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 include,deal with future events, and are subject to various risks and uncertainties that are difficult to predict, including, but are not limited to, statements about our future financial performance and business plans, the adequacy of our liquidity and capital resources, the continued payment of quarterly dividends, and 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 more completelyfurther in Part I of our Annual Report on Form 10-K for the year ended December 31, 2018.
BUSINESS OVERVIEW
We develop, market, license, host, and support enterprise software applications that help organizations transform the wayhow they engage with their customers and process and complete work across their enterprise. We also license our no-codelow-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 no-codelow-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.
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Performance metrics
We utilize several performance metrics in analyzingto analyze and assessingassess our overall performance, makingmake operating decisions, and forecastingforecast and planningplan for future periods.periods, including:
(Dollars in thousands, except per share amounts) | Three Months Ended September 30, | Change | Nine Months Ended September 30, | Change | |||||||||||||||||||||||
| 2019 | 2018 | 2019 | 2018 | ||||||||||||||||||||||||
| Total revenue | $ | 216,703 | $ | 203,263 | $ | 13,440 | 7 | % | $ | 634,841 | $ | 635,224 | $ | (383 | ) | — | % | ||||||||||
Subscription revenue (1) | $ | 154,513 | $ | 120,267 | $ | 34,246 | 28 | % | $ | 424,273 | $ | 382,485 | $ | 41,788 | 11 | % | |||||||||||
| Net (loss) | $ | (30,338 | ) | $ | (7,587 | ) | $ | (22,751 | ) | (300 | )% | $ | (91,351 | ) | $ | (5,796 | ) | $ | (85,555 | ) | (1,476 | )% | |||||
| (Loss) per share, diluted | $ | (0.38 | ) | $ | (0.10 | ) | $ | (0.28 | ) | (280 | )% | $ | (1.16 | ) | $ | (0.07 | ) | $ | (1.09 | ) | (1,557 | )% | |||||
Annual contract value (“ACV”) (1) (2)| Increased 21% since September 30, 2019
| September 30, | Change | Constant Currency Change | ||||||||||||||
| (Dollars in thousands) | 2019 | 2018 | ||||||||||||||
| Maintenance | $ | 281,484 | $ | 264,068 | $ | 17,416 | 7 | % | 9 | % | ||||||
| Term | 207,317 | 174,320 | $ | 32,997 | 19 | % | 20 | % | ||||||||
| Client Cloud | 488,801 | 438,388 | $ | 50,413 | 11 | % | 13 | % | ||||||||
| Pega Cloud | 145,549 | 98,373 | 47,176 | 48 | % | 51 | % | |||||||||
| Total ACV | $ | 634,350 | $ | 536,761 | $ | 97,589 | 18 | % | 20 | % | ||||||
Remaining performance obligations (“RPO”Backlog”) | Increased 38% since September 30, 2019
Year to date Pega Cloud revenue on existing contracts:
(1)Reflects client arrangements (term license, cloud,Our Pega Cloud revenue is derived from our hosted Pega Platform and maintenance) that are subject to renewal.Subscription revenue
Perpetual licenseThe decreases in perpetual license revenuemarketing in the three and nine months ended September 30, 2019 reflects the shift in client preferences in favor of our cloud offerings instead of our perpetual license arrangements.ConsultingOur consulting revenue fluctuates depending upon the mix of new implementation projects we perform as compared to those performed by our enabled clients or led by our partners. The decreases in consulting revenue in the three and nine months ended September 30, 20192020 were primarily due to decreases in billable hours.
