Document

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 September 30, 2019



☐	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)

____________________________



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)

____________________________

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	x	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 79,332,662 shares of the Registrant’s common stock, $0.01 par value per share, outstanding on October 31, 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 September 30, 2019 and December 31, 2018	3
Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2019 and 2018	4
Unaudited Condensed Consolidated Statements of Comprehensive (Loss) for the three and nine months ended September 30, 2019 and 2018	5
Unaudited Condensed Consolidated Statements of Stockholders’ Equity for the nine months ended September 30, 2019 and 2018	6
Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2019 and 2018	8
Notes to Unaudited Condensed Consolidated Financial Statements	9
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
Item 3. Quantitative and Qualitative Disclosures About Market Risk	24
Item 4. Controls and Procedures	24

PART II - OTHER INFORMATION

Item 1A. Risk Factors	25
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	25
Item 5. Other Information	25
Item 6. Exhibits	26

Signature	27

Table of Contents

PART I - FINANCIAL INFORMATION

ITEM 1. UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

PEGASYSTEMS INC.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)



	September 30, 2019			December 31, 2018
Assets
Current assets:
Cash and cash equivalents	$	92,104		$	114,422
Marketable securities	20,465			93,001
Total cash, cash equivalents, and marketable securities	112,569			207,423
Accounts receivable	123,268			180,872
Unbilled receivables	172,090			172,656
Other current assets	58,204			49,684
Total current assets	466,131			610,635
Long-term unbilled receivables	123,962			151,237
Goodwill	78,862			72,858
Other long-term assets	248,069			147,823
Total assets	$	917,024		$	982,553
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	15,435		$	16,487
Accrued expenses	41,520			45,506
Accrued compensation and related expenses	88,349			84,671
Deferred revenue	159,849			185,145
Other current liabilities	15,742			—
Total current liabilities	320,895			331,809
Operating lease liabilities	56,904			—
Other long-term liabilities	10,393			29,213
Total liabilities	388,192			361,022
Stockholders’ equity:
Preferred stock, 1,000 shares authorized; none issued	—			—
Common stock, 200,000 shares authorized; 79,324 and 78,526 shares issued and outstanding at September 30, 2019 and December 31, 2018, respectively	793			785
Additional paid-in capital	129,559			123,205
Retained earnings	412,389			510,863
Accumulated other comprehensive (loss)	(13,909		)	(13,322		)
Total stockholders’ equity	528,832			621,531
Total liabilities and stockholders’ equity	$	917,024		$	982,553

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,
	2019			2018			2019			2018
Revenue
Software license	$	58,005		$	52,342		$	165,543		$	184,899
Maintenance	70,371			66,017			207,406			196,448
Services	88,327			84,904			261,892			253,877
Total revenue	216,703			203,263			634,841			635,224
Cost of revenue
Software license	676			1,255			2,982			3,772
Maintenance	6,688			6,079			19,315			18,035
Services	73,534			67,089			210,118			202,047
Total cost of revenue	80,898			74,423			232,415			223,854
Gross profit	135,805			128,840			402,426			411,370
Operating expenses
Selling and marketing	115,237			87,490			341,064			269,845
Research and development	52,492			46,504			152,802			135,261
General and administrative	14,843			12,104			41,693			38,749
Total operating expenses	182,572			146,098			535,559			443,855
(Loss) from operations	(46,767		)	(17,258		)	(133,133		)	(32,485		)
Foreign currency transaction (loss) gain	(1,970		)	399			(3,577		)	558
Interest income, net	556			683			1,823			2,076
Other income, net	323			—			378			363
(Loss) before (benefit from) income taxes	(47,858		)	(16,176		)	(134,509		)	(29,488		)
(Benefit from) income taxes	(17,520		)	(8,589		)	(43,158		)	(23,692		)
Net (loss)	$	(30,338	)	$	(7,587	)	$	(91,351	)	$	(5,796	)
(Loss) per share
Basic	$	(0.38	)	$	(0.10	)	$	(1.16	)	$	(0.07	)
Diluted	$	(0.38	)	$	(0.10	)	$	(1.16	)	$	(0.07	)
Weighted-average number of common shares outstanding
Basic	79,200			78,700			78,928			78,525
Diluted	79,200			78,700			78,928			78,525

See notes to unaudited condensed consolidated financial statements.

PEGASYSTEMS INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS)

(in thousands)



	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
Net (loss)	$	(30,338	)	$	(7,587	)	$	(91,351	)	$	(5,796	)
Other comprehensive (loss), net of tax
Unrealized (loss) gain on available-for-sale marketable securities	(216		)	(162		)	396			(277		)
Foreign currency translation adjustments	(2,201		)	(1,934		)	(983		)	(4,898		)
Total other comprehensive (loss), net of tax	(2,417		)	(2,096		)	(587		)	(5,175		)
Comprehensive (loss)	$	(32,755	)	$	(9,683	)	$	(91,938	)	$	(10,971	)

See notes to unaudited condensed consolidated financial statements.



