PEGASYSTEMS INC - Quarter Report: 2017 September (Form 10-Q)

PEGASYSTEMS INC - Quarter Report: 2017 September (Form 10-Q)

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Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2017

☐	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.)

One Rogers Street, Cambridge, MA		02142-1209
(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 ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company,” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

There were 77,859,958 shares of the Registrant’s common stock, $.01 par value per share, outstanding on October 27, 2017.

PEGASYSTEMS INC.

Index to Form 10-Q


	Page
PART I—FINANCIAL INFORMATION

Item 1. Unaudited Condensed Consolidated Financial Statements
Unaudited Condensed Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016		2
Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2017 and 2016		3
Unaudited Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2017 and 2016		4
Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2017 and 2016		5
Notes to Unaudited Condensed Consolidated Financial Statements		6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		15
Item 3. Quantitative and Qualitative Disclosures About Market Risk		25
Item 4. Controls and Procedures		25

PART II—OTHER INFORMATION

Item 1A. Risk Factors		25
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		25
Item 6. Exhibits		26

Signature		27

PART I—FINANCIAL INFORMATION

ITEM 1.

UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

PEGASYSTEMS INC.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)


	September 30, 2017			December 31, 2016
Assets
Current assets:
Cash and cash equivalents	$	130,568		$	70,594
Marketable securities		63,812			63,167

Total cash, cash equivalents, and marketable securities		194,380			133,761
Trade accounts receivable, net of allowance of $6,189 and $4,126		191,161			265,028
Income taxes receivable		34,864			14,155
Other current assets		17,679			12,188

Total current assets		438,084			425,132
Property and equipment, net		39,849			38,281
Deferred income taxes		73,459			69,898
Long-term other assets		5,982			3,990
Intangible assets, net		34,755			44,191
Goodwill		72,941			73,164

Total assets	$	665,070		$	654,656

Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	12,535		$	14,414
Accrued expenses		39,681			36,751
Accrued compensation and related expenses		53,869			60,660
Deferred revenue		160,931			175,647

Total current liabilities		267,016			287,472
Income taxes payable		4,774			4,263
Long-term deferred revenue		6,130			10,989
Other long-term liabilities		15,449			16,043

Total liabilities		293,369			318,767

Stockholders’ equity:
Preferred stock, 1,000 shares authorized; no shares issued and outstanding		—			—
Common stock, 200,000 shares authorized; 77,839 shares and 76,591 shares issued and outstanding		778			766
Additional paid-in capital		146,728			143,903
Retained earnings		227,953			198,315
Accumulated other comprehensive loss		(3,758	)		(7,095	)

Total stockholders’ equity		371,701			335,889

Total liabilities and stockholders’ equity	$	665,070		$	654,656

See notes to unaudited condensed consolidated financial statements.

PEGASYSTEMS INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016
Revenue:
Software license	$	41,793		$	68,833		$	195,220		$	207,849
Maintenance		62,204			55,038			180,759			163,174
Services		75,818			58,931			225,063			179,633

Total revenue		179,815			182,802			601,042			550,656

Cost of revenue:
Software license		1,276			1,313			3,826			3,646
Maintenance		6,716			6,659			20,945			18,889
Services		61,739			52,465			180,925			154,512

Total cost of revenue		69,731			60,437			205,696			177,047

Gross profit		110,084			122,365			395,346			373,609

Operating expenses:
Selling and marketing		70,209			67,032			217,384			202,126
Research and development		41,031			38,036			121,089			108,530
General and administrative		13,133			11,725			38,174			34,067
Acquisition-related		—			74			—			2,903

Total operating expenses		124,373			116,867			376,647			347,626

(Loss)/income from operations		(14,289	)		5,498			18,699			25,983
Foreign currency transaction (loss)/gain		(552	)		1,082			(793	)		2,764
Interest income, net		144			172			470			650
Other income/(expense), net		—			(1,237	)		287			(4,891	)

(Loss)/income before (benefit)/provision for income taxes		(14,697	)		5,515			18,663			24,506
(Benefit)/provision for income taxes		(12,885	)		2,214			(17,952	)		6,269

Net (loss)/income	$	(1,812	)	$	3,301		$	36,615		$	18,237

(Loss)/earnings per share:
Basic		(0.03	)		0.04			0.47			0.24
Diluted		(0.03	)		0.04			0.44			0.23
Weighted-average number of common shares outstanding:
Basic		77,691			76,278			77,258			76,323
Diluted		77,691			79,548			82,717			79,401
Cash dividends declared per share	$	0.03		$	0.03		$	0.09		$	0.09

See notes to unaudited condensed consolidated financial statements.

PEGASYSTEMS INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017		2016
Net (loss)/income	$	(1,812	)	$	3,301		$	36,615	$	18,237
Other comprehensive income/(loss), net of tax
Unrealized gain/(loss) on available-for-sale marketable securities, net of tax		22			(174	)		148		168
Foreign currency translation adjustments		549			(169	)		3,189		(1,400	)

Total other comprehensive income/(loss), net of tax		571			(343	)		3,337		(1,232	)

Comprehensive (loss)/income	$	(1,241	)	$	2,958		$	39,952	$	17,005

See notes to unaudited condensed consolidated financial statements.

PEGASYSTEMS INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)


	Nine Months Ended September 30,
	2017			2016
Operating activities:
Net income	$	36,615		$	18,237
Adjustments to reconcile net income to cash provided by operating activities:
Deferred income taxes		(2,607	)		(2,841	)
Depreciation and amortization		18,703			17,896
Stock-based compensation expense		39,929			30,634
Foreign currency transaction loss/(gain)		793			(2,764	)
Other non-cash		(89	)		153
Change in operating assets and liabilities:
Trade accounts receivable		80,580			3,940
Income taxes receivable and other current assets		(25,943	)		(11,904	)
Accounts payable and accrued expenses		(8,546	)		(16,678	)
Deferred revenue		(25,639	)		(17,698	)
Other long-term assets and liabilities		130			1,581

Cash provided by operating activities		113,926			20,556
Investing activities:
Purchases of marketable securities		(25,687	)		(22,614	)
Proceeds from maturities and called marketable securities		23,124			21,838
Sales of marketable securities		—			62,283
Payments for acquisitions, net of cash acquired		(297	)		(49,113	)
Investment in property and equipment		(9,106	)		(15,253	)

Cash used in investing activities		(11,966	)		(2,859	)
Financing activities:
Dividend payments to shareholders		(6,941	)		(6,883	)
Common stock repurchases for tax withholdings for net settlement of equity awards		(34,113	)		(10,398	)
Common stock repurchases under share repurchase programs		(2,986	)		(25,750	)

Cash used in financing activities		(44,040	)		(43,031	)
Effect of exchange rates on cash and cash equivalents		2,054			(1,309	)

Net increase/(decrease) in cash and cash equivalents		59,974			(26,643	)
Cash and cash equivalents, beginning of period		70,594			93,026

Cash and cash equivalents, end of period	$	130,568		$	66,383

See notes to unaudited condensed consolidated financial statements.

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

Pegasystems Inc. (together with its subsidiaries, “the Company”) has prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“U.S.”) for complete financial statements and should be read in conjunction with the Company’s audited financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2016.