Gross profit
* not meaningfulThe recent shift in our revenue mix toward cloud arrangements has resulted in slower total gross profit growth as our cloud business continues to grow and scale. Revenue from cloud arrangements is generally recognized over the service period, while revenue from term and perpetual license arrangements is generally recognized upfront when the license rights become effective.The increase in total gross profit in the three months ended September 30, 2019 was primarily due to an increase in term revenue recognized from several large, multi-year term license contracts in the three months ended September 30, 2019. It was also due to an increase in cloud revenue reflecting the shift in client preferences to cloud arrangements from other types of arrangements, an increase in maintenance revenue due to the continued growth in the aggregate value of the installed base of our software and strong renewal rates in excess of 90%.The decrease in total gross profit in the nine months ended September 30, 2019 was primarily due to a decrease in term and perpetual license revenue and a decrease in consulting revenue due to a decrease in billable hours.The decrease in total gross profit percent in the nine months ended September 30, 2019 was driven by the shift in client preferences in favor of cloud arrangements, which are lower margin than our term and perpetual license revenue streams and decreases in cloud and consulting gross profit percent.The decreases in cloud gross profit percent in the three and nine months ended September 30, 2019 were driven by an increase in costs as we accelerated our investments in cloud infrastructure and service delivery to support future growth. The decreases in consulting gross profit percent in the three and nine months ended September 30, 2019 were driven by a decrease in billable hours as consulting resources were transitioning to new projects after completing a large project and an increase in consulting resource availability as we continue growing and leveraging our partner network.Operating expensesSelling and marketing
(1) Includes compensation, benefits, and other headcount-related expenses associated with selling and marketing activities, as well as advertising, promotions, trade shows, seminars, and the amortization of client-related intangibles.The increases in the three and nine months ended September 30, 2019 were primarily due to compensation and benefits of $22.6$24.4 million and $58.1$76.0 million, attributable to increased headcount, equity compensation, and increases of $4.0 million and $10.6 million in deferred contract cost amortization. Also, contributing to the increases were travel and entertainment of $2.6 million and $4.5 million. The increase in headcount reflectsand equity compensation. The increases in headcount reflect our efforts to increase our sales capacity to deepen relationships with existing clients and target new accounts.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.Research•The increases in research and development
(1) Includes compensation, benefits, contracted services, and other headcount-related expenses associated with the development of our products, as well as enhancements and design changes to existing products and the integration of acquired technologies.
The increases in the three and nine months ended September 30, 20192020 were primarily due to increases in compensation and benefits of $3.8$7.8 million and $10.5$23.6 million, attributable to an increaseincreases in headcount and equity compensation, and $1.2 million and $4.5 million in cloud hosting expenses as we expand our cloud-focused research and development activities.General and administrative
(1)• Includes compensation, benefits, and other headcount-related expenses associated with finance, legal, corporate governance, and other administrative headcount. It also includes accounting, legal, and other professional consultingThe increases in general and administrative fees. (2) The headcount includes employees in corporate services departments, whose costs are partially allocated to other operating expense areas.The increases in the three and nine months ended September 30, 20192020 were primarily due to increases in compensation and benefits of $3.2$0.8 million and $3.7$3.0 million, dueattributed to increased headcount.increases in headcount and equity compensation, and increases in professional services fees of $1.5 million and $4.2 million.
Stock-based compensation•
Other income (expense), net
* not meaningfulThe changes in foreign currency transaction (loss) gain2020 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.
| September 30, 2019 | |||||||||||||||||||||||||
| (Dollars in thousands) | Perpetual license | Term license | Maintenance | 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 | % | ||||||||||||
| Change in RPO Since September 30, 2018 | |||||||||||||||||||||||||
| $ | (23,651 | ) | $ | (25,740 | ) | $ | 36,959 | $ | 100,272 | $ | (1,587 | ) | $ | 86,253 | |||||||||||
| (71 | )% | (46 | )% | 24 | % | 38 | % | (10 | )% | 17 | % | ||||||||||||||
| September 30, 2018 | |||||||||||||||||||||||||
| (Dollars in thousands) | Perpetual license | Term license | Maintenance | Cloud | Consulting | Total | |||||||||||||||||||
| 1 year or less | $ | 25,343 | $ | 44,283 | $ | 140,591 | $ | 88,529 | $ | 14,107 | $ | 312,853 | 60 | % | |||||||||||
| 1-2 years | 6,490 | 10,063 | 8,877 | 70,815 | 1,830 | 98,075 | 19 | % | |||||||||||||||||
| 2-3 years | 360 | 1,598 | 2,586 | 54,646 | 449 | 59,639 | 11 | % | |||||||||||||||||
| Greater than 3 years | 1,306 | 218 | 1,079 | 49,110 | 50 | 51,763 | 10 | % | |||||||||||||||||
| $ | 33,499 | $ | 56,162 | $ | 153,133 | $ | 263,100 | $ | 16,436 | $ | 522,330 | 100 | % | ||||||||||||
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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, and 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 contained in the following locations in our Annual Report on Form 10-K for the year ended December 31, 2018:2019:
•“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”.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, 2018.2019 other than those listed below.