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			Additional Paid-In Capital			Retained Earnings			Accumulated Other Comprehensive (Loss) Income			Total Stockholders’ Equity
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
Repurchase of common stock	(242	)	(2		)	(14,277		)	—			—			(14,279		)
Issuance of common stock for share-based compensation plans	310		3			(8,399		)	—			—			(8,396		)
Stock-based compensation	—		—			16,408						—			16,408
Cash dividends declared ($0.12 per share)	—		—			—			(2,367		)	—			(2,367		)
Other comprehensive (loss)	—		—			—			—			(2,096		)	(2,096		)
Net (loss)	—		—			—			(7,587		)	—			(7,587		)
September 30, 2018	78,816		$	788		$	135,132		$	496,815		$	(11,880	)	$	620,855
See notes to unaudited condensed consolidated financial statements.



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			Additional Paid-In Capital			Retained Earnings			Accumulated Other Comprehensive (Loss) Income			Total Stockholders’ Equity
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
Repurchase of common stock	(88	)	(1		)	(6,396		)	—			—			(6,397		)
Issuance of common stock for share-based compensation plans	268		3			(8,804		)	—			—			(8,801		)
Stock-based compensation	—		—			21,879			—			—			21,879
Cash dividends declared ($0.12 per share)	—		—			—			(2,381		)	—			(2,381		)
Other comprehensive (loss)	—		—			—			—			(2,417		)	(2,417		)
Net (loss)	—		—			—			(30,338		)	—			(30,338		)
September 30, 2019	79,324		$	793		$	129,559		$	412,389		$	(13,909	)	$	528,832

See notes to unaudited condensed consolidated financial statements.

PEGASYSTEMS INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



	Nine Months Ended September 30,
	2019			2018
Operating activities
Net (loss)	$	(91,351	)	$	(5,796	)
Adjustments to reconcile net (loss) to cash (used in) provided by operating activities
Stock-based compensation	60,242			47,573
Amortization and depreciation	50,622			31,742
Deferred income taxes	(40,531		)	(1,388		)
Foreign currency transaction loss (gain)	3,577			(558		)
Other non-cash	(363		)	(1,377		)
Change in operating assets and liabilities, net	4,342			(3,108		)
Cash (used in) provided by operating activities	(13,462		)	67,088
Investing activities
Purchases of investments	(11,182		)	(68,177		)
Proceeds from maturities and called investments	13,066			26,456
Sales of investments	68,937			—
Payments for acquisitions, net of cash acquired	(10,934		)	—
Investment in property and equipment	(6,439		)	(7,874		)
Cash provided by (used in) investing activities	53,448			(49,595		)
Financing activities
Dividend payments to shareholders	(7,105		)	(7,067		)
Common stock repurchases	(54,836		)	(64,597		)
Cash (used in) financing activities	(61,941		)	(71,664		)
Effect of exchange rate changes on cash and cash equivalents	(363		)	(1,913		)
Net (decrease) in cash and cash equivalents	(22,318		)	(56,084		)
Cash and cash equivalents, beginning of period	114,422			162,279
Cash and cash equivalents, end of period	$	92,104		$	106,195

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 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

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 historical 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.

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.

3. MARKETABLE SECURITIES



	September 30, 2019
(in thousands)	Amortized Cost		Unrealized Gains		Unrealized Losses		Fair Value
Municipal bonds	$	10,680	$	69	$	—	$	10,749
Corporate bonds	9,611		105		—		9,716
	$	20,291	$	174	$	—	$	20,465



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

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

4. RECEIVABLES, CONTRACT ASSETS, AND DEFERRED REVENUE

Receivables



(in thousands)	September 30, 2019		December 31, 2018
Accounts receivable	$	123,268	$	180,872
Unbilled receivables	172,090		172,656
Long-term unbilled receivables	123,962		151,237
	$	419,320	$	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)	September 30, 2019
1 year or less	$	172,090	59	%
1-2 years	84,045		28	%
2-5 years	39,917		13	%
	$	296,052	100	%

Contract assets and deferred revenue



(in thousands)	September 30, 2019		December 31, 2018
Contract assets ⁽¹⁾	$	5,046	$	3,711
Long-term contract assets ⁽²⁾	2,381		2,543
	$	7,427	$	6,254

⁽¹⁾Included in other current assets.⁽²⁾ Included in other long-term assets.



(in thousands)	September 30, 2019		December 31, 2018
Deferred revenue	$	159,849	$	185,145
Long-term deferred revenue ⁽¹⁾	4,029		5,344
	$	163,878	$	190,489

⁽¹⁾Included in other long-term liabilities.

Contract assets are client committed amounts for which 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 nine months ended September 30, 2019 was primarily due to revenue recognized 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 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)	September 30, 2019		December 31, 2018
Deferred contract costs ⁽¹⁾	$	67,182	$	64,367

⁽¹⁾ Included in other long-term assets.



