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Edited Transcript of PEGA earnings conference call or presentation 12-Feb-20 10:00pm GMT

Q4 2019 Pegasystems Inc Earnings Call

CAMBRIDGE Mar 5, 2020 (Thomson StreetEvents) -- Edited Transcript of Pegasystems Inc earnings conference call or presentation Wednesday, February 12, 2020 at 10:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Alan Trefler

Pegasystems Inc. - Founder, CEO & Chairman of the Board

* Kenneth R. Stillwell

Pegasystems Inc. - SVP, Chief Administrative Officer & CFO

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Conference Call Participants

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* Mark Chen

JMP Securities LLC, Research Division - Research Analyst

* Mark William Schappel

The Benchmark Company, LLC, Research Division - Director of Research & Equity Research Analyst

* Rishi Nitya Jaluria

D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst

* Steven Lester Enders

KeyBanc Capital Markets Inc., Research Division - Associate

* Steven Richard Koenig

Wedbush Securities Inc., Research Division - MD

* Yun Suk Kim

Rosenblatt Securities Inc., Research Division - Senior Software Research Analyst

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Presentation

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Operator [1]

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Good day, everyone, and welcome to the Pegasystems' Fourth Quarter 2019 Earnings Results Conference Call. Today's call is being recorded.

At this time, I would like to turn the conference over to Ken Stillwell, CFO. Please go ahead.

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Kenneth R. Stillwell, Pegasystems Inc. - SVP, Chief Administrative Officer & CFO [2]

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Thank you. Good evening, ladies and gentlemen, and welcome to Pegasystems' Q4 2019 earnings call.

Before we begin, I'd like to read our safe harbor statement. Certain statements contained in this presentation may be construed as forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. The words expects, anticipates, intends, plans, believes, will, could, should, estimates, may, targets, strategies, intends to, projects, forecasts, guidance, likely and usually or variations of such words and other similar expressions identify forward-looking statements, which speak only as of the date that the statement was made and are based on current expectations and assumptions. Because such statements deal with future events, they are subject to various risks and uncertainties. Actual results for fiscal year 2019 and beyond could differ materially from the company's current expectations.

Factors that could cause the company's results to differ materially from those expressed in forward-looking statements are contained in the company's press release announcing its Q4 2019 earnings and in the company's filings with the Securities and Exchange Commission, including our annual report on Form 10-K for the year ended December 31, 2019, and other recent filings with the SEC. Investors are cautioned not to place undue reliance on such forward-looking statements, and there are no assurances that the matters contained in such statements will be achieved. Although subsequent events may cause our view to change, except as required by applicable law, we do not undertake and specifically disclaim any obligation to publicly update or revise these forward-looking statements, whether as a result of new information, future events or otherwise.

And with that, I will turn the call over to Alan Trefler, Founder and CEO of Pegasystems.

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Alan Trefler, Pegasystems Inc. - Founder, CEO & Chairman of the Board [3]

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Thank you, Ken. As seen in the earnings release, we delivered a very strong Q4, which capped off strong results throughout 2019. In 2019, we made significant progress on our key goals, accelerating growth and moving to a recurring model, beginning to see a payoff on our go-to-market investments and creating broader and deeper client engagement and positive business results.

I'm pleased with how we're executing on our strategy to help clients achieve their digital transformation goals. And our optimism is validated by clients and prospects and is also reflected in our ACV and backlog growth. This is driven by increasing Pega adoption with both new and long-standing clients.

We're very happy to see that ACV growth in total accelerated in Q4 to 22% year-over-year. And as we said, we believe ACV is the leading measure to most closely reflect our underlying business momentum. I want to congratulate the entire Pega team for solid execution in 2019, and I am very confident in our ability to execute.

We also know there's so much more we can do to capitalize on the immense and opportunity to help clients succeed with their digital transformation initiatives.

Now in 2019, I met with dozens of C-level execs, most recently in Davos and -- well, 2020 technically. We see a number of key trends affecting our clients. And regardless of industry, a common threat is their ongoing struggle with true digital transformation. And they're thinking about how to survive competitive onslaughts and what will take the drive over the next 3, 5 or more years and especially with the lack of predictability we see in so much of the world and in the economy. So there are 3 very clear common challenges that are emerging, and they line up perfectly with Pega's capability.

First, organizations need to build the right business and technology architectures to support business models that are evolving. They must pull together capabilities and assets from multiple sources, including outside the organizations, to build open platforms that will support these new business models. There are tactical challenges involved in leading together an enterprise-wide an open ecosystem of people, processes and data perfectly aligned with what we do exceptionally well.

Second, organizations are dealing with a shift from traditional product-oriented professional model to a world where everything is offered as a service. The conventional idea of product, some of the -- that was bought and owned is being turned upside down. And organizations are realizing the importance of a shift to this as-a-service mindset. They're adapting to be more customer-centric, frictionless, easier to engage and ultimately accountable in different ways. And this trend aligns equally well with our ability to enable organizational speed through intelligent automation and deliver powerful and hyper-personalized customer experiences to just bring everything together in a way.