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.
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RESULTS OF OPERATIONS
Revenue
| (Dollars in thousands) | Three Months Ended September 30, | Change | Nine Months Ended September 30, | Change | |||||||||||||||||||||||||||||||
| 2019 | 2018 | 2019 | 2018 | ||||||||||||||||||||||||||||||||
| Cloud | $ | 35,153 | 16 | % | $ | 22,184 | 11 | % | $ | 12,969 | 58 | % | $ | 94,610 | 15 | % | $ | 57,967 | 9 | % | $ | 36,643 | 63 | % | |||||||||||
| Term license | 48,989 | 23 | % | 32,066 | 16 | % | 16,923 | 53 | % | 122,257 | 19 | % | 128,070 | 20 | % | (5,813 | ) | (5 | )% | ||||||||||||||||
| Maintenance | 70,371 | 32 | % | 66,017 | 32 | % | 4,354 | 7 | % | 207,406 | 33 | % | 196,448 | 31 | % | 10,958 | 6 | % | |||||||||||||||||
Subscription (1) | 154,513 | 71 | % | 120,267 | 59 | % | 34,246 | 28 | % | 424,273 | 67 | % | 382,485 | 60 | % | 41,788 | 11 | % | |||||||||||||||||
| Perpetual license | 9,016 | 4 | % | 20,276 | 10 | % | (11,260 | ) | (56 | )% | 43,286 | 7 | % | 56,829 | 9 | % | (13,543 | ) | (24 | )% | |||||||||||||||
| Consulting | 53,174 | 25 | % | 62,720 | 31 | % | (9,546 | ) | (15 | )% | 167,282 | 26 | % | 195,910 | 31 | % | (28,628 | ) | (15 | )% | |||||||||||||||
| $ | 216,703 | 100 | % | $ | 203,263 | 100 | % | $ | 13,440 | 7 | % | $ | 634,841 | 100 | % | $ | 635,224 | 100 | % | $ | (383 | ) | — | % | |||||||||||
software applications. Our license revenue is derived from sales of our applications and the Pega Platform. Our cloud revenue is derived from our hosted Pega Platform and software applications.
Cloud Transition
We expect our revenue mix to continue to shift in favor of our subscription offerings, particularly cloud arrangements, which could result in slower total revenue growthare in the near term. Revenueprocess of transitioning our business to primarily sell software through subscription arrangements, particularly Pega Cloud. As revenue from cloudPega Cloud arrangements is generally recognized over the service period,contract term while revenue from perpetual and term and perpetual license arrangementslicenses is generally recognized upfront when the license rights become effective.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 increaseschanges in cloudtotal 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 reflectprimarily due to a greater number of large deals than in the shiftthree 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 client preferencesthe nine months ended September 30, 2020.
•The decrease in consulting revenue in the nine months ended September 30, 2020 was primarily due to cloud arrangements from other typeslower billable travel expenses as a result of arrangements.COVID-19. The increase in term licenseconsulting revenue in the three months ended September 30, 20192020 was primarily due to revenue recognized from several large, multi-year term license contractsincreased 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 the three months ended September 30, 2019. The decrease in term license revenue in the nine months ended September 30, 2019 was attributable to revenue recognized from term license contracts in the nine months ended September 30, 2019 with multi-year committed maintenance periods, which resulted in a greater portion of the contract value being allocated to maintenance. The increases in maintenance revenuegross profit in the three and nine months ended September 30, 20192020 were primarily due to the continuedour Cloud Transition, revenue growth, and cost efficiency gains as Pega Cloud grows and scales.
