UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended ~~March 31,~~June 30, 2004

¨	Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from to

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.)

101 Main Street

Cambridge, MA

02142-1590

(Address of principal executive offices)

(zip code)

(617) 374-9600

(Registrant’s telephone number including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes x No ¨

There were ~~35,534,595~~35,759,283 shares of the Registrant’s common stock, $.01 par value per share, outstanding on ~~April 12~~July 22,2004.

PEGASYSTEMS INC.

Index to Form 10-Q


		Page
Part I - Financial Information

Item 1.	Unaudited Condensed Consolidated Financial Statements

	Condensed Consolidated Balance Sheets at ~~March 31,~~June 30, 2004 and December 31, 2003	3

	Condensed Consolidated Statements of Income for the three and six months ended ~~March 31,~~June 30, 2004 and 2003	4

	Condensed Consolidated Statements of Cash Flows for the ~~three~~six months ended ~~March 31,~~June 30, 2004 and 2003	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	1412

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	2421

Item 4.	Controls and Procedures	2522

Part II -Other Information

Item 1.	Legal Proceedings	2623

Item 2.	Changes in Securities and Use of Proceeds and Issuer Purchases of Equity Securities	2623

Item 3.	Defaults upon Senior Securities	2623

Item 4.	Submission of Matters to a Vote of Security Holders	2623

Item 5.	Other Information	2623

Item 6.	Exhibits and Reports on Form 8-K	2623

SIGNATURES		2724

PEGASYSTEMS INC.

Condensed Consolidated Balance Sheets

(in thousands, except share-related amounts)


	March 31, 2004		December 31, 2003			June 30, 2004			December 31, 2003
Assets
Current assets
Cash and cash equivalents	$	72,492	$	67,989
Trade accounts receivable, net of allowance for doubtful accounts of $365 in 2004 and $365 in 2003		13,773		9,602
Current assets:
Cash and equivalents						$	49,957		$	67,989
Short-term investments							45,263			19,946

Total cash and short-term investments							95,220			87,935
Trade accounts receivable, net of allowance for doubtful accounts of $365 in 2004 and 2003							9,937			9,602
Short-term license installments		29,623		28,565			33,128			28,565
Short-term investments		19,876		19,946
Prepaid expenses and other current assets		1,065		727			1,221			727

Total current assets		136,829		126,829			139,506			126,829

Long-term license installments, net of unearned interest income		44,357		53,666			44,733			53,666
Equipment and improvements, net of accumulated depreciation and amortization		1,212		992
Equipment, furniture and improvements, net of accumulated depreciation and amortization							1,208			992
Acquired technology, net of accumulated amortization		642		729			554			729
Other assets		147		166			144			166
Goodwill		2,346		2,346			2,346			2,346

Total assets	$	185,533	$	184,728		$	188,491		$	184,728

Liabilities and Stockholders’ Equity
Current liabilities
Current liabilities:
Accrued payroll related expenses	$	5,380	$	8,886		$	5,285		$	8,886
Accounts payable and accrued expenses		8,427		7,784			8,087			7,784
Deferred revenue		13,870		14,180			13,224			14,180

Total current liabilities		27,677		30,850			26,596			30,850

Deferred income taxes		975		625			1,875			625
Other long-term liabilities		81		81			81			81

Total liabilities		28,733		31,556			28,552			31,556

Commitments and contingencies

Stockholders’ equity
Stockholders’ equity:
Preferred stock, $0.01 par value, 1,000,000 shares authorized; no shares issued and outstanding		—		—			—			—
Common stock, $0.01 par value, 45,000,000 shares authorized; 35,529,295 shares and 35,212,505 shares issued and outstanding in 2004 and 2003, respectively		355		352
Common stock, $0.01 par value, 70,000,000 shares authorized; 35,759,283 shares and 35,212,505 shares issued and outstanding in 2004 and 2003, respectively							358			352
Additional paid-in capital		119,412		117,391			120,791			117,391
Stock warrants		211		374			211			374
Retained earnings		35,477		33,735			37,599			33,735
Accumulated other comprehensive income (loss):
Net unrealized gain (loss) on investments available for sale		18		(9	)
Net unrealized loss on short-term investments							(183	)		(9	)
Foreign currency translation adjustments		1,327		1,329			1,163			1,329

Total stockholders’ equity		156,800		153,172			159,939			153,172

Total liabilities and stockholders’ equity	$	185,533	$	184,728		$	188,491		$	184,728

See notes to condensed consolidated financial statements.

PEGASYSTEMS INC.

Condensed Consolidated Statements of Income

(in thousands, except per share amounts)


	Three Months Ended March 31,						Three Months Ended June 30,					Six Months Ended June 30,
	2004			2003			2004			2003		2004			2003
Revenue
Revenue:
Software license	$	9,663		$	16,198		$	11,677		$	15,937	$	21,340		$	32,134
Services		14,993			9,427			12,363			9,550		27,357			18,977

Total revenue		24,656			25,625			24,040			25,487		48,697			51,111

Cost of revenue
Cost of revenue:
Cost of software license		88			88			87			88		175			175
Cost of services		6,651			6,396			6,028			6,525		12,680			12,921

Total cost of revenue		6,739			6,484			6,115			6,613		12,855			13,096

Gross profit		17,917			19,141			17,925			18,874		35,842			38,015

Operating expenses
Operating expenses:
Research and development		5,484			4,760			4,826			5,438		10,311			10,198
Selling and marketing		7,818			5,534			7,838			6,379		15,656			11,912
General and administrative		2,936			2,510			2,754			2,879		5,689			5,389

Total operating expenses		16,238			12,804			15,418			14,696		31,656			27,499

Income from operations		1,679			6,337			2,507			4,178		4,186			10,516

Installment receivable interest income		707			1,200			680			1,350		1,387			2,550
Other interest income, net		303			206			466			130		769			335
Other (expense), net		(7	)		(39	)
Other (expense) income, net								(371	)		260		(378	)		221

Income before provision for income taxes		2,682			7,704			3,282			5,918		5,964			13,622
Provision for income taxes		940			900			1,160			2,000		2,100			2,900

Net income	$	1,742		$	6,804		$	2,122		$	3,918	$	3,864		$	10,722

Earnings per share
Earnings per share:
Basic	$	0.05		$	0.20		$	0.06		$	0.11	$	0.11		$	0.31

Diluted	$	0.05		$	0.19		$	0.06		$	0.11	$	0.10		$	0.30

Weighted average number of common and common equivalent shares outstanding
Weighted average number of common and common equivalent shares outstanding:
Basic		35,390			34,353			35,648			34,337		35,521			34,345

Diluted		37,121			35,039			37,055			35,516		37,095			35,261

See notes to condensed consolidated financial statements.

PEGASYSTEMS INC.

Condensed Consolidated Statements of Cash Flows

(in thousands)


	Three Months Ended March 31,						Six Months Ended June 30,
	2004			2003			2004			2003
Cash flows from operating activities:
Net income	$	1,742		$	6,804		$	3,864		$	10,722
Adjustments to reconcile net income to net cash provided by operating activities:
Stock option income tax benefits		374			—			634			252
Deferred income taxes		350			—			1,250			1,100
Depreciation and amortization		288			474			687			860
Reduction in provision for doubtful accounts receivable								—			(90	)
Changes in operating assets and liabilities:
Trade accounts receivable and license installments		3,836			(7,285	)		3,915			(9,222	)
Prepaid expenses and other current assets		(111	)		7			(396	)		258
Accounts payable and accrued expenses		(2,874	)		(964	)		(3,258	)		1,537
Deferred revenue		(310	)		4,809			(956	)		5,222

Net cash provided by operating activities		3,295			3,845			5,740			10,639

Cash flows from investing activities:
Purchase of investments		(12,595	)		(2,257	)		(36,698	)		(3,620	)
Maturing and called investments		11,445			2,771			9,350			4,799
Sale of investments		1,247			—			1,749			—
Purchase of equipment and improvements		(413	)		(6	)
Purchase of equipment, furniture and improvements								(617	)		(84	)
Other long-term assets and liabilities		19			57			17			(20	)

Net cash used in investing activities		(297	)		565
Net cash (used in) provided by investing activities								(26,199	)		1,075

Cash flows from financing activities:
Proceeds from sale of stock under Employee Stock Purchase Plan								329			253
Exercise of stock options		1,486			353			2,280			419

Net cash provided by financing activities		1,486			353			2,609			672

Effect of exchange rate on cash and cash equivalents		19			(5	)
Effect of exchange rate on cash and equivalents								(182	)		346

NET INCREASE IN CASH AND CASH EQUIVALENTS		4,503			4,758
NET (DECREASE) INCREASE IN CASH AND EQUIVALENTS								(18,032	)		12,732

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		67,989			57,393
CASH AND EQUIVALENTS, BEGINNING OF PERIOD								67,989			57,393

CASH AND CASH EQUIVALENTS, END OF PERIOD	$	72,492		$	62,151
CASH AND EQUIVALENTS, END OF PERIOD							$	49,957		$	70,125

See notes to condensed consolidated financial statements.

PEGASYSTEMS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

The unaudited condensed consolidated financial statements of Pegasystems Inc. (“we” or the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the ~~three-months~~three and six month period ended ~~March 31,~~June 30, 2004 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2004. We suggest that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2003, included in our 2003 Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”).

2. SIGNIFICANT ACCOUNTING POLICIES

(a) Business

We develop, market, license and support software that enables transaction intensive organizations to manage a broad array of business processes. We also offer consulting, training and maintenance support services to facilitate the installation and use of our products.

(b) Management estimates and reporting

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates. Significant assets and liabilities with reported amounts based on estimates include trade and installment accounts receivable, long-term license installments, deferred income taxes and deferred revenue.

(c) Principles of consolidation

The consolidated financial statements include the accounts of Pegasystems Inc. and its wholly owned subsidiaries, Pegasystems Limited (a United Kingdom company), Pegasystems Company (a Canadian company), Pegasystems Worldwide Inc. (a United States corporation), Pegasystems Pty Ltd. (an Australian company), Pegasystems Investment Inc. (a United States corporation) and Pegasystems Private Limited (a Singapore company). All intercompany accounts and transactions have been eliminated in consolidation.