And third, powered by ubiquitous connectivity, mobile compute power and increased customer expectations, enterprises are shifting from a culture of reactive performance to a focus on proactive and even preemptive engagement using analytical principles that leverage information well beyond what's captured in a traditional CRM system to not just anticipate leads, but also to actually preempt potential negative customer issues or interactions. The old adage of, call it, fix the problem before the customer knows they have it is finally achievable, whether you're actually making a customer more satisfied or preempting a call.

These challenges are common across industries, though expressed in different ways. For example, in telecommunications, the industry is moving from selling phones to selling connectivity and content services. They understand the old style of data plan is going to be a race to the bottom and are looking for ways to better understand what customers want and deliver contextual engagement and offers for an expanded portfolio of services and content across channels. I'm not only know how to do it, but we all know that they need it.

A great example has been one of our largest 2019 deals with one of the world's largest telecommunication companies. They chose Pega to help them achieve strategical -- strategic digital transformation. Of the old services in the telecom sector becoming more commoditized, their intent on differentiating through superior proactive and preemptive service to deliver this customer experience and increase their revenue and massively drive cost out of the business, exactly the type of initiative we're suited for. They chose Pega because we were the vendor that could set help them meet the multifaceted needs: achieving scale, moving to the cloud, realizing low-code speed of delivery, differentiating customer service and integrating AI naturally into their customer journey. They expect to generate cases at a 1 billion a year rate in 2021, each able to take the next set of action and ensure fulfillment for the customers in the moment. This will lose tens of billions of next-step action decisions each year.

In financial services, many firms are still organized in silos. The credit card division thinking they could own these customers and doesn't talk to the mortgage group, which doesn't talk with the checking and savings. And these silos are going to be shattered by the emergence of open banking. The new steps of inter-bank standards would make it easy for organizations to compete and will require the organizations to put together a package with multiple products from across their own banks as well as from other institutions. This can create better customer loyalty and the customers managed from a centralized touchpoint environment, but it also opens the banks up for security of the risk. It's a real driver of forcing organizations that have been difficult.

And the health care industry, as the final one, has historically been transactional and ultimately incredibly reactive, strapped to the action around specific events like acute illness or hospitalization. But the industry is rapidly shifting to wellness and preemptive health outcomes, which means delivering a continuous proactive and nurturing wellness experience and being able to measure the results.

Common to all of these organizations is that they need a platform on which to build their own business platforms, and they need to respond and adapt quickly. With competitors using similar and sometimes identical language towards describe themselves, I want to remind you of the true power and promise and differentiation of our solutions. We are a modern and scalable platform that has both the brain, the intelligence to make brilliant decisions; and the muscle, the ability to get work done in a common architecture. And Pega Infinity is the only software to truly unify these capabilities.

Our architecture, technology and experience in intelligent automation is miles ahead of alternatives, and we continue to invest without taking anything for granted. I find it amusing to see some companies now dredging up terms from the 1990, like Workflow. Now even as you were the highest-rated company in that segment back then, and we were, I always found the word ironic and frankly sad. Especially in today's era, it shouldn't be about workflow, it should be about work-do, and that's exactly what Pega delivers.

Pega's unique capabilities position us to be the platform of platforms for enterprises that want to create real digital transformation and evolve with the client. Never has our brand promised Build for Change been more relevant.

We shall shift gears on our 2019 accomplishments. We continue to focus on the solutions, markets and industries that we think will generate the best returns for our business. And we both deepened our commitment to traditionally strong market, while accelerate in newer markets with high potential. We continue to invest in Project FNX to ensure our platform remains the best in the industry, providing clients with the most innovative and differentiated capabilities of the market with the fastest time to value, while building on our [prep] to very unique model-driven approach that makes it easier to take clients with us even as we make massive changes and introduce concepts like Cloud Choice.

At the core of this offering is Pega Infinity. This single unified powerful intelligent automation platform increasingly adopted by our clients and prospects as the platform that they want to use to deliver their business sample. And this month, we're releasing the latest version of Pega Infinity with exciting newer capabilities in our core areas of one-to-one client engagement, customer service and intelligent automation. There's some really exciting new features. Built-in design-thinking concepts directly incorporated to the software to make low-code and highly collaborative development faster and easier.

Called Pega Express, we literally take the development process and guide you step-by-step to quickly design and deploy their projects, ranging from minimum levels of projects more quickly to the traditional project that can handle the mission-critical things that drive a business. With less, customers start small, but take advantage of Pega Infinity's scale and evolve applications based on business need. We think the capability is going to be especially important as organizations develop new and more platform-oriented ways of thinking.

So our net 2019 results show strategy is working, we saw a good momentum, and we continue to develop customer engagement capabilities with new messaging and data visualization. We introduced major AI enhancements to make it easier and faster for clients to develop smart applications. And we have continuedly ranked highly in the major industry reports that matter to us in this category. Gartner and Forrester Customer Engagement, Multichannel Marketing Hubs, Real-Time Interaction Management, industry awards for CRM Customer Case Management and customer service.

We recently commissioned a report from Forrester that calculated the value of working with Pega on transforming customer engagement. Among clients Forrester analyzed, the average return on investment is a whopping 489% over a 3-year period, with 6 months to breakeven. There's an extraordinary amount of quantifiable value our customers get moving to the (inaudible). And you can feel free to check out the Forrester report on our website.

