Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2020
OR
☐
Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Commission File Number: 1-11859
____________________________
PEGASYSTEMS INC.
(Exact name of Registrant as specified in its charter)
____________________________
Massachusetts
04-2787865
(State or other jurisdiction of incorporation or organization)
(IRS Employer Identification No.)
One Rogers Street, Cambridge, MA02142-1209
(Address of principal executive offices, including zip code)
(617) 374-9600
(Registrant’s telephone number, including area code)
____________________________
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading symbol(s)
Name of each exchange on which registered
Common Stock, $.01 par value per share
PEGA
NASDAQ Global Select Market
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. Yesx No ¨
Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yesx 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.
Large accelerated filer
x
Accelerated filer
☐
Non-accelerated filer
☐
Smaller reporting company
☐
Emerging growth company
☐
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 80,697,696 shares of the Registrant’s common stock, $0.01 par value per share, outstanding on October 19, 2020.
Common stock, 200,000 shares authorized; 80,697 and 79,599 shares issued and outstanding at
September 30, 2020 and December 31, 2019, respectively
807
796
Additional paid-in capital
201,882
140,523
Retained earnings
338,300
410,919
Accumulated other comprehensive (loss)
(11,667)
(13,228)
Total stockholders’ equity
529,322
539,010
Total liabilities and stockholders’ equity
$
1,487,327
$
984,812
See notes to unaudited condensed consolidated financial statements.
3
PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
Three Months Ended September 30,
Nine Months Ended September 30,
2020
2019
2020
2019
Revenue
Software license
$
39,784
$
58,005
$
187,023
$
165,543
Maintenance
74,670
70,371
220,587
207,406
Pega Cloud
54,776
35,153
147,080
94,610
Consulting
56,721
53,174
164,227
167,282
Total revenue
225,951
216,703
718,917
634,841
Cost of revenue
Software license
691
676
2,354
2,982
Maintenance
5,478
6,688
16,645
19,315
Pega Cloud
19,717
17,824
56,238
47,769
Consulting
51,913
55,710
158,781
162,349
Total cost of revenue
77,799
80,898
234,018
232,415
Gross profit
148,152
135,805
484,899
402,426
Operating expenses
Selling and marketing
132,053
115,237
395,684
341,064
Research and development
60,024
52,492
177,620
152,802
General and administrative
17,907
14,843
49,192
41,693
Total operating expenses
209,984
182,572
622,496
535,559
(Loss) from operations
(61,832)
(46,767)
(137,597)
(133,133)
Foreign currency transaction gain (loss)
4,236
(1,970)
2,545
(3,577)
Interest income
243
598
1,092
1,865
Interest expense
(5,956)
(42)
(13,791)
(42)
Gain on capped call transactions
18,989
—
19,816
—
Other income, net
—
323
1,374
378
(Loss) before (benefit from) income taxes
(44,320)
(47,858)
(126,561)
(134,509)
(Benefit from) income taxes
(25,053)
(17,520)
(61,182)
(43,158)
Net (loss)
$
(19,267)
$
(30,338)
$
(65,379)
$
(91,351)
(Loss) per share
Basic
$
(0.24)
$
(0.38)
$
(0.82)
$
(1.16)
Diluted
$
(0.24)
$
(0.38)
$
(0.82)
$
(1.16)
Weighted-average number of common shares outstanding
Basic
80,537
79,200
80,191
78,928
Diluted
80,537
79,200
80,191
78,928
See notes to unaudited condensed consolidated financial statements.
4
PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS)
(in thousands)
Three Months Ended September 30,
Nine Months Ended September 30,
2020
2019
2020
2019
Net (loss)
$
(19,267)
$
(30,338)
$
(65,379)
$
(91,351)
Other comprehensive (loss) income, net of tax
Unrealized (loss) gain on available-for-sale securities
(166)
(216)
(66)
396
Foreign currency translation adjustments
113
(2,201)
1,627
(983)
Total other comprehensive (loss) income, net of tax
$
(53)
$
(2,417)
$
1,561
$
(587)
Comprehensive (loss)
$
(19,320)
$
(32,755)
$
(63,818)
$
(91,938)
See notes to unaudited condensed consolidated financial statements.
5
PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (in thousands, except per share amounts)
Common Stock
Additional Paid-In Capital
Retained Earnings
Accumulated Other Comprehensive (Loss)
Total Stockholders’ Equity
Number of Shares
Amount
December 31, 2018
78,526
$
785
$
123,205
$
510,863
$
(13,322)
$
621,531
Repurchase of common stock
(144)
(1)
(7,586)
—
—
(7,587)
Issuance of common stock for share-based compensation plans
514
5
(14,843)
—
—
(14,838)
Stock-based compensation
—
—
18,406
—
—
18,406
Cash dividends declared ($0.03 per share)
—
—
—
(2,367)
—
(2,367)
Other comprehensive income
—
—
—
—
2,001
2,001
Net (loss)
—
—
—
(28,717)
—
(28,717)
March 31, 2019
78,896
$
789
$
119,182
$
479,779
$
(11,321)
$
588,429
Repurchase of common stock
(88)
(1)
(6,301)
—
—
(6,302)
Issuance of common stock for share-based compensation plans
320
3
(11,217)
—
—
(11,214)
Issuance of common stock under the employee stock purchase plan
16
—
1,103
—
—
1,103
Stock-based compensation
—
—
20,113
—
—
20,113
Cash dividends declared ($0.03 per share)
—
—
—
(2,375)
—
(2,375)
Other comprehensive (loss)
—
—
—
—
(171)
(171)
Net (loss)
—
—
—
(32,296)
—
(32,296)
June 30, 2019
79,144
$
791
$
122,880
$
445,108
$
(11,492)
$
557,287
Repurchase of common stock
(88)
(1)
(6,396)
—
—
(6,397)
Issuance of common stock for share-based compensation plans
268
3
(8,804)
—
—
(8,801)
Stock-based compensation
—
—
21,879
—
—
21,879
Cash dividends declared ($0.03 per share)
—
—
—
(2,381)
—
(2,381)
Other comprehensive (loss)
—
—
—
—
(2,417)
(2,417)
Net (loss)
—
—
—
(30,338)
—
(30,338)
September 30, 2019
79,324
$
793
$
129,559
$
412,389
$
(13,909)
$
528,832
See notes to unaudited condensed consolidated financial statements.
6
PEGASYSTEMS INC. UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (in thousands, except per share amounts)
Common Stock
Additional Paid-In Capital
Retained Earnings
Accumulated Other Comprehensive (Loss)
Total Stockholders’ Equity
Number of Shares
Amount
December 31, 2019
79,599
$
796
$
140,523
$
410,919
$
(13,228)
$
539,010
Equity component of convertible senior notes, net
—
—
61,604
—
—
61,604
Repurchase of common stock
(87)
(1)
(5,999)
—
—
(6,000)
Issuance of common stock for share-based compensation plans
564
6
(23,017)
—
—
(23,011)
Stock-based compensation
—
—
23,199
—
—
23,199
Cash dividends declared ($0.03 per share)
—
—
—
(2,405)
—
(2,405)
Other comprehensive (loss)
—
—
—
—
(414)
(414)
Net (loss)
—
—
—
(25,372)
—
(25,372)
March 31, 2020
80,076
$
801
$
196,310
$
383,142
$
(13,642)
$
566,611
Repurchase of common stock
(23)
—
(2,199)
—
—
(2,199)
Issuance of common stock for share-based compensation plans
349
3
(14,085)
—
—
(14,082)
Issuance of common stock under the employee stock purchase plan
18
—
1,403
—
—
1,403
Stock-based compensation
—
—
25,674
—
—
25,674
Cash dividends declared ($0.03 per share)
—
—
—
(2,413)
—
(2,413)
Other comprehensive income
—
—
—
—
2,028
2,028
Net (loss)
—
—
—
(20,740)
—
(20,740)
June 30, 2020
80,420
$
804
$
207,103
$
359,989
$
(11,614)
$
556,282
Repurchase of common stock
(94)
(1)
(10,628)
—
—
(10,629)
Issuance of common stock for share-based compensation plans
371
4
(22,524)
—
—
(22,520)
Stock-based compensation
—
—
27,931
—
—
27,931
Cash dividends declared ($0.03 per share)
—
—
—
(2,422)
—
(2,422)
Other comprehensive (loss)
—
—
—
—
(53)
(53)
Net (loss)
—
—
—
(19,267)
—
(19,267)
September 30, 2020
80,697
$
807
$
201,882
$
338,300
$
(11,667)
$
529,322
See notes to unaudited condensed consolidated financial statements.