(d) ~~Foreign currency translation~~

The translation of assets and liabilities of our foreign subsidiaries is made at period-end exchange rates, while revenue and expense accounts are translated at the average exchange rates during the period transactions occurred. The resulting translation adjustments are reflected in accumulated other comprehensive income. Realized and unrealized exchange gains or losses from transactions and adjustments are reflected in other income (expense), net, in the accompanying consolidated statements of operations.

~~(e)~~ Revenue recognition

Our revenue is derived from two primary sources: software license fees and service fees. We offer both perpetual and term software licenses. Perpetual license fees are generally payable at the time the software is delivered, and are generally recognized as revenue when the software is delivered, any acceptance required by contract is obtained, and no significant obligations or contingencies exist related to the software, other than maintenance support. Payments subject to refund are recognized in revenue as refund provisions lapse.

PEGASYSTEMS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL ~~STATEMENTS~~STATEMENTS—(Continued)

Term software license fees are generally payable on a monthly basis under license agreements that generally have a five-year term and may be renewed for additional years at the customer’s option. The present value of future license payments is generally recognized as revenue upon customer acceptance, provided that no significant obligations or contingencies exist related to the software, other than maintenance support. A portion of the license fees payable under each term license agreement (equal to the difference between the total license payments and the discounted present value of those payments) is initially deferred and recognized as installment receivable interest income (and is not part of total revenue) over the license term. Many of our license agreements provide for license fee increases based on inflation. When such an increase occurs, as determined by the terms of the license agreement, we recognize the present value of such increases as revenue; the remainder of the increase is recognized as installment receivable interest income over the remaining license term. For purposes of the present value calculations, the discount rates used are estimates of customers’ borrowing rates at the time of recognition, typically below prime rate, and have varied between 3.25% and 8.0% for the past few years. As a result, revenue that we recognize relative to these types of license arrangements would be impacted by changes in market interest rates. For term license agreement renewals, license revenue is recognized with the same present value approach, when the customer becomes committed to the new license terms and no significant obligations or contingencies exist related to the software, other than maintenance support.

In certain circumstances, such as when license fees are not fixed or determinable, some term licenses are accounted for on a subscription basis, where revenue is recognized as payments become due over the term of the license.

Our services revenue is comprised of fees for software implementation, consulting, maintenance and training services. Our software implementation and consulting agreements typically require us to provide services for a fixed fee or at an hourly rate. Revenues for time and material projects are recognized as services are delivered and fees are billed. Until the fair value of the elements of a contract can be determined, the recognition of services revenue for fixed-price projects is limited to amounts equal to direct costs incurred, resulting in no gross profit. We do not have a reliable track record for accurately estimating the time and resources needed to complete fixed-price service projects. As a result, determination of the fair values of the elements of the contract has generally occurred late in the implementation process, typically when implementation is complete and remaining services are no longer significant to the project. If the fair values of the elements of a contract are then apparent, the remaining revenue and profit associated with the fixed-price services elements will be recognized when the project is completed. To the extent that a software license is included in the contract, any residual amounts remaining after revenue is allocated to the services elements are recorded as license revenues. All costs of services are expensed as incurred.

Software license customers are offered the option to enter into a maintenance contract, which usually requires the customer to pay a monthly maintenance fee over the term of the maintenance agreement, typically renewable annually. Prepaid maintenance fees are deferred and are recognized evenly over the term of the maintenance agreement. We generally recognize training fees revenue as the services are provided.

We reduce revenue for estimates of the fair values of potential concessions, such as disputed services, when revenue is initially recorded. These estimated amounts are deferred or reserved until the related elements of the agreement are completed and provided to the customer or the dispute is resolved.

Our agreements with customers generally require us to indemnify the customer against claims that our software infringes third party patent, copyright, trademark or other proprietary rights. Such indemnification obligations are generally limited in a variety of industry-standard respects, including our right to replace an infringing product. As of ~~March 31,~~June 30, 2004, we had not experienced any material losses related to these indemnification obligations and no ~~material~~ claims with respect thereto were outstanding. We do not expect significant claims related to these indemnification obligations, and consequently, we have not established any related reserves.

PEGASYSTEMS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

~~(f)~~(e) Cash and ~~cash~~ equivalents and short-term investments

(in thousands)    March 31, 2004
   Amortized
Cost
   Unrealized
Gains
   Unrealized
Losses
Fair
Value
Investments

U.S. government and agency securities
   $ 14,622    $ 20    $ —   $ 14,642
Commercial paper
   5,236       $ (2 ) 5,234




Total investments – Available-for-sale
   $ 19,858    $ 20    $ (2 ) $ 19,876


	June 30, 2004
(in thousands)	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
Cash and equivalents:
Cash	$	5,065	$	—	$	—		$	5,065
Certificates of deposit		12,871		—		—			12,871
Money market mutual funds		1,321		—		—			1,321
Auction rate securities		30,700		—		—			30,700

Cash and equivalents	$	49,957	$	—	$	—		$	49,957

Short-term investments:
U.S. government and agency securities	$	32,865	$	—	$	(139	)	$	32,726
Corporate bonds		12,581		—		(44	)		12,537

Short-term investments	$	45,446	$	—	$	(183	)	$	45,263

Cash and equivalents and short-term investments	$	95,403	$	—	$	(183	)	$	95,220


	December 31, 2003
(in thousands)	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
Cash and equivalents:
Cash	$	8,250	$	—	$	—		$	8,250
Certificates of deposit		6,608		—		—			6,608
Money market mutual funds		39,132							39,132
Fixed income mutual funds		13,999		—		—			13,999

Cash and equivalents	$	67,989	$	—	$	—		$	67,989

Short-term investments:
U.S. government and agency securities	$	16,509	$	—	$	(12	)	$	16,497
Corporate bonds		3,446		3		—			3,449

Short-term investments	$	19,955	$	3	$	(12	)	$	19,946

Cash and equivalents and short-term investments	$	87,944	$	3	$	(12	)	$	87,935

We consider debt securities with remaining maturities of three months or less, when purchased, to be cash equivalents. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. Purchases and sales of securities are recorded on a trade-date basis. Interest is recorded when earned. ~~Securities that we have the ability and intent to hold until maturity are carried at amortized cost, which approximates fair value.~~ Investments classified as available-for-sale are carried at fair value with unrealized gains and losses recorded as a component of accumulated other comprehensive income. Management determines the appropriate classification of its investment in debt securities at the time of purchase and re-evaluates such determination at each balance sheet date. There have been no reclassifications between investment categories. As of ~~March 31,~~June 30, 2004, remaining maturities of marketable debt securities ranged from ~~June 2004~~zero to ~~March 2006.~~thirty months. As of December 31, 2003 remaining maturities of marketable debt securities ranged from two to twenty-four months. We hold ~~$1.2~~$0.6 million of restricted cash, invested in money market funds, as collateral for a letter of credit in accordance with an office lease arrangement. As of ~~March 31,~~June 30, 2004, this balance was classified as a cash equivalent.

~~(g) Concentration of credit risk~~

Financial instruments that potentially subject us to a concentration of credit risk consist of short-term cash investments, trade accounts receivable and license installments receivable. We record long-term license installments in accordance with our revenue recognition policy, which results in long-term installment receivables from customers (due in periods exceeding one year from the reporting date, primarily from large organizations with strong credit ratings). We grant credit to customers who are located throughout the world. We perform credit evaluations of customers and generally do not request collateral from customers. Amounts due under long-term license installments as of March 31, 2004, are as follows:

   License Installments

   (in thousands)
For the calendar year

Remainder of 2004
   $ 17,883
   2005
   26,093
   2006
   20,394
   2007
   11,483
   2008
   3,315
   2009 and thereafter
   1,038

   80,206
Deferred license interest income
   (6,226 )

Total license installments receivable,net
   $ 73,980

~~(h) Equipment and improvements, net of accumulated depreciation and amortization~~

Equipment and improvements are recorded at cost. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets, which are three years for equipment and five years for furniture and fixtures. Leasehold improvements are amortized over the lesser of the life of the lease or the useful life of the asset. Repairs and maintenance costs are expensed as incurred.

PEGASYSTEMS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

~~(i) Impairment of long-lived assets~~

We evaluate our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Impairment is generally assessed by comparison of undiscounted cash flows expected to be generated by an asset to its carrying value, with the exception that goodwill impairment is assessed by use of a fair value model. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value. There were no impairments during the quarters ended March 31, 2004 and 2003.

~~(j) Research and development and software costs~~

Research and development costs, other than certain software related costs, are expensed as incurred. Capitalization of software costs begins upon the establishment of technical feasibility, generally demonstrated by a working model or an operative version of the computer software product. Such costs have not been material to date and, as a result, no internal costs were capitalized during the quarters ended March 31, 2004 and 2003.

Amortization of capitalized software is included in the cost of software license. No amortization expense for internally developed capitalized software costs was charged to cost of software license during the quarters ended March 31, 2004 and 2003.

~~(k)~~(f) Earnings per share

Basic earnings per share is computed based on the weighted average number of common shares outstanding during the period. Diluted earnings per share includes, to the extent inclusion of such shares would be dilutive to earnings per share, the effect of outstanding options and warrants, computed using the treasury stock method.