We continue to enhance the Pega Platform and intelligent automation with our robotic process automation solutions, and as I mentioned, the enterprise low-code factory to make it possible for citizen developers to create enterprise-compliant IT-less low-code solution. This continued to garner industry recognition by major analysts, and we were identified as being excellent in a number of key categories that are critical to our clients. And we have continued to invest in Pega Cloud to ensure we have awesome cloud solutions, while still supporting Cloud Choice to customers who want to run a private or partner cloud.

Since 2019, we expanded our Cloud Choice Guarantee with Kubernetes support, and we added several important security certifications, including HITRUST, IRAP and FedRAMP, making it much easier to do business in health care and with the government. More importantly, as seen in results, the demand for Pega Cloud and Cloud Choice continues to grow, we're thrilled to see.

So 2019 was a year of quality growth, and we continue to focus on expanding the field organization to better capture the remarkable opportunity in front of us. This includes our clients' success organization helping us capitalize on the opportunity for expansion within our client base. We have also increased engagement, which we judge based on high-quality interactions on the web or meetings or e-mail conversation by more than 30% with our target organization. And we expanded our certified ecosystem by more than 25%.

You may recall that in 2017, we launched our Pega Ventures program to invest in emerging Pega partners and helped accelerate their ecosystem. Since then, we've invested in 9 companies in the U.S. and EMEA. All of them are doing well and growing. We just had an announcement that we're really pleased to see, that TeleTech, a leading digital global consumer experience technology and services company, just bought one of the partners, Serendebyte. TeleTech is more than 48,000 employees on 6 continents, focused on delivering transformative customer experiences, engagements and growth solution. And the fact that they see an opportunity to grow their business with a Pega services practice is exactly the kind of results we were looking for when we established this program, and a great validation.

And then the final topic is PegaWorld. This is a significant event of the year. It's a flagship conference, and it's going to be very, very exciting this year. We have terrific clients signed up to present, over 100. So for example, UnitedHealthcare will be speaking about how to use AI for next-generation customer care. Ford will be talking about how they are harnessing Pega across the enterprise to enable citizen development. HSBC will be talking about how it's rolling Pega globally based on the successes that they saw in their early regions. And Munich Re will be talking about using Pega to build the future of insurance to what they call Insurance-in-a-Box. This year, we'll be in our hometown at Boston, and we hope you'll be able to join us, that what will be the biggest and best PegaWorld ever on June 1 and 2.

So it's not that we're very happy with our 2019 performance, I'm pleased to see our locations in cloud ACV growth in the way that it has, and 2020, you can just operate with an ongoing rhythm of continuous improvement to improve our product ecosystem, invest in sales and marketing to capture the full potential of the opportunity, while being mindful of cost and profitability.

I continue to be very positive about how our software is being adopted. And we have really, really excellent visibility to our revenue for next year and are thus guiding to be over $1 billion of revenue. I'm excited to see this milestone and grateful to the entire Pega team that has gotten us where we are today, carries us into the future. I'm thankful to our clients and shareholders for continuing to trust us.

And with that, I'll turn the call over to Ken.

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Kenneth R. Stillwell, Pegasystems Inc. - SVP, Chief Administrative Officer & CFO [4]

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Thank you, Alan. We've reached an important milestone in the history of Pega's evolution as a business, arriving at the approximate midpoint of our cloud transition.

Back in late 2017, we consciously shifted Pega's business model, moving from a company that primarily sold its software on a perpetual license basis to a much larger company that sells mostly on a subscription basis. We've made great progress on our transition so far. 2 of the most important success metrics that we've been tracking to show is the impact and progress of our strategic execution during this transition, of our Annual Contract Value, or ACV, and Remaining Performance Obligation, RPO, or sometimes referred to as backlog.

Let me first talk about ACV. Just to remind you, we entered 2019 with the target of increasing total ACV by about 20% in 2019. I'm pleased to report that total ACV growth exceeded our expectation. At the end of 2019, our total ACV was $693 million, a solid increase of 22% from 2018's total ACV of $570 million. Pega Cloud ACV grew 54% from $110 million in 2018 to $169 million in 2019. This impressive result drove this total ACV growth rate up to 22%. ACV growth continues to be our most important metric, reflecting the successful execution of our strategy.

Total ACV is the sum of recurring Pega Cloud and Client Cloud commitment, representing the annualized recurring spend from our clients for cloud, term license and maintenance. Another reason that ACV growth is so important is because it's the best leading indicator for our future revenue growth.

Now let's turn to Remaining Performance Obligation, RPO, also called backlog, which is another important metric. In 2019, Pega Cloud backlog increased by 41%, growing from $299 million as of December 31, 2018, to $422 million as of December 31, 2019.

Backlog reflects client commitments not recorded as revenue as of the period reported, providing visibility into where a significant portion of our future revenue will come from. Total backlog increased by $205 million from $631 million to $836 million, an increase of about 33% when compared to the balance at the end of fiscal 2018. A robust backlog is another benefit of our cloud transition. Historically, much of our bookings were taken as revenue in the current period, causing variability in our quarterly results. These days, the largest portion of our bookings are cloud, most of which goes into backlog, creating a more predictable revenue and cash flow stream.

