Pegasystems' Sales Growth Stalls

This week, business management software specialist Pegasystems (NASDAQ: PEGA) posted a quarterly net loss that was driven by a significant sales growth slowdown. Here's how the headline results stacked up against the prior-year period:

What happened this quarter?

Sales growth turned negative to complete a sharp fall from the 25% pace that Pegasystems had posted just two quarters ago. Much of the decline was due to customers' opting for cloud-based subscriptions at a quicker rate than management had expected, which is good for the long-term health of the business, but takes a toll in the short term. However, Pegasystems' sales team also failed to close several key deals during the quarter.

Here are key operating and financial highlights from the quarter:

  • Revenue dipped 2% as a decrease in perpetual license sales more than offset gains in term licenses and cloud-based revenue.
  • Higher costs led to a 9% decline in gross profit while elevated expenses, including on sales and marketing, pushed operating income down to a $14 million loss from a $5.5 million gain in the prior year.
  • Gross profit margin for the first three quarters of the year worsened to 66% of sales from 68%.
  • Recurring revenue rose to 54% of the sales base from 52%.
  • Backlog, representing contracted but not yet billed sales, rose 29%.

What management had to say

Executives said they were happy that Pegasystems' platform is delivering results to a growing list of customers. "We continue to increase our penetration in the CRM [customer relationship management] market and see an increasing number of new organizations adopting our software to support their strategic business goals," said CEO Alan Trefler in a press release.

The race toward cloud-based offerings, meanwhile, is hurting financial metrics over the short term, they explained. "This faster than expected shift to recurring has led to a headwind of over $40 million in revenue and $0.33 in diluted EPS year to date," said Chief Financial Officer Ken Stillwell. "Nonetheless, we are pleased by this transition to recurring and that our clients are increasing their move to cloud and subscription licensing."

In a call with Wall Street analysts, Trefler said, "We didn't execute as well as I feel we should have in closing some key Q3 deals, and I know we can do much better."

Looking forward

Trefler and his team are pursuing several large contracts that each represent $10 million or more of potential revenue, and they're hoping to close one or more of these during the fiscal fourth quarter. Success in capturing these big clients would be necessary to bring the company back toward its full-year sales target, given that it is running far behind that forecast right now. Revenue is up 9% over the past nine months, compared to the 15% that executives had initially predicted.

That growth outlook relied on expectations that Pegasystems' sales mix would be split equally between recurring revenue and perpetual licenses. Yet that's not the way 2017 is panning out, as 62% of revenue has been recurring, year to date. Shifting toward those cloud- and term-based licenses produces better sales and profit growth over time, but it also elevates costs and lowers revenue in the short term.

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Demitrios Kalogeropoulos has no position in any of the stocks mentioned. The Motley Fool recommends Pegasystems. The Motley Fool has a disclosure policy.