(in thousands, except per share data)    Three months ended
March 31,
   2004
   2003
Basic

Net income
   $ 1,742    $ 6,804


Weighted average common shares outstanding
   35,390    34,353
Earnings per share - basic
   $ 0.05    $ 0.20
Diluted

Net income
   $ 1,742    $ 6,804


Weighted average common shares outstanding
   35,390    34,353
Effect of assumed exercise of stock options and warrants
   1,731    686


Weighted average common shares outstanding, assuming dilution
   37,121    35,039


Earnings per share - diluted
   $ 0.05    $ 0.19
Outstanding options excluded as impact would be anti-dilutive
   1,395    4,622

~~PEGASYSTEMS INC.~~

~~NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)~~


	Three months ended June 30,				Six months ended June 30,
(in thousands, except per share data)	2004		2003		2004		2003
Basic
Net income	$	2,122	$	3,918	$	3,864	$	10,722

Weighted average common shares outstanding		35,648		34,337		35,521		34,345

Basic earnings per share	$	0.06	$	0.11	$	0.11	$	0.31

Diluted
Net income	$	2,122	$	3,918	$	3,864	$	10,722

Weighted average common shares outstanding		35,648		34,337		35,521		34,345
Effect of assumed exercise of stock options and warrants		1,407		1,179		1,574		916

Weighted average common shares outstanding, assuming dilution		37,055		35,516		37,095		35,261

Diluted earnings per share	$	0.06	$	0.11	$	0.10	$	0.30

Outstanding options excluded as impact would be anti-dilutive		1,528		4,181		1,383		4,429

~~(l)~~(g) Segment reporting

We currently operate in one operating segment – rules based business process management, or BPM, software. We derive substantially all of our operating revenue from the sale and support of one group of similar products and services. Substantially all of our assets are located within the United States. We derived our operating revenue from the following geographic areas (sales outside the United States are principally through export from the United States) ~~for~~:


	Three months ended June 30,								Six months ended June 30,
($ in thousands)	2004				2003				2004				2003
United States	$	13,689	57	%	$	21,571	85	%	$	29,589	61	%	$	43,360	85	%
United Kingdom		1,988	8	%		2,049	8	%		7,958	16	%		3,003	15	%
Europe, other		5,951	25	%		1,680	6	%		7,192	15	%		4,206	2	%
Other		2,412	10	%		187	1	%		3,958	8	%		542	3	%

	$	24,040	100	%	$	25,487	100	%	$	48,697	100	%	$	51,111	100	%

During the three months ended ~~March 31,:~~

($ in thousands)    2004
2003

United States
   $ 15,900    65 % $ 21,790    85 %
United Kingdom
   5,970    24 % 954    4 %
Europe, other
   1,241    5 % 2,526    10 %
Other
   1,545    6 % 355    1 %




   $ 24,656    100 % $ 25,625    100 %

~~For~~June 30, 2004, one customer represented 20% of our total revenue. During the ~~quarter~~three months ended ~~March 31, 2004,~~June 30, 2003, two customers ~~accounted for approximately 17%~~represented 27% and 15% of our total revenue, respectively. ~~For~~During the ~~quarter~~six months ended ~~March 31,~~June 30, 2004, one customer accounted for approximately 11% of our total revenue. During the six months ended June 30, 2003, two customers accounted for approximately ~~30%~~28% and 15% of our total revenue, respectively.

PEGASYSTEMS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

~~(m)~~(h) Stock options

We periodically grant stock options for a fixed number of shares to employees, directors and non-employee ~~contactors~~contractors with an exercise price equal to the fair market value of the shares at the date of the grant. We account for stock option grants to employees and directors using the intrinsic value ~~method and presently intend to continue to do so.~~method. Under the intrinsic value method, compensation associated with stock awards to employees and directors is determined as the difference, if any, between the current fair value of the underlying common stock on the date compensation is measured and the price an employee or director must pay to exercise the award. The measurement date for employee and director awards is generally the date of grant.

Stock options granted to non-employee contractors are accounted for using the fair value method. Under the fair value method, compensation associated with stock awards to ~~non-employees~~non-employee contractors is determined based on the estimated fair value of the award itself, measured using either current market data or an established option pricing model. The measurement date of non-employee contractor awards is generally the date performance of services is complete.

~~PEGASYSTEMS INC.~~

~~NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)~~

Stock options summary

The following table presents combined activity for stock options for the three months ended March 31, 2004 and June 30, 2004:


					Three months ended March 31, 2004				Three months ended June 30, 2004
	Number of Options (in thousands)		Weighted Average Exercise Price		Number of Options (in thousands)		Weighted Average Exercise Price		Number of Options (in thousands)		Weighted Average Exercise Price
Outstanding options at beginning of period	8,440		$	7.65	8,440		$	7.65	7,907		$	7.52
Granted	110			8.91	110			8.91	297			8.29
Exercised	(288	)		5.17	(288	)		5.17	(176	)		4.51
Canceled	(355	)		12.74	(355	)		12.74	(110	)		9.13

Outstanding options at end of period	7,907			7.52	7,907			7.52	7,918			7.60

Exercisable options at end of period	5,578			8.48	5,578			8.48	5,689			8.41

Weighted average fair value of options granted during the period			$	3.39	$3.39				$2.62

The following table presents weighted average price and life information about significant option groups outstanding and exercisable at ~~March 31,~~June 30, 2004:

Range of
Exercise Prices
   Options Outstanding
   Options Exercisable

Number
Outstanding
(in thousands)

Weighted
Average
Remaining
Contractual Life
(years)

Weighted
Average
Exercise Price

Number
Exercisable
(in thousands)

Weighted
Average
Exercise Price
$0.33 -   4.11
   2,004    7.88    $ 3.52    699    $ 2.69
  4.13 -   6.69
   1,983    6.44    4.70    1,663    4.67
  6.74 -   7.84
   2,251    6.07    7.69    1,734    7.74
  7.85 - 25.75
   1,669    6.10    15.46    1,482    16.34



   7,907          5,578


	Options Outstanding				Options Exercisable
Range of Exercise Prices	Number Outstanding (in thousands)	Weighted Average Remaining Contractual Life (years)	Weighted Average Exercise Price		Number Exercisable (in thousands)	Weighted Average Exercise Price
$ 0.33 - 4.22	2,477	7.10	$	3.69	1,319	$	3.43
4.27 - 7.75	3,070	6.17		6.51	2,385		6.48
7.78 - 18.56	2,328	6.31		12.87	1,942		13.78
19.19 - 25.75	43	5.62		25.38	43		25.38

	7,918				5,689

PEGASYSTEMS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following are the pro forma net income and income per share, as if compensation expense for the option plans had been determined based on the fair value at the date of grant:

(in thousands, except per share amounts)
Three months ended
March 31,

   2004
2003

Net income, as reported
   $ 1,742 $ 6,804
less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
   (1,009 ) (1,668 )


Pro forma net income
   $ 733 $ 5,136


Earnings per share:

Basic—as reported
   $ 0.05 $ 0.20
Basic—pro forma
   $ 0.02 $ 0.15
Diluted—as reported
   $ 0.05 $ 0.19
Diluted—pro forma
   $ 0.02 $ 0.15

~~PEGASYSTEMS INC.~~

~~NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)~~


	Three months ended June 30,						Six months ended June 30,
(in thousands, except per share amounts)	2004			2003			2004			2003
Net income, as reported	$	2,122		$	3,918		$	3,864		$	10,722
less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(601	)		(1,841	)		(1,610	)		(3,509	)

Pro forma net income	$	1,521		$	2,077		$	2,254		$	7,213

Earnings per share:
Basic—as reported	$	0.06		$	0.11		$	0.11		$	0.31
Basic—pro forma	$	0.04		$	0.06		$	0.06		$	0.21

Diluted—as reported	$	0.06		$	0.11		$	0.10		$	0.30
Diluted—pro forma	$	0.04		$	0.06		$	0.06		$	0.20

The fair ~~value~~values of options at the date of grant were estimated using the Black-Scholes option pricing model with the following assumptions:


	Three months ended March 31,
	2004		2003		2004		2003
Volatility	60	%	75	%	48	%	80	%
Expected option life-years from vest	1.0		1.0		1.0		1.0
Interest rate (risk free)	2.40	%	2.86	%	3.20	%	2.12	%
Dividends	None		None		None		None

The effects on three and six months ended ~~March 31,~~June 30, 2004 and 2003 pro forma net income and net income per share of the estimated fair value of stock options and shares are not necessarily representative of the effects on the results of operations in the future. In addition, the estimates utilize a pricing model developed for traded options with relatively short lives; our option grants typically have a life of up to ten years and are not transferable. Therefore, the actual fair value of a stock option grant may be different from our estimates. We believe that our estimates incorporate all relevant information and represent a reasonable approximation in light of the difficulties involved in valuing non-traded stock options.

~~(n) Fair value of financial instruments~~

The principal financial instruments held consist of cash equivalents, investments, accounts receivable and accounts payable, capital lease obligations, and license installment receivables arising from license transactions. The carrying values of cash equivalents, investments, accounts receivable and accounts payable approximate their fair value due to the relatively short-term nature of the accounts. Using current market rates, the fair value of license installment receivables approximated carrying value at March 31, 2004 and December 31, 2003.

~~(o) Acquired technology and goodwill~~

Intangible assets are recorded at cost and principally represent technology acquired in a business combination. Amortization is provided on a straight-line basis over the assets’ estimated useful lives. As of March 31, 2004 and December 31, 2003, intangible assets consisted of technology acquired in a business combination with a carrying value of $0.6 million and $0.7 million and accumulated amortization of $0.8 million and $0.7 million, respectively. Amortization expense for this acquired technology was $0.1 million for each of the quarters ended March 31, 2004 and March 31, 2003. We expect to recognize approximately $0.4 million of annual amortization expense related to these assets yearly until January 2006.

Goodwill represents the residual purchase price paid in a business combination after all identified assets have been recorded. Goodwill is not amortized, but is tested annually for impairment by comparing the implied fair value to its carrying value. During the first quarter of 2003, we made a claim against all of the 155,760 common shares in escrow from the acquisition of 1mind Corporation (1mind). In April 2003, the shares were returned, retired and cancelled. This resulted in a $0.9 million reduction of goodwill and additional paid in capital.

~~(p) Deferred taxes~~

Deferred taxes are provided for differences in the basis of our assets and liabilities for book and tax purposes and loss carry forwards based on tax rates expected to be in effect when these items reverse. Valuation allowances are provided to the extent it is more likely than not that some portion of the deferred tax assets will not be realized.