You can see further evidence of our successful transition to the recurring revenue business by looking at the change in our total revenue gaps. Over the past 4 years, we've moved from a business that was about 50% recurring revenue to a business that's over 67% recurring revenue at the end of 2019. That's a pretty spectacular shift in a relatively short period of time. When you include Pega Consulting, we have almost 90% visibility to our 2020 revenue target.

A core element of our strategy continues to be build a more valuable business by shifting a greater percentage of our annual revenue to the subscription model. We believe that satisfying demand for recurring arrangements not only enables us to capture significant lifetime value from existing customers, but also unlocks previously untapped customer segments, which can include business units that would prefer operating rather than capital expenses or companies whose cash constraint prevent them from making big advanced investments. We also enable our clients to start fast and scale, which aligns very well with a subscription-based model.

I want to drive on this point. We will continue to provide flexibility to our clients who see tremendous value in our Cloud Choice differentiator, and our clients continue to invest in Pega on a recurring basis. Our deliberate ongoing transformation to a recurring business model continues to track to plan. As we've discussed in the past, the cloud transition typically takes a software company about 4 to 5 years to complete. Today, we're to the approximate midpoint of our cloud transition. If our cloud transition continues at this pace, we will expect revenue and profitability optics to improve noticeably in 2020 and '21 and to normalize during 2022.

We continue to invest in sales capacity and build out our cloud infrastructure to continue to scale this significant growth engine, which in the near term has temporarily slowed our margin improvement. We expect the lag between the business we win and its revenue and the resulting mismatch between revenue and costs to diminish over time as we exit this transition. We remain very confident that the long-term benefits of a recurring business model, including a more predictable future revenue and cash flow stream, far outweigh the skewed short-term optics around reported revenue growth and the impact to short-term cash flow, EPS, margin and profitability.

For 2019, we reported both GAAP and non-GAAP results. A full reconciliation of all GAAP to non-GAAP measures are provided in the financial tables in the press release issued earlier today, and those are also available on the Investor Relations section of our website.

So let's turn to a few other details. In 2019, we returned about $74 million to shareholders, comprised of about $9 million of dividends and approximately $65 million in share buybacks and net settlements in equity. And we finished the quarter with just over 5,100 employees worldwide, an increase of approximately 13% from 1 year ago. More than half of the new hires joined our go-to-market organization. This growth reflects the fact that Pega continues to be seen by candidates as an extremely attractive place to work.

Turning to our fiscal year 2020 guidance. Given our strong ACV growth in 2019, this clears that Pega's annual revenue will see $1 billion for the first time in the company's history, an important milestone. Assuming that Pega Cloud continues and is approximately half of new client commitment, we expect $1.1 billion of revenue, representing total annual revenue growth of about 20% for 2020. From an earnings perspective, we expect to achieve approximately $0.20 of non-GAAP EPS.

We believe that the quarterly revenue and cost linearity for 2020 should resemble our quarterly linearity for 2019. We anticipate a slightly better gross margin in 2020, as our cloud business achieved better scale efficiency. The impact of the cloud shift will be significant to revenue and margins in 2020 as we cross the midway point of this cloud transition. So continuing to drive significant ACV growth is a priority and is the ultimate measure of the successful execution of our strategy.

In 2020 and beyond, we're focused on achieving several key goals. First, we aspire to increase our growth rate. The market for digital transformation is huge, and Pega is well positioned for continued success, given our outstanding team, our best-in-class product portfolio and our proven track record of customer success.

Second, we will continue to shift our business to an increasing recurring model, improving our revenue and cash flow visibility.

Third, we will continue to differentiate by offering Cloud Choice to our clients. Fourth, we are focused on building a business that can sustain greater improvement in profitability as we scale, allowing us to make progress running the business under the Rule of 40, seen balance in growth and margin, while we continue to invest in sales and marketing to capture this massive market opportunity in front of us.

Before opening the call for questions, I'd like to invite each of you to our annual Investor Day on Monday, June 1, during our annual conference, PegaWorld iNspire, which is in Boston, as Alan mentioned. To attend, please send an e-mail to PegaInvestorRelations@pega.com. For those who cannot join in person, we will hold a webcast the day the event is accessible on the Investor Relations section of our website.

And with that, operator, we will open the call to questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We'll go first to Rishi Jaluria from D.A. Davidson.

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Rishi Nitya Jaluria, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [2]

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Nice to see a strong finish to the year. A couple of ones. First, in thinking about the cloud gross margin side, I know we've talked about it, and there's the investments on the cloud infrastructure side, it was down a little bit this year. How should we be thinking about the opportunity for cloud gross margin expansion heading into next year and beyond?

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Kenneth R. Stillwell, Pegasystems Inc. - SVP, Chief Administrative Officer & CFO [3]

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So Rishi, it's Ken. So it's a great question. We originally had kind of ambitioned this cloud market being much more of a linear scaling between 2018 through 2022 as we start to achieve more normalized margins. And the reality is that we've talked about, we made some significant investments in 2019 like our Pega REST certification and also getting ahead of some of the accelerated growth in cloud to make sure we had the right infrastructure to support. So I think 2019, we've mentioned before and we firmly believe, is really a trough year for us. And that gross margin will improve in 2020 and '21 and '22 in a fairly kind of a linear fashion each year, getting up to where our kind of more steady-state margins are. So you will definitely see improvement in cloud margin. Some of that is scale improvement because the cloud is bigger, but it's also some specific things that we've done to really run our cloud more efficiently in -- at the end of 2019.