	Three Months Ended September 30,				Nine Months Ended September 30,
(in thousands)	2019		2018		2019		2018
Amortization of deferred contract costs ⁽¹⁾	$	8,193	$	4,208	$	22,372	$	11,806

⁽¹⁾Included in selling and marketing expenses.

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)	Nine Months Ended September 30, 2019
Balance as of January 1,	$	72,858
Acquisition ⁽¹⁾	6,179
Currency translation adjustments	(175		)
Balance as of September 30,	$	78,862

⁽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 intangible assets of $6.2 million and $5.1 million.

Intangibles

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



		September 30, 2019
(in thousands)	Useful Lives	Cost		Accumulated Amortization			Net Book Value ⁽¹⁾
Client-related	4-10 years	$	63,089	$	(53,960	)	$	9,129
Technology	2-10 years	64,843		(53,252		)	11,591
Other	1 - 5 years	5,361		(5,361		)	—
		$	133,293	$	(112,573	)	$	20,720

⁽¹⁾Included in other long-term assets.



		December 31, 2018
(in thousands)	Useful Lives	Cost		Accumulated Amortization			Net Book Value ⁽¹⁾
Client-related	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 September 30,				Nine Months Ended September 30,
(in thousands)	2019		2018		2019		2018
Cost of revenue	$	647	$	1,232	$	2,854	$	3,695
Selling and marketing	370		1,603		2,754		4,813
	$	1,017	$	2,835	$	5,608	$	8,508

7. ACCRUED EXPENSES



(in thousands)	September 30, 2019		December 31, 2018
Outside professional services expenses	$	8,568	$	10,367
Income and other taxes	5,418		10,387
Marketing and sales program expenses	5,969		5,860
Dividends payable	2,381		2,363
Employee-related expenses	4,785		3,536
Cloud hosting expenses	10,158		4,604
Other	4,241		8,389
	$	41,520	$	45,506

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 nine months ended September 30, 2019.

The Company’s assets and liabilities measured at fair value on a recurring basis were:



	September 30, 2019
(in thousands)	Level 1		Level 2		Level 3		Total
Cash equivalents	$	88	$	—	$	—	$	88
Marketable securities:
Municipal bonds	$	—	$	10,749	$	—	$	10,749
Corporate bonds	—		9,716		—		9,716
Total marketable securities	$	—	$	20,465	$	—	$	20,465
Investments in privately-held companies ⁽¹⁾	$	—	$	—	$	4,583	$	4,583

⁽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

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 September 30, 2019		Nine Months Ended September 30, 2019
Fixed lease costs	$	4,763	$	13,344
Variable lease costs	1,470		4,153
	$	6,233	$	17,497

Right of use assets and lease liabilities



(in thousands)	September 30, 2019
Right of use assets ⁽¹⁾	$	62,296
Lease liabilities ⁽²⁾	$	15,742
Long-term lease liabilities	$	56,904

⁽¹⁾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:



	September 30, 2019
Weighted-average remaining lease term	4.2 years
Weighted-average discount rate ⁽¹⁾	5.8	%

⁽¹⁾The rates implicit in most of the Company’s leases are not readily determinable, 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)	September 30, 2019
Remainder of 2019	$	3,402
2020	21,061
2021	18,800
2022	17,642
2023 and thereafter	21,375
Total lease payments	82,280
Less: imputed interest ⁽¹⁾	(9,634		)
Total short and long-term lease liabilities	$	72,646

⁽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 before 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.

Cash flow information



(in thousands)	Nine Months Ended September 30, 2019
Cash paid for leases	14,586
Right of use assets recognized for new leases and amendments (non-cash)	31,126

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

10. REVENUE

Geographic revenue



	Three Months Ended September 30,								Nine Months Ended September 30,
(Dollars in thousands)	2019				2018				2019				2018
U.S.	$	123,447	57	%	$	103,075	51	%	$	347,120	55	%	$	327,409	51	%
Other Americas	11,748		5	%	10,424		5	%	49,450		8	%	37,766		6	%
United Kingdom (“U.K.”)	23,034		11	%	19,277		9	%	64,269		10	%	68,450		11	%
Europe (excluding U.K.), Middle East, and Africa	34,761		16	%	42,254		21	%	102,342		16	%	101,150		16	%
Asia-Pacific	23,713		11	%	28,233		14	%	71,660		11	%	100,449		16	%
	$	216,703	100	%	$	203,263	100	%	$	634,841	100	%	$	635,224	100	%

Revenue streams



	Three Months Ended September 30,				Nine Months Ended September 30,
(in thousands)	2019		2018		2019		2018
Perpetual license	$	9,016	$	20,276	$	43,286	$	56,829
Term license	48,989		32,066		122,257		128,070
Revenue recognized at a point in time	58,005		52,342		165,543		184,899
Maintenance	70,371		66,017		207,406		196,448
Cloud	35,153		22,184		94,610		57,967
Consulting	53,174		62,720		167,282		195,910
Revenue recognized over time	158,698		150,921		469,298		450,325
	$	216,703	$	203,263	$	634,841	$	635,224