7
PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Nine Months Ended September 30,
2020
2019
Operating activities
Net (loss)
$
(65,379)
$
(91,351)
Adjustments to reconcile net (loss) to cash (used in) operating activities
Stock-based compensation
76,755
60,242
(Gain) on capped call transactions
(19,816)
—
Deferred income taxes
(43,476)
(40,531)
Amortization of deferred commissions
24,922
22,372
Lease expense
11,997
10,454
Amortization of debt discount and issuance costs
10,405
—
Amortization of intangible assets and depreciation
15,677
16,998
Amortization of investments
252
798
Foreign currency transaction (gain) loss
(2,545)
3,577
Other non-cash
(1,374)
(363)
Change in operating assets and liabilities, net
(33,675)
4,342
Cash (used in) operating activities
(26,257)
(13,462)
Investing activities
Purchases of investments
(190,319)
(11,182)
Proceeds from maturities and called investments
—
13,066
Sales of investments
1,424
68,937
Payments for acquisitions, net of cash acquired
—
(10,934)
Investment in property and equipment
(21,806)
(6,439)
Cash (used in) provided by investing activities
(210,701)
53,448
Financing activities
Proceeds from issuance of convertible senior notes
600,000
—
Purchase of capped calls related to convertible senior notes
(51,900)
—
Payment of debt issuance costs
(14,527)
—
Dividend payments to shareholders
(7,206)
(7,105)
Common stock repurchases
(76,737)
(54,836)
Cash provided by (used in) financing activities
449,630
(61,941)
Effect of exchange rate changes on cash and cash equivalents
183
(363)
Net increase (decrease) in cash and cash equivalents
212,855
(22,318)
Cash and cash equivalents, beginning of period
68,363
114,422
Cash and cash equivalents, end of period
$
281,218
$
92,104
See notes to unaudited condensed consolidated financial statements.
8
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 the information 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, 2019.
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.
All intercompany transactions and balances have been eliminated in consolidation. The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year 2020.
2. NEW ACCOUNTING PRONOUNCEMENTS
Convertible debt
In August 2020, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2020-06, “Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (ASU 2020-06), which simplifies the accounting for certain financial instruments with characteristics of liabilities and equity, including convertible instruments and contracts in an entity’s own equity. The standard eliminates the liability and equity separation model for convertible instruments with a cash conversion feature. As a result, after adoption, entities will no longer separately present in equity an embedded conversion feature for such debt. Additionally, the embedded conversion feature will no longer be amortized into income as interest expense over the instrument’s life. Instead, entities will account for a convertible debt instrument wholly as debt unless (1) a convertible instrument contains features that require bifurcation as a derivative under ASC Topic 815, Derivatives and Hedging, or (2) a convertible debt instrument was issued at a substantial premium. Additionally, the standard requires applying the if-converted method to calculate convertible instruments’ impact on diluted earnings per share (“EPS”). The standard is effective for fiscal years beginning after December 15, 2021, with early adoption permitted for fiscal years beginning after December 15, 2020. It can be adopted on either a full retrospective or modified retrospective basis. The Company is currently evaluating the effect this ASU will have on its consolidated financial statements and related disclosures. The Company expects to early adopt the new standard on January 1, 2021.
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 accounts receivable, upon initial recognition of that financial asset using a forward-looking expected loss model, rather than an incurred loss model. 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 asset’s amortized cost, removing the concept of “other-than-temporary” impairments. The Company adopted this standard effective January 1, 2020. The adoption of this standard did not have a material effect on the Company’s financial position or results of operations.
3. MARKETABLE SECURITIES
September 30, 2020
(in thousands)
Amortized Cost
Unrealized Gains
Unrealized Losses
Fair Value
Government debt
$
50,987
$
—
$
(11)
$
50,976
Corporate debt
136,045
1
(212)
135,834
$
187,032
$
1
$
(223)
$
186,810
As of September 30, 2020, maturities of marketable securities ranged from October 2020 to September 2023, with a weighted-average remaining maturity of approximately 1.3 years.
As of December 31, 2019, the Company did not hold any marketable securities.
9
PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
4. RECEIVABLES, CONTRACT ASSETS, AND DEFERRED REVENUE
Receivables
(in thousands)
September 30, 2020
December 31, 2019
Accounts receivable
$
137,953
$
199,720
Unbilled receivables
208,823
180,219
Long-term unbilled receivables
108,456
121,736
$
455,232
$
501,675
Unbilled receivables are client committed amounts for which revenue recognition precedes billing, and billing is solely subject to the passage of time.
Unbilled receivables are expected to be billed in the future as follows:
(Dollars in thousands)
September 30, 2020
1 year or less
$
208,823
66
%
1-2 years
91,325
29
%
2-5 years
17,131
5
%
$
317,279
100
%
Unbilled receivables based upon contract effective date:
(Dollars in thousands)
September 30, 2020
2020
$
105,380
33
%
2019
99,875
32
%
2018
39,281
12
%
2017
37,824
12
%
2016 and prior
34,919
11
%
$
317,279
100
%
Major clients
Clients accounting for 10% or more of the Company’s receivables:
September 30, 2020
December 31, 2019
Client A
11
%
*
* Client accounted for less than 10% of total receivables.
Contract assets and deferred revenue
(in thousands)
September 30, 2020
December 31, 2019
Contract assets (1)
$
8,104
$
5,558
Long-term contract assets (2)
5,579
5,420
13,683
10,978
Deferred revenue
181,680
190,080
Long-term deferred revenue (3)
6,673
5,407
$
188,353
$
195,487
(1) Included in other current assets. (2) Included in other long-term assets. (3) Included in other long-term liabilities.
Contract assets are client committed amounts for which 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. Contract assets and deferred revenue are netted at the contract level for each reporting period.
The change in deferred revenue in the nine months ended September 30, 2020 was primarily due to new billings in advance of revenue recognition, and $170.5 million of revenue recognized during the period that was included in deferred revenue at December 31, 2019.
5. DEFERRED COMMISSIONS
(in thousands)
September 30, 2020
December 31, 2019
Deferred commissions (1)
$
87,992
$
85,314
(1) Included in other long-term assets.
10
PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
Three Months Ended September 30,
Nine Months Ended September 30,
(in thousands)
2020
2019
2020
2019
Amortization of deferred commissions(1)
$
8,861
$
8,193
$
24,922
$
22,372
(1) Included in selling and marketing expense.
6. DEBT
Convertible senior notes and capped calls
Convertible senior notes
In February 2020, the Company issued Convertible Senior Notes (the "Notes") with an aggregate principal amount of $600 million, due March 1, 2025, in a private placement. The proceeds from the Notes were used or are anticipated to be used for the Capped Call Transactions (described below), working capital, and other general corporate purposes. There are no required principal payments prior to the maturity of the Notes. The Notes accrue interest at an annual rate of 0.75%, payable semi-annually in arrears on March 1 and September 1, beginning on September 1, 2020.
Proceeds from the Notes and Capped Call Transactions:
(in thousands)
Amount
Principal
$
600,000
Less: issuance costs
(14,527)
Less: Capped Call Transactions
(51,900)
$
533,573
Conversion rights
The conversion rate is 7.4045 shares of common stock per $1,000 principal amount of the Notes, representing an initial conversion price of approximately $135.05 per share of common stock. The Company will settle conversions by paying or delivering, as applicable, cash, shares of its common stock, or a combination of cash and shares of its common stock, at the Company’s election, based on the applicable conversion rate. The conversion rate will be adjusted upon the occurrence of certain events, including spin-offs, tender offers, exchange offers, and certain stockholder distributions.
Beginning on September 1, 2024, noteholders may convert their Notes at any time at their election. Before September 1, 2024, noteholders may convert their Notes in the following circumstances:
•During any calendar quarter commencing after the calendar quarter ending on June 30, 2020 (and only during such calendar quarter), if the last reported sale price per share of the Company’s common stock exceeds one hundred and thirty percent (130%) of the conversion price for each of at least twenty (20) trading days (whether or not consecutive) during the thirty (30) consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter.
