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PEGASYSTEMS INC - Quarter Report: 2019 June (Form 10-Q)


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
____________________________
FORM 10-Q
____________________________
Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2019
OR
Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 1-11859 
____________________________

PEGASYSTEMS INC.
(Exact name of Registrant as specified in its charter) 
____________________________

Massachusetts04-2787865
(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)
____________________________
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading symbol(s)
Name of each exchange on which registered
Common Stock, $.01 par value per share
PEGA
NASDAQ Global Select Market
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yes x 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.
Large accelerated filer
Accelerated filer
Non-accelerated filer
Smaller reporting company
Emerging growth company
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 79,131,665 shares of the Registrant’s common stock, $0.01 par value per share, outstanding on July 30, 2019 



Table of Contents


PEGASYSTEMS INC.

QUARTERLY REPORT ON FORM 10-Q

TABLE OF CONTENTS

 
Page
PART I - FINANCIAL INFORMATION
 
 
Item 1. Unaudited Condensed Consolidated Financial Statements
 
Unaudited Condensed Consolidated Balance Sheets as of June 30, 2019 and December 31, 2018
Unaudited Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2019 and 2018
Unaudited Condensed Consolidated Statements of Comprehensive (Loss) for the three and six months ended June 30, 2019 and 2018
Unaudited Condensed Consolidated Statements of Stockholders’ Equity for the six months ended June 30, 2019 and 2018
Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2019 and 2018
Notes to Unaudited Condensed Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
 
 
PART II - OTHER INFORMATION
 
 
Item 1A. Risk Factors
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 6. Exhibits
 
 
Signature
 

2

Table of Contents

PART I - FINANCIAL INFORMATION
ITEM 1.     UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)

 
June 30, 2019
 
December 31, 2018
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
95,500


$
114,422

Marketable securities
59,549


93,001

Total cash, cash equivalents, and marketable securities
155,049

 
207,423

Accounts receivable
134,965


180,872

Unbilled receivables
169,554


172,656

Other current assets
77,290


49,684

Total current assets
536,858

 
610,635

Long-term unbilled receivables
117,889


151,237

Goodwill
79,037


72,858

Other long-term assets
206,833


147,823

Total assets
$
940,617

 
$
982,553

Liabilities and stockholders’ equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
14,586


$
16,487

Accrued expenses
50,372


45,506

Accrued compensation and related expenses
62,880


84,671

Deferred revenue
169,009


185,145

Other current liabilities
14,576

 

Total current liabilities
311,423

 
331,809

Operating lease liabilities
54,292

 

Deferred income tax liabilities
6,918


6,939

Other long-term liabilities
10,697


22,274

Total liabilities
383,330

 
361,022

Stockholders’ equity:
 
 
 
Preferred stock, 1,000 shares authorized; none issued

 

Common stock, 200,000 shares authorized; 79,144 and 78,526 shares issued and outstanding at
June 30, 2019 and December 31, 2018, respectively
791


785

Additional paid-in capital
122,880


123,205

Retained earnings
445,108


510,863

Accumulated other comprehensive (loss)
(11,492
)
 
(13,322
)
Total stockholders’ equity
557,287

 
621,531

Total liabilities and stockholders’ equity
$
940,617

 
$
982,553


See notes to unaudited condensed consolidated financial statements.

3


PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)


Three Months Ended  
June 30,
 
Six Months Ended  
June 30,
 
2019
 
2018
 
2019
 
2018
Revenue
 
 
 
 
 
 
 
Software license
$
44,274

 
$
44,784

 
$
107,538

 
$
132,557

Maintenance
69,329

 
65,906

 
137,035

 
130,431

Services
91,989

 
86,089

 
173,565

 
168,973

Total revenue
205,592

 
196,779

 
418,138

 
431,961

Cost of revenue
 
 
 
 
 
 
 
Software license
928

 
1,262

 
2,306

 
2,517

Maintenance
6,292

 
5,874

 
12,627

 
11,956

Services
69,860

 
66,681

 
136,584

 
134,958

Total cost of revenue
77,080

 
73,817

 
151,517

 
149,431

Gross profit
128,512

 
122,962

 
266,621

 
282,530

Operating expenses
 
 
 
 
 
 
 
Selling and marketing
116,962

 
93,972

 
225,827

 
182,355

Research and development
49,714

 
41,972

 
100,310

 
88,757

General and administrative
14,174

 
10,181

 
26,850

 
26,645

Total operating expenses
180,850

 
146,125

 
352,987

 
297,757

(Loss) from operations
(52,338
)
 
(23,163
)
 
(86,366
)
 
(15,227
)
Foreign currency transaction gain (loss)
2,105

 
1,244

 
(1,607
)
 
159

Interest income, net
544

 
629

 
1,267

 
1,393

Other income, net
55

 

 
55

 
363

(Loss) before (benefit from) income taxes
(49,634
)
 
(21,290
)
 
(86,651
)
 
(13,312
)
(Benefit from) income taxes
(17,338
)
 
(10,881
)
 
(25,638
)
 
(15,103
)
Net (loss) income
$
(32,296
)
 
$
(10,409
)
 
$
(61,013
)
 
$
1,791

(Loss) earnings per share
 
 
 
 
 
 
 
Basic
$
(0.41
)
 
$
(0.13
)
 
$
(0.77
)
 
$
0.02

Diluted
$
(0.41
)
 
$
(0.13
)
 
$
(0.77
)
 
$
0.02

Weighted-average number of common shares outstanding
 
 
 
 
 
 
 
Basic
78,987

 
78,635

 
78,787

 
78,436

Diluted
78,987

 
78,635

 
78,787

 
83,247


See notes to unaudited condensed consolidated financial statements.

4


PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS)
(in thousands)

 
Three Months Ended  
June 30,
 
Six Months Ended  
June 30,
 
2019
 
2018
 
2019
 
2018
Net (loss) income
$
(32,296
)
 
$
(10,409
)
 
$
(61,013
)
 
$
1,791

Other comprehensive (loss) income, net of tax
 
 
 
 
 
 
 
Unrealized gain (loss) on available-for-sale marketable securities
238

 
73

 
612

 
(115
)
Foreign currency translation adjustments
(409
)
 
(7,414
)
 
1,218

 
(2,964
)
Total other comprehensive (loss) income, net of tax
(171
)
 
(7,341
)
 
1,830

 
(3,079
)
Comprehensive (loss)
$
(32,467
)
 
$
(17,750
)
 
$
(59,183
)
 
$
(1,288
)

See notes to unaudited condensed consolidated financial statements.

