TMCnet News
PEGASYSTEMS INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Business overview We develop, market, license, and support software solutions that help clients improve their business results by giving them the power to engage customers, simplify their operations, and adapt to change. Our unified software platform enables our clients to build, deploy, and change enterprise applications easily and quickly, by directly capturing business objectives, automating programming, and automating work. We also provide consulting services, maintenance, and training related to our software. We focus our sales efforts primarily on target accounts, which are large companies or divisions within companies and typically leaders in their industry. Our strategy is to sell a series of licenses that are focused on a specific purpose or area of operations. Our license revenue is primarily derived from sales of our PRPC software and related business solutions. PRPC is a comprehensive platform for building and managing BPM applications that unifies business rules and business processes. Our solutions, built on the capabilities of PRPC, are purpose or industry-specific collections of best practice functionality, which allow organizations to quickly implement new customer-facing practices and processes, bring new offerings to market, and provide customized or specialized processing. Our products are simpler, easier to use and often result in shorter implementation periods than competitive enterprise software products. PRPC and related business solutions can be used by a broad range of clients across markets including financial services, insurance, healthcare, communications and media, life sciences, manufacturing and high technology, and government markets. Our business solution products include CRM software, which enables unified predictive decisioning and analytics and optimizes the overall customer experience. Our decision management products and capabilities are designed to manage processes so that actions optimize the process outcomes based on business objectives. We continue to invest in the development of new products and intend to remain a leader in BPM, CRM, and decision management. We also offer Pega Cloud®, a service offering that allows our clients to immediately build, test, and deploy their applications in a secure cloud environment, while minimizing their infrastructure and hardware costs. Revenue from our Pega Cloud® offering is included in consulting services revenue. Our acquisition of Antenna expands Pega's Application Mobility Platform, which provides clients with a mobile application development platform to build, manage, and deploy mobile applications as part of a seamless omnichannel experience. Enterprises can manage the complex elements of the mobile application lifecycle including security, integration, testing, and management of mobile applications and devices. Pega's mobile application development solutions help businesses to significantly reduce their development time, deployment costs, and the complexity associated with run-the-business mobile applications. The operations of Antenna are included in our operating results from the date of acquisition. Total revenue attributable to Antenna included in our consolidated statements of operations in 2013 was $3.9 million. Due to the rapid integration of the products, sales force, and operations of Antenna, other than the maintenance and hosting revenue attributable to the recognition of the fair value of acquired deferred maintenance and hosting revenue, it may not be feasible for us to identify revenue from new arrangements attributable to Antenna. We offer training for our staff, clients, and partners at our regional training facilities, at third party facilities, and at client sites. In 2012, we began offering training online through PegaACADEMY, which provides an alternative way to learn our software in a virtual environment quickly and easily. We believe that this online training will continue to expand the number of trained experts at a faster pace. 19 -------------------------------------------------------------------------------- Table of Contents RESULTS OF OPERATIONS 2013 Compared to 2012 (Dollars in thousands) Year Ended December 31, Increase 2013 2012 Total revenue $ 508,954 $ 461,710 $ 47,244 10 % Gross profit 351,548 304,330 47,218 16 % Acquisition-related costs 1,306 - 1,306 n/m Restructuring costs 1,731 - 1,731 n/m Other operating expenses 290,414 272,904 17,510 6 % Total operating expenses 293,451 272,904 20,547 8 % Income from operations 58,097 31,426 26,671 85 % Income before provision for income taxes 56,393 30,945 25,448 82 % n/m - not meaningful Revenue (Dollars in thousands) Year Ended December 31, Increase 2013 2012 Software license revenue Perpetual licenses $ 122,644 64 % $ 102,438 63 % $ 20,206 Term licenses 62,711 33 % 46,638 28 % 16,073 Subscription 6,521 3 % 14,830 9 % (8,309 ) Total software license revenue $ 191,876 100 % $ 163,906 100 % $ 27,970 17 % The