(in thousands)	Three Months Ended September 30,				Nine Months Ended September 30,
(in thousands)	2019		2018		2019		2018
Term license	$	48,989	$	32,066	$	122,257	$	128,070
Cloud	35,153		22,184		94,610		57,967
Maintenance	70,371		66,017		207,406		196,448
Subscription ⁽¹⁾	154,513		120,267		424,273		382,485
Perpetual license	9,016		20,276		43,286		56,829
Consulting	53,174		62,720		167,282		195,910
	$	216,703	$	203,263	$	634,841	$	635,224

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

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Remaining performance obligations (“RPO”)

Expected future revenue on existing contracts:



	September 30, 2019
(Dollars in thousands)	Perpetual license		Term license		Maintenance		Cloud		Consulting		Total
1 year or less	$	7,689	$	25,948	$	158,220	$	133,785	$	13,145	$	338,787	56	%
1-2 years	853		3,798		18,590		105,081		863		129,185		21	%
2-3 years	1,306		591		8,323		72,915		841		83,976		14	%
Greater than 3 years	—		85		4,959		51,591		—		56,635		9	%
	$	9,848	$	30,422	$	190,092	$	363,372	$	14,849	$	608,583	100	%



	September 30, 2018
(Dollars in thousands)	Perpetual license		Term License		Maintenance		Cloud		Consulting		Total
1 year or less	$	25,343	$	44,283	$	140,591	$	88,529	$	14,107	$	312,853	60	%
1-2 years	6,490		10,063		8,877		70,815		1,830		98,075		19	%
2-3 years	360		1,598		2,586		54,646		449		59,639		11	%
Greater than 3 years	1,306		218		1,079		49,110		50		51,763		10	%
	$	33,499	$	56,162	$	153,133	$	263,100	$	16,436	$	522,330	100	%

Major clients

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



	Three Months Ended September 30,					Nine Months Ended September 30,
(in thousands)	2019		2018			2019		2018
Total revenue	$	216,703	$	203,263		$	634,841	$	635,224
Client A	*		10		%	*		*

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

11. STOCK-BASED COMPENSATION

Expense



	Three Months Ended September 30,						Nine Months Ended September 30,
(in thousands)	2019			2018			2019			2018
Cost of revenues	$	4,787		$	4,319		$	14,216		$	12,277
Selling and marketing	8,317			6,198			24,055			16,895
Research and development	4,858			3,917			13,990			11,356
General and administrative	3,884			1,974			7,981			7,045
	$	21,846		$	16,408		$	60,242		$	47,573
Income tax benefit	$	(4,430	)	$	(3,555	)	$	(12,226	)	$	(10,037	)

As of September 30, 2019, the Company had $95.6 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:



	Nine Months Ended September 30, 2019
(in thousands)	Shares	Total Fair Value
RSUs	1,153	$	75,510
Non-qualified stock options	2,165	$	41,260
Common stock	11	$	800

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

Common stock issued

During the nine months ended September 30, 2019, the Company issued 1.1 million shares of common stock under the Company’s stock-based compensation plans.

12. INCOME TAXES

Effective income tax rate



	Nine Months Ended September 30,
(Dollars in thousands)	2019			2018
(Benefit from) income taxes	$	(43,158	)	$	(23,692	)
Effective income tax rate	32		%	80		%

During the nine months ended September 30, 2019, the Company’s effective income tax rate decreased primarily due to the Global Intangible Low-Taxed Income (“GILTI”) provision of the Tax Reform Act. The Company’s effective income tax rate was also affected by excess tax benefits from stock-based compensation and an increase in U.S. research and development tax credits.

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 September 30,						Nine Months Ended September 30,
(in thousands, except per share amounts)	2019			2018			2019			2018
Basic
Net (loss)	$	(30,338	)	$	(7,587	)	$	(91,351	)	$	(5,796	)
Weighted-average common shares outstanding	79,200			78,700			78,928			78,525
(Loss) per share, basic	$	(0.38	)	$	(0.10	)	$	(1.16	)	$	(0.07	)

Diluted
Net (loss)	$	(30,338	)	$	(7,587	)	$	(91,351	)	$	(5,796	)
Weighted-average effect of dilutive securities:
Stock options	—			—			—			—
RSUs	—			—			—			—
Effect of dilutive securities	—			—			—			—
Weighted-average common shares outstanding, assuming dilution	79,200			78,700			78,928			78,525
(Loss) per share, diluted	$	(0.38	)	$	(0.10	)	$	(1.16	)	$	(0.07	)

Outstanding anti-dilutive stock options and RSUs ⁽¹⁾	5,953			6,119			5,923			6,380

⁽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.