~~PEGASYSTEMS INC.~~

~~NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)~~

3. VALUATION AND QUALIFYING ACCOUNTS

We maintain allowances for bad debts based on factors such as the composition of accounts receivable, historical bad debt experience, and current economic trends. These estimates are adjusted periodically to reflect changes in facts and circumstances. Our allowance for doubtful accounts was $0.4 million ~~and $0.4 million~~ at ~~March 31,~~June 30, 2004 and December 31, ~~2003, respectively.~~2003. The following is a summary of the activity of the allowance for doubtful accounts:


Description	Balance at beginning of year		Additions (reductions) charged to costs and expenses		Foreign exchange gain/ (loss)	Write-offs	Balance at end of period		Balance at beginning of year		Additions (reductions) charged to costs and expenses		Foreign exchange gain/ (loss)	Write-offs	Balance at end of period
	(in thousands)								(in thousands)
Allowance for doubtful accounts:
Three months ended March 31, 2004	$	365	—		—	—	$	365
Six months ended June 30, 2004									$	365	—		—	—	$	365
Year ended December 31, 2003	$	507	(146	)	4	—	$	365	$	507	(146	)	4	—	$	365

~~4. EQUIPMENT AND IMPROVEMENTS~~

~~The cost and accumulated depreciation of equipment and improvements consist of the following:~~

March 31,
2004

December 31,
2003

   (in thousands)
Computer equipment and purchased software
   $ 9,415 $ 9,004
Furniture and fixtures
   2,799 2,790
Leasehold improvements
   2,906 2,864
Equipment under capital leases
   914 914


   16,034 15,572
Less: accumulated depreciation and amortization
   (14,822 ) (14,580 )


Equipment and improvements, net of accumulated depreciation and amortization
   $ 1,212 $ 992

~~Depreciation expense was approximately $0.4 million for the quarters ended March 31, 2004 and 2003, respectively.~~

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Results of Operations

Overview

Total revenue ~~in the first quarter of 2004~~ decreased 4%5% to ~~$24.7 million from $25.6~~$48.7 million for the first ~~quarter~~half of 2004 from $51.1 million for the first half of 2003 due to a decrease in license revenue, which was partially offset by an increase in services revenue. ~~The increase in services~~A majority of our revenue in the first ~~quarter~~half of 2004 ~~was primarily due~~continued to ~~the completion~~be from existing customers who chose to add on to, renew or extend their use of ~~fixed price service projects with respect to which, under~~ our revenue recognition policies, we generally only recognize services revenue to the extent of direct costs incurred until completion at which time we recognize as revenue any profits on the project. The increase in services revenue insoftware. However, during the first ~~quarter~~half of 2004 ~~was also due to implementation services associated with recent~~we derived 35% of our total revenue from new ~~customer license signings.~~customers. The decrease in license revenue in the first half was due to a decrease in ~~part~~term license renewals, extensions and additions, and to anthe anticipated ~~$3.5 million~~ decline in license revenue from First Data Resources (“FDR”).

~~Income before provision for income taxes decreased to $2.7 million~~ Like other companies in our industry, we have been experiencing delays in customer signings and lengthy negotiations. The increase in services revenue in the first ~~quarter~~half of 2004 ~~from $7.7 million in the first quarter of 2003~~was primarily due to ~~a $6.5 million reduction in license gross margin, a $3.4 million increase in operating expenses partially offset by a $5.3 million improvement in service margins. Net income for the first quarter~~implementation services associated with new licenses and to maintenance services associated with an expanded installed base of 2004 decreased to $1.7 million from $6.8 million for the first quarter of 2003. We ended the first quarter of 2004 with $92.4 million in cash and marketable securities and $74.0 million in combined short and long-term license installment receivables.software.

We ~~face~~are facing several challenges to growth in 2004, including an anticipated reduction of license revenue from FDR of approximately $10.6 million and reduced scheduled renewals of term licenses. In response to these challenges, we have increased our sales force and the number of ~~engagements with~~ third party partners capable of supplementing our sales and implementation efforts. Consequently, we anticipate incurring significant additional sales and marketing expenses in advance of generating incremental ~~sales and the corresponding revenue.~~sales. Additionally, our effective tax rate is approaching statutory rates in 2004, higher than in prior periods, contributing to an expected earnings per share decline on a year-over-year basis.

Income before provision for income taxes decreased to $6.0 million in the first half of 2004 from $13.6 million in the first half of 2003 primarily due to a $10.8 million reduction in license gross margin, a $4.2 million increase in operating expenses, partially offset by an $8.6 million improvement in service margins. Net income for the first half of 2004 decreased to $3.9 million from $10.7 million for the first half of 2003. We ended the first half of 2004 with $95.2 million in cash and short-term investments compared to $87.9 million at the end of 2003, and $77.9 million in combined short and long-term license installment receivables compared to $82.2 million at the end of 2003.

Three and Six Months Ended June 30, 2004 Compared to Three and Six Months Ended June 30, 2003

Revenue

~~Our total~~Total revenue for the second quarter of 2004 decreased 6% to $24.0 million from $25.5 million for the second quarter of 2003. Total revenue for the first ~~quarter~~half of 2004 decreased 4%5% to ~~$24.7~~$48.7 million from ~~$25.6~~$51.1 million for the first ~~quarter~~half of 2003. The ~~decrease was~~decreases were due to ~~a $6.5 million decrease~~declines in license revenue, partially offset by ~~a $5.6 million increase~~increases in services revenue. The following table summarizes our revenue composition:


					Three months ended June 30,				Six months ended June 30,
(in millions)	Three months ended March 31,				2004		2003		2004		2003
	2004		2003
License revenue
Term license renewals, extensions and additions	$	2.2	$	11.1	$	5.6	$	11.3	$	7.8	$	22.4
Perpetual and subscription licenses		7.5		5.1		6.1		4.6		13.5		9.7

Total license revenue		9.7		16.2		11.7		15.9		21.3		32.1

Services revenue
Implementation, consulting and training services		11.6		6.8		8.4		7.0		20.0		13.8
Maintenance		3.4		2.6		3.9		2.6		7.4		5.2

Total services revenue		15.0		9.4		12.3		9.6		27.4		19.0

Total revenue	$	24.7	$	25.6	$	24.0	$	25.5	$	48.7	$	51.1

Total license revenue for the ~~first~~second quarter of 2004 decreased to ~~$9.7~~$11.7 million from ~~$16.2~~$15.9 million for the ~~first~~second quarter of 2003. The decrease in total license revenue was the result of ~~an $8.9~~a $5.7 million decrease in term license renewals, extensions and additions, and a $3.5 million decline in license revenue from FDR, partially offset by a ~~$2.4~~$5.0 million increase in other perpetual and subscription licenses. Approximately half of our license revenue in

the second quarter of 2004 was from products based on our new PegaRULES technology. Software license revenue for the first half of 2004 decreased to $21.3 million from $32.1 million for the first half of 2003. The decrease in total license revenue for the first half was ~~due~~the result of a $14.6 million decrease in ~~part to an increase of $2.6~~term license renewals, extensions and additions, and a $7.1 million decline in the amount sold to customers as licenses but recognized as services revenue. This resulted from customer transactions involving both a software license and the provision of services. After those transactions were entered into, we provided more services to the customer than initially contemplated. In such situations, under our revenue recognition policies, we generally

~~recognize as~~ license revenue ~~only the residual revenue~~ from ~~the transaction remaining after revenue has been allocated to the fair value of the services provided. A majority of our~~FDR, offset by a $10.9 million increase in other perpetual and subscription license ~~revenue in the first quarter of 2004 was attributable to our new PegaRULES technology.~~revenue.

The ~~$8.9~~$5.7 million decrease in term license renewals, extensions and additions reflects an unusually large amount of such revenue in the ~~first~~second quarter of 2003, primarily attributable to one large financial institution renewing and extending its use of ~~Pegasystems~~our software. The decrease also reflects the lesser value of scheduled renewals in the ~~first~~second quarter of 2004. In recent years, a significant portion of our revenue has been attributable to term license renewals. In 2004, the dollar value of licenses scheduled to renew is materially less than in 2003. Consequently, absent an increase in the volume of license renewals in advance of the scheduled renewal dates, or an increase in the scope (and the value) of the licenses renewed on schedule, license renewal revenue will be less in 2004 as a whole compared to 2003. Any increase in ~~early~~mid-term license renewals in 2004 may adversely impact license revenue in subsequent periods.

~~The $2.4 million increase in perpetual and subscription revenue was primarily due to license transactions with both new and existing customers, partially offset by~~ In a ~~$3.5 million reduction in license revenue~~change from ~~FDR.~~

In the ~~future,~~past, we ~~expect to enter~~are presently entering into more perpetual license transactions than term licenses with new customers, the effect of which may be to increase our license revenue and cash flow in the short ~~term and to decrease the amount of revenue and cash flow in the future, unless we are able to expand our current volume of business.~~term.

Services revenue for the ~~first~~second quarter of 2004 increased ~~59%~~29% to ~~$15.0~~$12.4 million from ~~$9.4~~$9.6 million for the ~~first~~second quarter of 2003. Implementation, consulting and training services increased ~~68%~~$1.4 million to ~~$11.6~~$8.4 million in the ~~first~~second quarter of 2004 from ~~$6.8~~$7.0 million for the ~~first~~second quarter of 2003, primarily due to ~~the completion of fixed price service projects with respect to which, under our~~new license implementations. Services revenue recognition policies, we generally only recognize services revenue to the extent of direct costs incurred until completion at which time we recognize as revenue any profits on the project. The increase in services revenue infor the first ~~quarter~~half of 2004 ~~was also~~increased 44% to $27.4 million from $19.0 million for the first half of 2003. Implementation, consulting and training services increased $6.2 million to $20.0 million from $13.8 million for the first half of 2003 primarily due to ~~implementation services associated with recent~~ new ~~customer~~ license ~~signings.~~implementations. Typically, we derive a substantial portion of our services revenue from services provided in connection with the implementation of new software ~~licensed by new customers.~~licenses. Maintenance services revenue for the ~~first~~second quarter of 2004 increased ~~34%~~$1.3 million to ~~$3.4~~$3.9 million from $2.6 million for the ~~first~~second quarter of ~~2003~~2003. Maintenance revenue for the first half of 2004 increased $2.2 million to $7.4 million from $5.2 million for the first half of 2003. The increase in maintenance revenue was due to a larger installed base of ~~software.~~software and improved pricing for maintenance support.

Deferred revenue at ~~March 31,~~June 30, 2004, consisted primarily of advance payment of maintenance fees and the billed fees from arrangements for which acceptance of the software license or service milestone had not occurred. Deferred revenue balances decreased to ~~$13.9~~$13.2 million as of ~~March 31,~~June 30, 2004, from $14.2 million as of December 31, 2003. The decrease was primarily due to the recognition of revenue on the completion of ~~several large~~ projects in the first ~~quarter~~half of 2004, partially offset by an increase in advance payment of maintenance fees.