In the opinion of management, the Company has prepared the accompanying unaudited condensed consolidated financial statements on the same basis as its audited financial statements, and these financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results of the interim periods presented. The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year 2017.

2. NEW ACCOUNTING PRONOUNCEMENTS

Stock-Based Compensation

In May 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-09 “Stock Compensation (Topic 718), Scope of Modification Accounting” to clarify when to account for a change to the terms or conditions of a share-based payment award as a modification. Under the new guidance, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. The effective date for the Company will be January 1, 2018. The Company does not expect the adoption of this standard to have a material effect on its financial position or results of operations.

Financial Instruments

In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments,” which requires measurement and recognition of expected credit losses for financial assets measured at amortized cost, including trade accounts receivable, upon initial recognition of that financial asset using a forward-looking expected loss model, rather than an incurred loss model for credit losses. Credit losses relating to available-for-sale debt securities should be recorded through an allowance for credit losses when the fair value is below the amortized cost of the asset, removing the concept of “other-than-temporary” impairments. The effective date for the Company will be January 1, 2020, with early adoption permitted. The Company is currently evaluating the effect this ASU will have on its consolidated financial statements and related disclosures.

Leases

In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842),” which requires lessees to record most leases on their balance sheets, recognizing a lease liability for the obligation to make lease payments and a right-of-use asset for the right to use the underlying asset for the lease term. The effective date for the Company will be January 1, 2019, with early adoption permitted. The Company expects that most of its operating lease commitments will be subject to this ASU and recognized as operating lease liabilities and right-of-use assets upon adoption with no material impact to its results of operations and cash flows.

Revenue

In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606)”. This ASU amends the guidance for revenue recognition, creating the new Accounting Standards Codification Topic 606 (“ASC 606”). ASC 606 requires entities to apportion consideration from contracts to performance obligations on a relative standalone selling price basis, based on a five-step model. Under ASC 606, revenue is recognized when a customer obtains control of a promised good or service and is recognized in an amount that reflects the consideration which the entity expects to receive in exchange for the good or service. In addition, ASC 606 requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.

The Company has elected the full retrospective adoption model, effective January 1, 2018. The Company’s quarterly results beginning with the quarter ending March 31, 2018 and comparative prior periods will be compliant with ASC 606. The Company’s Annual Report on Form 10-K for the year ended December 31, 2018 will be the Company’s first Annual Report that will be issued in compliance with ASC 606.

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

The Company has made significant progress on quantifying the impact of its adoption and identifying necessary changes to our policies, processes, systems, and controls.

The Company expects the following impacts:

•

Currently, the Company recognizes revenue from term licenses and perpetual licenses with extended payment terms over the term of the agreement as payments become due or earlier if prepaid, provided all other criteria for revenue recognition have been met, and any corresponding maintenance over the term of the agreement. The adoption of ASC 606 will result in revenue for performance obligations being recognized as they are satisfied. Therefore, revenue from the term and perpetual license performance obligations with extended payment terms is recognized when control is transferred to the customer. Any unrecognized license revenue from these arrangements, included in deferred revenue at December 31, 2015, will not be recognized in revenue in future periods but as a cumulative adjustment to retained earnings. Further, term license revenue from new arrangements executed in 2016 and 2017 will be recognized in full in the year that control of the license is transferred to the customer instead of over the term of the agreement. Revenue from the maintenance performance obligations is expected to be recognized on a straight-line basis over the contractual term. Due to the revenue from term and perpetual licenses with extended payment terms being recognized prior to amounts being billed to the customer, the Company expects to recognize a net contract asset on the balance sheet.

•

Currently, the Company allocates revenue to licenses under the residual method when it has Vendor Specific Objective Evidence (“VSOE”) for the remaining undelivered elements, which allocates any future credits or significant discounts entirely to the license. The adoption of ASC 606 will result in future credits, significant discounts, and material rights under ASC 606, to be allocated to all performance obligations based upon their relative selling price. Under ASC 606, additional license revenue from the reallocation of such arrangement considerations will be recognized when control is transferred to the customer, which is generally upon delivery of the license.

•

Currently, the Company does not have VSOE for fixed price services, time and materials services in certain geographical areas, and unspecified future products, which results in revenue being deferred in such instances until such time as VSOE exists for all undelivered elements or recognized ratably over the longest performance period. The adoption of ASC 606 eliminates the requirement for VSOE and replaces it with the concept of a stand-alone selling price. Once the transaction price is allocated to each of the performance obligations, the Company can recognize revenue as the performance obligations are delivered, either at a point in time or over time. Under ASC 606, license revenue will be recognized when control is transferred to the customer, professional services revenue will be recognized over time based on input or output measures that reflect the Company’s performance on the contract. This will result in the acceleration of professional services revenue when compared to the current practice of ratable recognition for professional services when there is a lack of VSOE.

•

Sales commissions and other third party acquisition costs resulting directly from securing contracts with customers are currently expensed when incurred. ASC 606 will require these costs to be recognized as an asset when incurred and to be expensed over the associated contract term. As a practical expedient, if the term of the contract is one year or less, the Company will expense these costs as incurred. The Company expects this change to impact its multi-year cloud offerings and term and perpetual licenses with additional rights of use that extend beyond one year.

•

ASC 606 provides additional accounting guidance for contract modifications whereby changes must be accounted for either as a retrospective change (creating either a catch up or deferral of past revenues), prospectively with a reallocation of revenues amongst identified performance obligations, or prospectively as separate contracts which will not require any reallocation. This may result in a difference in the timing of the recognition of revenue as compared to how contract modifications are recognized currently.

•

There will be a corresponding effect on tax liabilities in relation to all of the above impacts.

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

3. MARKETABLE SECURITIES

The Company’s marketable securities are as follows:


(in thousands)	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
September 30, 2017
Municipal bonds	$	32,764	$	12	$	(17	)	$	32,759
Corporate bonds		31,079		12		(38	)		31,053

	$	63,843	$	24	$	(55	)	$	63,812

December 31, 2016
Municipal bonds	$	36,746	$	—	$	(139	)	$	36,607
Corporate bonds		26,610		1		(51	)		26,560

	$	63,356	$	1	$	(190	)	$	63,167

As of September 30, 2017, the Company did not hold any investments with unrealized losses that are considered to be other-than-temporary.

As of September 30, 2017, remaining maturities of marketable debt securities ranged from October 2017 to September 2020, with a weighted-average remaining maturity of approximately 14 months.

4. DERIVATIVE INSTRUMENTS

In May 2017, the Company discontinued its forward contracts program; however, it will continue to evaluate periodically its foreign exchange exposures and may re-initiate this program if it is deemed necessary.

The Company has historically used foreign currency forward contracts (“forward contracts”) to hedge its exposure to fluctuations in foreign currency exchange rates associated with its foreign currency denominated cash, accounts receivable, and intercompany receivables and payables held primarily by the U.S. parent company and its United Kingdom (“U.K.”) subsidiary.

At December 31, 2016, the total notional value of the Company’s outstanding forward contracts was $128.4 million.