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Rishi Nitya Jaluria, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [4]

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Got it. And then on the hiring side, you mentioned the growth in both our employees and go-to-market. Looks like the headcount this quarter is up about 33% versus last year and has been accelerating pretty steady for the past couple of quarters. Can you give us a sense for how do you feel you are in terms of sales and go-to-market hires? And when I think should we kind of expect the catch-up curve to be over and see hiring rates maybe drop back in line with ACV growth?

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Alan Trefler, Pegasystems Inc. - Founder, CEO & Chairman of the Board [5]

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Yes, I think the solution to that problem, to be candid, is because the ACV growth's up. If that doesn't happen, then we're going to not continue to accelerate. If we can't get to a high level of confidence that we're going to get to a return. I think what's happened in the last 18 months, in particular, to just give sort of a little subjective flavor to it, as we've really deepened our engagements with some of these enormous, enormous companies we deal with, we're, a, finding way more opportunity; and b, it's a reminder that it takes a while to get introduced, reintroduced and build those relationships. I actually had a meeting at the beginning of 2019 with a very senior executive of one of the world's largest banks who was already a customer. Here is what we did, I had a discussion, and he looked at me and said, "Where the hell have you guys been?" He said, "I can't escape." You can guess with the concept of how he can't escape was about. And what you average is way better than what they have. And frankly, there's business this that will be coming from that. Takes a certain critical mass. This is going to be an important test year for us to demonstrate that we can get returns and get them more reliably, and we're committed to showing that.

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Rishi Nitya Jaluria, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [6]

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All right. Great. That's helpful. In terms of maybe cash flow question for you, Ken. It did look a little light in the quarter and then just going through the balance sheet, it looks like that may be a little bit on the receivable side. Can you maybe shed a little bit more light on cash flow? I mean based on guidance, you're talking about something in the neighborhood of 600 basis points of margin expansion on the income statement. But how should we be thinking about cash flow margins next year?

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Kenneth R. Stillwell, Pegasystems Inc. - SVP, Chief Administrative Officer & CFO [7]

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So as you go through a cloud transition, I mean, there's some people that talk about it, they refer to this concept as a financing the transition, right? Because you're going away from receiving all your perpetual revenue upfront. And not only do you have the revenue trough, you actually do create a natural delay in billing because the billing matches, it really matches the revenue a little bit more closely for our cloud business. So we're about halfway through our cloud transition, and we've largely funded that through cash that we have on the balance sheet, et cetera. So we are -- we believe that 2020 will be better than 2019, and 2021 will be better than 2020, and 2022 will kind of be back to more normal level. But naturally, if you go through a cloud transition, there is a pressure on cash flow, just like there is on the optic of top line revenue. But it's nothing unusual, and we're well positioned to get through the transition.

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Rishi Nitya Jaluria, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [8]

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All right. Got it. And then last one for me, and I'll hop. Just in terms of the guidance for next year, I apologize if I missed this. What are you assuming in terms of Pega Cloud as a percent of new sales in 2020 versus what we saw in 2019?

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Kenneth R. Stillwell, Pegasystems Inc. - SVP, Chief Administrative Officer & CFO [9]

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So we have assumed a 50% mix of Pega Cloud again because that would seem -- because it seems directionally in line with what we saw in 2019 and also we're trying to -- with Cloud Choice, we really feel that there's a lot of choice and a lot of flexibility our clients need and want. And so we believe that cloud -- Pega Cloud, excuse me, will be somewhere in the 50% range again for next year.

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Operator [10]

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And next, we'll go to Steve Koenig from Wedbush Securities.

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Steven Richard Koenig, Wedbush Securities Inc., Research Division - MD [11]

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I'll just give you 2 here. Maybe 1 more for Ken and 1 more for Alan. So Ken, apologies, I dropped a couple of times, sorry if you already answered this. But talk to me a little bit about your ACV expectations. You did 22% year-on-year in Q4. Was that a result of some large deals coming in? Or was it result of you feel solidly that the hiring you've done is now becoming more productive and you've got a new baseline for next year, or what would you look to improve upon? Maybe some thoughts on how that could trend?

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Kenneth R. Stillwell, Pegasystems Inc. - SVP, Chief Administrative Officer & CFO [12]

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So yes, Steve, we -- the ACV that we did in 2019, I would not attribute to a small number of deals that skewed the number. We always do sale to size, as everyone probably knows on this call. So there's always a certain amount of our bookings that are with larger transactions. But I would say that I don't -- I wouldn't have said that 2019 was skewed in that direction. In terms of the -- what's the -- hopefully, the new normal, right, in terms of the ACV number, naturally we want that number to, at a minimum, be above 20%. Because if we can keep it above that, we can really stick close to our longer-term target. However, we're investing in a case, in go-to-market that we should yield something higher than that. Seeing 22% for fiscal '19 is really promising to suggest that maybe this is the start of an acceleration of that number, which would then really validate the strategy of us increasing go to market.