•During the five consecutive business days immediately after any five consecutive trading day period (the “Measurement Period”), if the trading price per $1,000 principal amount of Notes for each trading day of the Measurement Period was less than 98% of the product of the last reported sale price per share of common stock on such trading day and the conversion rate on such trading day.
•Upon the occurrence of certain corporate events or distributions, or if the Company calls all or any Notes for redemption, then the noteholder of any Note may convert such Note at any time before the close of business on the business day immediately before the related redemption date (or if the Company fails to pay the redemption price due on such redemption date in full, at any time until the Company pays such redemption price in full).
As of September 30, 2020, no Notes were eligible for conversion at the noteholders’ election.
Repurchase rights
On or after March 1, 2023 and on or before the 40th scheduled trading day immediately before the maturity date, the Company may redeem for cash all or part of the Notes, at a repurchase price equal to 100% of the principal amount, plus accrued and unpaid interest, if the last reported sale price of the Company’s common stock exceeded 130% of the conversion price then in effect for at least 20 trading days (whether or not consecutive) during any 30 consecutive trading day period ending on, and including, the trading day immediately preceding the date on which the Company provides a redemption notice.
If certain corporate events that constitute a “Fundamental Change” (as described below) occur at any time, each noteholder will have the right, at such noteholder’s option, to require the Company to repurchase for cash all of such noteholder’s Notes, or any portion of the principal thereof that is equal to $1,000 or an integral multiple of $1,000, at a repurchase price equal to 100% of the principal amount thereof, plus accrued and unpaid interest. A fundamental change relates to events such as mergers, changes in control of the Company, liquidation/dissolution of the Company, or the delisting of the Company’s common stock.
11
PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
Impact of the Notes
In accounting for the transaction, the Notes have been separated into liability and equity components.
•The initial carrying amount of the liability component was calculated by measuring a similar debt instrument’s fair value that does not have an associated conversion feature. The excess of the Notes’ principal amount over the initial carrying amount of the liability component, the debt discount, is amortized as interest expense over the Notes’ contractual term.
•The equity component was recorded as an increase to additional paid-in capital and is not remeasured as long as it continues to meet the conditions for equity classification.
The Company incurred issuance costs of $14.5 million related to the Notes, allocated between the Notes’ liability and equity components proportionate to the initial carrying amount of the liability and equity components.
•Issuance costs attributable to the liability component are recorded as an offset to the Notes’ principal balance. They are amortized as interest expense using the effective interest method over the contractual term of the Notes.
•Issuance costs attributable to the equity component are recorded as an offset to the equity component in additional paid-in capital and are not amortized.
Net carrying amount of the liability component:
(in thousands)
September 30, 2020
Principal
$
600,000
Unamortized debt discount
(75,061)
Unamortized issuance costs
(11,145)
$
513,794
Net carrying amount of the equity component, included in additional paid-in capital:
(in thousands)
September 30, 2020
Conversion options (1)
$
61,604
(1) Net of issuance costs and taxes.
Interest expense related to the Notes:
Three Months Ended September 30,
Nine Months Ended September 30,
(in thousands)
2020
2019
2020
2019
Contractual interest expense (0.75% coupon)
$
1,125
$
—
$
2,700
$
—
Amortization of debt discount (1)
3,807
—
9,060
—
Amortization of issuance costs (1)
565
—
1,345
—
$
5,497
$
—
$
13,105
$
—
(1) Amortized based upon an effective interest rate of 4.31%.
Future payments of principal and contractual interest:
September 30, 2020
(in thousands)
Principal
Interest
Total
2020
$
—
$
—
$
—
2021
—
4,500
4,500
2022
—
4,500
4,500
2023
—
4,500
4,500
2024
—
4,500
4,500
2025
600,000
1,488
601,488
$
600,000
$
19,488
$
619,488
Capped call transactions
In February 2020, the Company entered into privately negotiated capped call transactions (“Capped Call Transactions”) with certain financial institutions. The Capped Call Transactions cover approximately 4.4 million shares (representing the number of shares for which the Notes are initially convertible) of the Company’s common stock. They are generally expected to reduce potential dilution to the common stock upon any conversion of Notes and/or offset any potential cash payments the Company is required to make in excess of the principal amount of converted Notes, as the case may be, with such reduction and/or offset subject to a cap. The cap price of the Capped Call Transactions is $196.44, subject to adjustment upon the occurrence of specified extraordinary events affecting the Company, including merger events and tender offers.
12
PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
The Capped Call Transactions are accounted for as derivative instruments. The Capped Call Transactions do not qualify for the Company’s own equity scope exception in ASC 815 since, in some cases of early settlement, the settlement value of the Capped Call Transactions, calculated in accordance with the governing documents, may not represent a fair value measurement. The Capped Call Transactions are classified as “other long term assets” and remeasured to fair value at the end of each reporting period, resulting in a non-operating gain or loss.
Change in value of Capped Call Transactions:
(in thousands)
Nine Months Ended September 30, 2020
Value at issuance
$
51,900
Fair value adjustment
19,816
Balance as of September 30,
$
71,716
Credit facility
In November 2019, and as amended in February 2020, July 2020, and October 2020, the Company entered into a five-year $100 million senior secured revolving credit agreement (the “Credit Facility”) with PNC Bank, National Association (“PNC”). The Company may use borrowings to finance working capital needs and for general corporate purposes. Subject to specific conditions, the Credit Facility allows the Company to increase the aggregate commitment to $200 million. The commitments expire on November 4, 2024, and any outstanding loans will be payable on such date. The Credit Facility, as amended, contains customary covenants, including, but not limited to, those relating to additional indebtedness, liens, asset divestitures, and affiliate transactions.
The Company is also required to comply with financial covenants, including:
•Beginning with the fiscal quarter ended on September 30, 2020 and ending with the fiscal quarter ended December 31, 2021 at least $200 million in cash and investments held by Pegasystems Inc.
•Beginning with the quarter ended on March 31, 2022 a maximum net consolidated leverage ratio of 3.5 to 1.0 (with a step-up in the event of certain acquisitions) and a minimum consolidated interest coverage ratio of 3.5 to 1.0.
As of September 30, 2020 and December 31, 2019, we had no outstanding borrowings under the Credit Facility.
7. FAIR VALUE MEASUREMENTS
Assets and liabilities measured at fair value on a recurring basis
The Company records its cash equivalents, Capped Call Transactions, and venture investments 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 minimize unobservable inputs when determining fair value.
The fair value of the Capped Call Transactions at the end of each reporting period is determined using a Black-Scholes option-pricing model. The valuation models use various market-based inputs, including stock price, remaining contractual term, expected volatility, risk-free interest rate, and expected dividend yield, as applicable. The Company applies judgment in its determination of expected volatility. The Company considers both historical and implied volatility levels of the underlying equity security and, to a lesser extent, historical peer group volatility levels. The Company’s venture investments are recorded at fair value based on valuation methods using the observable transaction price and other unobservable inputs, including the volatility, rights, and obligations of the securities the Company holds.
The Company’s assets and liabilities measured at fair value on a recurring basis:
September 30, 2020
December 31, 2019
(in thousands)
Level 1
Level 2
Level 3
Total
Level 1
Level 2
Level 3
Total
Cash equivalents (1)
$
212,917
$
—
$
—
$
212,917
$
—
$
—
$
—
$
—
Marketable securities
$
—
$
186,810
$
—
$
186,810
$
—
$
—
$
—
$
—
Capped Call Transactions (2) (3)
$
—
$
71,716
$
—
$
71,716
$
—
$
—
$
—
$
—
Venture investments (2) (4)
$
—
$
—
$
7,927
$
7,927
$
—
$
—
$
4,871
$
4,871
(1) Investments in money market funds. (2) Included in other long-term assets. (3) See "6. Debt" for additional information. (4) Investments in privately-held companies.
13
PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
Change in venture investments:
(in thousands)
Nine Months Ended September 30, 2020
December 31, 2019
$
4,871
New investments
3,006
Sales of investments
(1,424)
Fair value adjustment
1,474
September 30, 2020
$
7,927
The carrying value of certain other financial instruments, including receivables and accounts payable, approximates fair value due to the relatively short maturity of these items.
Fair value of the Notes
The fair value of the Company’s Notes was recorded at $515.9 million upon issuance, which reflected the principal amount of the Notes less the fair value of the conversion feature. The fair value of the debt component was determined based on a discounted cash flow model. The discount rate used reflected both the time value of money and credit risk inherent in the Notes. The carrying value of the Notes will be accreted, over the remaining term to maturity, to their principal value of $600 million.