The fair value of the Company’s outstanding forward contracts was as follows:


	December 31, 2016
(in thousands)	Recorded In:		Fair Value
Asset Derivatives
Foreign currency forward contracts		Other current assets	$	628
Liability Derivatives
Foreign currency forward contracts		Accrued expenses	$	883

As of September 30, 2017, the Company did not have any forward contracts outstanding.

The Company had forward contracts outstanding with total notional values as of September 30, 2016 as follows:


(in thousands)
Euro	€	21,810
British pound	£	5,919
Australian dollar	A$	19,515
United States dollar	$	59,450

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

The income statement impact of the Company’s outstanding forward contracts and foreign currency transactions was as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
(in thousands)	2017			2016			2017			2016
Gain (loss) from the change in the fair value of forward contracts included in other income (expense), net	$	—		$	(1,237	)	$	286		$	(4,955	)
Foreign currency transaction (loss) gain from the remeasurement of foreign currency assets and liabilities		(552	)		1,082			(793	)		2,764

	$	(552	)	$	(155	)	$	(507	)	$	(2,191	)

5. FAIR VALUE MEASUREMENTS

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The Company records its money market funds, marketable securities, and forward contracts at fair value on a recurring basis. Fair value is an exit price, representing the amount that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants based on assumptions that market participants would use in pricing an asset or liability. As a basis for classifying the fair value measurements, a three-tier fair value hierarchy, which classifies the fair value measurements based on the inputs used in measuring fair value, was established as follows: (Level 1) observable inputs such as quoted prices in active markets for identical assets or liabilities; (Level 2) significant other inputs that are observable either directly or indirectly; and (Level 3) significant unobservable inputs on which there is little or no market data, which require the Company to develop its own assumptions. This hierarchy requires the Company to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value.

The Company’s money market funds are classified within Level 1 of the fair value hierarchy. The Company’s marketable securities classified within Level 2 of the fair value hierarchy are valued based on a market approach using quoted prices, when available, or matrix pricing compiled by third party pricing vendors, using observable market inputs such as interest rates, yield curves, and credit risk. The Company’s foreign currency forward contracts, which were all classified within Level 2 of the fair value hierarchy, are valued based on the notional amounts and rates under the contracts and observable market inputs such as currency exchange rates and credit risk. If applicable, the Company will recognize transfers into and out of levels within the fair value hierarchy at the end of the reporting period in which the actual event or change in circumstance occurs. There were no transfers between Level 1 and Level 2 during the nine months ended September 30, 2017.

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

The Company’s assets and liabilities measured at fair value on a recurring basis consisted of the following:


	Fair Value Measurements at Reporting Date Using				Total
(in thousands)	Level 1		Level 2		Total
September 30, 2017
Fair Value Assets:
Money market funds	$	655	$	—	$	655
Marketable securities:
Municipal bonds	$	—	$	32,759		32,759
Corporate bonds		—		31,053		31,053

	$	—	$	63,812	$	63,812
December 31, 2016
Fair Value Assets:
Money market funds	$	458	$	—	$	458
Marketable securities:
Municipal bonds	$	—	$	36,607	$	36,607
Corporate bonds		—		26,560		26,560

	$	—	$	63,167	$	63,167
Foreign currency forward contracts		—		628		628
Fair Value Liabilities:
Foreign currency forward contracts	$	—	$	883	$	883

For certain other financial instruments, including accounts receivable and accounts payable, the carrying value approximates their fair value due to the relatively short maturity of these items.

Assets Measured at Fair Value on a Nonrecurring Basis

Assets recorded at fair value on a nonrecurring basis, such as property and equipment and intangible assets, are recognized at fair value when they are impaired. During the nine months ended September 30, 2017 and 2016, the Company did not recognize any impairments of its assets recorded at fair value on a nonrecurring basis.

6. TRADE ACCOUNTS RECEIVABLE, NET OF ALLOWANCE


(in thousands)	September 30, 2017			December 31, 2016
Trade accounts receivable	$	164,530		$	234,473
Unbilled trade accounts receivable		32,820			34,681

Total trade accounts receivable		197,350			269,154
Allowance for sales credit memos		(6,189	)		(4,126	)

	$	191,161		$	265,028

Unbilled trade accounts receivable primarily relate to services earned under time and materials arrangements and to license, maintenance, and cloud arrangements that have commenced or been delivered in excess of scheduled invoicing.

7. GOODWILL AND OTHER INTANGIBLE ASSETS

The changes in the carrying amount of goodwill for the nine months ended September 30, 2017 as follows:


(in thousands)
Balance as of January 1,	$	73,164
Purchase price adjustments to goodwill		(354	)
Currency translation adjustments		131

Balance as of September 30,	$	72,941

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Intangible assets are recorded at cost and are amortized using the straight-line method over their estimated useful lives as follows:


(in thousands)	Range of Remaining Useful Lives		Cost		Accumulated Amortization			Net Book Value
September 30, 2017
Customer related intangibles		4-10 years	$	63,158	$	(43,205	)	$	19,953
Technology		7-10 years		58,942		(44,140	)		14,802
Other intangibles		—		5,361		(5,361	)		—

			$	127,461	$	(92,706	)	$	34,755

December 31, 2016
Customer related intangibles		4-10 years	$	63,091	$	(37,573	)	$	25,518
Technology		3-10 years		58,942		(40,269	)		18,673
Other intangibles		—		5,361		(5,361	)		—

			$	127,394	$	(83,203	)	$	44,191

Amortization expense of intangibles assets is reflected in the Company’s unaudited condensed consolidated statements of operations as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
(in thousands)	2017		2016		2017		2016
Cost of revenue	$	1,232	$	1,642	$	3,871	$	4,626
Selling and marketing		1,873		1,867		5,608		5,274
General and administrative		—		90		—		268

	$	3,105	$	3,599	$	9,479	$	10,168

Future estimated amortization expense related to intangible assets as of September 30, 2017 is as follows:


(in thousands)
Remainder of 2017	$	2,846
2018		11,347
2019		5,555
2020		2,659
2021		2,637
2022 and thereafter		9,711

	$	34,755

8. ACCRUED EXPENSES


(in thousands)	September 30, 2017		December 31, 2016
Outside professional services	$	13,447	$	10,204
Income and other taxes		5,947		10,422
Marketing and sales program expenses		4,679		3,707
Dividends payable		2,336		2,298
Employee related expenses		4,715		3,806
Other		8,557		6,314

	$	39,681	$	36,751

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

9. DEFERRED REVENUE


(in thousands)	September 30, 2017		December 31, 2016
Term license	$	5,636	$	15,843
Perpetual license		20,844		23,189
Maintenance		105,588		112,397
Cloud		18,805		13,604
Professional Services		10,058		10,614

Current deferred revenue		160,931		175,647
Perpetual license		4,085		7,909
Maintenance		828		1,802
Cloud		1,217		1,278

Long-term deferred revenue		6,130		10,989

	$	167,061	$	186,636

10. STOCK-BASED COMPENSATION

Stock-based compensation expense is reflected in the Company’s unaudited condensed consolidated statements of operations as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
(in thousands)	2017			2016			2017			2016
Cost of revenues	$	3,613		$	3,117		$	10,913		$	8,711
Selling and marketing		3,976			3,468			11,482			9,395
Research and development		3,420			2,260			10,306			7,480
General and administrative		2,480			1,983			7,228			4,706
Acquisition-related		—			(10	)		—			342

Total stock-based compensation before tax	$	13,489		$	10,818		$	39,929		$	30,634

Income tax benefit	$	(4,129	)	$	(3,227	)	$	(12,231	)	$	(8,917	)

During the nine months ended September 30, 2017, the Company issued approximately 1,299,000 shares of common stock to its employees and 18,000 shares of common stock to its non-employee directors under the Company’s stock-based compensation plans.