5


PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except per share amounts)
 
Common Stock
 
Additional
Paid-In
Capital
 
Retained Earnings
 
Accumulated Other Comprehensive (Loss) Income 
 
Total
Stockholders’ Equity
 
Number
of Shares
 
Amount
 
 
 
 
December 31, 2017
78,081

 
$
781

 
$
152,097

 
$
509,697

 
$
(6,705
)
 
$
655,870

Repurchase of common stock
(101
)
 
(1
)
 
(5,688
)
 

 

 
(5,689
)
Issuance of common stock for share-based compensation plans
566

 
5

 
(15,556
)
 

 

 
(15,551
)
Stock-based compensation

 

 
15,109

 

 

 
15,109

Cash dividends declared ($0.12 per share)

 

 

 
(2,355
)
 

 
(2,355
)
Other comprehensive income

 

 

 
 
 
4,262

 
4,262

Net income

 

 

 
12,200

 

 
12,200

March 31, 2018
78,546

 
785

 
145,962

 
519,542

 
(2,443
)
 
663,846

Repurchase of common stock
(171
)
 
(2
)
 
(10,179
)
 

 

 
(10,181
)
Issuance of common stock for share-based compensation plans
358

 
4

 
(11,395
)
 

 

 
(11,391
)
Issuance of common stock under Employee Stock Purchase Plan
15

 

 
849

 

 

 
849

Stock-based compensation

 

 
16,163

 

 

 
16,163

Cash dividends declared ($0.12 per share)

 

 

 
(2,364
)
 

 
(2,364
)
Other comprehensive loss

 

 

 

 
(7,341
)
 
(7,341
)
Net loss

 

 

 
(10,409
)
 

 
(10,409
)
June 30, 2018
78,748

 
$
787

 
$
141,400

 
$
506,769

 
$
(9,784
)
 
$
639,172

 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
78,526

 
$
785

 
$
123,205

 
$
510,863

 
$
(13,322
)
 
$
621,531

Repurchase of common stock
(144
)
 
(1
)
 
(7,586
)
 

 

 
(7,587
)
Issuance of common stock for share-based compensation plans
514

 
5

 
(14,843
)
 

 

 
(14,838
)
Stock-based compensation

 

 
18,406

 

 

 
18,406

Cash dividends declared ($0.12 per share)

 

 

 
(2,367
)
 

 
(2,367
)
Other comprehensive income

 

 

 

 
2,001

 
2,001

Net (loss)

 

 

 
(28,717
)
 

 
(28,717
)
March 31, 2019
78,896

 
789

 
119,182

 
479,779

 
(11,321
)
 
588,429

Repurchase of common stock
(88
)
 
(1
)
 
(6,301
)
 

 

 
(6,302
)
Issuance of common stock for share-based compensation plans
320

 
3

 
(11,217
)
 

 

 
(11,214
)
Issuance of common stock under Employee Stock Purchase Plan
16

 

 
1,103

 

 

 
1,103

Stock-based compensation

 

 
20,113

 

 

 
20,113

Cash dividends declared ($0.12 per share)

 

 

 
(2,375
)
 

 
(2,375
)
Other comprehensive (loss)

 

 

 

 
(171
)
 
(171
)
Net (loss)

 

 

 
(32,296
)
 

 
(32,296
)
June 30, 2019
79,144

 
$
791

 
$
122,880

 
$
445,108

 
$
(11,492
)
 
$
557,287


See notes to unaudited condensed consolidated financial statements.

6


PEGASYSTEMS INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

 
Six Months Ended  
June 30,
 
2019
 
2018
Operating activities
 
 
 
Net (loss) income
$
(61,013
)
 
$
1,791

Adjustments to reconcile net (loss) income to cash provided by operating activities
 
 
 
Stock-based compensation
38,397

 
31,165

Amortization and depreciation
33,788

 
20,921

Foreign currency transaction loss (gain)
1,607

 
(159
)
Other non-cash
(230
)
 
(846
)
Change in operating assets and liabilities, net
(4,829
)
 
22,560

Cash provided by operating activities
7,720

 
75,432

Investing activities


 
 
Purchases of investments
(10,497
)
 
(51,395
)
Proceeds from maturities and called investments
13,545

 
11,546

Sales of investments
29,965

 

Payments for acquisitions, net of cash acquired
(10,921
)
 

Investment in property and equipment
(4,882
)
 
(6,520
)
Cash provided by (used in) investing activities
17,210

 
(46,369
)
Financing activities
 
 
 
Dividend payments to shareholders
(4,730
)
 
(4,702
)
Common stock repurchases
(39,637
)
 
(41,123
)
Cash (used in) financing activities
(44,367
)
 
(45,825
)
Effect of exchange rate changes on cash and cash equivalents
515

 
(1,226
)
Net (decrease) in cash and cash equivalents
(18,922
)
 
(17,988
)
Cash and cash equivalents, beginning of period
114,422

 
162,279

Cash and cash equivalents, end of period
$
95,500

 
$
144,291


See notes to unaudited condensed consolidated financial statements.

7

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 the information 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, 2018.
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 2019.
2. NEW ACCOUNTING PRONOUNCEMENTS
Financial instruments
In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 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 accounts receivable, upon initial recognition of that financial asset using a forward-looking expected loss model, rather than an incurred loss model. 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 does not expect the adoption of this standard will have a material effect on its financial position or results of operations.
Leases
On January 1, 2019, the Company adopted Accounting Standards Codification 842 “Leases” (“ASC 842”) using the modified retrospective method, reflecting any cumulative effect as an adjustment to equity. Results for reporting periods beginning on or after January 1, 2019 are presented under ASC 842, while prior period amounts were not adjusted and continue to be reported in accordance with the Company’s historic accounting under ASC 840 “Leases”.
The Company elected the permitted practical expedients to not reassess the following related to leases that commenced before the effective date of ASC 842: (i) whether any expired or existing contracts contain leases; (ii) the lease classification for any expired or existing leases; and (iii) initial direct costs for any existing leases. Upon adoption, the Company recorded right of use assets of $41.8 million and lease liabilities of $54.2 million. The difference between the value of the right of use assets and lease liabilities is due to the reclassification of existing deferred rent, prepaid rent, and unamortized lease incentives as of January 1, 2019.
See Note 9. “Leases” for additional information.
3. MARKETABLE SECURITIES
 
June 30, 2019
(in thousands)
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Municipal bonds
$
29,495

 
$
156

 
$
(5
)
 
$
29,646

Corporate bonds
29,620

 
291

 
(8
)
 
29,903

 
$
59,115

 
$
447

 
$
(13
)
 
$
59,549

 
December 31, 2018
(in thousands)
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Fair Value
Municipal bonds
$
44,802

 
$
13

 
$
(110
)
 
$
44,705

Corporate bonds
48,499

 
23

 
(226
)
 
48,296

 
$
93,301

 
$
36

 
$
(336
)
 
$
93,001


As of June 30, 2019, maturities of marketable securities ranged from January 2020 to August 2022, with a weighted-average remaining maturity of approximately 1.5 years.

