking capability that we have around our statistically AI. I think a lot of people with the excitement about generative AI, should not forget the importance of statistical AI, which, for example, comes from our decisioning and our process AI capabilities, and those are also super important. Those need different controls to Generative Al. And we've got -- we've already got tremendous things there as well.
Operator: Our next question comes from Austin Cole with [indiscernible] GMP Securities.
Unidentified Analyst: Just really quick, I've been looking at the AI demo that you mentioned. Where do you see this technology in 3 to 5 years and what it's doing for clients in adding value?
Alan Trefler: Yes. So what it's going to do actually well before 3 years, is it's going to make it possible for us to take the knowledge of the Internet, the clients' best practices as they've identified and documented it, the Pega best practices as our experts have drawn on our experience with multiple clients and the information in their Pegasystems themselves so that they're able to use their own information and configurations and put those things together in a way that is candidly completely different than you would have to approach this a year ago. So it's going to really drive much, much greater iteration in our clients operate with their customers, and it's really going to help customers build for change, which, of course, is our grand promise. Thank you. And let me thank everyone we've run a few minutes over here. We're very excited about both where we are and what we're going to be able to do going forward. And I look forward to talking to all of you very soon. Thank you very much.
Operator: This concludes today's conference call. You may disconnect your lines at this time. Thank you for your participation, and have a great day.