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Alan Trefler, Pegasystems Inc. - Founder, CEO & Chairman of the Board [13]

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Well, look, we made -- it's not a secret that we really think that for companies with high quality, executing well, that the right number for growth should be meaningfully above 20% or 22%. It should be in the 30s, I would say at a minimum. And so we're investing and working to do that. The good news is that the pipeline, what we consider to be a qualified pipeline, actually grew at a faster rate than our ACV growth. So that, I think, sets us up well and suggest that if we can even convert at the current rate, we should be able to certainly not flip back.

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Steven Richard Koenig, Wedbush Securities Inc., Research Division - MD [14]

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Great. That's really helpful color. I appreciate both of you guys weighing in on that. Great. And then for the follow-up, kind of change the pace here. Alan, as you look at your development work on Project FNX, how do you expect -- kind of how should we think about the rollout to when that goes GA, how it goes GA? Does it replace Infinity? Is it incremental to Infinity? Kind of help us understand the shape of that development as it goes to market?

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Alan Trefler, Pegasystems Inc. - Founder, CEO & Chairman of the Board [15]

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Yes. So when we announced and had a deep dive with the one of the architects from our clients at PegaWorld last year, we did a whole extra day on the Wednesday to really do a deep dive of about 150 clients and architects. And what some of the stuff we want to be really clear about is, a, this is something that is rolled out in increments. And we have already rolled out some meaningful pieces of Infinity in terms of being able to, frankly, modernize and inter-operate with our client systems and it is not going to be something we just rip out and replace Infinity with. FNX is a project, not a product. And it's the project to really actually take advantage of cloud-native technologies, take advantage of state-of-the-art new user experiences. If you want to see an example of what we're talking about, if you go to design.pega.com, you can see an entire new design system we've put out, and that FNX will bring that into the absolutely latest state-of-the-art front end organized around React. We expect, because we're model-driven, we'll be able to take huge amounts of what our customers have already done with us. So this is not a replacement plan. This is entirely a build for change, built into the architecture play. I'm really happy with how it's going. And you can imagine I'm actually personally pretty close to it.

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Steven Richard Koenig, Wedbush Securities Inc., Research Division - MD [16]

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Congrats on the Q4.

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Alan Trefler, Pegasystems Inc. - Founder, CEO & Chairman of the Board [17]

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Thanks, Steve.

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Operator [18]

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And next, we'll go to Yun Kim from Rosenblatt Securities.

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Yun Suk Kim, Rosenblatt Securities Inc., Research Division - Senior Software Research Analyst [19]

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Congrats on a strong quarter, Alan and Ken. Alan, can you just qualitatively talk about the trend around large deals? I know Steve talked about it in the previous question. But I'm not sure if you guys qualify large deals as $1 million-plus deals or not. But has that been trending up? Or has that been trending down? Or do you move away from the perpetual license business? Just wanted to better understand the overall dynamics there. Or is the large deal activity or the mega deal activity is the one that's been trending down?

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Alan Trefler, Pegasystems Inc. - Founder, CEO & Chairman of the Board [20]

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Yes. I would say that the total contract value, if you wanted to sort of normalize that, is similar or, frankly, a little smaller because we're more open. I mean we've changed our attitude about a bunch of things. If you think about December of 2017, before we flipped, our sales comp plans and everything else that we did were geared to try to get the salespeople to shove a fifth year on, even if the customer only wanted to go for 3. So duration used to be routinely really close to 5 years. And naturally, a lot of customers in an as-a-service business, really are more accustomed to signing up typically for 3- to 4-year term. And whereas we used to overcompensate, frankly, hindsight for that extra fifth year of commitment, we're now, I think, doing it much smarter. It means duration is going down a little. It didn't have to, but we've been stubborn about some of the stuff. We could have kept it up. But the reality is the fact that duration has gone down to be in the 3-something sort of range, means that -- it means actually 2 things. One, I think we're writing better business; and two, the RPO, the backlog, if we had forced like we were, duration to be 5 years, would be at least 1/3 higher, right? So those numbers, which are already good, would look really terrific. And of course, a bunch of it would have come in as perpetual. We'd rather have the cash upfront, but the pattern of the business is exactly the way we want it to look. And it's not dependent on big deals. I, by the way, don't consider a $1 million deal that big. In fact, in many ways with the clients who we do business with, that's kind of an entrée deal that will be -- and instead of working real hard to sell on the $4 million a year deal upfront, we want to buy the $0.5 million or $1 million deal, and then work on being successful and upselling them. I think that's going to be a lot more reliable, too.

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Yun Suk Kim, Rosenblatt Securities Inc., Research Division - Senior Software Research Analyst [21]

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Great. That does really help. And then on the professional services or consulting services line, can you just -- obviously, that's been trending down as you try to offload some of that work to your system integrated channel. Is that -- can you just update us on the progress there? And should we continue to expect the revenue trend to trend down in 2020?

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Kenneth R. Stillwell, Pegasystems Inc. - SVP, Chief Administrative Officer & CFO [22]

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No. So I'll take that one, Yun. I don't suspect the professional services will decline in 2020 like it did in 2019. However, we're also not expecting professional services to grow at the pace that our ACV would be growing. Because, I think, quite frankly, that would be a failure with our ecosystem build to be able to make sure that we're encouraging lots more people entering the ecosystem to help support Pega Solutions. So -- but I don't believe you'll see a decline. I think we've been thinking about professional services being more of a single-digit grower, right, year-over-year for the next few years, which then will, of course, bring the total mix in our favor from -- more towards software-related subscription.