8

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



4. RECEIVABLES, CONTRACT ASSETS, AND DEFERRED REVENUE
Receivables
(in thousands)
June 30, 2019
 
December 31, 2018
Accounts receivable
$
134,965

 
$
180,872

Unbilled receivables
169,554

 
172,656

Long-term unbilled receivables
117,889

 
151,237


$
422,408

 
$
504,765


Unbilled receivables are client committed amounts for which revenue recognition precedes billing, and billing is solely subject to the passage of time.
Unbilled receivables are expected to be billed in the future as follows:
(Dollars in thousands)
June 30, 2019
1 year or less
$
169,554

59
%
1-2 years
79,128

28
%
2-5 years
38,761

13
%
 
$
287,443

100
%

Contract assets and deferred revenue
(in thousands)
June 30, 2019
 
December 31, 2018
Contract assets (1)
$
3,770

 
$
3,711

Long-term contract assets (2)
2,190

 
2,543

 
$
5,960

 
$
6,254

(1) Included in other current assets. (2) Included in other long-term assets.
(in thousands)
June 30, 2019
 
December 31, 2018
Deferred revenue
$
169,009

 
$
185,145

Long-term deferred revenue (1)
4,342

 
5,344

 
$
173,351

 
$
190,489

(1) Included in other long-term liabilities.
Contract assets are amounts under client contracts where revenue recognized exceeds the amount billed to the client and the right to payment is subject to conditions other than the passage of time, such as the completion of a related performance obligation. Deferred revenue consists of billings and payments received in advance of revenue recognition. Contract assets and deferred revenue are netted at the contract level for each reporting period.
The change in deferred revenue in the six months ended June 30, 2019 was primarily due to $135.8 million of revenue recognized, excluding the impact of netting contract assets and deferred revenue at the contract level, during the period that was included in deferred revenue at December 31, 2018, partially offset by new billings in advance of revenue recognition.
5. DEFERRED CONTRACT COSTS
The Company recognizes an asset for the incremental costs of obtaining a client contract, which primarily relate to sales commissions. The Company expects to benefit from those costs for more than one year, as the Company generally only pays sales commissions on the initial contract, and not any subsequent contract renewals. As a result, there are no commensurate commissions paid on contract renewals. Deferred costs are amortized on a straight-line basis over the benefit period, which is on average 5 years.
(in thousands)
June 30, 2019
 
December 31, 2018
Deferred contract costs (1)
$
64,809

 
$
64,367

(1) Included in other long-term assets.
 
Three Months Ended  
June 30,
 
Six Months Ended  
June 30,
(in thousands)
2019
 
2018
 
2019
 
2018
Amortization of deferred contract costs (1)
$
5,878

 
$
3,809

 
$
14,179

 
$
7,598

(1) Included in selling and marketing expenses.

9

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



6. GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill
The change in the carrying amount of goodwill was:
(in thousands)
Six Months Ended  
June 30, 2019
Balance as of January 1,
$
72,858

Acquisition (1)
6,179

Currency translation adjustments

Balance as of June 30,
$
79,037


(1) In May 2019, the Company acquired In the Chat Communications Inc., a privately-held software provider of digital customer service software for $10.9 million, net of cash acquired. The Company also expects to issue up to approximately 15 thousand shares in retention-based bonus payments to a key employee upon the achievement of specified retention milestones. The principal assets and liabilities acquired as part of the business combination were additional goodwill and technology intangibles assets of $6.2 million and $5.1 million. The allocation of the purchase price is preliminary for income taxes as the Company is still gathering information.
Intangibles
Intangible assets are recorded at cost and amortized using the straight-line method over their estimated useful lives as follows:
 
 
 
June 30, 2019
(in thousands)
Useful Lives
 
Cost
 
Accumulated
Amortization
 
Net Book Value (1)
Client-related intangibles
4-10 years
 
$
63,115

 
$
(53,608
)
 
$
9,507

Technology
2-10 years
 
64,843

 
(52,605
)
 
12,238

Other
1 - 5 years
 
5,361

 
(5,361
)
 

 
 
 
$
133,319

 
$
(111,574
)
 
$
21,745

(1) Included in other long-term assets.
 
 
 
December 31, 2018
(in thousands)
Useful Lives
 
Cost
 
Accumulated Amortization
 
Net Book Value (1)
Client-related intangibles
4-10 years
 
$
63,115

 
$
(51,224
)
 
$
11,891

Technology
2-10 years
 
59,742

 
(50,398
)
 
9,344

Other
1 - 5 years
 
5,361

 
(5,361
)
 

 
 
 
$
128,218

 
$
(106,983
)
 
$
21,235

(1) Included in other long-term assets.
Amortization of intangible assets was:
(in thousands)
Three Months Ended  
June 30,
 
Six Months Ended  
June 30,
2019
 
2018
 
2019
 
2018
Cost of revenue
$
875

 
$
1,231

 
$
2,207

 
$
2,463

Selling and marketing
781

 
1,605

 
2,385

 
3,210

 
$
1,656

 
$
2,836

 
$
4,592

 
$
5,673


7. ACCRUED EXPENSES
(in thousands)
June 30, 2019
 
December 31, 2018
Outside professional services expenses
$
8,513

 
$
10,367

Income and other taxes
6,401

 
10,387

Marketing and sales program expenses
12,115

 
5,860

Dividends payable
2,375

 
2,363

Employee-related expenses
5,378

 
3,536

Cloud hosting expenses
11,978

 
4,604

Other
3,612

 
8,389

 
$
50,372

 
$
45,506



10

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



8. FAIR VALUE MEASUREMENTS
Assets and liabilities measured at fair value on a recurring basis
The Company records its cash equivalents, marketable securities, and investments in privately-held companies 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 cash equivalents are composed of money market funds and time deposits, which are classified within Level 1 and Level 2, respectively, in the fair value hierarchy. The Company’s marketable securities, which are 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 investments in privately-held companies are classified within Level 3 of the fair value hierarchy.
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 levels during the six months ended June 30, 2019.
The Company’s assets and liabilities measured at fair value on a recurring basis were:
 
June 30, 2019
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Cash equivalents
$
5,653

 
$

 
$

 
$
5,653

Marketable securities:
 
 
 
 
 
 
 
Municipal bonds
$

 
$
29,646

 
$

 
$
29,646

Corporate bonds

 
29,903

 

 
29,903

Total marketable securities
$

 
$
59,549

 
$

 
$
59,549

Investments in privately-held companies (1)
$

 
$

 
$
3,890

 
$
3,890

(1) Included in other long-term assets.
 
December 31, 2018
(in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Cash equivalents
$
10,155

 
$
10,000

 
$

 
$
20,155

Marketable securities:
 
 
 
 
 
 
 
Municipal bonds
$

 
$
44,705

 
$

 
$
44,705

Corporate bonds

 
48,296

 

 
48,296

Total marketable securities
$

 
$
93,001

 
$

 
$
93,001

Investments in privately-held companies (1)
$

 
$

 
$
3,390

 
$
3,390

(1) Included in other long-term assets.
For certain other financial instruments, including accounts receivable and accounts payable, the carrying value approximates fair value due to the relatively short maturity of these items.
9. LEASES
The Company’s leases are primarily for office space used in the ordinary course of business.
Accounting policy
All the Company’s leases are operating leases. The Company accounts for a contract as a lease when it has the right to control the asset for a period of time while obtaining substantially all of the asset’s economic benefits. The Company determines the initial classification and measurement of its operating right of use assets and lease liabilities at the lease commencement date and thereafter if modified. Fixed lease costs are recognized on a straight-line basis over the term of the lease. Variable lease costs are recognized in the period in which the obligation for those payments is incurred. The Company combines lease and non-lease components in the determination of lease costs for its office space leases. The lease liability includes lease payments related to options to extend or renew the lease term, if the Company is