During the nine months ended September 30, 2017, the Company granted approximately 1,052,000 restricted stock units (“RSUs”) and 1,520,000 non-qualified stock options to its employees with total fair values of approximately $47.5 million and $20.6 million, respectively. This includes approximately 175,000 RSUs which were granted in connection with the election by employees to receive 50% of their 2017 target incentive compensation under the Company’s Corporate Incentive Compensation Plan in the form of RSUs instead of cash. Stock-based compensation of approximately $7.7 million associated with this RSU grant will be recognized over a one-year period beginning on the grant date.

The Company recognizes stock based compensation on the accelerated recognition method, treating each vesting tranche as if it were an individual grant. As of September 30, 2017, the Company had approximately $56.8 million of unrecognized stock-based compensation expense, net of estimated forfeitures, related to all unvested RSUs and unvested stock options that is expected to be recognized over a weighted-average period of 2.1 years.

11. EARNINGS PER SHARE

Basic earnings per share is computed using the weighted-average number of common shares outstanding during the applicable period. Diluted earnings per share is computed using the weighted-average number of common shares outstanding during the applicable period, plus the dilutive effect of outstanding options and RSUs, using the treasury stock method. Certain shares related to some of the Company’s outstanding stock options and RSUs were excluded from the computation of diluted earnings per share because they were anti-dilutive in the periods presented, but could be dilutive in the future.

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

The calculation of the Company’s basic and diluted earnings per share is as follows:


	Three Months Ended September 30,					Nine Months Ended September 30,
(in thousands, except per share amounts)	2017			2016		2017		2016
Basic
Net (loss)/income	$	(1,812	)	$	3,301	$	36,615	$	18,237

Weighted-average common shares outstanding		77,691			76,278		77,258		76,323

(Loss)/earnings per share, basic	$	(0.03	)	$	0.04	$	0.47	$	0.24

Diluted
Net (loss)/income	$	(1,812	)	$	3,301	$	36,615	$	18,237

Weighted-average effect of dilutive securities:
Stock options		—			1,933		3,519		1,851
RSUs		—			1,337		1,940		1,227

Effect of assumed exercise of stock options and RSUs		—			3,270		5,459		3,078

Weighted-average common shares outstanding, assuming dilution		77,691			79,548		82,717		79,401

(Loss)/earnings per share, diluted	$	(0.03	)	$	0.04	$	0.44	$	0.23

Outstanding stock options and RSUs excluded as impact would be anti-dilutive		7,232			296		219		368

In periods of loss, all equity awards are excluded, as the inclusion of any equity awards would be anti-dilutive.

12. GEOGRAPHIC INFORMATION AND MAJOR CLIENTS

Geographic Information

Operating segments are defined as components of an enterprise, about which separate financial information is available that is evaluated regularly by the chief operating decision maker (“CODM”) in deciding how to allocate resources and in assessing performance.

The Company develops and licenses software applications for customer engagement and its Pega^® Platform, and provides consulting services, maintenance, and training related to its offerings. The Company derives substantially all of its revenue from the sale and support of one group of similar products and services—software that provides case management, business process management, and real-time decisioning solutions to improve customer engagement and operational excellence in the enterprise applications market. To assess performance, the Company’s CODM, who is the chief executive officer, reviews financial information on a consolidated basis. Therefore, the Company determined it has one reportable segment—Customer Engagement Solutions and one reporting unit.

The Company’s international revenue, based upon the clients’ location, is as follows:


	Three Months Ended September 30,								Nine Months Ended September 30,
(Dollars in thousands)	2017				2016				2017				2016
U.S.	$	95,087	53	%	$	111,274	61	%	$	351,330	59	%	$	308,049	56	%
Other Americas		8,722	5	%		7,952	4	%		30,243	5	%		49,494	9	%
U.K.		18,485	10	%		21,490	12	%		68,003	11	%		77,181	14	%
Other EMEA⁽¹⁾		28,100	16	%		23,656	13	%		76,958	13	%		67,314	12	%
Asia Pacific		29,421	16	%		18,430	10	%		74,508	12	%		48,618	9	%

	$	179,815	100	%	$	182,802	100	%	$	601,042	100	%	$	550,656	100	%

⁽¹⁾	Includes Europe, the Middle East and Africa, but excludes the United Kingdom.

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Major Clients

Clients accounting for 10% or more of the Company’s total revenue were as follows:


	Three Months Ended September 30,					Nine Months Ended September 30,
(in thousands)	2017			2016		2017		2016
Total revenue	$	179,815		$	182,802	$	601,042	$	550,656
Client A		10.6	%		*		*		*

*	Client accounted for less than 10% of total revenue.

Clients accounting for 10% or more of the Company’s total trade accounts receivable were as follows:


(in thousands)	September 30, 2017			December 31, 2016
Total trade accounts receivable		197,350			269,154
Client A		12.4	%		*

*	Client accounted for less than 10% of total trade account receivable

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains or incorporates forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, but are not limited to, statements about our future financial performance and business plans, the adequacy of our liquidity and capital resources, the continued payment of quarterly dividends by the Company, and the timing of revenue recognition under license and cloud arrangements and are described more completely in Part I of our Annual Report on Form 10-K for the year ended December 31, 2016.

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,” “could,” “estimate,” “may,” “target,” “strategy,” “is intended to,” “project,” “guidance,” “likely,” “usually,” or 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. Important factors that could cause actual future activities and results to differ materially from those expressed in such forward-looking statements include, among others, variation in demand for our products and services and the difficulty in predicting the completion of product acceptance and other factors affecting the timing of license revenue recognition; reliance on third party relationships; the potential loss of vendor specific objective evidence for our consulting services; the inherent risks associated with international operations and the continued uncertainties in international economies; the Company’s continued effort to market and sell both domestically and internationally; foreign currency exchange rates; the financial impact of any future acquisitions; the potential legal and financial liabilities and reputation damage due to cyber-attacks and security breaches; and management of the Company’s growth. These risks, and other factors that could cause actual results to differ materially from those expressed in such forward-looking statements, are described more completely in Part I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2016 as well as other filings we make with the Securities and Exchange Commission

We have no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or risks. New information, future events or risks may cause the forward-looking events we discuss in this report not to occur or to materially change.

Business overview

We develop, market, license, and support software applications for marketing, sales, service, and operations. In addition, we license our Pega^® Platform for clients that wish to build and extend their own applications. The Pega Platform assists our clients in building, deploying, and evolving enterprise applications, creating an environment in which business and IT can collaborate to manage back office operations, front office sales, marketing, and/or customer service needs. We also provide consulting services, maintenance, and training for our software. Our software applications and Pega Platform can be deployed on Pega, partner, or customer-managed cloud architectures.