aggregate value of new license arrangements executed in 2013 was higher than in 2012. The aggregate value of new license arrangements executed in the fourth quarter of 2013 was down slightly as compared to the fourth quarter of 2012.The aggregate value of new license arrangements executed fluctuates quarter to quarter. During 2013 and 2012, approximately 80% and 74%, respectively, of the value of new license arrangements were executed with existing clients. The mix between perpetual and term license arrangements executed in a particular period varies based on client needs. A change in the mix between perpetual and term license arrangements executed may cause our revenues to vary materially from period to period. A higher proportion of term license arrangements executed would result in more license revenue being recognized over longer periods as payments become due or earlier if prepaid. However, some of our perpetual license arrangements include extended payment terms or additional rights of use, which also result in the recognition of revenue over longer periods. The increase in perpetual license revenue was primarily due to higher value perpetual arrangements executed during 2013 and the fourth quarter of 2012 than during 2012 and the fourth quarter of 2011. The increase in term license revenue was primarily due to revenue recognized on term license arrangements executed in 2012 and 2011. The aggregate value of payments due under noncancellable term licenses increased to $233.6 million as of December 31, 2013 compared to $211.5 million as of December 31, 2012. See the table of future cash receipts from these term licenses on page 31. 20-------------------------------------------------------------------------------- Table of Contents Subscription revenue primarily consists of the ratable recognition of license, maintenance and bundled services revenue on perpetual license arrangements that include a right to unspecified future products. Subscription revenue does not include revenue from our Pega Cloud® offerings, which is included in consulting services revenue. The timing of scheduled payments under client arrangements may limit the amount of revenue recognized in a reporting period. Consequently, our subscription revenue may vary quarter to quarter. The decrease in subscription revenue in 2013 was primarily due to revenue recognized in the second quarter of 2012 for a large payment that became due. (Dollars in thousands) Year Ended December 31, Increase 2013 2012 Maintenance revenue Maintenance $ 157,309 $ 133,527 $ 23,782 18 % The increase in maintenance revenue was primarily due to the growth in the aggregate value of the installed base of our software and continued strong renewal rates. Maintenance revenue primarily attributable to recognition of the fair value of the acquired Antenna deferred maintenance revenue was $0.8 million in 2013. (Dollars in thousands) Year Ended December 31, (Decrease) 2013 2012 Services revenue Consulting services $ 154,500 97 % $ 157,792 96 % $ (3,292 ) (2 )% Training 5,269 3 % 6,485 4 % (1,216 ) (19 )% Total Services $ 159,769 100 % $ 164,277 100 % $ (4,508) (3 )% Consulting services revenue includes revenue from our Pega Cloud® service offerings. Consulting services revenue decreased, partially offset by a $4.4 million revenue increase from our Pega Cloud® service offerings, of which $1.1 million was attributable to the acquired Antenna business. The decrease was primarily the result of more clients becoming enabled and our partners leading more implementation projects. If this trend continues, our consulting services revenue may continue to decrease in future periods. The decrease in our training revenue was primarily due to the increased adoption of our PegaACADEMY self-service online training by our partners, which has a significantly lower average price per student as compared to our traditional instructor-led training. (Dollars in thousands) Year Ended December 31, Increase (Decrease) 2013 2012 Gross Profit Software license $ 185,595 $ 157,567 $ 28,028 18 % Maintenance 142,037 118,740 23,297 20 % Services 23,916 28,023 (4,107 ) (15 )% Total gross profit $ 351,548 $ 304,330 $ 47,218 16 % Total gross profit % 69 % 66 % Software license gross profit % 97 % 96 % Maintenance gross profit % 90 % 89 % Services gross profit % 15 % 17 % The increase in total gross profit was due to increases in license and maintenance revenue. 