11

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



reasonably certain it will exercise those options. The Company’s leases do not contain any material residual value guarantees or restrictive covenants.
Expense
(in thousands)
Three Months Ended  
June 30, 2019
 
Six Months Ended  
June 30, 2019
Operating lease costs (1)
$
4,281

 
$
8,581

Variable lease costs
1,362

 
2,683

 
$
5,643

 
$
11,264

(1) Lease costs that are fixed.
Right of use assets and lease liabilities
(in thousands)
June 30, 2019
Right of use assets (1)
$
57,772

Lease liabilities (2)
$
14,576

Long-term lease liabilities
$
54,292

(1) An asset that represents the Company’s right to use the leased asset during the lease term. Included in other long-term assets. (2) Included in other current liabilities.
The weighted-average remaining lease term and discount rate for the Company’s leases were:
 
June 30, 2019
Weighted-average remaining lease term
4.3 years

Weighted-average discount rate (1)
5.7
%
(1) The rates implicit in most of the Company’s leases are not readily determinable, and therefore the Company uses its incremental borrowing rate as the discount rate when measuring operating lease liabilities. The incremental borrowing rate represents an estimate of the interest rate the Company would incur to borrow an amount equal to the lease payments on a collateralized basis over the term of the lease.
Maturities of lease liabilities are:
(in thousands)
June 30, 2019
Remainder of 2019
$
8,290

2020
18,976

2021
17,099

2022
16,166

2023 and thereafter
17,393

Total lease payments
77,924

Less: imputed interest (1)
(9,056
)
 
$
68,868

(1) Lease liabilities are measured at the present value of the remaining lease payments using a discount rate determined at lease commencement unless the discount rate is updated as a result of a lease reassessment event.
As of December 31, 2018, the Company’s future minimum rental payments required under operating leases with noncancellable terms in excess of one year as determined prior to the adoption of ASC 842 were:
(in thousands)
Operating Leases (1)
2019
$
15,993

2020
14,807

2021
13,262

2022
12,279

2023
11,084

 
$
67,425

(1) Operating leases include future minimum rent payments, net of estimated sublease income for facilities that the Company has vacated pursuant to its restructuring activities.

12

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



Cash flow information
(in thousands)
Six Months Ended  
June 30, 2019
Cash paid for leases
9,638

Right of use assets recognized for new leases and amendments (non-cash)
22,667


10. REVENUE
Geographic revenue
 
Three Months Ended  
June 30,
 
Six Months Ended  
June 30,
(Dollars in thousands)
2019
 
2018
 
2019
 
2018
U.S.
$
119,682

59
%
 
$
110,349

55
%
 
$
223,673

54
%
 
$
224,334

52
%
Other Americas
8,873

4
%
 
9,627

5
%
 
37,702

9
%
 
27,342

6
%
United Kingdom (“U.K.”)
16,686

8
%
 
23,079

12
%
 
41,235

10
%
 
49,173

11
%
Europe (excluding U.K.), Middle East, and Africa
33,395

16
%
 
27,070

14
%
 
67,581

16
%
 
58,896

14
%
Asia-Pacific
26,956

13
%
 
26,654

14
%
 
47,947

11
%
 
72,216

17
%
 
$
205,592

100
%
 
$
196,779

100
%
 
$
418,138

100
%
 
$
431,961

100
%
Revenue streams
 
Three Months Ended  
June 30,
 
Six Months Ended  
June 30,
(in thousands)
2019
 
2018
 
2019
 
2018
Perpetual license
$
19,320

 
$
13,475

 
$
34,270

 
$
36,553

Term license
24,954

 
31,309

 
73,268

 
96,004

Revenue recognized at a point in time
44,274

 
44,784

 
107,538

 
132,557

Maintenance
69,329

 
65,906

 
137,035

 
130,431

Cloud
31,699

 
20,201

 
59,457

 
35,783

Consulting
60,290

 
65,888

 
114,108

 
133,190

Revenue recognized over time
161,318

 
151,995

 
310,600

 
299,404

 
$
205,592

 
$
196,779

 
$
418,138

 
$
431,961

(in thousands)
Three Months Ended  
June 30,
 
Six Months Ended  
June 30,
2019
 
2018
 
2019
 
2018
Term license
$
24,954

 
$
31,309

 
$
73,268

 
$
96,004

Cloud
31,699

 
20,201

 
59,457

 
35,783

Maintenance
69,329

 
65,906

 
137,035

 
130,431

Subscription (1)
125,982

 
117,416

 
269,760

 
262,218

Perpetual license
19,320

 
13,475

 
34,270

 
36,553

Consulting
60,290

 
65,888

 
114,108

 
133,190

 
$
205,592

 
$
196,779

 
$
418,138

 
$
431,961

(1)  Reflects client arrangements (term license, cloud, and maintenance) that are subject to renewal.

13

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



Remaining performance obligations (“RPO”)
Expected future revenue on existing contracts:
 
June 30, 2019
(Dollars in thousands)
Perpetual license
 
Term License
 
Maintenance
 
Cloud
 
Consulting
 
Total
1 year or less
$
8,429

 
$
38,080

 
$
173,421

 
$
124,134

 
$
16,259

 
$
360,323

57
%
1-2 years
915

 
4,678

 
12,530

 
98,842

 
942

 
117,907

19
%
2-3 years
1,306

 
641

 
5,801

 
75,828

 
227

 
83,803

13
%
Greater than 3 years

 
185

 
2,812

 
63,259

 

 
66,256

11
%
 
$
10,650

 
$
43,584

 
$
194,564

 
$
362,063

 
$
17,428

 
$
628,289

100
%
 
June 30, 2018
(Dollars in thousands)
Perpetual license
 
Term License
 
Maintenance
 
Cloud
 
Consulting
 
Total
1 year or less
$
28,626

 
$
20,457

 
$
111,086

 
$
41,036

 
$
12,039

 
$
213,244

45
%
1-2 years
15,862

 
9,878

 
43,837

 
66,529

 
4,103

 
140,209

29
%
2-3 years
2,423

 
5,665

 
5,265

 
50,250

 

 
63,603

13
%
Greater than 3 years
362

 
944

 
2,103

 
55,995

 
200

 
59,604

13
%
 
$
47,273

 
$
36,944

 
$
162,291

 
$
213,810

 
$
16,342

 
$
476,660

100
%

11. STOCK-BASED COMPENSATION
Expense
 
Three Months Ended  
June 30,
 
Six Months Ended  
June 30,
(in thousands)
2019
 
2018
 
2019
 
2018
Cost of revenues
$
4,911


$
4,257

 
$
9,430


$
7,958

Selling and marketing
8,364


6,038

 
15,738


10,696

Research and development
4,572


3,802

 
9,132


7,439

General and administrative
2,200


1,959

 
4,097


5,072

 
$
20,047


$
16,056

 
$
38,397


$
31,165

Income tax benefit
$
(4,056
)

$
(3,341
)
 
$
(7,796
)

$
(6,482
)

As of June 30, 2019, the Company had $99.5 million of unrecognized stock-based compensation expense, net of estimated forfeitures, which is expected to be recognized over a weighted-average period of 2.2 years.
Grants
The Company granted the following stock-based compensation awards:
 
Six Months Ended  
June 30, 2019
(in thousands)
Shares
 
Total Fair Value
RSUs
949

 
$
60,855

Non-qualified stock options
1,828

 
$
34,481


Vestings and exercises
During the six months ended June 30, 2019, 0.8 million shares of common stock were issued due to stock option exercises and RSU vestings under the Company’s stock-based compensation plans.