International revenue was ~~35%~~43% of total revenue for the ~~first~~second quarter of 2004 and 15% for the second quarter of 2003. International revenue was 39% of total revenue for the first ~~quarter~~half of 2004 and 15% for the first half of 2003. Our international revenue may fluctuate in the future because such revenue is generally dependent upon a small number of license transactions during a given period. Historically, most of our customer transactions have been denominated in U.S. dollars. We expect, however, that in the future more of our customer transactions may be denominated in foreign currencies which may expose us to increased currency exchange risk.

Cost of revenue

Cost of software license includes the amortization of technology we purchased in connection with a business acquisition in 2002 and was unchanged in the second quarter and first ~~quarter~~half of 2004 from the second quarter and first ~~quarter~~half of 2003. As a percentage of software license revenue, cost of software license revenue was less than 1% for the second quarter and first ~~quarter~~half of 2004 and for the second quarter and first ~~quarter~~half of 2003.

Cost of services consists primarily of the cost of providing implementation, consulting, maintenance, and training services. Cost of services for the ~~first~~second quarter of 2004 ~~increased 4%~~decreased 8% to ~~$6.7~~$6.0 million from ~~$6.4~~$6.5 million for the ~~first~~second quarter of 2003, primarily due to ~~increased use~~redeployment of ~~third party implementation~~some services ~~contractors.~~staff to pre-sales support and product development activities. Cost of services as a percentage of services revenue decreased to ~~44%~~49% for the ~~first~~second quarter of 2004 from 68% for the ~~first~~second quarter of ~~2003 due to increased services revenue.~~2003. Service gross margin was ~~$8.3~~$6.3 million for the ~~first~~second quarter of 2004, as compared to $3.0 million for the ~~first~~second quarter of 2003. The increase in services gross ~~margins~~margin reflects recognition of margin on completed services engagements and improved utilization of our professional services staff achieved in part through the increased use of third party contractors when necessary to meet higher demand.

~~Operating expenses~~

~~Research and development expenses~~Cost of services for the first ~~quarter~~half of 2004 ~~increased 15%~~decreased 2% to ~~$5.5~~$12.7 million from ~~$4.8~~$12.9 million for the first ~~quarter~~half of ~~2003. As~~2003, primarily due to redeployment of some services staff to pre-sales support and product development activities. Cost of services as a percentage of ~~total~~services revenue ~~research and development expenses increased~~decreased to ~~22%~~46% for the first ~~quarter~~half of 2004 ~~compared to 19%~~from 68% for the first ~~quarter~~half of 2003. The percentage decrease was primarily due to increased services revenue and to reduced compensation and contracted services expenses. Service gross margin was $14.7 million for the first half of 2004, as compared to $6.1 million for the first half of 2003. The increase in ~~research~~services gross margin reflects recognition of margin on completed services engagements and ~~development expenses was primarily due to~~improved utilization of our professional services staff achieved in part through the increased use of ~~independent contractor engineers working on our new PegaRULES platform and related applications.~~third party contractors when necessary to meet higher demand.

Operating expenses

Selling and marketing expenses for the ~~first~~second quarter of 2004 increased ~~41%~~23% to $7.8 million from ~~$5.5~~$6.4 million for the second quarter of 2003. For the first half of 2004, selling and marketing expenses increased 31% to $15.7 million from $11.9 million for the first half of 2003. These planned increases were due to the hiring of additional sales personnel, partially offset by a decrease in marketing program spending. The effort to hire additional sales personnel commenced in the ~~first quarter~~second half of 2003. As a percentage of total revenue, selling and marketing expenses increased to 33% for the second quarter of 2004, compared to 25% for the second quarter of 2003, and increased to 32% for the first half of 2004, compared to 23% for the first half of 2003. These increases were due to the combined effect of increased spending and lower total revenue.

Research and development expenses for the second quarter of 2004 decreased 11% to $4.8 million from $5.4 million for the second quarter of 2003. As a percentage of total revenue, research and development expenses for the second quarter of 2004 decreased to 20% compared to 21% for the second quarter of 2003. These decreases were primarily due to the completion of certain large projects in early 2004, which led to temporarily reduced use of contractors and reduced employee compensation expense. Research and development expenses for the first half of 2004 increased 1% to $10.3 million from $10.2 million for the first half of 2003 primarily due to the increased use of contractors in the first quarter of 2004 ~~from 22% for the first quarter of 2003. Such increases were primarily due~~ to ~~the hiring of additional sales personnel,~~complete work on various projects related to our new products, partially offset by ~~a decrease in spending on marketing programs.~~reduced incentive compensation expense. Our increased use of contractors and outsourced activity when required for product development projects has increased the variability of our research and development expenses.

General and administrative expenses for the ~~first~~second quarter of 2004 ~~increased 17%~~decreased 4% to $2.8 million from $2.9 million for the second quarter of 2003. As a percentage of total revenue, general and administrative expenses remained unchanged at 11% for the second quarter of 2004 and 2003. General and administrative expenses for the first half of 2004 increased 6% to $5.7 million from ~~$2.5~~$5.4 million for the first ~~quarter~~half of 2003. As a percentage of total revenue, general and administrative expenses increased to 12% for the first ~~quarter~~half of 2004 ~~from 10%~~compared to 11% for the first ~~quarter~~half of 2003. Such increases were primarily due to increased spending during the first half of 2004 on ~~audit and internal~~ audit activities and compliance with the requirements of the Sarbanes-Oxley Act of 2002 and related regulations. ~~We expect an increased level of spending in these areas to continue for the foreseeable future.~~

Installment receivable interest income

Installment receivable interest income, which consists of the portion of all term license fees under ~~term~~ software license agreements attributable to the time value of money, decreased ~~41%~~ in the ~~first~~second quarter of 2004 to $0.7 million from ~~$1.2~~$1.4 million for the second quarter of 2003. Installment receivable interest income for the first half of 2004 decreased to $1.4 million from $2.6 million for the first ~~quarter~~half of 2003. The decrease was due to a lower average discount rate for our portfolio of term software licenses. A portion of the fee from each term license arrangement is initially deferred and recognized as installment receivable interest income over the remaining term of the license. For purposes of the present value calculations, the discount rates used are estimates of customers’ borrowing rates, typically below prime rate, and have varied between 3.25% and 8.0% during the past few years.

Other interest income, net

Other interest income ~~net~~ increased to $0.5 million for the second quarter of 2004 from $0.1 million for the second quarter of 2003. Other interest income increased to $0.8 million for the first half of 2004 compared to $0.3 million for the first ~~quarter~~half of ~~2004 from $0.2 million for the first quarter of 2003~~2003. These increases were primarily due ~~primarily~~ to increased cash and investment balances.

Other (expense) income, net

Other (expense) income, net, which consists mostly of currency exchange gain and losses, was $0.4 million expense for the second quarter of 2004 versus $0.3 million income for the second quarter of 2003. Other (expense) income, net, was $0.4 million expense for the first half of 2004 compared to $0.2 million income for the first half of 2003. The change was due to currency exchange losses in 2004 versus gains in 2003, and expenses in 2004 associated with restructuring our investment portfolio.

Income before provision for income taxes

Income before provision for income taxes decreased ~~65%~~45% to ~~$2.7~~$3.3 million for the second quarter of 2004 from $5.9 million for the second quarter of 2003. Income before provision for income taxes decreased to $6.0 million for the first ~~quarter~~half of 2004 ~~from $7.7~~compared to $13.6 million for the first ~~quarter~~half of ~~2003~~2003. This decrease was due to a ~~$6.5~~$10.8 million decrease in license revenue, ~~and increased~~a $4.2 million increase in operating expenses ~~of $3.4~~primarily due to investments in sales and marketing, a $1.3 million decrease in other income and expenses, partially offset by ~~a $5.3~~an $8.6 million improvement in services gross margin.

Provision for income taxes

~~Our~~The provision for income taxes decreased to $1.2 million, a 35% effective ~~income~~ tax rate, ~~increased from 12%~~ in the ~~first~~second quarter of 2004 from $2.0 million, a 34% effective tax rate, in the second quarter of 2003 due to ~~35%~~lower income before provision for income taxes in the ~~first~~second quarter of 2004. The provision for income taxes for the first half of 2004 was ~~$0.9~~$2.1 million, a 35% effective rate, compared to $2.9 million, a 21% effective rate, for the first half of 2003. The net decrease was due to a decrease in income before provision for income taxes partially offset by an increase in the effective tax rate in 2004. The effective tax rate increased as a result of benefits recognized in the first quarter of 2003 from the reversal of previously established valuation allowances on loss and ~~in the first quarter of 2004 due to lower income before income taxes in the first quarter of 2004.~~credit carry forwards.

Liquidity and Capital Resources

We have funded our operations primarily from cash flow from ~~operations and the proceeds of our public stock offerings.~~operations. At ~~March 31,~~June 30, 2004, we had cash and ~~cash~~ equivalents ~~of $72.5 million,~~and short-term investments of ~~$19.9~~$95.2 million, ~~and working~~a $7.3 million increase from $87.9 million at December 31, 2003. Working capital ~~of $109.3 million.~~was $112.9 million at June 30, 2004, a $16.9 million increase from $96.0 million at December 31, 2003.

Net cash provided by operations for the first ~~quarter~~half of 2004 was ~~$3.3~~$5.7 million compared with ~~$3.8~~$10.6 million for the first ~~quarter~~half of 2003. The decrease was primarily due to a decrease of $6.9 million in net ~~income and an increase in accounts receivable. Our accounts receivable days billings outstanding increased from 30 days as of December 31, 2003 to 35 days as of March 31, 2004.~~income.

Net cash used in investing activities for the first ~~quarter~~half of 2004 was ~~$(0.3)~~$26.2 million ~~and related primarily to purchases of equipment. This compares~~compared with ~~$0.6~~$1.1 million ~~of cash~~ provided by investing activities in the first ~~quarter~~half of ~~2003~~2003. This change was primarily ~~from maturing investments in excess~~due to increased purchases of ~~purchases of~~short-term investments.