Our clients include Global 3000 companies and government agencies that seek to manage complex enterprise systems and customer service issues with greater agility and cost-effectiveness. Our strategy is to sell a client a series of licenses, each focused on a specific purpose or area of operations in support of longer term enterprise-wide digital transformation initiatives.

Our license revenue is primarily derived from sales of our applications and our Pega Platform. Our cloud revenue is derived from the licensing of our hosted Pega Platform and software application environments. Our consulting services revenue is primarily related to new license implementations.

Financial and Performance Metrics

Management evaluates our financial performance, based a number of select financial and performance metrics. The performance metrics are periodically reviewed and revised to reflect any changes in our business. Historically, Recurring Revenue and License and Cloud Backlog have been our primary performance metrics. However, due to the change in the revenue recognition patterns of term license arrangements as a result of the expected implementation of the new revenue accounting standard (See Note 2) in the first quarter of 2018, we have started tracking Annual Contract Value (“ACV”), a new performance measure.

Select Financial Metrics


(Dollars in thousands, except per share amounts)	Three Months Ended September 30,											Nine Months Ended September 30,
(Dollars in thousands, except per share amounts)	2017			2016			Change					2017			2016			Change
Total revenue	$	179,815		$	182,802			(2,987	)	(2	)%	$	601,042		$	550,656		$	50,386	9	%
Operating margin		(8	)%		3	%							3	%		5	%
Diluted (loss)/earnings per share	$	(0.03	)	$	0.04		$	(0.07	)	(175	)%	$	0.44		$	0.23		$	0.21	91	%
Cash flow provided by operating activities													113,926			20,556			93,370	454	%

Select Performance Metrics

Annual Contract Value (“ACV”)

The change in ACV measures the growth and predictability of future cash flows from committed term license, cloud, and maintenance arrangements as of the end of the particular reporting period.

ACV is the sum of the following two components:

•

Term and Cloud contract value divided by the number of committed contract years

•

Quarterly Maintenance revenue reported for the current three months ended period multiplied by 4.


	September 30,
(in thousands)	2017		2016		Change
Term License and Cloud ACV	$	200,180	$	163,408	$	36,772	23	%
Maintenance ACV		248,816		220,152	$	28,664	13	%

Term License, Cloud and Maintenance ACV	$	448,996	$	383,560	$	65,436	17	%

LOGO

Recurring Revenue

A measure of the predictability and repeatability of our revenue.


	Three Months Ended September 30,											Nine Months Ended September 30,
(Dollars in thousands)	2017			2016			Change					2017			2016			Change
Recurring revenue
Term license	$	21,678		$	28,919		$	(7,241	)	(25	)%	$	106,170		$	102,115		$	4,055	4	%
Maintenance		62,204			55,038		$	7,166		13	%		180,759			163,174		$	17,585	11	%
Cloud		13,354			10,873		$	2,481		23	%		36,914			30,640		$	6,274	20	%

Total recurring revenue	$	97,236		$	94,830		$	2,406		3	%	$	323,843		$	295,929		$	27,914	9	%

Recurring revenue as a percent of total revenue		54	%		52	%							54	%		54	%

License and Cloud Backlog

A measure of the continued growth of our business as a result of future contractual commitments by our clients.

License and Cloud Backlog is the sum of the following two components:

•

Deferred license and cloud revenue as recorded on the Company’s balance sheet. (See Note 9 “Deferred Revenue”)

•

License and cloud contractual commitments, which are not recorded on our balance sheet because we have not yet invoiced our clients, nor have we recognized the associated revenue. (See “Future Cash Receipts from Committed License and Cloud Arrangements” which can be found in “Liquidity and Capital Resources” contained elsewhere in this Quarterly Report on Form 10-Q for additional information)

License and cloud backlog may vary in any given period depending on the amount and timing of when the arrangements are executed, as well as the mix between perpetual, term, and cloud license arrangements, which may depend on our clients’ deployment preferences. A change in the mix may cause our revenues to vary materially from period to period. A higher proportion of term and cloud license arrangements executed will generally result in revenue being recognized over longer periods.


	September 30,								Change
(Dollars in thousands)	2017				2016				Change
Deferred license and cloud revenue on the balance sheet
Term license and cloud	$	25,658	51	%	$	19,627	42	%		31	%
Perpetual license		24,929	49	%		27,653	58	%		(10	)%

Total deferred license and cloud revenue		50,587	100	%		47,280	100	%		7	%

License and cloud contractual commitments not on the balance sheet
Term license and cloud		450,535	91	%		352,804	94	%		28	%
Perpetual license		46,459	9	%		23,483	6	%		98	%

Total license and cloud commitments		496,994	100	%		376,287	100	%		32	%

Total license (term and perpetual) and cloud backlog	$	547,581			$	423,567				29	%

Total term license and cloud backlog		476,193	87	%		372,431	88	%		28	%

LOGO

Critical accounting policies

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. and the rules and regulations of the SEC for interim financial reporting. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and the related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions, and expectations of what could occur in the future given available information.

There have been no changes in our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2016. For more information regarding our critical accounting policies, we encourage you to read the discussion contained in Item 7 under the heading “Critical Accounting Estimates and Significant Judgments” and Note 2 “Significant Accounting Policies” included in the notes to the Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2016.

Results of Operations


	Three Months Ended September 30,											Nine Months Ended September 30,
(Dollars in thousands)	2017			2016			Change					2017			2016			Change
Total revenue	$	179,815		$	182,802		$	(2,987	)	(2	)%	$	601,042		$	550,656		$	50,386		9	%
Gross profit	$	110,084		$	122,365		$	(12,281	)	(10	)%	$	395,346		$	373,609		$	21,737		6	%
Total operating expenses	$	124,373		$	116,867		$	7,506		6	%	$	376,647		$	347,626		$	29,021		8	%
(Loss)/income from operations	$	(14,289	)	$	5,498		$	(19,787	)	(360	)%	$	18,699		$	25,983		$	(7,284	)	(28	)%
Operating margin		(8	)%		3	%							3	%		5	%
(Loss)/income before (benefit)/provision for income taxes	$	(14,697	)	$	5,515		$	(20,212	)	(366	)%	$	18,663		$	24,506		$	(5,843	)	(24	)%

Revenue

Software license revenue


(Dollars in thousands)	Three Months Ended September 30,													Nine Months Ended September 30,
(Dollars in thousands)	2017				2016				Change					2017				2016				Change
Perpetual license	$	20,115	48	%	$	39,914	58	%	$	(19,799	)	(50	)%	$	89,050	46	%	$	105,734	51	%	($	16,684	)	(16	)%
Term license		21,678	52	%		28,919	42	%		(7,241	)	(25	)%		106,170	54	%		102,115	49	%		4,055		4	%

Total license revenue	$	41,793	100	%	$	68,833	100	%	$	(27,040	)	(39	)%	$	195,220	100	%	$	207,849	100	%	($	12,629	)	(6	)%

The mix between perpetual and term license arrangements executed in a particular period varies based on clients’ deployment preferences. A change in the mix may cause our revenues to vary materially from period to period. A higher proportion of term license arrangements executed will generally result in license revenue being recognized over longer periods. Additionally, some of our perpetual license arrangements include extended payment terms or additional rights of use, which may also result in the recognition of revenue over longer periods.