14

PEGASYSTEMS INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)



12. INCOME TAXES
Effective income tax rate
 
Six Months Ended  
June 30,
(Dollars in thousands)
2019
 
2018
(Benefit from) income taxes
$
(25,638
)
 
$
(15,103
)
Effective income tax rate
30
%
 
113
%

During the six months ended June 30, 2019, the Company’s effective income tax rate decreased primarily due to the Global Intangible Low-Taxed Income (“GILTI”) and Foreign Derived Intangible Income (“FDII”) provisions of the Tax Reform Act. The Company’s effective income tax rate was also affected by excess tax benefits from stock-based compensation, an increase in U.S. research and development tax credits, and a decrease in uncertain tax positions as a result of the lapse of the statute of limitations on certain foreign reserves.
13. 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 stock options and RSUs, using the treasury stock method. In periods of loss, all stock options and RSUs are excluded, as their inclusion would be anti-dilutive.
The calculation of the basic and diluted earnings per share was:
 
Three Months Ended  
June 30,
 
Six Months Ended  
June 30,
(in thousands, except per share amounts)
2019
 
2018
 
2019
 
2018
Basic
 
 
 
 
 
 
 
Net (loss) income
$
(32,296
)
 
$
(10,409
)
 
$
(61,013
)
 
$
1,791

Weighted-average common shares outstanding
78,987


78,635


78,787


78,436

(Loss) earnings per share, basic
$
(0.41
)
 
$
(0.13
)
 
$
(0.77
)
 
$
0.02

 
 
 
 
 
 
 
 
Diluted
 
 
 
 
 
 
 
Net (loss) income
$
(32,296
)
 
$
(10,409
)
 
$
(61,013
)
 
$
1,791

Weighted-average effect of dilutive securities:
 
 
 
 
 
 
 
Stock options

 

 

 
3,132

RSUs

 

 

 
1,679

Effect of dilutive securities

 

 

 
4,811

Weighted-average common shares outstanding, assuming dilution
78,987

 
78,635

 
78,787

 
83,247

(Loss) earnings per share, diluted
$
(0.41
)
 
$
(0.13
)
 
$
(0.77
)
 
$
0.02


 
 
 
 
 
 
 
Outstanding anti-dilutive stock options and RSUs (1)
6,253

 
6,500

 
5,908

 
242

(1) Certain outstanding stock options and RSUs were excluded from the computation of diluted earnings per share because they were anti-dilutive in the period presented. These awards may be dilutive in the future.

15

Table of Contents

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, the timing of revenue recognition, and are described more completely in Part I of our Annual Report on Form 10-K for the year ended December 31, 2018.
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.
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, reliance on third party relationships, reliance on key personnel, the inherent risks associated with international operations and the continued uncertainties in the global economy, our continued effort to market and sell both domestically and internationally, foreign currency exchange rates, the potential legal and financial liabilities and reputation damage due to cyber-attacks and security breaches, and management of our 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 our Annual Report on Form 10-K for the year ended December 31, 2018 and other filings we make with the U.S. Securities and Exchange Commission (“SEC”).
Investors are cautioned not to place undue reliance on such forward-looking statements and there are no assurances that the results contained in such statements will be achieved. Although new information, future events, or risks may cause actual results to differ materially from future results expressed or implied by such forward-looking statements, 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 the result of new information, future events, or otherwise.
BUSINESS OVERVIEW
We develop, market, license, and support enterprise software applications that help organizations transform the way they engage with their customers and process and complete work across their enterprise. We also license our no-code Pega Platform™ for rapid application development to clients that wish to build and extend their own business applications. Our cloud-architected portfolio of customer engagement and digital process automation applications leverages artificial intelligence (“AI”), case management, and robotic automation technology, built on our unified no-code Pega Platform, empowering businesses to quickly design, extend, and scale their enterprise applications to meet strategic business needs.
Our target clients are Global 3000 organizations and government agencies that require applications to differentiate themselves in the markets they serve. Our applications achieve and facilitate differentiation by increasing business agility, driving growth, improving productivity, attracting and retaining customers, and reducing risk. We deliver applications tailored to our clients’ specific industry needs.
Performance metrics
We utilize a number of performance measures in analyzing and assessing our overall performance, making operating decisions, and forecasting and planning for future periods.
(Dollars in thousands,
except per share amounts)
Three Months Ended  
June 30,
 
Change
 
Six Months Ended  
June 30,
 
Change
2019
 
2018
 
 
2019
 
2018
 
Total revenue
$
205,592

 
$
196,779

 
$
8,813

4
 %
 
$
418,138

 
$
431,961

 
$
(13,823
)
(3
)%
Subscription revenue (1)
$
125,982

 
$
117,416

 
$
8,566

7
 %
 
$
269,760

 
$
262,218

 
$
7,542

3
 %
Net (loss) income
$
(32,296
)
 
$
(10,409
)
 
$
(21,887
)
(210
)%
 
$
(61,013
)
 
$
1,791

 
$
(62,804
)
*

(Loss) earnings per share, diluted
$
(0.41
)
 
$
(0.13
)
 
$
(0.28
)
(215
)%
 
$
(0.77
)
 
$
0.02

 
$
(0.79
)
*

* not meaningful  
(1) Reflects client arrangements (term license, cloud, and maintenance) that are subject to renewal.


16

Table of Contents

Annual Contract Value (“ACV”) (1) (2) 
The change in ACV measures the growth and predictability of future cash flows from Pega Cloud and Client Cloud committed arrangements as of the end of the particular reporting period.
q22019acvcharttnrcc.jpg
 
June 30,
 
Change
 
Constant Currency
Change
(Dollars in thousands)
2019
 
2018
 
 
Maintenance ACV
$
277,316

 
$
263,624

 
$
13,692

5
%
 
7
%
Term ACV
199,299

 
168,528

 
$
30,771

18
%
 
19
%
Client Cloud ACV
476,615

 
432,152

 
$
44,463

10
%
 
12
%
Pega Cloud ACV
136,074

 
82,376

 
53,698

65
%
 
67
%
Total ACV
$
612,689

 
$
514,528

 
$
98,161

19
%
 
21
%
(1) Total ACV, as of a given date, is the sum of the following two components:
Client Cloud: the sum of (1) the annual value of each term license contract in effect on such date, which is equal to its total license value divided by the total number of years and (2) maintenance revenue reported for the quarter ended on such date, multiplied by four. We do not provide hosting for Client Cloud arrangements.
Pega Cloud: the total of the annual value of each cloud contract in effect on such date, which is equal to its total value divided by the total number of years.
(2) As foreign currency exchange rates are an important factor in understanding period to period comparisons, we believe the presentation of ACV growth rates on a constant currency basis enhances the understanding of our results and evaluation of our performance in comparison to prior periods. The percent change in constant currency is calculated by applying the applicable current period exchange rates to prior period ACV.