The Notes’ fair value (inclusive of the conversion feature, which is embedded in the Notes) was $680 million as of September 30, 2020. The fair value was determined based on the Notes’ quoted price in an over-the-counter market on the last trading day of the reporting period and classified within Level 2 in the fair value hierarchy. See "6. Debt" for additional information.
8. REVENUE
Geographic revenue
Three Months Ended September 30,
Nine Months Ended September 30,
(Dollars in thousands)
2020
2019
2020
2019
U.S.
$
120,971
53
%
$
123,447
57
%
$
436,199
61
%
$
347,120
55
%
Other Americas
10,737
5
%
11,748
5
%
35,009
5
%
49,450
8
%
United Kingdom (“U.K.”)
25,150
11
%
23,034
11
%
68,246
9
%
64,269
10
%
Europe (excluding U.K.), Middle East, and Africa
39,656
18
%
34,761
16
%
106,472
15
%
102,342
16
%
Asia-Pacific
29,437
13
%
23,713
11
%
72,991
10
%
71,660
11
%
$
225,951
100
%
$
216,703
100
%
$
718,917
100
%
$
634,841
100
%
Revenue streams
Three Months Ended September 30,
Nine Months Ended September 30,
(in thousands)
2020
2019
2020
2019
Perpetual license
$
3,852
$
9,016
$
16,568
$
43,286
Term license
35,932
48,989
170,455
122,257
Revenue recognized at a point in time
39,784
58,005
187,023
165,543
Maintenance
74,670
70,371
220,587
207,406
Pega Cloud
54,776
35,153
147,080
94,610
Consulting
56,721
53,174
164,227
167,282
Revenue recognized over time
186,167
158,698
531,894
469,298
$
225,951
$
216,703
$
718,917
$
634,841
14
PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands)
Three Months Ended September 30,
Nine Months Ended September 30,
2020
2019
2020
2019
Pega Cloud
$
54,776
$
35,153
$
147,080
$
94,610
Maintenance
74,670
70,371
220,587
207,406
Term license
35,932
48,989
170,455
122,257
Subscription (1)
165,378
154,513
538,122
424,273
Perpetual license
3,852
9,016
16,568
43,286
Consulting
56,721
53,174
164,227
167,282
$
225,951
$
216,703
$
718,917
$
634,841
(1) Reflects client arrangements subject to renewal (Pega Cloud, maintenance, and term license).
Remaining performance obligations ("Backlog")
Expected future revenue on existing contracts:
September 30, 2020
(Dollars in thousands)
Perpetual license
Term license
Maintenance
Pega Cloud
Consulting
Total
1 year or less
$
8,708
$
50,788
$
170,643
$
211,661
$
14,977
$
456,777
54
%
1-2 years
1,700
5,341
40,631
157,500
2,042
207,214
25
%
2-3 years
—
7,052
18,277
93,283
770
119,382
14
%
Greater than 3 years
—
4
9,597
44,363
653
54,617
7
%
$
10,408
$
63,185
$
239,148
$
506,807
$
18,442
$
837,990
100
%
September 30, 2019
(Dollars in thousands)
Perpetual license
Term license
Maintenance
Pega Cloud
Consulting
Total
1 year or less
$
7,689
$
25,948
$
158,220
$
133,785
$
13,145
$
338,787
56
%
1-2 years
853
3,798
18,590
105,081
863
129,185
21
%
2-3 years
1,306
591
8,323
72,915
841
83,976
14
%
Greater than 3 years
—
85
4,959
51,591
—
56,635
9
%
$
9,848
$
30,422
$
190,092
$
363,372
$
14,849
$
608,583
100
%
9. STOCK-BASED COMPENSATION
Expense
Three Months Ended September 30,
Nine Months Ended September 30,
(in thousands)
2020
2019
2020
2019
Cost of revenue
$
5,100
$
4,787
$
15,636
$
14,216
Selling and marketing
12,658
8,317
33,968
24,055
Research and development
5,765
4,858
17,066
13,990
General and administrative
4,402
3,884
10,085
7,981
$
27,925
$
21,846
$
76,755
$
60,242
Income tax benefit
$
(5,604)
$
(4,430)
$
(15,293)
$
(12,226)
As of September 30, 2020, the Company had $115.0 million of unrecognized stock-based compensation expense, net of estimated forfeitures, which is expected to be recognized over a weighted-average period of 2.2 years.
Grants
The Company granted the following stock-based compensation awards:
Nine Months Ended September 30, 2020
(in thousands)
Shares
Total Fair Value
RSUs
1,026
$
92,456
Non-qualified stock options
1,886
$
44,505
Common stock
6
$
701
15
PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
10. INCOME TAXES
Effective income tax rate
Three Months Ended September 30,
Nine Months Ended September 30,
(Dollars in thousands)
2020
2019
2020
2019
(Benefit from) income taxes
$
(25,053)
$
(17,520)
$
(61,182)
$
(43,158)
Effective income tax rate
48
%
32
%
During the nine months ended September 30, 2020, the Company’s effective income tax rate benefit increased primarily due to the excess tax benefits from stock-based compensation and a carryback claim benefit as a result of the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”).
11. (LOSS) PER SHARE
Basic (loss) per share is calculated using the weighted-average number of common shares outstanding during the period. Diluted (loss) per share is calculated using the weighted-average number of common shares outstanding during the period, plus the dilutive effect of outstanding stock options, RSUs, and the conversion spread of the Company’s convertible senior notes.
Calculation of the basic and diluted earnings per share:
Three Months Ended September 30,
Nine Months Ended September 30,
(in thousands, except per share amounts)
2020
2019
2020
2019
Net (loss)
$
(19,267)
$
(30,338)
$
(65,379)
$
(91,351)
Weighted-average common shares outstanding
80,537
79,200
80,191
78,928
(Loss) per share, basic
$
(0.24)
$
(0.38)
$
(0.82)
$
(1.16)
Net (loss)
$
(19,267)
$
(30,338)
$
(65,379)
$
(91,351)
Weighted-average common shares outstanding, assuming dilution (1) (2)
80,537
79,200
80,191
78,928
(Loss) per share, diluted
$
(0.24)
$
(0.38)
$
(0.82)
$
(1.16)
Outstanding anti-dilutive stock options and RSUs (3)
6,622
5,953
6,166
5,923
(1) The Company expects to settle the principal amount of the Notes in cash. As a result, only the amount by which the conversion value exceeds the aggregated principal amount of the Notes is included in the diluted earnings per share computation under the treasury stock method. The conversion spread has a dilutive impact on diluted net income per share when the average market price of the Company’s common stock for a given period exceeds the initial conversion price of $135.05 per share for the Notes. In connection with the Notes’ issuance, the Company entered into Capped Call Transactions, which were not included in calculating the number of diluted shares outstanding, as their effect would have been anti-dilutive.
(2) In periods of loss, all dilutive securities are excluded as their inclusion would be anti-dilutive.
(3) Certain outstanding stock options and RSUs were excluded from the computation of diluted earnings per share because they were anti-dilutive in the period presented. These awards may be dilutive in the future.
16
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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.
Words such as expects, anticipates, intends, plans, believes, will, could, should, estimates, may, targets, strategies, intends to, projects, forecasts, guidance, likely, and usually, or variations of such words and other similar expressions identify forward-looking statements, which are based on current expectations and assumptions.
These forward-looking statements deal with future events, and are subject to various risks and uncertainties that are difficult to predict, including, but 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, the timing of revenue recognition, management of our transition to a more subscription-based business model, variation in demand for our products and services, including among clients in the public sector, the impact of actual or threatened public health emergencies, such as the Coronavirus (COVID-19), reliance on third-party service providers, compliance with our debt obligations and debt covenants, the potential impact of our convertible senior notes and related Capped Call Transactions, reliance on key personnel, the continued uncertainties in the global economy, foreign currency exchange rates, the potential legal and financial liabilities and reputation damage due to cyber-attacks, security breaches and security flaws, our ability to protect our intellectual property rights and costs associated with defending such rights, maintenance of our client retention rate, and management of our growth. These risks and others that may cause actual results to differ materially from those expressed in such forward-looking statements are described further in Part I of our Annual Report on Form 10-K for the year ended December 31, 2019, and other filings we make with the U.S. Securities and Exchange Commission (“SEC”).