PEGASYSTEMS INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

14. SUBSEQUENT EVENTS

On November 6, 2019, the Company entered into a five-year $100 million, senior secured revolving credit agreement (the “Credit Agreement”) with PNC Bank, National Association (“PNC”). The Company may use borrowings to finance working capital needs and for general corporate purposes. Subject to specific circumstances, the Credit Agreement allows the Company to increase the aggregate commitment up to $200 million.

The Credit Agreement contains customary covenants, including, but not limited to, those relating to additional indebtedness, liens, asset divestures and affiliate transactions. The Company is also required to comply with financial covenants that consist of a maximum net consolidated leverage ratio of 3.5 (with a step-up in the event of certain acquisitions) and a minimum consolidated interest coverage ratio of 3.5. The commitments expire on November 4, 2024, and any outstanding loans will be payable on such date.

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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, and 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 expressly 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 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 several performance metrics 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 September 30,						Change					Nine Months Ended September 30,						Change
(Dollars in thousands, except per share amounts)	2019			2018			Change					2019			2018			Change
Total revenue	$	216,703		$	203,263		$	13,440		7	%	$	634,841		$	635,224		$	(383	)	—	%
Subscription revenue ⁽¹⁾	$	154,513		$	120,267		$	34,246		28	%	$	424,273		$	382,485		$	41,788		11	%
Net (loss)	$	(30,338	)	$	(7,587	)	$	(22,751	)	(300	)%	$	(91,351	)	$	(5,796	)	$	(85,555	)	(1,476	)%
(Loss) per share, diluted	$	(0.38	)	$	(0.10	)	$	(0.28	)	(280	)%	$	(1.16	)	$	(0.07	)	$	(1.09	)	(1,557	)%

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

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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.



	September 30,				Change				Constant Currency Change
(Dollars in thousands)	2019		2018		Change				Constant Currency Change
Maintenance	$	281,484	$	264,068	$	17,416	7	%	9	%
Term	207,317		174,320		$	32,997	19	%	20	%
Client Cloud	488,801		438,388		$	50,413	11	%	13	%
Pega Cloud	145,549		98,373		47,176		48	%	51	%
Total ACV	$	634,350	$	536,761	$	97,589	18	%	20	%

⁽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 services for Client Cloud arrangements.


•	Pega Cloud: the sum 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.

Remaining performance obligations (“RPO”)

Expected future revenue on existing contracts:



	September 30, 2019
(Dollars in thousands)	Perpetual license			Term license			Maintenance			Cloud			Consulting			Total
1 year or less	$	7,689		$	25,948		$	158,220		$	133,785		$	13,145		$	338,787		56	%
1-2 years	853			3,798			18,590			105,081			863			129,185			21	%
2-3 years	1,306			591			8,323			72,915			841			83,976			14	%
Greater than 3 years	—			85			4,959			51,591			—			56,635			9	%
	$	9,848		$	30,422		$	190,092		$	363,372		$	14,849		$	608,583		100	%
Change in RPO Since September 30, 2018
	$	(23,651	)	$	(25,740	)	$	36,959		$	100,272		$	(1,587	)	$	86,253
	(71		)%	(46		)%	24		%	38		%	(10		)%	17		%



	September 30, 2018
(Dollars in thousands)	Perpetual license		Term license		Maintenance		Cloud		Consulting		Total
1 year or less	$	25,343	$	44,283	$	140,591	$	88,529	$	14,107	$	312,853	60	%
1-2 years	6,490		10,063		8,877		70,815		1,830		98,075		19	%
2-3 years	360		1,598		2,586		54,646		449		59,639		11	%
Greater than 3 years	1,306		218		1,079		49,110		50		51,763		10	%
	$	33,499	$	56,162	$	153,133	$	263,100	$	16,436	$	522,330	100	%

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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 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 September 30,								Change					Nine Months Ended September 30,								Change
(Dollars in thousands)	2019				2018				Change					2019				2018				Change
Cloud	$	35,153	16	%	$	22,184	11	%	$	12,969		58	%	$	94,610	15	%	$	57,967	9	%	$	36,643		63	%
Term license	48,989		23	%	32,066		16	%	16,923			53	%	122,257		19	%	128,070		20	%	(5,813		)	(5	)%
Maintenance	70,371		32	%	66,017		32	%	4,354			7	%	207,406		33	%	196,448		31	%	10,958			6	%
Subscription ⁽¹⁾	154,513		71	%	120,267		59	%	34,246			28	%	424,273		67	%	382,485		60	%	41,788			11	%
Perpetual license	9,016		4	%	20,276		10	%	(11,260		)	(56	)%	43,286		7	%	56,829		9	%	(13,543		)	(24	)%
Consulting	53,174		25	%	62,720		31	%	(9,546		)	(15	)%	167,282		26	%	195,910		31	%	(28,628		)	(15	)%
	$	216,703	100	%	$	203,263	100	%	$	13,440		7	%	$	634,841	100	%	$	635,224	100	%	$	(383	)	—	%

⁽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.