•The increase in consulting gross profit in the aggregate valuethree 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 installed base of our softwarefuture growth rate.
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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 strong renewal rates in excess of 90%.
| Three Months Ended September 30, | Change | Nine Months Ended September 30, | Change | ||||||||||||||||||||||||||||||||
| (Dollars in thousands) | 2019 | 2018 | 2019 | 2018 | |||||||||||||||||||||||||||||||
| Software license | $ | 57,329 | 99 | % | $ | 51,087 | 98 | % | $ | 6,242 | 12 | % | $ | 162,561 | 98 | % | $ | 181,127 | 98 | % | $ | (18,566 | ) | (10 | )% | ||||||||||
| Maintenance | 63,683 | 90 | % | 59,938 | 91 | % | 3,745 | 6 | % | 188,091 | 91 | % | 178,413 | 91 | % | 9,678 | 5 | % | |||||||||||||||||
| Cloud | 17,329 | 49 | % | 12,569 | 57 | % | 4,760 | 38 | % | 46,841 | 50 | % | 31,853 | 55 | % | 14,988 | 47 | % | |||||||||||||||||
| Consulting | (2,536 | ) | (5 | )% | 5,246 | 8 | % | (7,782 | ) | * | 4,933 | 3 | % | 19,977 | 10 | % | (15,044 | ) | (75 | )% | |||||||||||||||
| $ | 135,805 | 63 | % | $ | 128,840 | 63 | % | $ | 6,965 | 5 | % | $ | 402,426 | 63 | % | $ | 411,370 | 65 | % | $ | (8,944 | ) | (2 | )% | |||||||||||
| Three Months Ended September 30, | Change | Nine Months Ended September 30, | Change | ||||||||||||||||||||||||
| (Dollars in thousands) | 2019 | 2018 | 2019 | 2018 | |||||||||||||||||||||||
Selling and marketing (1) | $ | 115,237 | $ | 87,490 | $ | 27,747 | 32 | % | $ | 341,064 | $ | 269,845 | $ | 71,219 | 26 | % | |||||||||||
| As a percent of total revenue | 53 | % | 43 | % | 54 | % | 42 | % | |||||||||||||||||||
Selling and marketing headcount, end of period | 1,532 | 1,194 | 338 | 28 | % | ||||||||||||||||||||||
| Three Months Ended September 30, | Change | Nine Months Ended September 30, | Change | ||||||||||||||||||||||||
| (Dollars in thousands) | 2019 | 2018 | 2019 | 2018 | |||||||||||||||||||||||
Research and development (1) | $ | 52,492 | $ | 46,504 | $ | 5,988 | 13 | % | $ | 152,802 | $ | 135,261 | $ | 17,541 | 13 | % | |||||||||||
| As a percent of total revenue | 24 | % | 23 | % | 24 | % | 21 | % | |||||||||||||||||||
Research and development headcount, end of period | 1,631 | 1,595 | 36 | 2 | % | ||||||||||||||||||||||
| Three Months Ended September 30, | Change | Nine Months Ended September 30, | Change | ||||||||||||||||||||||||
| (Dollars in thousands) | 2019 | 2018 | 2019 | 2018 | |||||||||||||||||||||||
General and administrative (1) | $ | 14,843 | $ | 12,104 | $ | 2,739 | 23 | % | $ | 41,693 | $ | 38,749 | $ | 2,944 | 8 | % | |||||||||||
| As a percent of total revenue | 7 | % | 6 | % | 7 | % | 6 | % | |||||||||||||||||||
General and administrative headcount, end of period (2) | 420 | 326 | 94 | 29 | % | ||||||||||||||||||||||
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
| Three Months Ended September 30, | Change | Nine Months Ended September 30, | Change | ||||||||||||||||||||||||
| (Dollars in thousands) | 2019 | 2018 | 2019 | 2018 | |||||||||||||||||||||||
| Cost of revenues | $ | 4,787 | $ | 4,319 | $ | 468 | 11 | % | $ | 14,216 | $ | 12,277 | $ | 1,939 | 16 | % | |||||||||||
| Selling and marketing | 8,317 | 6,198 | 2,119 | 34 | % | 24,055 | 16,895 | 7,160 | 42 | % | |||||||||||||||||
| Research and development | 4,858 | 3,917 | 941 | 24 | % | 13,990 | 11,356 | 2,634 | 23 | % | |||||||||||||||||
| General and administrative | 3,884 | 1,974 | 1,910 | 97 | % | 7,981 | 7,045 | 936 | 13 | % | |||||||||||||||||
| $ | 21,846 | $ | 16,408 | $ | 5,438 | 33 | % | $ | 60,242 | $ | 47,573 | $ | 12,669 | 27 | % | ||||||||||||