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Yun Suk Kim, Rosenblatt Securities Inc., Research Division - Senior Software Research Analyst [23]

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Okay. Great. And then just quickly, Ken, also on cash flow. What is besides the billings just being the biggest driver of cash flow dynamics, is there any other component that could potentially have an impact in 2020? I mean do you expect receivables to have an impact or any other line item?

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Kenneth R. Stillwell, Pegasystems Inc. - SVP, Chief Administrative Officer & CFO [24]

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No, no. Not at all. Our receivables are well in check. We have really -- sometimes the receivables peaked up at the end of the year just because of the timing of annual maintenance billings, et cetera, that tend to be more skewed towards Q4. So the AR tends to jump up in a Q4 than kind of deep down through the year. You kind of -- if you look at the last few years, you'll see that trend. There's not -- there's no DSO or collection issues, whatsoever. The real challenge as you go through a cloud transition is just going from billing many years upfront to that perpetual and going to billing year by year, and you just -- you have to kind of get through that transition to normalize things. And that's just what's going on with the billing, maybe like flattening over the last few years as we get through that transition.

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Operator [25]

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And next, we'll go to Mark Schappel from Benchmark.

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Mark William Schappel, The Benchmark Company, LLC, Research Division - Director of Research & Equity Research Analyst [26]

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Nice job on the quarter. Ken, starting with you, during the past, I don't know, 12 to 18 months or so, reducing contract durations has been a focus of the company or something you've been working on. And I just wondered if you could just give us an update of where you are on your contract durations today? I think you started off 12 months or so ago, about 3.5 years?

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Kenneth R. Stillwell, Pegasystems Inc. - SVP, Chief Administrative Officer & CFO [27]

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Yes. So just one clarification, Mark. Just so there's no misunderstanding with that. We aren't dropping duration just for -- I don't think you're implying this, just for the sake of dropping duration, is that what happens is when you push for longer duration, something has to give, and typically you have to give deeper price discount to get that longer commitment. That's just kind of the way it works in software. And given our retention rates being very high, there really isn't a necessary counter balance. There's not a benefit for us to really push hard for that 5-, 6-, 7-year contract because you're giving up ACV to get that. So what happened is as we pushed more to be more agile and nimble with selling and really not try to force or as Alan said, be stubborn around pushing for a longer duration, it's actually freed up market opportunity for us to sell actually higher ACV. But the duration question that you asked is, we started this journey, we were a little bit north of 4 years on an average duration. And now we're quite kind of closer to just north or just a little bit above 3 years. So the great thing about that is we went through that, and backlog has still grown handily, and ACV is still grown. And it's a really -- and we've seen good pricing and unit economics on the deals that we've done. But our duration has come down by somewhere north of 4 to maybe somewhere north of 3 years.

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Mark William Schappel, The Benchmark Company, LLC, Research Division - Director of Research & Equity Research Analyst [28]

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That's helpful. And then, Alan, moving on here. It's been 8 or -- I don't know, 8 or 9 months since you bought a small little messaging broker vendor, I think it was in the chat. And anyway, I was just wondering if you could just give us an update of where that product stands right now, that's kind of a -- at a growing and kind of emerging space these days?

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Alan Trefler, Pegasystems Inc. - Founder, CEO & Chairman of the Board [29]

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Yes, we were -- that's an example of bringing in both talent and technology that we tend to do the work upfront to really work to incorporate it into a really sensible coherent platform. And part of our announcement in the next like week is going to highlight some really impressive new capabilities that, that brings us in this area, what I sometimes refer to as direct messaging where organizations want to communicate with their customers through chat but do it personally and effectively. And so that's been a very, very nice add-in. And we're also very pleased with the talent that we got. So I think that's the perfect example of the types of things we're going to continue to do more of that are not very controversial, and I think still allow us to improve the offering to our clients.

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Mark William Schappel, The Benchmark Company, LLC, Research Division - Director of Research & Equity Research Analyst [30]

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Great. And then finally, I was wondering if you could just give us a sense of where you view the demand environment today versus, say, a year or so ago?

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Alan Trefler, Pegasystems Inc. - Founder, CEO & Chairman of the Board [31]

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Well, pipeline is meaningfully up. And customers are really interested in having these conversations. You're never sure what the future is going to be, but right now, it looks pretty darn good. So I think the demand environment is excellent. We're able to both complement, and in some cases, compete with some of the players like the Salesforce and whatever that are out there. We find there's a lot of gap filling that we can do with those organizations. And so companies that had thought that they might go one place for a solution realize that sometimes they need a little bit more. And we're having the right conversations with the right people. Go on the website and take a look at some of the videos that have been posted in the last 6 months. Well, some of these clients are saying, look at Commonwealth Bank of Australia, "Its mind-numbingly good." So I think that environment is strong.

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Operator [32]

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And next, we'll go to Steve Enders from KeyBanc.