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 nine months ended September 30, 2019 reflect the shift in client preferences to cloud arrangements from other types of arrangements. The increase in term license revenue in the three months ended September 30, 2019 was due to revenue recognized from several large, multi-year term license contracts in the three months ended September 30, 2019. The decrease in term license revenue in the nine months ended September 30, 2019 was attributable to revenue recognized from term license contracts in the nine months ended September 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 nine months ended September 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 decreases in perpetual license revenue in the three and nine months ended September 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 nine months ended September 30, 2019 were primarily due to decreases in billable hours.

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Gross profit



	Three Months Ended September 30,									Change					Nine Months Ended September 30,								Change
(Dollars in thousands)	2019					2018				Change					2019				2018				Change
Software license	$	57,329		99	%	$	51,087	98	%	$	6,242		12	%	$	162,561	98	%	$	181,127	98	%	$	(18,566	)	(10	)%
Maintenance	63,683			90	%	59,938		91	%	3,745			6	%	188,091		91	%	178,413		91	%	9,678			5	%
Cloud	17,329			49	%	12,569		57	%	4,760			38	%	46,841		50	%	31,853		55	%	14,988			47	%
Consulting	(2,536		)	(5	)%	5,246		8	%	(7,782		)	*		4,933		3	%	19,977		10	%	(15,044		)	(75	)%
	$	135,805		63	%	$	128,840	63	%	$	6,965		5	%	$	402,426	63	%	$	411,370	65	%	$	(8,944	)	(2	)%

* not meaningful

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 September 30, 2019 was primarily due to an increase in term revenue recognized from several large, multi-year term license contracts in the three months ended September 30, 2019. It was also due to an increase in cloud revenue reflecting the shift in client preferences to cloud arrangements from other types of arrangements, 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 nine months ended September 30, 2019 was primarily due to a decrease in term and perpetual license revenue and a decrease in consulting revenue due to a decrease in billable hours.

The decrease in total gross profit percent in the nine months ended September 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 and decreases in cloud and consulting gross profit percent.

The decreases in cloud gross profit percent in the three and nine months ended September 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 decreases in consulting gross profit percent in the three and nine months ended September 30, 2019 were 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.

Operating expenses

Selling and marketing



	Three Months Ended September 30,						Change				Nine Months Ended September 30,						Change
(Dollars in thousands)	2019			2018			Change				2019			2018			Change
Selling and marketing ⁽¹⁾	$	115,237		$	87,490		$	27,747	32	%	$	341,064		$	269,845		$	71,219	26	%
As a percent of total revenue	53		%	43		%					54		%	42		%
Selling and marketing headcount, end of period											1,532			1,194			338		28	%

⁽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 nine months ended September 30, 2019 were primarily due to compensation and benefits of $22.6 million and $58.1 million, attributable to increased headcount, equity compensation, and increases of $4.0 million and $10.6 million in deferred contract cost amortization. Also, contributing to the increases were travel and entertainment of $2.6 million and $4.5 million. 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 September 30,						Change				Nine Months Ended September 30,						Change
(Dollars in thousands)	2019			2018			Change				2019			2018			Change
Research and development ⁽¹⁾	$	52,492		$	46,504		$	5,988	13	%	$	152,802		$	135,261		$	17,541	13	%
As a percent of total revenue	24		%	23		%					24		%	21		%
Research and development headcount, end of period											1,631			1,595			36		2	%

⁽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.

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The increases in the three and nine months ended September 30, 2019 were primarily due to compensation and benefits of $3.8 million and $10.5 million, attributable to an increase in headcount and equity compensation, and $1.2 million and $4.5 million in cloud hosting expenses as we expand our cloud-focused research and development activities.

General and administrative



	Three Months Ended September 30,						Change				Nine Months Ended September 30,						Change
(Dollars in thousands)	2019			2018			Change				2019			2018			Change
General and administrative ⁽¹⁾	$	14,843		$	12,104		$	2,739	23	%	$	41,693		$	38,749		$	2,944	8	%
As a percent of total revenue	7		%	6		%					7		%	6		%
General and administrative headcount, end of period ⁽²⁾											420			326			94		29	%

⁽¹⁾ Includes compensation, benefits, and other headcount-related expenses associated with finance, legal, corporate governance, and other administrative headcount. It 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 increases in the three and nine months ended September 30, 2019 were primarily due to compensation and benefits of $3.2 million and $3.7 million, due to increased headcount.