The increaseschanges in foreign currency transaction gain (loss) in the three and nine months ended September 30, 2019 were primarily due to the increased value of our annual periodic equity awards granted in March 2019 and 2018 and increased headcount. These awards generally have a five-year vesting schedule.
| Three Months Ended September 30, | Change | Nine Months Ended September 30, | Change | ||||||||||||||||||||||||
| (Dollars in thousands) | 2019 | 2018 | 2019 | 2018 | |||||||||||||||||||||||
| Foreign currency transaction (loss) gain | $ | (1,970 | ) | $ | 399 | $ | (2,369 | ) | * | $ | (3,577 | ) | $ | 558 | $ | (4,135 | ) | * | |||||||||
| Interest income, net | 556 | 683 | (127 | ) | (19 | )% | 1,823 | 2,076 | (253 | ) | (12 | )% | |||||||||||||||
| Other income, net | 323 | — | 323 | * | 378 | 363 | 15 | 4 | % | ||||||||||||||||||
| $ | (1,091 | ) | $ | 1,082 | $ | (2,173 | ) | * | $ | (1,376 | ) | $ | 2,997 | $ | (4,373 | ) | * | ||||||||||
•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.
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(Benefit from) income taxes
| Three Months Ended September 30, | Nine Months Ended September 30, | Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||||||||||||||||||||||
| (Dollars in thousands) | 2019 | 2018 | 2019 | 2018 | (Dollars in thousands) | 2020 | 2019 | 2020 | 2019 | |||||||||||||||||||||||||||||
| (Benefit from) income taxes | $ | (17,520 | ) | $ | (8,589 | ) | $ | (43,158 | ) | $ | (23,692 | ) | (Benefit from) income taxes | $ | (25,053) | $ | (17,520) | $ | (61,182) | $ | (43,158) | |||||||||||||||||
| Effective income tax rate | 32 | % | 80 | % | 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 vestings,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, 2019, the Company’s2020, our effective income tax rate changedbenefit increased primarily due to the Global Intangible Low-Taxed Income (“GILTI”) provision of the Tax Reform Act. The Company’s effective income tax rate was also affected by excess tax benefits from stock-based compensation and an increase in U.S. researcha carryback claim benefit as a result of the Coronavirus Aid, Relief, and development tax credits.Economic Security Act (“CARES Act”).
LIQUIDITY AND CAPITAL RESOURCES
| Nine Months Ended September 30, | |||||||
| (in thousands) | 2019 | 2018 | |||||
| Cash provided by (used in): | |||||||
| Operating activities | $ | (13,462 | ) | $ | 67,088 | ||
| Investing activities | 53,448 | (49,595 | ) | ||||
| Financing activities | (61,941 | ) | (71,664 | ) | |||
| Effect of exchange rates on cash and cash equivalents | (363 | ) | (1,913 | ) | |||
| Net (decrease) in cash and cash equivalents | $ | (22,318 | ) | $ | (56,084 | ) | |
| (in thousands) | September 30, 2019 | December 31, 2018 | |||||
| Held by U.S. entities | $ | 41,484 | $ | 143,533 | |||
| Held by foreign entities | 71,085 | 63,890 | |||||
| Total cash, cash equivalents, and marketable securities | $ | 112,569 | $ | 207,423 | |||
| 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 equivalents, marketable securities, cash flow from operations, and borrowing capacity will be sufficient to fund our operations and quarterly cash dividends and stock repurchases 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 meetrespond 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. state and local taxes, as well as foreign taxes upon repatriation. Due to the complexity of income tax laws and regulations, and the effects of the Tax Reform Act,Act’s effects, it is impracticable to estimate the amount of taxes we would have to pay.