The decrease in perpetual license revenue in the three months ended September 30, 2017 was primarily due to a decrease in the average value of perpetual arrangements executed and a lower percentage of perpetual arrangements executed and recognized in revenue in the current period. The decrease in perpetual license revenue in the nine months ended September 30, 2017 was primarily due to a lower percentage of perpetual arrangements executed and recognized in revenue.

The decrease in term license revenue in the three months ended September 30, 2017 was primarily due to a large term license renewal for which the second year of the term was recognized as revenue in the three months ended September 30, 2016. If the second year of this term license arrangement was not paid in advance in the three months ended September 30, 2016, term license revenue would have decreased 2%. The increase in term license revenue in the nine months ended September 30, 2017 was primarily due to broad based growth amongst new and existing customers offset by a large term license arrangement which was prepaid and recognized in revenue in the three months ended March 31, 2016. If this term license arrangement was not prepaid and recognized in revenue in the three months ended March 31, 2016 term license revenue would have increased 26%.

The aggregate value of future revenue expected to be recognized during the remainder of the year under existing noncancellable perpetual arrangements not reflected in deferred revenue was $13.3 million as of September 30, 2017 compared to $3.9 million as of September 30, 2016.

The aggregate value of future revenue expected to be recognized during the remainder of the year under existing noncancellable term and cloud arrangements not reflected in deferred revenue was $37.7 million as of September 30, 2017 compared to $26.7 million as of September 30, 2016. For additional information see “Future Cash Receipts from Committed License and Cloud Arrangements” which can be found in “Liquidity and Capital Resources.”

Maintenance revenue


	Three Months Ended September 30,								Nine Months Ended September 30,
(Dollars in thousands)	2017		2016		Change				2017		2016		Change
Maintenance	$	62,204	$	55,038	$	7,166	13	%	$	180,759	$	163,174	$	17,585	11	%

The increases were primarily due to the continued growth in the aggregate value of the installed base of our software and strong renewal rates significantly in excess of 90%.

Services revenue


	Three Months Ended September 30,													Nine Months Ended September 30,
(Dollars in thousands)	2017				2016				Change					2017				2016				Change
Consulting services	$	61,535	81	%	$	46,829	80	%	$	14,706		31	%	$	183,447	82	%	$	144,263	80	%	$	39,184		27	%
Cloud		13,354	18	%		10,873	18	%		2,481		23	%		36,914	16	%		30,640	17	%		6,274		20	%
Training		929	1	%		1,229	2	%		(300	)	(24	)%		4,702	2	%		4,730	3	%		(28	)	(1	)%

Total services	$	75,818	100	%	$	58,931	100	%	$	16,887		29	%	$	225,063	100	%	$	179,633	100	%	$	45,430		25	%

Consulting services revenue is primarily generated from new license implementations. Our consulting services revenue may fluctuate in future periods depending on the mix of new implementation projects we perform as compared to those performed by our enabled clients or led by our partners.

The increases in consulting services revenue were primarily due to higher billable hours during the three and nine months ended September 30, 2017 driven by a large project which began in the second half of 2016.

Cloud revenue represents revenue from our Pega Cloud offerings. The increases in cloud revenue were primarily due to continued growth of our cloud client base.

Gross profit


	Three Months Ended September 30,											Nine Months Ended September 30,
(Dollars in thousands)	2017			2016			Change					2017			2016			Change
Software license	$	40,517		$	67,520		$	(27,003	)	(40	)%	$	191,394		$	204,203		$	(12,809	)	(6	)%
Maintenance		55,488			48,379			7,109		15	%		159,814			144,285			15,529		11	%
Services		14,079			6,466			7,613		118	%		44,138			25,121			19,017		76	%

Total gross profit	$	110,084		$	122,365		$	(12,281	)	(10	)%	$	395,346		$	373,609		$	21,737		6	%
Software license gross profit %		97	%		98	%							98	%		98	%
Maintenance gross profit %		89	%		88	%							88	%		88	%
Services gross profit %		19	%		11	%							20	%		14	%

Total gross profit %		61	%		67	%							66	%		68	%

The decrease in total gross profit in the three months ended September 30, 2017 was primarily due to a shift in the mix of license arrangements executed from perpetual to term licenses and an increase in lower margin services revenue.

The increase in total gross profit in the nine months ended September 30, 2017 was primarily due to increased total revenue.

The increases in service gross profit percent in the three and nine months ended September 30, 2017 was driven by a large project which began in the second half of 2016 and several additional large projects for which costs were recognized in 2016 but whose associated revenue was not recognized until after September 30, 2016.

Operating expenses

Selling and marketing


	Three Months Ended September 30,										Nine Months Ended September 30,
(Dollars in thousands)	2017			2016			Change				2017			2016			Change
Selling and marketing	$	70,209		$	67,032		$	3,177	5	%	$	217,384		$	202,126		$	15,258	8	%
As a percent of total revenue		39	%		37	%						36	%		37	%
Selling and marketing headcount, end of period												934			875			59	7	%

Selling and marketing expenses include compensation, benefits, and other headcount-related expenses associated with our selling and marketing personnel as well as advertising, promotions, trade shows, seminars, and other programs. Selling and marketing expenses also include the amortization of customer related intangibles.

The increase in the three months ended September 30, 2017 was primarily due to an increase in compensation and benefits of $1.8 million, driven by increased headcount and equity compensation, partially offset by a decrease in sales commissions associated with the lower value of new license arrangements executed during the three months ended September 30, 2017.

The increase in the nine months ended September 30, 2017 was primarily due to an increase in compensation and benefits of $12.7 million, respectively, driven by increased headcount and equity compensation, and an increase in employee travel and entertainment, partially offset by a decrease in brand marketing program expenses of $2.2 million.

The increase in headcount reflects our efforts to increase our sales capacity to target new accounts in existing industries, as well as to expand coverage in new industries and geographies and to increase the number of sales opportunities.

Research and development


	Three Months Ended September 30,										Nine Months Ended September 30,
(Dollars in thousands)	2017			2016			Change				2017			2016			Change
Research and development	$	41,031		$	38,036		$	2,995	8	%	$	121,089		$	108,530		$	12,559	12	%
As a percent of total revenue		23	%		21	%						20	%		20	%
Research and Development headcount, end of period												1,474			1,437			37	3	%

Research and development expenses include compensation, benefits, contracted services, and other headcount-related expenses associated with the creation and development of our products, as well as enhancements and design changes to existing products and integration of acquired technologies.

The increases in the three and nine months ended September 30, 2017 were primarily due to increases in compensation and benefits of $2.9 million and $12.6 million, respectively, attributable to increased headcount and equity compensation.