17

Table of Contents

Remaining performance obligations (“RPO”)
Expected future revenue on existing contracts:
 
June 30, 2019
(Dollars in thousands)
Perpetual license
 
Term license
 
Maintenance
 
Cloud
 
Consulting
 
Total
1 year or less
$
8,429

 
$
38,080

 
$
173,421

 
$
124,134

 
$
16,259

 
$
360,323

57
%
1-2 years
915

 
4,678

 
12,530

 
98,842

 
942

 
117,907

19
%
2-3 years
1,306

 
641

 
5,801

 
75,828

 
227

 
83,803

13
%
Greater than 3 years

 
185

 
2,812

 
63,259

 

 
66,256

11
%
 
$
10,650

 
$
43,584

 
$
194,564

 
$
362,063

 
$
17,428

 
$
628,289

100
%
Change in RPO Since June 30, 2018
 
 
 
 
 
 
 
 
 
 
 

$
(36,623
)
 
$
6,640

 
$
32,273

 
$
148,253

 
$
1,086

 
$
151,629

 

(77
)%
 
18
%
 
20
%
 
69
%
 
7
%
 
32
%
 
 
June 30, 2018
(Dollars in thousands)
Perpetual license
 
Term license
 
Maintenance
 
Cloud
 
Consulting
 
Total
1 year or less
$
28,626

 
$
20,457

 
$
111,086

 
$
41,036

 
$
12,039

 
$
213,244

45
%
1-2 years
15,862

 
9,878

 
43,837

 
66,529

 
4,103

 
140,209

29
%
2-3 years
2,423

 
5,665

 
5,265

 
50,250

 

 
63,603

13
%
Greater than 3 years
362

 
944

 
2,103

 
55,995

 
200

 
59,604

13
%
 
$
47,273

 
$
36,944

 
$
162,291

 
$
213,810

 
$
16,342

 
$
476,660

100
%
CRITICAL ACCOUNTING POLICES
Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (“U.S.”) and the rules and regulations of the SEC for interim financial reporting. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and the related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions, and expectations of what could occur in the future given available information.
For more information regarding our critical accounting policies, we encourage you to read the discussion contained in the following locations in our Annual Report on Form 10-K for the year ended December 31, 2018:
“Critical Accounting Estimates and Significant Judgments” in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and
Note 2. “Significant Accounting Policies” in Item 8. “Financial Statements and Supplementary Data”.
There have been no significant changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2018.
RESULTS OF OPERATIONS
Revenue
(Dollars in thousands)
Three Months Ended  
June 30,
 
Change
 
Six Months Ended  
June 30,
 
Change
2019
 
2018
 
 
2019
 
2018
 
Cloud
$
31,699

15
%
 
$
20,201

10
%
 
$
11,498

57
 %
 
$
59,457

14
%
 
$
35,783

8
%
 
$
23,674

66
 %
Term license
24,954

12
%
 
31,309

16
%
 
(6,355
)
(20
)%
 
73,268

18
%
 
96,004

22
%
 
(22,736
)
(24
)%
Maintenance
69,329

34
%
 
65,906

34
%
 
3,423

5
 %
 
137,035

33
%
 
130,431

31
%
 
6,604

5
 %
Subscription (1)
125,982

61
%
 
117,416

60
%
 
8,566

7
 %
 
269,760

65
%
 
262,218

61
%
 
7,542

3
 %
Perpetual license
19,320

9
%
 
13,475

7
%
 
5,845

43
 %
 
34,270

8
%
 
36,553

8
%
 
(2,283
)
(6
)%
Consulting
60,290

30
%
 
65,888

33
%
 
(5,598
)
(8
)%
 
114,108

27
%
 
133,190

31
%
 
(19,082
)
(14
)%
 
$
205,592

100
%
 
$
196,779

100
%
 
$
8,813

4
 %
 
$
418,138

100
%
 
$
431,961

100
%
 
$
(13,823
)
(3
)%
(1) Reflects client arrangements (term license, cloud, and maintenance) that are subject to renewal.
Our license revenue is derived from sales of our applications and Pega Platform. Our cloud revenue is derived from our hosted Pega Platform and software applications.

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We expect our revenue mix to continue to shift in favor of our subscription offerings, particularly cloud arrangements, which could result in slower total revenue growth in the near term. Revenue from cloud arrangements is generally recognized over the service period, while revenue from term and perpetual license arrangements is generally recognized upfront when the license rights become effective.
Subscription revenue
The increases in cloud revenue in the three and six months ended June 30, 2019 reflect the shift in client preferences to cloud arrangements from other types of arrangements.
The decreases in term license revenue in the three and six months ended June 30, 2019 were due to revenue recognized from several large, multi-year term license contracts in the three and six months ended June 30, 2018 and reflect the shift in client preferences in favor of our cloud offerings. The decreases are also attributable to revenue recognized from term license contracts in the six months ended June 30, 2019 with multi-year committed maintenance periods, which resulted in a greater portion of the contract value being allocated to maintenance.
The increases in maintenance revenue in the three and six months ended June 30, 2019 were primarily due to the continued growth in the aggregate value of the installed base of our software and strong renewal rates in excess of 90%.
Perpetual license
The increase in perpetual license revenue in the three months ended June 30, 2019 was primarily due to revenue recognized from a large perpetual license contract in the second quarter of 2019. The decrease in perpetual license revenue in the six months ended June 30, 2019 reflects the shift in client preferences in favor of our cloud offerings instead of our perpetual license arrangements.
Consulting
Our consulting revenue fluctuates depending upon the mix of new implementation projects we perform as compared to those performed by our enabled clients or led by our partners. The decreases in consulting revenue in the three and six months ended June 30, 2019 were primarily due to a decrease in billable hours.
Gross profit
 