Cash (used in) provided by 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 cloudPega Cloud arrangements, we could continue to experience slower operating cash flow growth, or negative cash flow, in the near term. Cash
In the nine months ended September 30, 2020, COVID-19 did not have a material impact on our cash flows from cloud arrangements is generally collected over an average service period of three years, while cash from perpetual license arrangements is generally collected upfront, shortly after the license rights become effective.operations. See “Coronavirus (“COVID-19”)” under Item 1A. Risk Factors for additional information.
The primary driver of the decreasechange in cash (used in) operating activities in the nine months ended September 30, 20192020 was the recent shift inprimarily due to our revenue mix toward cloud arrangements, which are generally collected over an average service period of three years,Cloud Transition and increased costs as the Companywe accelerated investments in its cloud offeringsour 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) investing activities
In February 2020, we issued $600 million in financing activities for repurchasesaggregate principal amount of our common stockconvertible 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 our publicly announced stock repurchase programs, stock repurchasesthe Credit Facility. See "6. Debt" in Item 1 of this Quarterly Report for tax withholdings for the net settlement of our equity awards, and the payment of our quarterly dividend.additional information.
Stock repurchase program (1)
| Nine Months Ended September 30, | |||
| (in thousands) | 2019 | ||
| January 1, | $ | 6,620 | |
Authorizations (2) | 60,000 | ||
| Repurchases | (20,286 | ) | |
| September 30, | $ | 46,334 | |
| (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 these programsthis program have been made on the open market. (2) On MarchJune 15, 2019,2020, we announced that our Board of Directors extended the expiration date of the current stock repurchase programprogram’s expiration date to June 30, 20202021 and increased the amount of commonremaining stock we are authorizedrepurchase authority to repurchase by $60 million .million.
Common stock repurchases
| Nine Months Ended September 30, | |||||||||||||
| 2019 | 2018 | ||||||||||||
| (in thousands) | Shares | Amount | Shares | Amount | |||||||||
| Tax withholdings for net settlement of equity awards | 514 | $ | 34,871 | 591 | $ | 35,530 | |||||||
Stock repurchase program (1) | |||||||||||||
| Repurchases paid | 318 | 20,086 | 512 | 29,949 | |||||||||
| Repurchases unsettled at period end | 3 | 200 | 3 | 200 | |||||||||
Activity in period (2) | 835 | $ | 55,157 | 1,106 | $ | 65,679 | |||||||
| 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, 20192020 and 2018,2019, instead of receiving cash from the equity holders, we withheld shares with a value of $31.6$49.5 million and $28.2$31.6 million, respectively, for the exercise price of options. These amounts have been excluded from the table above.
| Nine Months Ended September 30, | |||||||
| (in thousands) | 2019 | 2018 | |||||
| Dividend payments to shareholders | $ | 7,105 | $ | 7,067 | |||
| 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,share. However, the Board of Directors may terminate or modify the dividend program at any time without prior notice.
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
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 nine months ended September 30, 2019U.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 market risk exposure disclosedAustralian dollar, Euro, and U.S. dollar would result in our Annual Report on Form 10-K for the year ended December 31, 2018.following impact:
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, 2019.2020. 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, 20192020.
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(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, 20192020 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.
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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, 2018.2019, 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 managementmanagement.