Except as required by applicable law, we do not undertake and expressly disclaim any obligation to publicly update or revise these forward-looking statements whether as the result of new information, future events, or otherwise.
BUSINESS OVERVIEW
We develop, market, license, host, and support enterprise software applications that help organizations transform how they engage with their customers and process work across their enterprise. We also license our low-code Pega Platform™ for rapid application development to clients that wish to build and extend their business applications. Our cloud-architected portfolio of customer engagement and digital process automation applications leverages artificial intelligence (“AI”), case management, and robotic automation technology, built on our unified low-code Pega Platform, empowering businesses to quickly design, extend, and scale their enterprise applications to meet strategic business needs.
Our target clients are Global 3000 organizations and government agencies that require applications to differentiate themselves in the markets they serve. Our applications achieve and facilitate differentiation by increasing business agility, driving growth, improving productivity, attracting and retaining customers, and reducing risk. We deliver applications tailored to our clients’ specific industry needs.
Cloud Transition
We are in the process of transitioning our business to primarily sell software through subscription arrangements, particularly Pega Cloud (“Cloud Transition”). Until we substantially complete our Cloud Transition, which we expect to occur in early 2023, we expect to continue to experience lower revenue growth and lower operating cash flow growth or negative cash flow. The actual mix of perpetual license, term license, and Pega Cloud in a given period can fluctuate based on client preferences.
Additional information on the transition’s impact can be found below and in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2019.
COVID-19
As of September 30, 2020, COVID-19 has not had a material impact on our results of operations or financial condition.
The ultimate impact of COVID-19 on our operational and financial performance will depend on future developments, including the duration and spread of the outbreak, impact on our clients and our sales cycles, and impact on our partners, vendors, or employees, all of which are uncertain and unpredictable. Our shift towards subscription-based revenue streams, the industry mix of our clients, our product mix, the fact that many of our clients are well-known and of large size, and the critical nature of our products to our clients may reduce or delay the impact of COVID-19 on our business. However, it is not possible to estimate the ultimate impact that COVID-19 will have on our business. See “Coronavirus (“COVID-19”)” under Item 1A. Risk Factors for additional information.
17
Performance metrics
We utilize several performance metrics to analyze and assess our overall performance, make operating decisions, and forecast and plan for future periods, including:
Annual contract value (“ACV”) | Increased 21% since September 30, 2019
•ACV represents the annualized value of our active contracts as of the measurement date. The contract's total value is divided by its duration in years to calculate ACV for term license and Pega Cloud contracts. Maintenance revenue for the quarter then ended is multiplied by four to calculate ACV for maintenance. Client Cloud ACV is composed of maintenance ACV and ACV from term license contracts. We believe the presentation of ACV on a constant currency basis enhances the understanding of our results, as it provides visibility into the impact of changes in foreign currency exchange rates, which are outside of our control. All periods shown reflect foreign currency exchange rates as of September 30, 2020.
Remaining performance obligations (“Backlog”) | Increased 38% since September 30, 2019
•Backlog represents contracted revenue that has not yet been recognized and includes deferred revenue and non-cancellable amounts expected to be invoiced and recognized as revenue in future periods.
Year to date Pega Cloud revenue | Increased 55% since September 30, 2019
•Pega Cloud revenue is revenue as reported under U.S. GAAP for cloud contracts.
18
CRITICAL ACCOUNTING POLICIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (“U.S.”) and the rules and regulations of the SEC for interim financial reporting. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses, and the related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions, and expectations of what could occur in the future given the available information.
For more information regarding our critical accounting policies, we encourage you to read the discussion in the following locations in our Annual Report on Form 10-K for the year ended December 31, 2019:
•“Critical Accounting Estimates and Significant Judgments” in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations”; and
•Note 2. “Significant Accounting Policies” in Item 8. “Financial Statements and Supplementary Data.”
There have been no significant changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2019 other than those listed below.
Capped Call Transactions
In February 2020, we entered into privately negotiated capped call transactions (“Capped Call Transactions”) with certain financial institutions. The Capped Call Transactions cover approximately 4.4 million shares (representing the number of shares for which the Notes are initially convertible) of our common stock and are generally expected to reduce potential dilution of our common stock upon any conversion of the Notes. The fair value of the Capped Call Transactions at the end of each reporting period is determined using a Black-Scholes option-pricing model. The valuation models use various market-based inputs, including stock price, remaining contractual term, expected volatility, risk-free interest rate, and expected dividend yield, as applicable. Management applies judgment in its determination of expected volatility. We consider both historical and implied volatility levels of the underlying equity security and, to a lesser extent, historical peer group volatility levels.
The Capped Call Transactions are classified as “other long-term assets” and remeasured to fair value at the end of each reporting period, resulting in a non-operating gain or loss.
See "6. Debt" and “7. Fair Value Measurements” in Item 1 of this Quarterly Report for additional information.
19
RESULTS OF OPERATIONS
Revenue
Our Pega Cloud revenue is derived from our hosted Pega Platform and software applications. Our license revenue is derived from sales of our applications and the Pega Platform.
Cloud Transition
We are in the process of transitioning our business to primarily sell software through subscription arrangements, particularly Pega Cloud. As revenue from Pega Cloud arrangements is generally recognized over the contract term while revenue from perpetual and term licenses is generally recognized when the license rights become effective, the shift has and is expected to continue to result in slower revenue growth during the transition.
(Dollars in thousands)
Three Months Ended September 30,
Change
Nine Months Ended September 30,
Change
2020
2019
2020
2019
Pega Cloud
$
54,776
24
%
$
35,153
16
%
$
19,623
56
%
$
147,080
20
%
$
94,610
15
%
$
52,470
55
%
Maintenance
74,670
33
%
70,371
32
%
4,299
6
%
220,587
31
%
207,406
33
%
13,181
6
%
Term license
35,932
16
%
48,989
23
%
(13,057)
(27)
%
170,455
24
%
122,257
19
%
48,198
39
%
Subscription (1)
$
165,378
73
%
$
154,513
71
%
10,865
7
%
$
538,122
75
%
$
424,273
67
%
113,849
27
%
Perpetual license
3,852
2
%
9,016
4
%
(5,164)
(57)
%
16,568
2
%
43,286
7
%
(26,718)
(62)
%
Consulting
56,721
25
%
53,174
25
%
3,547
7
%
164,227
23
%
167,282
26
%
(3,055)
(2)
%
$
225,951
100
%
$
216,703
100
%
$
9,248
4
%
$
718,917
100
%
$
634,841
100
%
$
84,076
13
%
(1) Reflects client arrangements subject to renewal (Pega Cloud, maintenance, and term license).
The changes in total revenue in the three and nine months ended September 30, 2020 generally reflect our Cloud Transition. Other factors impacting our revenue included:
•Term license revenue was higher in the three months ended September 30, 2019 primarily due to a greater number of large deals than in the three months ended September 30, 2020.
•An increasing portion of our term license contracts include multi-year committed maintenance periods instead of annually renewable maintenance. Under such arrangements, a greater portion of the total contract value is recorded as maintenance revenue, which is recognized over the contract term, rather than as term revenue, as the license rights become effective which is usually shortly after contract execution. In the three and nine months ended September 30, 2020 multi-year committed maintenance contributed $2.9 million and $7.7 million to maintenance revenue growth. In the nine months ended September 30, 2020 multi-year committed maintenance reduced term revenue growth by $10.2 million.
•Maintenance renewal rates remained over 90% in the nine months ended September 30, 2020.
•The decrease in consulting revenue in the nine months ended September 30, 2020 was primarily due to lower billable travel expenses as a result of COVID-19. The increase in consulting revenue in the three months ended September 30, 2020 was primarily due to increased billable hours which more than offset the impact of reduced billable travel expenses due to COVID-19.