Three Months Ended  
June 30,
 
Change
 
Six Months Ended  
June 30,
 
Change
(Dollars in thousands)
2019
 
2018
 
 
2019

2018
 
Software license
$
43,346

98
%
 
$
43,522

97
%
 
$
(176
)
 %
 
$
105,232

98
%
 
$
130,040

98
%
 
$
(24,808
)
(19
)%
Maintenance
63,037

91
%
 
60,032

91
%
 
3,005

5
 %
 
124,408

91
%
 
118,475

91
%
 
5,933

5
 %
Cloud
15,052

47
%
 
11,423

57
%
 
3,629

32
 %
 
29,512

50
%
 
19,284

54
%
 
10,228

53
 %
Consulting
7,077

12
%
 
7,985

12
%
 
(908
)
(11
)%
 
7,469

7
%
 
14,731

11
%
 
(7,262
)
(49
)%
 
$
128,512

63
%
 
$
122,962

62
%
 
$
5,550

5
 %
 
$
266,621

64
%
 
$
282,530

65
%
 
$
(15,909
)
(6
)%
The recent shift in our revenue mix toward cloud arrangements has resulted in slower total gross profit growth as our cloud business continues to grow and scale. Revenue from cloud arrangements is generally recognized over the service period, while revenue from term and perpetual license arrangements is generally recognized upfront when the license rights become effective.
The increase in total gross profit in the three months ended June 30, 2019 was primarily due to an increase in cloud revenue reflecting the shift in client preferences to cloud arrangements from other types of arrangements, and an increase in maintenance revenue due to the continued growth in the aggregate value of the installed base of our software and strong renewal rates in excess of 90%. The decrease in total gross profit in the six months ended June 30, 2019 was primarily due to a decrease in term and perpetual license revenue reflecting the shift in client preferences toward our cloud offerings and a decrease in consulting revenue due to a decrease in billable hours.
The increase in total gross profit percent in the three months ended June 30, 2019 was driven by an increase in higher margin maintenance revenue. The decrease in total gross profit percent in the six months ended June 30, 2019 was driven by the shift in client preferences in favor of cloud arrangements, which are lower margin than our term and perpetual license revenue streams.
The decreases in cloud gross profit percent in the three and six months ended June 30, 2019 were driven by an increase in costs as we accelerated our investments in cloud infrastructure and service delivery to support future growth. The decrease in consulting gross profit percent in the six months ended June 30, 2019 was driven by a decrease in billable hours as consulting resources were transitioning to new projects after completing a large project and an increase in consulting resource availability as we continue growing and leveraging our partner network.

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Operating expenses
Selling and marketing
 
Three Months Ended  
June 30,
 
Change
 
Six Months Ended  
June 30,
 
Change
(Dollars in thousands)
2019
 
2018
 
 
2019
 
2018
 
Selling and marketing (1)
$
116,962

 
$
93,972

 
$
22,990

24
%
 
$
225,827

 
$
182,355

 
$
43,472

24
%
As a percent of total revenue
57
%
 
48
%
 
 
 
 
54
%
 
42
%
 
 
 
Selling and marketing headcount,
end of period
 
 
 
 
 
 
 
1,428

 
1,159

 
269

23
%
(1) Includes compensation, benefits, and other headcount-related expenses associated with selling and marketing activities, as well as advertising, promotions, trade shows, seminars, and the amortization of client-related intangibles.
The increases in the three and six months ended June 30, 2019 were primarily due to increases in compensation and benefits of $17.7 million and $35.4 million, attributable to increased headcount, equity compensation, and increases of $2.1 million and $6.6 million in deferred contract cost amortization. The increase in headcount reflects our efforts to increase our sales capacity to deepen relationships with existing clients and target new accounts.
Research and development
 
Three Months Ended  
June 30,
 
Change
 
Six Months Ended  
June 30,
 
Change
(Dollars in thousands)
2019
 
2018
 
 
2019
 
2018
 
Research and development (1)
$
49,714

 
$
41,972

 
$
7,742

18
%
 
$
100,310

 
$
88,757

 
$
11,553

13
%
As a percent of total revenue
24
%
 
21
%
 
 
 
 
24
%
 
21
%
 
 
 
Research and development headcount,
end of period
 
 
 
 
 
 
 
1,667

 
1,563

 
104

7
%
(1) Includes compensation, benefits, contracted services, and other headcount-related expenses associated with the development of our products, as well as enhancements and design changes to existing products and the integration of acquired technologies.
The increases in the three and six months ended June 30, 2019 were primarily due to increases in compensation and benefits of $4.6 million and $6.7 million, attributable to an increase in headcount and equity compensation, and increases of $1.7 million and $3.3 million in cloud hosting expenses as we expand our cloud-focused research and development activities.
General and administrative
 
Three Months Ended  
June 30,
 
Change
 
Six Months Ended  
June 30,
 
Change
(Dollars in thousands)
2019
 
2018
 
 
2019
 
2018
 
General and administrative (1)
$
14,174

 
$
10,181

 
$
3,993

39
%
 
$
26,850

 
$
26,645

 
$
205

1
%
As a percent of total revenue
7
%
 
5
%
 
 
 
 
6
%
 
6
%
 
 
 
General and administrative headcount,
end of period (2)
 
 
 
 
 
 
 
383

 
310

 
73

24
%
(1) Includes compensation, benefits, and other headcount-related expenses associated with finance, legal, corporate governance, and other administrative headcount. Also includes accounting, legal, and other professional consulting and administrative fees. (2) The headcount includes employees in corporate services departments, whose costs are partially allocated to other operating expense areas.
The increase in the three months ended June 30, 2019 was primarily due to an increase in compensation and benefits of $1.7 million, due to increased headcount.
Stock-based compensation
 
Three Months Ended  
June 30,
 
Change
 
Six Months Ended  
June 30,
 
Change
(Dollars in thousands)
2019
 
2018
 
 
2019
 
2018
 
Cost of revenues
$
4,911

 
$
4,257

 
$
654

15
%
 
$
9,430

 
$
7,958

 
$
1,472

18
 %
Selling and marketing
8,364

 
6,038

 
2,326

39
%
 
15,738

 
10,696

 
5,042

47
 %
Research and development
4,572

 
3,802

 
770

20
%
 
9,132

 
7,439

 
1,693

23
 %
General and administrative
2,200

 
1,959

 
241

12
%
 
4,097

 
5,072

 
(975
)
(19
)%
 
$
20,047

 
$
16,056

 
$
3,991

25
%
 
$
38,397

 
$
31,165

 
$
7,232

23
 %
The increases in the three and six months ended June 30, 2019 were primarily due to the increased value of our annual periodic equity awards granted in March 2019 and 2018. These awards generally have a five-year vesting schedule.

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Other income (expense), net
 
Three Months Ended  
June 30,
 
Change
 
Six Months Ended  
June 30,
 
Change
(Dollars in thousands)
2019
 
2018
 
 
2019
 
2018
 
Foreign currency transaction gain (loss)
$
2,105

 
$
1,244

 
$
861

69
 %
 
$
(1,607
)
 
$
159

 
$
(1,766
)
*

Interest income, net
544

 
629

 
(85
)
(14
)%
 
1,267

 
1,393

 
(126
)
(9
)%
Other income, net
55

 

 
55

 %
 
55

 
363

 
(308
)
(85
)%

$
2,704

 
$
1,873

 
$
831

44
 %
 
$
(285
)
 
$
1,915

 
$
(2,200
)
*

* not meaningful
The changes in foreign currency transaction gain (loss) were primarily due to the impact of fluctuations in foreign currency exchange rates associated with our foreign currency denominated cash, accounts receivable, and intercompany receivables and payables held by our United Kingdom (“U.K.”) subsidiary.
(Benefit from) income taxes
 
Three Months Ended  
June 30,
 
Six Months Ended  
June 30,
(Dollars in thousands)
2019
 
2018
 
2019
 
2018
(Benefit from) income taxes
$
(17,338
)
 
$
(10,881
)
 
$
(25,638
)
 
$
(15,103
)
Effective income tax rate
 
 
 