Stock-based compensation



	Three Months Ended September 30,				Change				Nine Months Ended September 30,				Change
(Dollars in thousands)	2019		2018		Change				2019		2018		Change
Cost of revenues	$	4,787	$	4,319	$	468	11	%	$	14,216	$	12,277	$	1,939	16	%
Selling and marketing	8,317		6,198		2,119		34	%	24,055		16,895		7,160		42	%
Research and development	4,858		3,917		941		24	%	13,990		11,356		2,634		23	%
General and administrative	3,884		1,974		1,910		97	%	7,981		7,045		936		13	%
	$	21,846	$	16,408	$	5,438	33	%	$	60,242	$	47,573	$	12,669	27	%

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

Other income (expense), net



	Three Months Ended September 30,					Change					Nine Months Ended September 30,					Change
(Dollars in thousands)	2019			2018		Change					2019			2018		Change
Foreign currency transaction (loss) gain	$	(1,970	)	$	399	$	(2,369	)	*		$	(3,577	)	$	558	$	(4,135	)	*
Interest income, net	556			683		(127		)	(19	)%	1,823			2,076		(253		)	(12	)%
Other income, net	323			—		323			*		378			363		15			4	%
	$	(1,091	)	$	1,082	$	(2,173	)	*		$	(1,376	)	$	2,997	$	(4,373	)	*

* not meaningful

The changes in foreign currency transaction (loss) gain 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 September 30,						Nine Months Ended September 30,
(Dollars in thousands)	2019			2018			2019			2018
(Benefit from) income taxes	$	(17,520	)	$	(8,589	)	$	(43,158	)	$	(23,692	)
Effective income tax rate							32		%	80		%

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, 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 nine months ended September 30, 2019, the Company’s effective income tax rate changed primarily due to the Global Intangible Low-Taxed Income (“GILTI”) provision of the Tax Reform Act. The Company’s effective income tax rate was also affected by excess tax benefits from stock-based compensation and an increase in U.S. research and development tax credits.

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LIQUIDITY AND CAPITAL RESOURCES



	Nine Months Ended September 30,
(in thousands)	2019			2018
Cash provided by (used in):
Operating activities	$	(13,462	)	$	67,088
Investing activities	53,448			(49,595		)
Financing activities	(61,941		)	(71,664		)
Effect of exchange rates on cash and cash equivalents	(363		)	(1,913		)
Net (decrease) in cash and cash equivalents	$	(22,318	)	$	(56,084	)



(in thousands)	September 30, 2019		December 31, 2018
Held by U.S. entities	$	41,484	$	143,533
Held by foreign entities	71,085		63,890
Total cash, cash equivalents, and marketable securities	$	112,569	$	207,423

On November 6, 2019, we entered into a five-year $100 million senior secured revolving credit agreement (the “Credit Agreement”) with PNC Bank, National Association (“PNC”). We may use borrowings to finance working capital needs and for general corporate purposes. Subject to specific circumstances, the Credit Agreement allows us to increase the aggregate commitment up to $200 million. See Item 5. “Other Information” for additional information.

We believe that our current cash, cash equivalents, marketable securities, cash flow from operations, and borrowing capacity will be sufficient to fund our operations, quarterly cash dividends, and stock repurchases for at least the next 12 months. Whether these resources are adequate to meet our liquidity needs beyond that period will depend on our growth, operating results, and the investments required to meet possible increased demand for our services. If we require additional capital resources to grow our business, we may seek to finance our operations from available funds or additional external financing.

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 (used in) 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, or negative cash flow, 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.

The primary driver of the decrease in the nine months ended September 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 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 were:



	Nine Months Ended September 30,
(in thousands)	2019
January 1,	$	6,620
Authorizations ⁽²⁾	60,000
Repurchases	(20,286		)
September 30,	$	46,334

⁽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 .

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Common stock repurchases



	Nine Months Ended September 30,
	2019			2018
(in thousands)	Shares	Amount		Shares	Amount
Tax withholdings for net settlement of equity awards	514	$	34,871	591	$	35,530
Stock repurchase program ⁽¹⁾
Repurchases paid	318	20,086		512	29,949
Repurchases unsettled at period end	3	200		3	200
Activity in period ⁽²⁾	835	$	55,157	1,106	$	65,679

⁽¹⁾ Represents activity under our publicly announced stock repurchase programs. ⁽²⁾ During the nine months ended September 30, 2019 and 2018, instead of receiving cash from the equity holders, we withheld shares with a value of $31.6 million and $28.2 million, respectively, for the exercise price of options. These amounts have been excluded from the table above.

Dividends



	Nine Months Ended September 30,
(in thousands)	2019		2018
Dividend payments to shareholders	$	7,105	$	7,067

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 nine months ended September 30, 2019 to the market risk exposure disclosed in our Annual Report on Form 10-K for the year ended December 31, 2018.

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 September 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 September 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 September 30, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II - OTHER INFORMATION

ITEM 1A. RISK FACTORS

We encourage you to carefully consider the risk factors identified below and 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 they 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.