General and administrative


	Three Months Ended September 30,										Nine Months Ended September 30,
(Dollars in thousands)	2017			2016			Change				2017			2016			Change
General and administrative	$	13,133		$	11,725		$	1,408	12	%	$	38,174		$	34,067		$	4,107	12	%
As a percent of total revenue		7	%		6	%						6	%		6	%
General and administrative headcount, end of period												407			371			36	10	%

General and administrative expenses include compensation, benefits, and other headcount-related expenses associated with finance, legal, corporate governance, and other administrative headcount. They also include accounting, legal, and other professional consulting and administrative fees. The general and administrative headcount includes employees in human resources, information technology, and corporate services departments, whose costs are partially allocated to other operating expense areas.

The increases in the three and nine months ended September 30, 2017 were primarily due to increases in compensation and benefits of $0.4 million and $4 million, respectively, attributable to increased headcount and equity compensation. The increase in the nine months ended September 30, 2017 was partially offset by a decrease of $1.5 million in legal fees.

Stock-based compensation


	Three Months Ended September 30,											Nine Months Ended September 30,
(in thousands)	2017			2016			Change					2017			2016			Change
Cost of revenues	$	3,613		$	3,117		$	496		16	%	$	10,913		$	8,711		$	2,202		25	%
Selling and marketing		3,976			3,468			508		15	%		11,482			9,395			2,087		22	%
Research and development		3,420			2,260			1,160		51	%		10,306			7,480			2,826		38	%
General and administrative		2,480			1,983			497		25	%		7,228			4,706			2,522		54	%
Acquisition-related		—			(10	)		10		(100	)%		—			342			(342	)	(100	)%

Total stock-based compensation before tax	$	13,489		$	10,818		$	2,671		25	%	$	39,929		$	30,634		$	9,295		30	%

Income tax benefit	$	(4,129	)	$	(3,227	)	$	(902	)	28	%	$	(12,231	)	$	(8,917	)	$	(3,314	)	37	%

The increases were primarily due to the increased value of our annual periodic equity awards granted in March 2016 and 2017. These awards generally have a five-year vesting schedule.

Amortization of intangibles


	Three Months Ended September 30,									Nine Months Ended September 30,
(Dollars in thousands)	2017		2016		Change					2017		2016		Change
Cost of revenue	$	1,232	$	1,642	$	(410	)	(25	)%	$	3,871	$	4,626	$	(755	)	(16	)%
Selling and marketing		1,873		1,867		6		—	%		5,608		5,274		334		6	%
General and administrative		—		90		(90	)	(100	)%		—		268		(268	)	(100	)%

	$	3,105	$	3,599	$	(494	)	(14	)%	$	9,479	$	10,168	$	(689	)	(7	)%

The decreases in amortization of intangibles in the three and nine months ended September 30, 2017 were due to the amortization in full of certain intangibles acquired through past acquisitions.

Non-operating (expense)/income, net


	Three Months Ended September 30,											Nine Months Ended September 30,
(Dollars in thousands)	2017			2016			Change					2017			2016			Change
Foreign currency transaction (loss)/gain	$	(552	)	$	1,082		$	(1,634	)	n/m		$	(793	)	$	2,764		$	(3,557	)	n/m
Interest income, net		144			172		$	(28	)	(16	)%		470			650			(180	)	(28	)%
Other (expense)/income, net		—			(1,237	)	$	1,237		(100	)%		287			(4,891	)		5,178		n/m

	$	(408	)	$	17		$	(425	)	n/m		$	(36	)	$	(1,477	)	$	1,441		(98	)%

n/m - not meaningful

In May 2017, we discontinued our forward contracts program; however, we will continue to evaluate periodically our foreign exchange exposures and may re-initiate this program if it is deemed necessary.

Historically, we have used foreign currency forward contracts (“forward contracts”) to hedge our exposure to fluctuations in foreign currency exchange rates associated with our foreign currency denominated cash, accounts receivable, and intercompany receivables and payables held primarily by the U.S. parent company and its United Kingdom (“U.K.”) subsidiary. See Note 4 “Derivative Instruments” of this Quarterly Report on Form 10-Q for additional information.

The total change in the fair value of our foreign currency forward contracts recorded in other income (expense), net, during the three months ended September 30, 2016 was a loss of $1.2 million. The total change in the fair value of our foreign currency forward contracts recorded in other (expense)/income, net, during the nine months ended September 30, 2017 and 2016 was a gain of $0.3 million and a loss of $5 million, respectively.

(Benefit)/provision for income taxes


	Three Months Ended September 30,										Nine Months Ended September 30,
(Dollars in thousands)	2017			2016			Change				2017			2016			Change
(Benefit)/provision for income taxes	$	(12,885	)	$	2,214		$	(15,099	)	n/m	$	(17,952	)	$	6,269		$	(24,221	)	n/m
Effective income tax rate		88	%		40	%						(96	)%		26	%

n/m - not meaningful

The (benefit)/provision for income taxes represents current and future amounts for federal, state, and foreign taxes.

The increase in the effective income tax rate in the three months ended September 30, 2017 is primarily due to the significant increase of $3.5 million in excess tax benefits generated by our stock compensation plans on significantly lower income before (benefit)/provision for income taxes, which decreased by $20.2 million.

The decrease in the effective income tax rate in the nine months ended September 30, 2017 is primarily due to the significant increase of $19.1 million in excess tax benefits generated by our stock compensation plans, on significantly lower income before (benefit)/provision for income taxes, which decreased by $5.8 million.

The inclusion of excess tax benefits as a component of the provision for income taxes may increase volatility in the effective tax rates of future periods as the amount of excess tax benefits from share-based compensation awards varies depending on our future stock price in relation to the fair value of awards, the timing of RSU vesting and exercise behavior of our stock option holders, and the total value of future grants of share-based compensation awards.

Liquidity and capital resources


	Nine Months Ended September 30,
(in thousands)	2017			2016
Cash provided by (used in):
Operating activities	$	113,926		$	20,556
Investing activities		(11,966	)		(2,859	)
Financing activities		(44,040	)		(43,031	)
Effect of exchange rate on cash		2,054			(1,309	)

Net increase/(decrease) in cash and cash equivalents	$	59,974		$	(26,643	)


(in thousands)	September 30, 2017			December 31, 2016
Total cash, cash equivalents, and marketable securities	$	194,380		$	133,761

We believe that our current cash, cash equivalents, marketable securities, and cash flow from operations will be sufficient to fund our operations, our dividend payments, and our share repurchase program for at least the next 12 months.

As of September 30, 2017, approximately $61.1 million of our cash and cash equivalents was held in our foreign subsidiaries. If it becomes necessary to repatriate these funds, we may be required to pay U.S. tax, net of any applicable foreign tax credits, upon repatriation. We consider the earnings of our foreign subsidiaries to be permanently reinvested and, as a result, U.S. taxes on such earnings are not provided. It is impractical to estimate the amount of U.S. tax we may be required to pay upon repatriation due to the complexity of the foreign tax credit calculations. 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.

Cash provided by operating activities

The primary drivers during the nine months ended September 30, 2017 were net income of $36.6 million and $80.6 million from trade accounts receivable, largely due to increased cash collections and the timing of billings.

The primary driver during the nine months ended September 30, 2016 was net income of $18.2 million.

Future Cash Receipts from Committed License and Cloud Arrangements

As of September 30, 2017, none of the amounts shown in the table below had been billed and no revenue had been recognized.