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 time.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:
•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 entered into a five-year $100may 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 senior secured revolving credit agreementaggregate principal amount of indebtedness under our Convertible Senior Notes due 2025 (the “Credit Agreement”) with PNC Bank, National Association (“PNC”“Notes”). We may use borrowings
Our indebtedness may:
•limit our ability to financeborrow additional funds for working capital, needs andcapital 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 corporate purposes. Subject to specific circumstances, the Credit Agreement allowsbusiness 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
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•increase our vulnerability to the aggregate commitment up to $200 million. See Item 5. “Other Information” for additional information.
Our ability to repay any amounts we borrow underpay our Credit Agreement will dependdebt when due or refinance our indebtedness, including the Notes, depends on market conditions and our future performance, which areis subject to economic, financial, competitive, and other factors beyond our control. If we areOur business may not profitablegenerate 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 use moreelect to deliver solely shares of our common stock to settle such conversion, we will be obligated to make cash than we generatepayments. 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 levelfuture 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 such timethe 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 operations by increasingreported or future financial results, the trading price of our vulnerabilitycommon 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 adverse changesthe 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 general economic and industry conditions and by limiting or prohibiting our abilityshares, is included in the denominator to obtain additional financing for additional capital expenditures, acquisitions and general corporate and other purposes.calculate diluted earnings per share. We cannot be sure that the accounting standards will continue to permit the treasury stock method. If we incur significantly more debt, thisare 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 intensifybe adversely affected.
The Capped Call Transactions may affect the risks described above.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.
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We are requiredsubject to complycounterparty 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 and operating covenantsdifficulties 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 revolving credit facility. Any failureexposure will generally increase if the market price or the volatility of our common stock increases. In addition, upon default or other failures to complyperform, or termination of obligations, by an option counterparty, we may suffer more dilution than we currently anticipate with those covenants could cause amounts borrowedrespect to become immediately due and payable and/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 from borrowing under the credit facility.
Furthermore, the financial and operating covenantsIndenture will prohibit us from engaging in certain mergers or acquisitions unless, among other things, the surviving entity assumes our obligations under the Credit Agreement atNotes. These and other provisions in the timeIndenture 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 wishdeliver 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 borrow funds, we will be unable to borrow funds. The financial and operating covenants undersatisfy short positions, or anticipated conversion of the Credit Agreement also may limitNotes into shares of our ability to borrow funds, including for strategic acquisitions and share repurchases.common stock could depress the price of our common stock.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Issuer Purchasespurchases of Equity Securitiesequity securities
Common stock repurchased in the three months ended September 30, 20192020 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 | ||||||||||||||||||||
| (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, 2019 - July 31, 2019 | 37 | $ | 75.30 | 29 | $ | 50,532 | |||||||
| August 1, 2019 - August 31, 2019 | 94 | $ | 72.06 | 31 | $ | 48,333 | |||||||
| September 1, 2019 - September 30, 2019 | 199 | $ | 71.12 | 28 | $ | 46,334 | |||||||
| 330 | $ | 71.86 | |||||||||||
(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"Liquidity and Capital Resources”Resources" in Item 2. “ Management’s Discussion and Analysis2 of Financial Condition and Results of Operations” for additional information.
ITEM 6. EXHIBITS
| Exhibit No. | Description | |||||||
| 31.1+ | ||||||||
| 32++ | ||||||||
| 10.2+ | ||||||||
| 10.3+ | ||||||||
| 101.INS | 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. | |||||||
| 101.SCH | Inline XBRL Taxonomy Extension Schema Document. | |||||||
| 101.CAL | Inline XBRL Taxonomy Calculation Linkbase Document. | |||||||
| 101.DEF | Inline XBRL Taxonomy Extension Definition Linkbase Document. | |||||||
| 101.LAB | Inline XBRL Taxonomy Label Linkbase Document. | |||||||
| 101.PRE | Inline XBRL Taxonomy Presentation Linkbase Document. | |||||||
| 104 | 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 | |||||||||||
| (Principal Financial Officer) | |||||||||||
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