Gross profit
Three Months Ended September 30,
Change
Nine Months Ended September 30,
Change
(Dollars in thousands)
2020
2019
2020
2019
Software license
$
39,093
98
%
$
57,329
99
%
$
(18,236)
(32)
%
$
184,669
99
%
$
162,561
98
%
$
22,108
14
%
Maintenance
69,192
93
%
63,683
90
%
5,509
9
%
203,942
92
%
188,091
91
%
15,851
8
%
Pega Cloud
35,059
64
%
17,329
49
%
17,730
102
%
90,842
62
%
46,841
50
%
44,001
94
%
Consulting
4,808
8
%
(2,536)
(5)
%
7,344
*
5,446
3
%
4,933
3
%
513
10
%
$
148,152
66
%
$
135,805
63
%
$
12,347
9
%
$
484,899
67
%
$
402,426
63
%
$
82,473
20
%
* not meaningful
•The changes in gross profit in the three and nine months ended September 30, 2020 were primarily due to our Cloud Transition, revenue growth, and cost efficiency gains as Pega Cloud grows and scales.
•The increase in consulting gross profit in the three months ended September 30, 2020 was primarily due to an increase in consultant utilization. Consultant utilization is impacted by several factors, including the scope and timing of new implementation projects and our level of involvement in implementation projects compared to our consulting partners and enabled clients. To support our long-term strategy, we intend to grow and increasingly leverage our partners and enabled clients for future implementation projects, which may reduce the future growth rate.
20
Operating expenses
(Dollars in thousands)
Three Months Ended September 30,
Change
Nine Months Ended September 30,
Change
2020
2019
2020
2019
% of Revenue
% of Revenue
% of Revenue
% of Revenue
Selling and marketing
$
132,053
58
%
$
115,237
53
%
$
16,816
15
%
$
395,684
55
%
$
341,064
54
%
$
54,620
16
%
Research and development
$
60,024
27
%
$
52,492
24
%
$
7,532
14
%
$
177,620
25
%
$
152,802
24
%
$
24,818
16
%
General and administrative
$
17,907
8
%
$
14,843
7
%
$
3,064
21
%
$
49,192
7
%
$
41,693
7
%
$
7,499
18
%
•The increases in selling and marketing in the three and nine months ended September 30, 2020 were primarily due to increases in compensation and benefits of $24.4 million and $76.0 million, attributable to increases in headcount and equity compensation. The increases in headcount reflect our efforts to increase our sales capacity to deepen relationships with existing clients and target new accounts. These increases were partially offset by decreases in travel and entertainment of $8.5 million and $17.4 million as a result of COVID-19.
•The increases in research and development in the three and nine months ended September 30, 2020 were primarily due to increases in compensation and benefits of $7.8 million and $23.6 million, attributable to increases in headcount and equity compensation.
•The increases in general and administrative in the three and nine months ended September 30, 2020 were primarily due to increases in compensation and benefits of $0.8 million and $3.0 million, attributed to increases in headcount and equity compensation, and increases in professional services fees of $1.5 million and $4.2 million.
Other income (expense), net
(Dollars in thousands)
Three Months Ended September 30,
Change
Nine Months Ended September 30,
Change
2020
2019
2020
2019
Foreign currency transaction gain (loss)
$
4,236
$
(1,970)
$
6,206
*
$
2,545
$
(3,577)
$
6,122
*
Interest income
243
598
(355)
(59)
%
1,092
1,865
(773)
(41)
%
Interest expense
(5,956)
(42)
(5,914)
(14,081)
%
(13,791)
(42)
(13,749)
(32,736)
%
Gain on capped call transactions
18,989
—
18,989
*
19,816
—
19,816
*
Other income, net
—
323
(323)
(100)
%
1,374
378
996
263
%
$
17,512
$
(1,091)
$
18,603
*
$
11,036
$
(1,376)
$
12,412
*
* not meaningful
•The changes in foreign currency transaction gain (loss) in the three and nine months ended September 30, 2020 were primarily due to the impact of fluctuations in foreign currency exchange rates associated with our foreign currency-denominated cash, accounts receivable, and intercompany receivables and payables held by our United Kingdom (“U.K.”) subsidiary.
•The decreases in interest income in the three and nine months ended September 30, 2020 were due to the decreases in market interest rates.
•The increases in interest expense in the three and nine months ended September 30, 2020 were due to our issuance of $600 million in aggregate principal amount of the Notes on February 24, 2020. See "6. Debt" in Item 1 of this Quarterly Report for additional information.
Interest expense related to the Notes:
Three Months Ended September 30,
Change
Nine Months Ended September 30,
Change
(in thousands)
2020
2019
2020
2019
Contractual interest expense (0.75% coupon)
$
1,125
$
—
$
1,125
$
2,700
$
—
$
2,700
Amortization of debt discount
3,807
—
3,807
9,060
—
9,060
Amortization of issuance costs
565
—
565
1,345
—
1,345
$
5,497
$
—
$
5,497
$
13,105
$
—
$
13,105
•The increases in the gain on capped call transactions in the three and nine months ended September 30, 2020 were due to fair value adjustments on the Capped Call Transactions entered into in connection with our issuance of the Notes. See "6. Debt" in Item 1 of this Quarterly Report for additional information.
•The increase in other income, net in the nine months ended September 30, 2020 was due to a gain from our venture investments portfolio.
21
(Benefit from) income taxes
Three Months Ended September 30,
Nine Months Ended September 30,
(Dollars in thousands)
2020
2019
2020
2019
(Benefit from) income taxes
$
(25,053)
$
(17,520)
$
(61,182)
$
(43,158)
Effective income tax rate
48
%
32
%
The inclusion of excess tax benefits from stock-based compensation in the provision for income taxes has increased the variability of the effective tax rates in recent periods. This fluctuation may continue in future periods, depending on our future stock price in relation to the fair value of awards, the timing of the vestings of RSU awards, the exercise behavior of our stock option holders, and the total value of future grants of stock-based compensation awards.
During the nine months ended September 30, 2020, our effective income tax rate benefit increased primarily due to the excess tax benefits from stock-based compensation and a carryback claim benefit as a result of the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”).
LIQUIDITY AND CAPITAL RESOURCES
Nine Months Ended September 30,
(in thousands)
2020
2019
Cash provided by (used in):
Operating activities
$
(26,257)
$
(13,462)
Investing activities
(210,701)
53,448
Financing activities
449,630
(61,941)
Effect of exchange rates on cash and cash equivalents
183
(363)
Net increase (decrease) in cash and cash equivalents
$
212,855
$
(22,318)
(in thousands)
September 30, 2020
December 31, 2019
Held by U.S. entities
$
415,358
$
23,437
Held by foreign entities
52,670
44,926
Total cash, cash equivalents, and marketable securities
$
468,028
$
68,363
We believe that our current cash, cash flow from operations, and borrowing capacity will be sufficient to fund our operations and quarterly cash dividends for at least the next 12 months. Whether these resources are adequate to meet our liquidity needs beyond that period will depend on our growth, operating results, and the investments required to respond to the possible increased demand for our services. If we require additional capital resources to grow our business, we may seek to finance our operations from available funds or additional external financing.
If it became necessary to repatriate foreign funds, we may be required to pay U.S. and foreign taxes upon repatriation. Due to the complexity of income tax laws and regulations, and the Tax Reform Act’s effects, it is impracticable to estimate the amount of taxes we would have to pay.
Cash (used in) operating activities
We are in the process of transitioning our business to primarily sell software through subscription arrangements, particularly Pega Cloud. As cash from Pega Cloud and term arrangements is generally collected over the contract term while cash from perpetual licenses is generally collected when the license rights become effective, the shift has and is expected to continue to impact our cash collections. As client preferences continue to shift in favor of Pega Cloud arrangements, we could continue to experience slower operating cash flow growth, or negative cash flow, in the near term.
In the nine months ended September 30, 2020, COVID-19 did not have a material impact on our cash flows from operations. See “Coronavirus (“COVID-19”)” under Item 1A. Risk Factors for additional information.
The change in cash (used in) operating activities in the nine months ended September 30, 2020 was primarily due to our Cloud Transition and increased costs as we accelerated investments in our Pega Cloud offering and selling and marketing activities to support future growth.
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Cash (used in) provided by investing activities
The change in cash (used in) provided by investing activities in the nine months ended September 30, 2020 was primarily driven by purchases of financial instruments and investments in property and equipment at several of our office locations.
Cash provided by (used in) financing activities
Convertible senior notes
In February 2020, we issued $600 million in aggregate principal amount of our convertible senior notes (“Notes”) due March 1, 2025, which provided proceeds as follows:
(in thousands)
Amount
Principal
$
600,000
Less: issuance costs
(14,527)
Less: Capped Call Transactions
(51,900)
$
533,573
A portion of the proceeds of the Notes was used to fund the Capped Call Transactions with the remainder to be used for working capital and other general corporate purposes. See "6. Debt" in Item 1 of this Quarterly Report for additional information.