Net cash provided by financing activities for the first ~~quarter~~half of 2004 was ~~$1.5~~$2.6 million compared with ~~$0.4~~$0.7 million for the first ~~quarter~~half of 2003. The increase was due to higher proceeds from employee stock option exercises.

We believe that current cash, cash equivalents, and cash flow from ongoing operations will be sufficient to fund our operations for at least the next twelve months. Material risks to additional cash flow from operations include declines in services revenue and delayed or reduced cash payments accompanying sales of new licenses. There can be no assurance that changes in our plans or other events affecting our operations will not result in materially accelerated or unexpected expenditures. In addition, there can be no assurance that additional capital if needed will be available on reasonable terms, if at all, at such time as we require.

As of ~~March 31,~~June 30, 2004, we did not have material commitments for capital or operating expenditures other than operating leases. We lease certain equipment and office space under non-cancelable operating leases. Future minimum rental payments required under the operating leases with non-cancelable terms in excess of one year at ~~March 31,~~June 30, 2004 ~~are~~were as follows:


	*Operating Leases*
	(in thousands)
For the calendar year			*Operating Leases* (in thousands)
Remainder of 2004	$	2,491	$	1,741
2005		3,390		3,375
2006		3,438		3,428
2007		3,400		3,397
2008		3,473		3,470

2009 and thereafter		15,972		15,967

	$	32,164	$	31,378

Our liquidity is affected by the manner in which we collect cash for certain types of license transactions. Historically, our term licenses have provided for monthly license payments, generally over five years. The following amounts of cash are due for receipt in connection with our existing term license agreements:


	*License Installments*
	(in thousands)
For the calendar year			*License Installments* (in thousands)
Remainder of 2004	$	17,883	$	16,699
2005		26,093		28,490
2006		20,394		22,431
2007		11,483		11,392
2008		3,315		3,493

2009 and thereafter		1,038		1,071

	$	80,206	$	83,576

Critical accounting policies and estimates

Management’s discussion and analysis of the financial condition and results of operations is based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. 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 related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions and beliefs of what could occur in the future given available information. We consider the following accounting policies to be both those most important to the portrayal of our financial condition and those that require the most subjective judgment. If actual results differ significantly from management’s estimates and projections, there could be a material effect on our financial statements. The significant accounting policies that we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

Revenue recognition

and deferred revenue,

Term software license fees are generally payable on a monthly basis under term license agreements that generally have a five-year term and may be renewed for additional years at the customer’s option. The present value of future license payments is generally recognized as revenue upon customer acceptance, provided that no significant obligations or contingencies exist related to the software, other than maintenance support. A portion of the license fees payable under each term license agreement (equal to the difference between the total license payments and the discounted present value of those payments) is initially deferred and recognized as installment receivable interest income (and is not part of total revenue) over the license term. Many of our license agreements provide for license fee increases based on inflation. When such an increase occurs, as determined by the terms of the license agreement, we recognize the present value of such increases as revenue; the remainder of the increase is recognized as installment receivable interest income over the remaining license term. For purposes of the present value calculations, the discount rates used are estimates of customers’ borrowing rates at the time of recognition, typically below prime rate, and have varied between 3.25% and 8.0% for the past few years. As a result, revenue that we recognize relative to these types of license arrangements would be impacted by changes in market interest rates. For term license agreement renewals, license revenue is recognized with the same present value approach, when the customer becomes committed to the new license terms and no significant obligations or contingencies exist related to the software, other than maintenance support.

Our services revenue is comprised of fees for software implementation, consulting, maintenance, and training services. Our software implementation and consulting agreements typically require us to provide services for a fixed fee or at an hourly rate. Revenues for time and material projects are recognized as fees are billed. Until the fair value of the elements of a contract can be determined, the recognition of services revenue for fixed-price projects is limited to amounts equal to direct costs incurred, resulting in no gross profit. We do not have a reliable track record for accurately estimating the time and resources needed to complete fixed price service projects. As a result, determination of the fair value of the elements of the contract has generally occurred late in the implementation process, typically when implementation is complete and remaining services are no longer significant to the project. If the fair values of the elements of a contract are then apparent, the remaining revenue and profit associated with the fixed price services elements will be recognized when the project is completed. To the extent that a software license is included in the contract, any residual amounts remaining after revenue is allocated to the services elements are recorded as license revenues. All costs of services are expensed as incurred.

Our agreements with customers generally require us to indemnify the customer against claims that our software infringes third party patent, copyright, trademark or other proprietary rights. Such indemnification obligations are generally limited in a variety of industry-standard respects, including our right to replace an infringing product. As of March 31, 2004, we had not experienced any material losses related to these indemnification obligations and no material claims with respect thereto were outstanding. We do not expect significant claims related to these indemnification obligations, and consequently, we have concluded that the fair value of these obligations is negligible and we have not established any related reserves.

~~Deferred revenue~~

Deferred revenue consists primarily of billed fees from arrangements, for which acceptance of the software license or service milestone has not occurred, the unearned portion of services revenue and advance payment of maintenance fees. We estimate the value of committed and undelivered services to be delivered after license implementation, and defer that amount until the related elements of the agreement are completed and provided to the customer. We base these estimates on our historical experience. The timing of revenue recognized under our arrangements with customers is impacted by these estimates, but the total value of revenue recognized during the arrangements is not.

Allowance for doubtful accounts, and

Accounting for income taxes.

~~We maintain an allowance for doubtful accounts using estimates~~A full discussion of these accounting policies is included in our 2003 Annual Report on Form 10-K filed with the Securities and Exchange Commission and we refer the reader to that we make based on factors we believe appropriate such as the composition of the accounts receivable aging, historical bad debts, changes in payment patterns, customer creditworthiness and current economic trends. If we used different assumptions, or if the financial condition of customers were to deteriorate, resulting in an impairment of their ability to make payments, additional provisions for doubtful accounts would be required and would increase bad debt expense.discussion.

~~Accounting for income taxes~~

We account for income taxes in accordance with Statement of Financial Accounting Standards No. 109, or SFAS 109, “Accounting for Income Taxes,” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. We evaluate the realizability of our deferred tax assets quarterly by assessing our valuation allowance and by adjusting the amount of such allowance, if necessary. At March 31, 2004, we had net deferred tax assets primarily resulting from temporary differences between the book and tax bases of assets and liabilities, and loss and credit carry forwards. We continue to provide a valuation allowance on certain deferred tax assets based on an assessment of the likelihood of their realization. In reaching our conclusion, we evaluated certain relevant criteria including deferred tax liabilities that can be used to offset deferred tax assets, estimates of future taxable income of appropriate character within the carry forward period available under tax law, and tax planning strategies. Our judgments regarding future taxable income may change due to market conditions, changes in U.S. or international tax laws, and other factors. These changes, if any, may require material adjustments to these deferred tax assets, resulting in either a tax benefit, if it is estimated that future taxable income is likely, or a reduction in the value of the deferred tax assets, if it is determined that their value is impaired, resulting in a reduction in net income or an increase in net loss in the period when such determinations are made.

Principal differences between our book and tax accounts are related to the treatment of our license transactions. We use the installment method of recognition of licenses for tax purposes, so that to the extent we continue to enter into term license contracts, we establish deferred tax liabilities for such future taxable income. In addition, because we defer recognition of this income into future periods for tax purposes, we have generated substantial tax loss carry forwards, which partially offset the related liabilities. We also earn tax credits in various jurisdictions for our ongoing investment in research and development activities.

As our business has grown and generated substantial book and tax profits, we have reduced valuation allowances previously provided for our loss and credit carry forwards. As of March 31, 2004, our remaining valuation allowance related to credits, which we expect will expire before we will be able to utilize them, and to loss carry forwards acquired in the 1mind acquisition, the recognition of which will generally reduce goodwill.

~~We expect our provision for income taxes in current and future periods to reflect an effective tax rate significantly higher than past periods.~~

We have provided for potential tax liabilities due in foreign jurisdictions. Judgment is required in determining our worldwide income tax expense provision. In the ordinary course of conducting a global business enterprise, there are many transactions and calculations undertaken whose ultimate tax outcome cannot be certain. Some of these uncertainties arise as a consequence of transactions and arrangements made among related parties. Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from what is reflected in our historical income tax provisions and accruals. Such differences could have a material impact on our income tax provision and operating results in the period in which such a determination is made.

~~Contingencies~~

From time to time, we are threatened with or become party to litigation. We periodically assess each matter in order to determine if a contingent liability in accordance with Statement of Financial Accounting Standards No. 5, or SFAS 5, “Accounting for Contingencies,” should be recorded. In making this determination, we may, depending on the nature of the matter, consult with internal and external legal counsel and technical experts. Based on the information we obtain, combined with our judgment regarding all the facts and circumstances of each matter, we determine whether it is probable that a contingent loss may be incurred and whether the amount of such loss can be estimated. Should a loss be probable and estimable, we record a contingent loss in accordance with SFAS 5. In determining the amount of a contingent loss, we consider advice received from experts in the specific matter, current status of legal proceedings, settlement negotiations that may be ongoing, prior case history and other factors. Should the judgments and estimates made by us be incorrect, we may need to record additional contingent losses that could materially adversely impact our results of operations.

Inflation

Inflation has not had a significant impact on our operating results to date, and we do not expect it to have a significant impact in the future. Our unbilled license and maintenance fees are typically subject to annual increases based on recognized inflation indices.

Significant customers

During the ~~first~~second quarter of 2004, one customer accounted for approximately 20% of our total revenue. During the second quarter of 2003, two customers accounted for approximately ~~17%~~27% and 15% of our total revenue, respectively. During the first ~~quarter~~half of 2004, one customer accounted for approximately 11% of our total revenue. During the first half of 2003, two customers accounted for approximately ~~30%~~28% and 15% of our total revenue, respectively.