 
30
%
 
113
%
The inclusion of excess tax benefits from stock-based compensation in the provision for income taxes has increased the variability of the effective tax rates in recent periods. This fluctuation may continue in future periods, as the amount of excess tax benefits from stock-based compensation awards varies depending on our future stock price in relation to the fair value of awards, the timing of RSU vestings, the exercise behavior of our stock option holders, and the total value of future grants of stock-based compensation awards.
During the six months ended June 30, 2019, the Company’s effective income tax rate changed primarily due to the Global Intangible Low-Taxed Income (“GILTI”) and Foreign Derived Intangible Income (“FDII”) provisions of the Tax Reform Act. The Company’s effective income tax rate was also affected by excess tax benefits from stock-based compensation, an increase in U.S. research and development tax credits, and a decrease in uncertain tax positions as a result of the lapse of the statute of limitations on certain foreign reserves.
LIQUIDITY AND CAPITAL RESOURCES
 
Six Months Ended  
June 30,
 (in thousands)
2019
 
2018
Cash provided by (used in):
 
 
 
Operating activities
$
7,720

 
$
75,432

Investing activities
17,210

 
(46,369
)
Financing activities
(44,367
)
 
(45,825
)
Effect of exchange rates on cash and cash equivalents
515

 
(1,226
)
Net (decrease) in cash and cash equivalents
$
(18,922
)
 
$
(17,988
)
(in thousands)
June 30, 2019
 
December 31, 2018
Held by U.S. entities
$
81,482

 
$
143,533

Held by foreign entities
73,567

 
63,890

Total cash, cash equivalents, and marketable securities
$
155,049

 
$
207,423

We believe that our current cash, cash equivalents, marketable securities, and cash flow from operations will be sufficient to fund our operations, quarterly cash dividends, and stock repurchases for at least the next 12 months.
If it became necessary to repatriate foreign funds, we may be required to pay U.S. state and local taxes, as well as foreign taxes, upon repatriation. Due to the complexity of income tax laws and regulations, and the effects of the Tax Reform Act, it is impracticable to estimate the amount of taxes we would have to pay.
Cash provided by operating activities
As client preferences continue to shift in favor of cloud arrangements, we could continue to experience slower operating cash flow growth in the near term. Cash from cloud arrangements is generally collected over an average service period of three years, while cash from perpetual license arrangements is generally collected upfront, shortly after the license rights become effective.

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The primary driver of the decrease in the six months ended June 30, 2019 was the recent shift in our revenue mix toward cloud arrangements, which are generally collected over an average service period of three years, and increased costs as the Company accelerated investments in its cloud offerings and selling and marketing activities to support future growth.
Cash provided by (used in) investing activities
The change in cash provided by (used in) investing activities was primarily driven by the timing of investment maturities and sales, purchases of new investments, and the payment of consideration for the acquisition of In the Chat Communications Inc. in May 2019.
Cash (used in) financing activities
We primarily used cash in financing activities for repurchases of our common stock under our publicly announced stock repurchase programs, stock repurchases for tax withholdings for the net settlement of our equity awards, and the payment of our quarterly dividend.
Stock repurchase program (1) 
The changes in the remaining stock repurchase authority was:
 
Six Months Ended  
June 30,
(in thousands)
2019
January 1,
$
6,620

Authorizations (2)
60,000

Repurchases
(13,889
)
June 30,
$
52,731

(1) Purchases under these programs have been made on the open market. (2) On March 15, 2019, we announced that our Board of Directors extended the expiration date of the current stock repurchase program to June 30, 2020 and increased the amount of common stock we are authorized to repurchase by $60 million between March 15, 2019 and June 30, 2020.
Common stock repurchases
 
Six Months Ended  
June 30,
 
2019
 
2018
(in thousands)
Shares
 
Amount
 
Shares
 
Amount
Tax withholdings for net settlement of equity awards
390

 
$
26,054

 
454

 
$
26,992

Stock repurchase program (1)
 
 
 
 
 
 
 
Repurchases paid
229

 
13,689

 
254

 
14,871

Repurchases unsettled at period end
3

 
200

 
18

 
998

Activity in period (2)
622

 
$
39,943

 
726

 
$
42,861

(1) Represents activity under our publicly announced stock repurchase programs. (2) During the six months ended June 30, 2019 and 2018, instead of receiving cash from the equity holders, we withheld shares with a value of $23.1 million and $21.1 million, respectively, for the exercise price of options. These amounts have been excluded from the table above.
Dividends
 
Six Months Ended  
June 30,
(in thousands)
2019
 
2018
Dividend payments to shareholders
$
4,730

 
$
4,702

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 the dividend program at any time without prior notice.
ITEM 3.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes during the six months ended June 30, 2019 to the market risk exposure disclosed in our Annual Report on Form 10-K for the year ended December 31, 2018.

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ITEM 4.     CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures
Our management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”)) as of June 30, 2019. 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 June 30, 2019.
(b) Changes in internal control over financial reporting
There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended June 30, 2019 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 Item 1A. “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2018. 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 six months ended June 30, 2019 to the risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2018.
ITEM 2.     UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Issuer Purchases of Equity Securities
The following table sets forth information regarding our repurchases of our common stock during the three months ended June 30, 2019.
(in thousands, except per share amounts)
Total Number of Shares Purchased (1)
 
Average 
Price Paid
per Share (1)
 
Total Number of Shares Purchased as Part of Publicly Announced Share Repurchase Program
 
Approximate Dollar Value of Shares That May Yet Be Purchased at Period End Under Publicly Announced Share Repurchase Programs (2)  
April 1, 2019 - April 30, 2019
39

 
$
70.05

 
30

 
$
56,930

May 1, 2019 - May 31, 2019
189

 
$
71.57

 
30

 
$
54,731

June 1, 2019 - June 30, 2019
170

 
$
71.19

 
28

 
$
52,731


398

 
$
71.26

 
 
 
 
(1) Shares withheld to cover the option exercise price and tax withholding obligations under the net settlement provisions of our stock compensation awards have been included in these amounts.
(2) On March 15, 2019, we announced that our Board of Directors extended the expiration date of the current stock repurchase program to June 30, 2020 and increased the amount of common stock we are authorized to repurchase by $60 million between March 15, 2019 and June 30, 2020 (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 Exchange Act, and Rule 10b-18 under the Exchange Act (the “10b5-1 Plan”). All stock repurchases under the Current Program during closed trading window periods will be made pursuant to the 10b5-1 Plan.
Recent Sales of Unregistered Securities
In connection with our acquisition of In the Chat Communications Inc. on May 10, 2019 and in reliance on the Regulation D exemption from registration requirements under the Securities Act, we granted an employee the right to obtain up to 14,497 shares of our common stock, which will be issued in five equal tranches contingent upon continued employment. No general solicitation or advertising to market the securities occurred.

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ITEM 6.     EXHIBITS
Exhibit No.
 
Description
31.1
 
31.2
 
32+
 
101.INS
 
XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document.
101.SCH
 
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.
+ Indicates that the exhibit is being furnished with this report and is not filed as a part of it.

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
Pegasystems Inc.
 
 
 
Dated:
August 7, 2019
By:
/s/ KENNETH STILLWELL
 
 
 
Kenneth Stillwell
 
 
 
Chief Financial Officer and Chief Administrative Officer
 
 
 
(Principal Financial Officer)


25