Credit facility
In November 2019, and as amended in February 2020, July 2020, and October 2020, we entered into a five-year $100 million senior secured revolving credit agreement (the “Credit Facility”) with PNC Bank, National Association (“PNC”). As of September 30, 2020, we had no outstanding borrowings under the Credit Facility. See "6. Debt" in Item 1 of this Quarterly Report for additional information.
Stock repurchase program (1)
Changes in the remaining stock repurchase authority:
(in thousands)
Nine Months Ended September 30, 2020
December 31, 2019
$
45,484
Authorizations (2)
20,516
Repurchases
(18,828)
September 30, 2020
$
47,172
(1) Purchases under this program have been made on the open market. (2) On June 15, 2020, we announced that our Board of Directors extended the current stock repurchase program’s expiration date to June 30, 2021 and increased the remaining stock repurchase authority to $60 million.
Common stock repurchases
Nine Months Ended September 30,
2020
2019
(in thousands)
Shares
Amount
Shares
Amount
Tax withholdings for net settlement of equity awards
599
$
59,613
514
$
34,871
Stock repurchase program
204
18,828
321
20,286
803
$
78,441
835
$
55,157
During the nine months ended September 30, 2020 and 2019, instead of receiving cash from the equity holders, we withheld shares with a value of $49.5 million and $31.6 million, respectively, for the exercise price of options. These amounts have been excluded from the table above.
Dividends
Nine Months Ended September 30,
(in thousands)
2020
2019
Dividend payments to shareholders
$
7,206
$
7,105
We currently intend to pay a quarterly cash dividend of $0.03 per share. However, the Board of Directors may terminate or modify the dividend program at any time without prior notice.
23
Contractual obligations
As of September 30, 2020, our contractual obligations were:
Payments due by period
(in thousands)
2020
2021
2022-2023
2024-2025
2026 and thereafter
Other
Total
Purchase obligations (1)
$
21,627
$
56,689
$
61,117
$
173
$
—
$
—
$
139,606
Investment commitments (2)
300
500
—
—
—
—
800
Liability for uncertain tax positions (3)
—
—
—
—
—
5,441
5,441
Operating lease obligations
5,490
22,887
43,888
13,187
9,959
—
95,411
$
27,417
$
80,076
$
105,005
$
13,360
$
9,959
$
5,441
$
241,258
(1) Represents the fixed or minimum amounts due under purchase obligations for hosting services and sales and marketing programs.
(2) Represents the maximum funding that would be expected under existing venture investment agreements. Our investment agreements generally allow us to withhold unpaid committed funds at our discretion.
(3) We are unable to reasonably estimate the timing of the cash outflow due to uncertainties in the timing of the effective settlement of tax positions.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk represents the risk of loss that may affect us due to adverse changes in financial market prices and rates.
Foreign currency exposure
Translation risk
Our foreign operations’ operating expenses are primarily denominated in foreign currencies. However, our international sales are also primarily denominated in foreign currencies, which partially offsets our foreign currency exposure.
A hypothetical 10% strengthening in the U.S. dollar against other currencies would result in the following impact:
Nine Months Ended September 30,
2020
2019
(Decrease) increase in revenue
(4)
%
(4)
%
(Decrease) increase in net (loss)
(13)
%
(6)
%
Remeasurement risk
We experience fluctuations in transaction gains or losses from remeasurement of monetary assets and liabilities denominated in currencies other than the functional currency of the entities in which they are recorded.
We are primarily exposed to changes in foreign currency exchange rates associated with the Australian dollar, Euro, and U.S. dollar-denominated cash and cash equivalents, accounts receivable, unbilled receivables, and intercompany receivables and payables held by our U.K. subsidiary, a British pound functional entity.
A hypothetical 10% strengthening in the British pound exchange rate in comparison to the Australian dollar, Euro, and U.S. dollar would result in the following impact:
Nine Months Ended September 30,
(in thousands)
2020
2019
Foreign currency gain (loss)
$
(6,326)
$
1,099
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures
Our management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”)) as of September 30, 2020. In designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and our management necessarily applied its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of September 30, 2020.
24
(b) Changes in internal control over financial reporting
There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended September 30, 2020 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.
COVID-19
In response to COVID-19, we have undertaken measures to protect our employees, partners, and clients, including encouraging employees to work remotely. These changes have compelled us to modify some of our control procedures. However, those changes have so far not been material.
25
PART II - OTHER INFORMATION
ITEM 1A. RISK FACTORS
We encourage you to carefully consider the risk factors identified below and in Item 1A. “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2019, filed with the Securities and Exchange Commission on February 12, 2020. These risk factors could materially affect our business, financial condition, and future results, and they could cause our actual business and financial results to differ materially from those contained in forward-looking statements made in this Quarterly Report on Form 10-Q or elsewhere by management.
Coronavirus (“COVID-19”)
Epidemic diseases, such as the recent global COVID-19 outbreak, could harm our business and results of operations.
The recent outbreak of a novel coronavirus disease (“COVID-19”), which has been declared by the World Health Organization to be a pandemic, has spread across the globe and is impacting worldwide economic activity. A pandemic, including COVID-19, or other public health epidemics pose the risk that our employees, partners, and clients may be prevented from conducting business activities at full capacity for an indefinite period, including due to the spread of the disease within these groups or due to the shutdowns that are requested or mandated by governmental authorities. Moreover, these conditions can affect the rate of IT spending and may adversely affect our clients’ willingness to purchase our solutions, delay prospective clients’ purchasing decisions, reduce the value or duration of their contracts, request concessions including extended payment terms or better pricing, or affect attrition rates, all of which could adversely affect our future sales and operating results. The global spread of COVID-19 has created significant volatility, uncertainty, and economic disruption.
We have undertaken measures to protect our employees, partners, and clients, including by adopting a virtual-only meeting format for our annual PegaWorld conference and encouraging employees to work remotely. There can be no assurance that these measures will be sufficient, however, or that we can implement them without adversely affecting our business operations.
We continue to monitor the situation, and adjust our policies as more information and public health guidance become available. Precautionary measures that have been adopted, or may be adopted in the future, could negatively affect our client success efforts, sales, and marketing efforts, delay and lengthen our sales cycles, or create operational or other challenges, any of which could harm our business and results of operations. In addition, COVID-19 may disrupt our clients’, vendors’, and partners’ operations for an indefinite period, including as a result of travel restrictions and/or business shutdowns, all of which could negatively impact our business and results of operations, including cash flows.
At this time, it is not possible to estimate the ultimate impact that COVID-19 could have on our business, as the impact will depend on future developments, which are highly uncertain and cannot be predicted. Furthermore, due to our shift to a renewable model, the effect of COVID-19 may not be fully reflected in our results of operations until future periods. The extent to which COVID-19 impacts our business, operations, and financial results will depend on numerous evolving factors that we may not be able to predict accurately, including:
•the duration and scope of the pandemic;
•governmental, business, and individual actions taken in response to the pandemic and the impact of those actions on global economic activity;
•the actions taken in response to economic disruption;
•the impact of business disruptions and reductions in our clients’ business and the resulting impact on their demand for our services and solutions; and
•our ability to provide our services and solutions, including as a result of our employees or our clients’ employees working remotely and/or closures of offices and facilities.
Risks related to our Convertible Senior Notes
We have a significant amount of debt that may decrease our business flexibility, access to capital, and/or increase our borrowing costs, and we may still incur additional debt in the future, which may adversely affect our operations and financial results.
As of September 30, 2020, we had $600 million aggregate principal amount of indebtedness under our Convertible Senior Notes due 2025 (the “Notes”).
Our indebtedness may:
•limit our ability to borrow additional funds for working capital, capital expenditures, acquisitions, or other business purposes;
•limit our ability to use our cash flow or obtain additional financing for future working capital, capital expenditures, acquisitions, or other general business purposes;
•require us to use a substantial portion of our cash flow from operations to make debt service payments;
•limit our flexibility to plan for, or react to, changes in our business and industry;
•place us at a competitive disadvantage compared to our less leveraged competitors;
•dilute the interests of our existing stockholders as a result of issuing shares of our common stock upon the conversion of the Notes; and
26
•increase our vulnerability to the impact of adverse economic and industry conditions.