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Steven Lester Enders, KeyBanc Capital Markets Inc., Research Division - Associate [33]

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Just wondering how the sales ramp that you guys have been implementing over the past couple of years, how those investments and those hires are ramping. And how do you feel about their ability to execute on the strong pipeline growth that you've been seeing?

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Kenneth R. Stillwell, Pegasystems Inc. - SVP, Chief Administrative Officer & CFO [34]

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So I'll take part of that, and then I'll give the second to Alan. So one of the things that I think we've been watching closely is, as we hire more of our go-to-market team, how fast are they able to build pipe, what's the quality of that pipe? And then naturally, the next part of that is how quickly can they convert that pipe into their first or their second and their third deal, right? And what's the time? And we've traditionally had a relatively longer ramping for new sales staff, previous to the last couple of years. What's really encouraging is that we started this bigger push for sales capacity about 18 months ago. And not only have we had good pipe built, but we've already seen ACV accelerate above the 20% target that we've been offering. So that kind of gives us a level of optimism that there is this increased capacity. It certainly helps to drive an accelerated growth. Now we're not seeing the full yield of that yet because a lot of people are still ramping. Well, I'll hand it over to Alan on other thoughts.

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Alan Trefler, Pegasystems Inc. - Founder, CEO & Chairman of the Board [35]

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Yes, look, this is a business where having greater experience, having great confidence, et cetera, can help. And so people do need some time to come up the curve. We've also been putting quite a bit of effort, and we've invested frankly a lot in really improving on enablement, making it so that it is better and more structured. We just had a sales kickoff in January that was entirely really organized around getting organization, getting account executives to really understand what the strategy is for every one of their organizations. And we pretty uniformly heard that it was the best education, the best training and the most practical advice that we had ever received. So I think we've really seen things that make me quite optimistic that we'll see increased growth. And frankly, we need to figure out how to accelerate.

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Steven Lester Enders, KeyBanc Capital Markets Inc., Research Division - Associate [36]

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Okay. That's really helpful. And just kind of on that same front, how are you thinking about these same kind of sales force investments into next year? And I guess how do you think about incremental OpEx growth on the sales fronts?

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Kenneth R. Stillwell, Pegasystems Inc. - SVP, Chief Administrative Officer & CFO [37]

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So let me make a comment about OpEx in total. So OpEx will grow at a slower pace than our revenue growth, obviously, because you see the non-GAAP EPS improvement. That will be the case in 2021, likely, and the case of 2022 as well, but you will start to see operating leverage over the next 3 years. If you look at where that OpEx growth is coming from, it will be largely skewed towards the market. And so the increase -- the adjustments that we will do, assuming that we are getting the yield and the return, as Alan mentioned earlier, on those investments, we are certainly skewing it that way because even growing at 22% or even 25% in the markets we're in at our scale, there's still a lot more cannibalization we can do for our competitors in those markets. And so we feel like that is an investment worth making.

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Operator [38]

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And next, we'll go to Pat Walravens from JMP Securities.

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Mark Chen, JMP Securities LLC, Research Division - Research Analyst [39]

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This is Mark for Pat. So just wondering in terms of the market trend, if you see any new CRM or BPM trends in 2020 or if there's any change in competitive dynamic there?

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Alan Trefler, Pegasystems Inc. - Founder, CEO & Chairman of the Board [40]

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So I think it's pretty much as it has been historically. Now in the process space, in the automation space, we're pretty advantaged with our technology. You still see competitors running around. Our competitors willing to drop prices. But dropping prices doesn't deliver outcomes. So we've found that we've been able to be quite successful at maintaining a rational price model and also having clients be successful. I think the biggest competitive dynamic has been the change in our behavior, whereas, historically, we were just so skewed and, in hindsight, I would say, just naturally biased to whale deals. We really have an openness, and we've really staffed the company with people that understand that in an ACV world and in an as-a-service world, it's great to eat the whale in lots of bites, and I would say that behavior has meaningfully changed in the last 24 months. And I think that's all for the best. There's lots of noise out in the market. Everyone is talking about stuff, but I'm not seeing a material change.

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Operator [41]

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And at this time, I'd like to turn the call back over to Alan Trefler for closing remarks.

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Alan Trefler, Pegasystems Inc. - Founder, CEO & Chairman of the Board [42]

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Yes, thank you very much, everybody. I think that we worked hard in 2019. It's nice to have seen it close the way that it did. We're already deeply into 2020, and 2019 actually feels like a long time ago. I will end with a final pitch for PegaWorld. We're expecting order of magnitude over 7,000 people. It should be terrific. There is this awesome presentations already on the docket with new companies like Procter & Gamble talking about what they're doing and existing clients like, well, Sainsbury's and Unilever and a whole variety of governmental functions, so it's been a great business for us. If you go online at PegaWorld, you could see what they're going to be talking about. And it's not just BS pie in the sky stuff. I will tell you that many of our customers compete with each other, so we're not really allowed to talk about what they do. But when they come to this conference, they will usually be remarkably transparent. And it's a great opportunity to see how these forward-thinking companies are actually really getting it done.

So thank you for listening and hope to see you June 1 and 2 at PegaWorld, and obviously, we'll be talking to you before that. Thank you very much.

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Operator [43]

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And that does conclude our call for today. Thank you for your participation. You may now disconnect.