On November 6, 2019, we entered into a five-year $100 million, senior secured revolving credit agreement (the “Credit Agreement”) with PNC Bank, National Association (“PNC”). We may use borrowings to finance working capital needs and for general corporate purposes. Subject to specific circumstances, the Credit Agreement allows us to increase the aggregate commitment up to $200 million. See Item 5. “Other Information” for additional information.

Any failure to meet our debt obligations would damage our business.

Our ability to repay any amounts we borrow under our Credit Agreement will depend on market conditions and our future performance, which are subject to economic, financial, competitive, and other factors beyond our control. If we are not profitable in the future or if we use more cash than we generate in the future, our level of indebtedness at such time could adversely affect our operations by increasing our vulnerability to adverse changes in general economic and industry conditions and by limiting or prohibiting our ability to obtain additional financing for additional capital expenditures, acquisitions and general corporate and other purposes. If we incur significantly more debt, this could intensify the risks described above.

We are required to comply with certain financial and operating covenants under our revolving credit facility. Any failure to comply with those covenants could cause amounts borrowed to become immediately due and payable and/or prevent us from borrowing under the credit facility.

We are required to comply with certain financial and operating covenants under our Credit Agreement. Any failure to comply with those covenants could cause amounts borrowed to become immediately due and payable and/or prevent us from borrowing under the Credit Agreement. We are required to comply with specified financial and operating covenants under our Credit Agreement and to make payments, which limit our ability to operate our business as we otherwise might operate it. Our failure to comply with any of these covenants or to meet any debt payment obligations could result in an event of default which, if not cured or waived, would result in any amounts outstanding, including any accrued interest and/or unpaid fees, becoming immediately due and payable. We might not have sufficient working capital or liquidity to satisfy any repayment obligations in the event of an acceleration of those obligations. In addition, if we are not in compliance with the financial and operating covenants under the Credit Agreement at the time we wish to borrow funds, we will be unable to borrow funds. The financial and operating covenants under the Credit Agreement also may limit our ability to borrow funds, including for strategic acquisitions and share repurchases.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Issuer Purchases of Equity Securities

Common stock repurchased in the three months ended September 30, 2019 was:



(in thousands, except per share amounts)	Total Number of Shares Purchased ^{(1) (2)}	Average Price Paid per Share ^{(1) (2)}		Total Number of Shares Purchased as Part of Publicly Announced Share Repurchase Program ⁽²⁾	Approximate Dollar Value of Shares That May Yet Be Purchased at Period End Under Publicly Announced Share Repurchase Programs ⁽²⁾
July 1, 2019 - July 31, 2019	37	$	75.30	29	$	50,532
August 1, 2019 - August 31, 2019	94	$	72.06	31	$	48,333
September 1, 2019 - September 30, 2019	199	$	71.12	28	$	46,334
	330	$	71.86

⁽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⁾ See “Liquidity and Capital Resources” in Item 2. “ Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional information.

ITEM 5. OTHER INFORMATION

The Credit Agreement contains customary representations and warranties, affirmative and negative covenants, and events of default. Principal covenants include a maximum net consolidated leverage ratio of 3.5 (with a step-up in the event of certain acquisitions) and a minimum consolidated interest coverage ratio of 3.5. Our obligations under the Credit Agreement may be accelerated upon the occurrence of an event of default under the Credit Agreement, which includes, among other things, payment defaults, defaults in the performance of

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affirmative and negative covenants, the inaccuracy of representations or warranties, cross-defaults, bankruptcy and insolvency-related defaults, defaults relating to judgments, certain events resulting in a material adverse effect on us and a change of control of us.

The interest rates applicable to revolving loans under the Credit Agreement are, at our option, either:


•	the London Interbank Offered Rates (“LIBOR”) Rate plus an interest margin based on our net consolidated leverage ratio; or


•	a base rate (which is the highest of (1) PNC’s prime rate, (2) the Federal Funds open rate in effect on such day plus 0.5%, and (3) the daily LIBOR Rate plus 1%) plus an interest margin based on our net consolidated leverage ratio.

We are obligated to pay an unused commitment fee during the term of the Credit Agreement that varies between 0.15% and 0.225% depending on our net consolidated leverage ratio. The credit facility includes a provision for the replacement of the LIBOR rate in the event that such rate is no longer available. The replacement rate will be determined by PNC in consultation with us. The revolving credit facility may be prepaid before maturity in whole or in part at our option without penalty or premium. We may at any time reduce or terminate the commitments under the credit facility.

The description of the Credit Agreement contained herein is qualified in its entirety by reference to the Credit Agreement, a copy of which is filed as Exhibit 10.1 to this Quarterly Report on Form 10-Q.

ITEM 6. EXHIBITS



Exhibit No.		Description
10.1		Credit Facility Agreement
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 - 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.
104		Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101)

+ 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:	November 7, 2019	By:	/s/ KENNETH STILLWELL
			Kenneth Stillwell
			Chief Financial Officer and Chief Administrative Officer
			(Principal Financial Officer)