Our ability to pay our debt when due or refinance our indebtedness, including the Notes, depends on our future performance, which is subject to economic, financial, competitive, and other factors beyond our control. Our business may not generate cash flow from operations in the future sufficient to service our debt and make necessary investments in our business. Our ability to refinance our indebtedness will depend on the capital markets and our financial condition at such time. We may not be able to engage in any of these activities or engage in these activities on desirable terms, which could result in a default on our debt obligations which could, in turn, result in that and our other indebtedness becoming immediately payable in full. In addition, we may incur additional debt to meet future financing needs. If we incur additional indebtedness, the risks related to our business and our ability to service or repay our indebtedness will increase.
The conditional conversion feature of the Notes, if triggered, may adversely affect our financial condition and operating results.
Under certain circumstances, the noteholders may convert their Notes at their option prior to the scheduled maturities. Upon conversion of the Notes, unless we elect to deliver solely shares of our common stock to settle such conversion, we will be obligated to make cash payments. In addition, holders of our Notes will have the right to require us to repurchase their Notes upon the occurrence of a fundamental change (as defined in the indenture, dated as of February 24, 2020, between U.S. Bank National Association, as trustee (the “Trustee”) and us (the “Indenture”)), at a repurchase price equal to 100% of the principal amount of the Notes to be repurchased, plus accrued and unpaid interest, if any, to, but not including, the fundamental change repurchase date. Although it is our intention and we currently expect to settle the conversion value of the Notes in cash up to the principal amount and any excess in shares, there is a risk that we may not have enough available cash or be able to obtain financing at the time we are required to make repurchases of Notes surrendered therefor or Notes being converted. In addition, our ability to make payments may be limited by law, by regulatory authority, or by agreements governing our future indebtedness. Our failure to repurchase Notes when the Indenture requires the repurchase or to pay any cash payable on future conversions of the Notes as required by the Indenture would constitute a default under the Indenture. A default under the Indenture or the fundamental change itself could also lead to a default under agreements governing our future indebtedness. If the repayment of the related indebtedness were to be accelerated after any applicable notice or grace periods, we may not have sufficient funds to repay the indebtedness and repurchase the Notes or make cash payments upon conversions thereof. In addition, even if holders of Notes do not elect to convert their Notes, we could be required under applicable accounting rules to reclassify all or a portion of the outstanding principal of the Notes as a current rather than long-term liability, which would result in a material reduction of our net working capital.
The accounting method for convertible debt securities that may be settled in cash, such as the Notes, could have a material impact on our reported financial results.
Under Accounting Standards Codification 470-20, Debt with Conversion and Other Options (ASC 470-20), an entity must separately account for the liability and equity components of the convertible debt instruments (such as the Notes) that may be settled entirely or partially in cash upon conversion in a manner that reflects the issuer’s economic interest cost. The effect of ASC 470-20 on the accounting for the Notes is that the equity component is required to be included in the additional paid-in capital section of stockholders’ equity on our consolidated balance sheet at the issuance date and the value of the equity component is treated as debt discount for purposes of accounting for the debt component of the Notes. As a result, we will be required to record non-cash interest expense through the amortization of the excess of the face amount over the carrying amount of the expected life of the Notes. We will report larger net losses (or lower net income) in our financial results because ASC 470-20 requires interest to include both the amortization of the debt discount and the instrument’s cash coupon interest rate, which could adversely affect our reported or future financial results, the trading price of our common stock, and the trading price of the Notes.
In addition, under certain circumstances, convertible debt instruments (such as the Notes) that may be settled entirely or partially in cash may be accounted for utilizing the treasury stock method, the effect of which is that the shares issuable upon conversion of such Notes are not included in the calculation of diluted earnings per share except to the extent that the conversion value of such Notes exceeds their principal amount. Under the treasury stock method, the number of common stock shares that would be necessary to settle such excess, if we elected to settle such excess in shares, is included in the denominator to calculate diluted earnings per share. We cannot be sure that the accounting standards will continue to permit the treasury stock method. If we are unable or otherwise elect not to use the treasury stock method in accounting for the shares issuable upon conversion of the Notes, our diluted earnings per share could be adversely affected.
The Capped Call Transactions may affect the value of the Notes and our common stock.
In connection with the Notes’ issuance, we entered into Capped Call Transactions with certain financial institutions (“option counterparties”). The Capped Call Transactions are generally expected to reduce the potential dilution to our common stock upon any conversion of the Notes and/or offset any cash payments we are required to make in excess of the principal amount of converted Notes, as the case may be, with such reduction and/or offset subject to a cap. From time to time, the option counterparties that are parties to the Capped Call Transactions or their respective affiliates may modify their hedge positions by entering into or unwinding various derivative transactions with respect to our common stock and/or purchasing or selling our common stock or other securities of ours in secondary market transactions prior to the maturity of the Notes. This activity could cause a decrease in the market price of our common stock.
27
We are subject to counterparty risk with respect to the Capped Call Transactions.
The option counterparties are financial institutions, and we are subject to the risk that one or more of the option counterparties may default or otherwise fail to perform, or may exercise certain rights to terminate, their obligations under the Capped Call Transactions. Our exposure to the credit risk of the option counterparties is not secured by any collateral. Recent global economic conditions have resulted in the actual or perceived failure or financial difficulties of many financial institutions. If an option counterparty becomes subject to insolvency proceedings, we will become an unsecured creditor in those proceedings with a claim equal to our exposure at the time under such transaction. Our exposure depends on many factors, but our exposure will generally increase if the market price or the volatility of our common stock increases. In addition, upon default or other failures to perform, or termination of obligations, by an option counterparty, we may suffer more dilution than we currently anticipate with respect to our common stock. We can provide no assurances as to the financial stability or viability of the option counterparties.
Provisions in the Notes’ Indenture may deter or prevent a business combination that may be favorable to our stockholders.
If a fundamental change occurs prior to the Notes’ maturity date, holders of the Notes will have the right, at their option, to require us to repurchase all or a portion of their Notes. In addition, if a “make-whole fundamental change” (as defined in the Indenture) occurs prior to the maturity date, we will in some cases be required to increase the conversion rate of the Notes for a holder that elects to convert its Notes in connection with such make-whole fundamental change.
Furthermore, the Indenture will prohibit us from engaging in certain mergers or acquisitions unless, among other things, the surviving entity assumes our obligations under the Notes. These and other provisions in the Indenture could deter or prevent a third party from acquiring us even when the acquisition may be favorable to our stockholders.
Conversion of the Notes may dilute the ownership interest of existing stockholders.
The conversion of some or all of the Notes will dilute the ownership interests of existing stockholders to the extent we deliver shares of our common stock upon conversion of any of the Notes. Any sales in the public market of the common stock issuable upon such conversion could adversely affect our common stock’s prevailing market prices. In addition, the existence of the Notes may encourage short selling by market participants because the conversion of the Notes could be used to satisfy short positions, or anticipated conversion of the Notes into shares of our common stock could depress the price of our common stock.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Issuer purchases of equity securities
Common stock repurchased in the three months ended September 30, 2020 was:
(in thousands, except per share amounts)
Total Number of Shares Purchased (1) (2)
Average
Price Paid
per Share (1) (2)
Total Number of Shares Purchased as Part of Publicly Announced Share Repurchase Program (2)
Approximate Dollar Value of Shares That May Yet Be Purchased at Period End Under Publicly Announced Share Repurchase Programs (2)
July 1, 2020 - July 31, 2020
135
$
109.36
42
$
53,470
August 1, 2020 - August 31, 2020
162
$
120.08
26
$
50,321
September 1, 2020 - September 30, 2020
138
$
124.88
26
$
47,172
435
$
118.29
94
(1) Shares withheld to cover the option exercise price and tax withholding obligations under the net settlement provisions of our stock compensation awards have been included in these amounts.
(2) On June 15, 2020, we announced that our Board of Directors extended the current stock repurchase program’s expiration date to June 30, 2021 and increased the remaining stock repurchase authority to $60 million. See "Liquidity and Capital Resources" in Item 2 of this Quarterly Report for additional information.
Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document.
Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101)
+ Filed herewith.
++ Indicates that the exhibit is being furnished with this report and is not filed as a part of it.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Pegasystems Inc.
Dated:
October 28, 2020
By:
/s/ KENNETH STILLWELL
Kenneth Stillwell
Chief Financial Officer and Chief Administrative Officer