Forward-looking statements

This Report on Form 10-Q contains or incorporates forward-looking statements within the meaning of section 27A of the Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which we operate and management’s beliefs and assumptions. In addition, other written or oral statements that constitute forward-looking statements may be made by us or on our behalf. Words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate,” “may,” variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. We have included important factors in the cautionary statements below under the heading “Factors That May Affect Future Results” that we believe could cause our actual results to differ materially from the forward-looking statements we make. We do not intend to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

Factors that may affect future results

We need to close more license transactions with new customers to increase or maintain our current revenue level. In recent years, the majority of our license revenue has been derived from existing customers. We have been particularly dependent on First Data Resources, or FDR, for a significant portion of our revenue during the past few years. With the perpetual license entered into with FDR in 2002, FDR is not likely to represent a large portion of our revenue ~~after 2003.~~in the future. Therefore, it will be necessary for us to close more license transactions with new customers or expand our relationships with existing customers to replace the FDR revenue. In addition, because we derive a substantial portion of our services revenue from implementation of software licensed by new customers, we will need to close more license transactions with new customers if we are to maintain or grow our services revenue. While we increased our license bookings in 2004 and 2003 as compared to 2002, we will need to continue to grow bookings in the future for us to increase or maintain our 2003 revenue level in 2004 and there can be no assurance that we will be successful in doing so.

The timing of license revenues is often related to the completion of implementation services and product acceptance by the customer, the timing of which has been difficult to predict ~~accurately~~accurately.. Quarterly results have fluctuated and are likely to continue to fluctuate significantly. There can be no assurance that we will be profitable on an annual or quarterly basis or that earnings or revenues will meet analysts’ expectations. Fluctuations may be particularly pronounced because a significant portion of revenues in any quarter is attributable to product acceptance or license renewal by a relatively small number of customers. Fluctuations also reflect our policy of recognizing revenue upon product acceptance or, in the case of term licenses, license ~~renewal in an amount equal to the present value of the total committed payments due during the term.~~renewal. Customers generally do not accept products until the end of a lengthy sales cycle and an implementation period, typically ranging from six to twelve months but in some cases significantly longer. We are currently in the process of introducing our new PegaRULES technology. This may result in even lengthier sales and implementation cycles which may adversely affect our financial performance, including recognition of sales staff and commission costs in advance of revenue recognition. This may increase the volatility in our quarterly operating results. Risks over which we have little or no control, including customers’ budgets, staffing allocation, and internal authorization reviews, can significantly affect the sales and acceptance cycles. Changes requested by customers may delay product implementation and revenue recognition.

License renewal revenue may be less in 2004 than in 2003 because of the lower value of term licenses scheduled to renew in 2004. In recent years a significant portion of our revenue has been attributable to term license renewals. In 2004, the dollar value of licenses scheduled to renew is materially less than in 2003. Consequently, absent an increase in the volume of license renewals in advance of the scheduled renewal dates or an increase in the scope (and hence the value) of the licenses renewed on schedule, license renewal revenue will likely be less in 2004 than in 2003. Any increase in early license renewals in 2004 may adversely impact license revenue in subsequent periods.

In the future, we expect to enter into more perpetual license transactions than term licenses with new customers, the net effect of which may be to increase our license revenue and cash flow in the short term and to decrease the amount of revenue and cash flow in the future, unless we are able to expand our ~~current~~overall volume of ~~business~~business.. Historically, we have generally licensed our software under term licenses requiring the customer to make monthly payments over the license term. More recently, we have begun selling perpetual licenses to our software with a single license fee being payable at the commencement of the ~~license term.~~license. The effect of this change in strategy may be to increase our license revenue and cash flow in the short term but to decrease the amount of revenue and cash flow in the future, unless we are able to expand our overall volume of business.

Our stock price has been volatile. ~~Quarterly results have fluctuated and are likely to continue to fluctuate significantly.~~ The market price of our common stock has been and may continue to be highly volatile. Factors that are difficult to predict, such as quarterly revenues and operating results, statements and ratings by financial analysts, and overall market performance, will have a significant effect on the price for shares of our common stock. ~~Revenues and~~

Our quarterly operating results have varied considerably in the past ~~from period to period~~ and are likely to vary considerably in the future. We plan selling and marketing, product development and other expenses based on anticipated future revenue. If revenue falls below expectations, financial performance is likely to be adversely affected because only small portions of expenses vary with revenue. As a result, period-to-period comparisons of operating results are not necessarily meaningful and should not be relied upon to predict future performance.

If existing customers do not renew their term licenses, our financial results may suffer. Term license renewal negotiations have required more effort due to economic pressures and consolidation among our customers. A significant portion of total revenue has been attributable to term license renewals. While historically a majority of

customers have renewed their term licenses, there can be no assurance that a majority of customers will continue to renew expiring term licenses. A decrease in term license renewals absent offsetting revenue from other sources would have a material adverse effect on future financial performance.

We will need to develop new products, evolve existing ones, and adapt to technology change. Technical developments, customer requirements, programming languages and industry standards change frequently in our markets. As a result, success in current markets and new markets will depend upon our ability to enhance current products, to develop and introduce new products that meet customer needs, keep pace with technology changes, respond to competitive products, and achieve market acceptance. Product development requires substantial investments for research, refinement and testing. There can be no assurance that we will have sufficient resources to make necessary product development investments. We may experience difficulties that will delay or prevent the successful development, introduction or implementation of new or enhanced products. Inability to introduce or implement new or enhanced products in a timely manner would adversely affect future financial performance. Our products are complex and may contain errors. Errors in products will require us to ship corrected products to customers. Errors in products could cause the loss of or delay in market acceptance or sales and revenue, the diversion of development resources, injury to our reputation, or increased service and warranty costs which would have an adverse effect on financial performance.

Investor confidence and share value may be adversely impacted if our independent auditors are unable to provide us with the attestation of the adequacy of our internal controls over financial reporting as of December 31, 2004, as required by Section 404 of the Sarbanes-Oxley Act of 2002. The Securities and Exchange Commission, as directed by Section 404 of the Sarbanes-Oxley Act of 2002, adopted rules requiring public companies to include a report of management on the company’s internal controls over financial reporting in its annual reports on Form 10-K that contain an assessment by management of the effectiveness of the company’s internal controls over financial reporting. In addition, the company’s independent auditors must attest to and report on management’s assessment of the effectiveness of the company’s internal controls over financial reporting. This requirement will first apply to our Annual Report on Form 10-K for the fiscal year ending December 31, 2004. Although we intend to diligently and vigorously review our internal controls over financial reporting in order to ensure compliance with the Section 404 requirements, if our independent auditors are not satisfied with our internal controls over financial reporting or the level at which these controls are documented, designed, operated or reviewed, or if the independent auditors interpret the requirements, rules or regulations differently from us, then they may decline to attest to management’s assessment or may issue a report that is qualified. This could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of our financial statements, which ultimately could negatively impact the market price of our shares.

The market for our offerings is increasingly and intensely competitive, rapidly changing, and highly fragmented. The market for business process management software and related implementation, consulting and training services is intensely competitive and highly fragmented. We currently encounter significant competition from internal information systems departments of potential or existing customers that develop custom software. We also compete with companies that target the customer interaction and workflow markets and professional service organizations that develop custom software in conjunction with rendering consulting services. Competition for market share and pressure to reduce prices and make sales concessions are likely to increase. Many competitors have far greater resources and may be able to respond more quickly and efficiently to new or emerging technologies, programming languages or standards or to changes in customer requirements or preferences. Competitors may also be able to devote greater managerial and financial resources to develop, promote and distribute products and provide related consulting and training services. There can be no assurance that we will be able to compete successfully against current or future competitors or that the competitive pressures faced by us will not materially adversely affect our business, operating results, and financial condition.

We have historically sold to the financial services ~~market.~~and healthcare markets. ~~This market is~~These markets are continuing to consolidate, and ~~faces~~face uncertainty due to many other factors. We have historically derived a significant portion of our revenue from customers in the financial services ~~market,~~and healthcare markets, and our future growth depends, in part, upon increased sales to ~~this market.~~these markets. Competitive pressures, industry consolidation, decreasing operating margins within ~~this industry,~~these industries, currency fluctuations, geographic expansion and deregulation affect the financial condition of our customers and their willingness to pay. In addition, customers’ purchasing patterns are somewhat discretionary. As a result, some or all of the factors listed above may adversely affect the demand by customers. The financial services market is undergoing intense domestic and international consolidation. Consolidation may interrupt normal buying behaviors and increase the volatility of our operating results. In recent years, several customers have been merged or consolidated. Future mergers or consolidations may cause a decline in revenues and adversely affect our future financial performance.

We depend on certain key personnel, and must be able to attract and retain qualified personnel in the future. The business is dependent on a number of key, highly skilled technical, managerial, consulting, sales, and marketing personnel, including Mr. Alan Trefler, our Chief Executive Officer. The loss of key personnel could adversely affect financial performance. We do not have any significant key-man life insurance on any officers or employees and do not plan to obtain any. Our success will depend in large part on the ability to hire and retain qualified personnel. The number of potential employees who have the extensive knowledge of computer hardware and operating systems needed to develop, sell and maintain our products is limited, and competition for their services is intense, and there can be no assurance that we will be able to attract and retain such personnel. If we are unable to do so, our business, operating results, and financial condition could be materially adversely affected.

We rely on certain third-party relationships. We have a number of relationships with third parties that are significant to sales, marketing and support activities, and product development efforts. We rely on relational database management system applications and development tool vendors, software and hardware vendors, and

consultants to provide marketing and sales opportunities for the direct sales force and to strengthen our products through the use of industry-standard tools and utilities. We also have relationships with third parties that distribute our products. In particular, we benefit from our non-exclusive relationship with First Data Resources for the distribution of products to the credit card market and with PFPC Inc. for distribution of products to the mutual fund market. FDR can sell applications based on our software to their credit card customers who have less than an agreed number of active credit card accounts as identified in the perpetual license agreements, without paying an additional fee to us. There can be no assurance that these companies, most of which have significantly greater financial and marketing resources, will not develop or market products that compete with ours in the future or will not otherwise end their relationships with or support of us.

We may face product liability and warranty claims. Our license agreements typically contain provisions intended to limit the nature and extent of our risk of product liability and warranty claims. There is a risk that a court might interpret these terms in a limited way or could hold part or all of these terms to be unenforceable. Also, there is a risk that these contract terms might not bind a party other than the direct customer. Furthermore, some of our licenses with our customers are governed by non-U.S. law, and there is a risk that foreign law might give us less or different protection. Although we have not experienced any material product liability claims to date, a product liability suit or action claiming a breach of warranty, whether or not meritorious, could result in substantial costs and a diversion of management’s attention and our resources.