The below amounts for 2018 and subsequent periods may not be recognized in the periods shown below as a result of the adoption of the new revenue recognition standard (ASC 606). (See Note 2. New Accounting Pronouncements contained elsewhere in this Quarterly Report on Form 10-Q for additional information)


	September 30, 2017
(in thousands)	Term and cloud contracts		Perpetual contracts ⁽¹⁾		Total
Remainder of 2017	$	37,723	$	13,274	$	50,997
2018		150,629		21,213		171,842
2019		125,165		10,033		135,198
2020		85,939		1,572		87,511
2021		38,203		367		38,570
2022 and thereafter		12,876		—		12,876

Total	$	450,535	$	46,459	$	496,994

⁽¹⁾	These amounts are for perpetual licenses with extended payment terms and/or additional rights of use.

Total contractual future cash receipts due from our existing license and cloud arrangements were approximately $376.3 million as of September 30, 2016.

Cash used in investing activities

During the nine months ended September 30, 2017, we purchased $25.7 million of marketable debt securities and made investments of $9.1 million in property and equipment, partially offset by proceeds received from maturities of marketable debt securities (including called marketable debt securities) of $23.1 million.

During the nine months ended September 30, 2016, we acquired OpenSpan for $48.8 million, net of cash acquired, and invested $15.3 million primarily in internally developed software and leasehold improvements at our corporate headquarters, partially offset by proceeds received from the sales of marketable debt securities of $62.3 million.

Cash used in financing activities

We used cash primarily for repurchases of our common stock, share repurchases for tax withholdings for the net settlement of our equity awards, and the payment of our quarterly dividend.

Since 2004, our Board of Directors has approved annual stock repurchase programs that have authorized the repurchase in the aggregate of up to $195 million of our common stock. Purchases under these programs have been made on the open market.

The following table is a summary of our repurchase activity:


	Nine Months Ended September 30,
	2017								2016
(in thousands)	Shares		Amount			Authorization Remaining Under Publicly Announced Share Repurchased Programs			Shares		Amount			Authorization Remaining Under Publicly Announced Share Repurchased Programs
Balance as of January 1,						$	39,385							$	40,534
Authorizations		—		—			—			—		—			25,879
Repurchase for net settlement of tax under stock-based compensation		682		(34,791	)		—			414		(10,791	)		—
Repurchases paid under authorized share repurchase program		68		(2,986	)		(2,986	)		1,028		(25,530	)		(25,530	)
Repurchases unsettled		—		—			—			6		(177	)		(177	)

Activity in Period		750	$	(37,777	)	$	(2,986	)		1,448	$	(36,498	)	$	172

Balance as of September 30,						$	36,399							$	40,706

In addition to the share repurchases made under our repurchase programs, we net settled the majority of our employee stock option exercises and RSU vestings, which resulted in the withholding of shares to cover the option exercise price and the minimum statutory tax withholding obligations.

During the nine months ended September 30, 2017 and 2016, option and RSU holders net settled a total of 2.4 million shares and 1.6 million shares, respectively, of which only 1.3 million shares and 0.8 million shares, respectively, were issued to the option and RSU holders. The balance of the shares were surrendered to us to pay for the exercise price with respect to options and the applicable taxes for both options and RSUs. During the nine months ended September 30, 2017 and 2016, instead of receiving cash from the equity holders, we withheld shares with a value of $23.7 million and $10.1 million, respectively, for the exercise price of options.

Dividends


	Nine Months Ended September 30,
(per share)	2017		2016
Dividends Declared	$	0.09	$	0.09
Dividends Paid	$	0.09	$	0.09

It is our current intention to pay a quarterly cash dividend of $0.03 per share, however, the Board of Directors may terminate or modify this dividend program at any time without notice.

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURE

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 related to fluctuations in foreign exchange rates.

As of September 30, 2017, we did not have any forward contracts outstanding. See Note 4 “Derivative Instruments” of this Quarterly Report on Form 10-Q for further discussion.

Other than the item discussed above, there were no significant changes to our quantitative and qualitative disclosures about market risk during the first nine months ended September 30, 2017. See Part II, Item 7A. Quantitative and Qualitative Disclosures about Market Risk included in our Annual Report on Form 10-K for the year ended December 31, 2016 for a more complete discussion of our market risk exposure.

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 September 30, 2017. In designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and our management necessarily applied its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of September 30, 2017.

(b) Changes in Internal Control over Financial Reporting

There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act) during the quarter ended September 30, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II—OTHER INFORMATION

ITEM 1A.

RISK FACTORS

We encourage you to carefully consider the risk factors identified in Part I, Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2016. These risk factors could materially affect our business, financial condition, and future results and could cause our actual business and financial results to differ materially from those contained in forward-looking statements made in this Quarterly Report on Form 10-Q or elsewhere by management from time to time. There have been no material changes during the nine months ended September 30, 2017 to the risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2016.

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

The following table sets forth information regarding our repurchases of our common stock during the three months ended September 30, 2017:


Period	Total Number of Shares Purchased (in thousands)		Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Share Repurchase Program (1) (in thousands)		Approximate Dollar Value of Shares That May Yet Be Purchased at Period End Under Publicly Announced Share Repurchased Programs (1) (in thousands)
July 1, 2017 - July 31, 2017		12	$	58.54		—	$	36,399
August 1, 2017 - August 31, 2017		55		56.16		—		36,399
September 1, 2017 - September 30, 2017		108		56.56		—		36,399

Total		175	$	56.57

1.	Shares withheld to cover the option exercise price and statutory tax withholding obligations under the net settlement provisions of the company’s stock compensation awards have been included in the above table.

Since 2004, our Board of Directors has approved stock repurchase programs that have authorized the repurchase, in the aggregate, of up to $195 million of our common stock. On May 30, 2017, we announced that our Board of Directors extended the expiration date of the current stock repurchase program to June 30, 2018 (the “Current Program”). Under the Current Program, purchases may be made from time to time on the open market or in privately negotiated transactions. Shares may be repurchased in such amounts as market conditions warrant, subject to regulatory and other considerations. We have established a pre-arranged stock repurchase plan, intended to comply with the requirements of Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Rule 10b-18 under the Exchange Act (the “10b5-1 Plan”). All share repurchases under the Current Program during closed trading window periods will be made pursuant to the 10b5-1 Plan.

ITEM 6.

EXHIBITS

The following exhibits are filed or furnished, as the case may be, as part of this report.

EXHIBIT INDEX


Exhibit No.		Description

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

101.INS		XBRL Instance document.

101.SCH		XBRL Taxonomy Extension Schema Document.

101.CAL		XBRL Taxonomy Calculation Linkbase Document.

101.DEF		XBRL Taxonomy Extension Definition Linkbase Document.

101.LAB		XBRL Taxonomy Label Linkbase Document.

101.PRE		XBRL Taxonomy Presentation Linkbase Document.

⁺⁺	Management contracts and compensatory plan or arrangements

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


		Pegasystems Inc.

Date:	November 8, 2017	By:	/s/ KENNETH STILLWELL
			Kenneth Stillwell
			Chief Financial Officer and Chief Administrative Officer
			(Principal Financial Officer)

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