We face risks from operations and customers based outside of the U.S. Sales to customers headquartered outside of the United States represented approximately ~~20%, 22% and 23%~~39% of our total revenue in the first half of 2004, 20% in 2003, ~~2002~~ and ~~2001, respectively.~~22% in 2002. We, in part through our wholly-owned subsidiaries based in the United Kingdom, Singapore, Canada, and Australia, market products and render consulting and training services to customers based in Canada, the United Kingdom, France, Germany, the Netherlands, Belgium, Switzerland, Austria, Ireland, Sweden, South Africa, Mexico, Australia, Hong Kong, and Singapore. We have established offices in continental Europe and Australia. We believe that growth will necessitate expanded international operations requiring a diversion of managerial attention and financial resources. We anticipate hiring additional personnel to accommodate international growth, and we may also enter into agreements with local distributors, representatives, or resellers. If we are unable to do one or more of these things in a timely manner, our growth, if any, in our foreign operations will be restricted, and our business, operating results, and financial condition could be materially and adversely affected.

In addition, there can be no assurance that we will be able to maintain or increase international market demand for our products. Most of our international sales are denominated in U.S. dollars. Accordingly, any appreciation of the value of the U.S. dollar relative to the currencies of those countries in which we distribute our products may place us at a competitive disadvantage by effectively making our products more expensive as compared to those of our competitors. Additional risks inherent in our international business activities generally include unexpected changes in regulatory requirements, increased tariffs and other trade barriers, the costs of localizing products for local markets and complying with local business customs, longer accounts receivable patterns and difficulties in collecting foreign accounts receivable, difficulties in enforcing contractual and intellectual property rights, heightened risks of political and economic instability, the possibility of nationalization or expropriation of industries or properties, difficulties in managing international operations, potentially adverse tax consequences (including restrictions on repatriating earnings and the threat of “double taxation”), enhanced accounting and internal control expenses, and the burden of complying with a wide variety of foreign laws. There can be no assurance that one or more of these factors will not have a material adverse effect on our foreign operations, and, consequentially, our business, operating results, and financial condition.

We face risks related to intellectual property claims or appropriation of our intellectual property rights. We rely primarily on a combination of copyright, trademark and trade secrets laws, as well as confidentiality agreements to protect our proprietary rights. In October 1998, we were granted a patent by the United States Patent and Trademark Office relating to the architecture of our systems. We cannot assure that such patent will not be invalidated or circumvented or that rights granted there under or the description contained therein will provide competitive advantages to our competitors or others. Moreover, despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain the use of information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. There can be no assurance that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology.

We are not aware that any of our products infringe the proprietary rights of third parties. There can be no assurance, however, that third parties will not claim infringement by us with respect to current or future products.

We expect that software product developers will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays, or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could have a material adverse effect upon our business, operating results, and financial condition.

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. Our market risk exposure is primarily fluctuations in foreign exchange rates and interest rates. We have not entered into derivative or hedging transactions to manage risk in connection with such fluctuations.

Foreign currency exposure

We derived approximately ~~35%~~39% of our total revenue infor the six months ending June 30, 2004 from sales to customers based outside of the United States. Some of our international sales are denominated in foreign currencies, such as the British pound and Euro. The price in United States dollars of products and services sold outside the United States in foreign currencies will vary as the value of the United States dollar fluctuates against those foreign currencies. There can be no assurance that sales denominated in foreign currencies will not be material in the future and that there will not be increases in the value of the United States dollar against such currencies that will reduce the dollar return to us on the sale of our products and services in such foreign currencies. The foreign currency exposure related to revenue is currently offset by the expenses we incur in foreign currencies.

We had net assets valued in foreign currencies, consisting primarily of cash, investments, license installments, and receivables, partially offset by accounts payable and accruals, with a carrying value of ~~$26~~$28 million as of ~~March 31,~~June 30, 2004. A ten percent change in currency exchange rates would change by approximately $3 million the carrying value of those net assets as reported on our balance sheet as of ~~March 31,~~June 30, 2004, with most of that change recognized in the statement of income as other income (expense).

Interest rate exposure

Our balance sheet contains interest bearing assets which have fixed rates of interest. These assets are license installments receivable generated in the normal course of business through transactions with customers and investments of excess cash in marketable debt securities.

License installments receivable bear interest at a fixed rate equal to the discount rate in effect when the license revenue was recognized. We believe that at current market interest rates, the fair market value of license installments receivable approximates the carrying value as reported on our balance sheets. However, there can be no assurance that the fair market value will approximate the carrying value in the future. Changes in market rates do not affect net earnings, as the license installments receivable are carried at cost and, since they are not financial instruments and are held until maturity, are not marked to market to reflect changes in the fair value of the portfolio. Factors such as increasing interest rates can reduce the fair market value of the license installments receivable. The carrying value of license installments receivable of ~~$74~~$78 million as of ~~March 31,~~June 30, 2004 reflects a weighted average of historic discount rates. The average rate changes with market rates as new license installments receivable are added

to the portfolio, which mitigates exposure to market interest rate risk. A 200 basis point increase in market interest rates would have decreased the fair market value of our license installments receivable by approximately ~~$2.4~~$2.2 million as of ~~March 31,~~June 30, 2004.

We have invested in fixed rate marketable debt securities. A 200 basis point increase in market interest rates would have reduced the fair market value of our marketable debt securities by ~~less than $1~~approximately $1.6 million as of ~~March 31, 2004, due to the relatively short maturities of those investments.~~June 30, 2004. Changes in market rates and the related impact on the fair market value of the investments do not generally affect net earnings as our investments are fixed rate securities and are classified as available-for-sale. Investments classified as available-for-sale are carried at fair market value with unrealized gains and losses recorded as a component of accumulated other comprehensive income.

Item 4. Controls and Procedures

(a)

Evaluation of Disclosure Controls and Procedures. Our management, with the participation of our Chief Executive Officer, or CEO, and Chief Financial Officer, or 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) as of ~~March 31,~~June 30, 2004. 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. In addition, our management recognized that improvements were necessary to our disclosure controls and procedures relating to how we document our customer agreements, which at present are complex and varied. Based on this evaluation and subject to the foregoing limitations, our CEO and CFO concluded that, as of ~~March 31,~~June 30, 2004, our disclosure controls and procedures were (1) designed to ensure that material information relating to us, including our consolidated subsidiaries, is made known to our CEO and CFO by others within those entities, particularly during the period in which this report was being prepared and (2) effective, in that they provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities Exchange Commission’s rules and forms.

(b)

Changes in Internal Controls. No change in internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act) occurred during the fiscal quarter ended ~~March 31,~~June 30, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II - Other Information:

Item 1. Legal Proceedings

Not applicable.

Item 2. Changes in Securities and Use of Proceeds and Issuer Purchases of Equity Securities

Not applicable.

Item 3. Defaults upon Senior Securities

Not applicable.

Item 4. Submission of Matters to a Vote of Security Holders

~~None.~~Our annual meeting of shareholders was held on June 3, 2004. The following matters were voted upon:

Henry Ancona, Alexander V. D’Arbeloff, William H. Keough and Edward A. Maybury were elected to serve as Directors of the Company until the 2007 Annual Meeting of Stockholders and until their successors are duly elected and qualified. Mr. Ancona was elected with 34,052,834 votes “FOR” and 823,993 votes “WITHHELD”. Mr. D’Arbeloff was elected with 33,752,611 votes “FOR” and 1,124,216 votes “WITHHELD”. Mr. Keough was elected with 33,816,703 votes “FOR” and 1,060,124 votes “WITHHELD”. Mr. Maybury was elected with 33,752,511 votes “FOR” and 1,124,316 votes “WITHHELD”.

b.	The stockholders approved the amendment to our restated articles of organization to increase the number of authorized shares of common stock from 45,000,000 to 70,000,000 with 34,132,494 votes “FOR”, 736,467 votes “AGAINST” and 7,866 votes “ABSTAINING”.

c.	The stockholders approved the Pegasystems Inc. 2004 Long-Term Incentive Plan with 23,851,879 votes “FOR”, 5,098,061 votes “AGAINST”, 543,017 votes “ABSTAINING” and 5,383,870 with “NO VOTE”.

d.	The stockholders approved the ratification of the Audit Committee’s selection of Deloitte & Touche LLP as the independent auditors of Pegasystems Inc. for the fiscal year ending December 31, 2004 with 34,589,557 votes “FOR”, 278,214 votes “AGAINST”, and 9,056 votes “ABSTAINING”.

Item 5. Other Information

None.

Item 6. Exhibits and Reports on Form 8-K

(a)

Exhibits:

The exhibits listed in the Exhibit Index immediately preceding such exhibits are filed as part of this report.

(b)

Reports on Form 8-K:

On ~~February 17,~~April 29, 2004, we furnished a Current Report on Form 8-K under item 12 containing a press release announcing our results of operations for the quarter ~~and year~~ ended ~~December~~March 31, ~~2003.~~2004.

SIGNATURES

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.

Date: ~~April 28,~~July 26, 2004	By:	/s/ Alan Trefler
		Chairman and Chief Executive Officer
		(principal executive officer)

Date: ~~April 28,~~July 26, 2004	By:	/s/ Christopher Sullivan
		Senior Vice President, Chief Financial Officer and Treasurer
		(principal financial and accounting officer)

PEGASYSTEMS INC.

Exhibit Index


Exhibit No.		Description
3.3		Restated Articles of Organization of Pegasystems Inc., as amended

31.1		Certification pursuant to Exchange Act Rules 13a-14 and 15d-14 of the Chief Executive Officer.

31.2		Certification pursuant to Exchange Act Rules 13a-14 and 15d-14 of the Chief Financial Officer.

32.1		Certification pursuant to 18 U.S.C. Section 1350 of the Chief Executive Officer.

32.2		Certification pursuant to 18 U.S.C. Section 1350 of the Chief Financial Officer.

2825


(in thousands)	March 31, 2004
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
Investments
U.S. government and agency securities	$	14,622	$	20	$	—		$	14,642
Commercial paper		5,236			$	(2	)		5,234

Total investments – Available-for-sale	$	19,858	$	20	$	(2	)	$	19,876