21 -------------------------------------------------------------------------------- Table of Contents The decrease in services gross profit percent was primarily due to lower consulting revenues, costs incurred on several projects for which the corresponding revenue will be recognized in future periods as revenue recognition criteria had not been met, and increased employee incentive expenses. (Dollars in thousands) Year Ended December 31, Increase 2013 2012 Amortization of intangibles: Cost of revenue $ 6,443 $ 6,189 $ 254 4 % Selling and marketing 5,174 4,928 246 5 % General and administrative 396 20 376 1,880 % $ 12,013 $ 11,137 $ 876 8 % The increase in amortization expense was due to the amortization associated with $10.4 million of intangibles acquired from Antenna. Operating expenses (Dollars in thousands) Year Ended December 31, Increase 2013 2012 Selling and marketing Selling and marketing $ 181,094 $ 167,263 $ 13,831 8 % As a percent of total revenue 36 % 36 % Selling and marketing headcount 598 520 78 15 % Selling and marketing expenses include compensation, benefits, and other headcount-related expenses associated with our selling and marketing personnel as well as advertising, promotions, trade shows, seminars, and other programs. Selling and marketing expenses also include the amortization of customer related intangibles. The increase in selling and marketing expenses was primarily due to a $9.9 million increase in compensation and benefit expenses associated with higher headcount, a $1.7 million increase in marketing programs, a $1.2 million increase in commission expense, and a $1.3 million increase in partner commission expense. (Dollars in thousands) Year Ended December 31, Increase 2013 2012 Research and development Research and development $ 79,726 $ 76,726 $ 3,000 4 % As a percent of total revenue 16 % 17 % Research and development headcount 913 727 186 26 % Research and development expenses include compensation, benefits, contracted services, and other headcount-related expenses associated with research and development. The increase in headcount reflects growth in our India research facility as we have been replacing contractors with employees. The increase in offshore headcount lowered our average compensation expense per employee. 22-------------------------------------------------------------------------------- Table of Contents The increase in research and development expenses was primarily due to a $7.4 million increase in compensation and benefit expenses associated with higher headcount, partially offset by a $2.3 million decrease in engineering contractor expenses and a decrease in rent and equipment-related expenses. (Dollars in thousands) Year Ended December 31, Increase 2013 2012 General and administrative General and administrative $ 29,594 $ 28,915 $ 679 2 % As a percent of total revenue 6 % 6 % General and administrative headcount 271 251 20 8 % General and administrative expenses include compensation, benefits, and other headcount-related expenses associated with the finance, legal, corporate governance, and other administrative headcount. It also includes accounting, legal, and other professional consulting, and administrative fees. The general and administrative headcount includes employees in human resources, information technology and corporate services departments whose costs are allocated to the rest of our functional departments. The increase in general and administrative expenses was primarily due to increase in compensation and benefits associated with higher headcount. Acquisition-related costs Acquisition-related costs are expensed as incurred and include direct and incremental costs associated with an impending or completed acquisition. During 2013, the $1.3 million of acquisition-related costs were primarily professional fees associated with our acquisition of Antenna. Restructuring costs In 2013, restructuring costs include future lease payments and demising costs, net of estimated sublease income, for the elimination of space within one facility related to the integration of Antenna. See Note 12 "Accrued Restructuring Costs" in the notes to the accompanying consolidated financial statements for further detail. Stock-based compensation We recognize stock-based compensation expense associated with equity awards in our consolidated statements of operations based on the fair value of these awards at the date of grant. (Dollars in thousands) Year Ended December 31, Increase 2013 2012 Stock-based compensation: Cost of services $ 4,085 $ 3,655 $ 430 12 % Operating expenses 8,784 7,851 933 12 % Total stock-based compensation before tax 12,869 11,506 $ 1,363 12 % Income tax benefit (3,918 ) (3,699 ) 23 -------------------------------------------------------------------------------- Table of Contents The increase in stock-based compensation expense was primarily due to a full year of expense on the December 2012 annual employee equity grants. See Note 15 "Stock-Based Compensation" in the notes to the accompanying audited consolidated financial statements for further information on our stock-based awards. Non-operating income and (expenses), net (Dollars in thousands) Year Ended December 31, Change 2013 2012 Foreign currency transaction (loss) gain $ (1,593 ) $ 780 $ (2,373 ) (304 )% Interest income, net 524 419 105 25 % Other (expense) income, net (635 ) (1,680 ) 1,045 (62 )% $ (1,704 ) $ (481 ) $ (1,223 ) 254 % We use foreign currency forward contracts ("forward contracts") to manage our exposure to changes in foreign currency denominated accounts receivable, intercompany payables, and cash primarily held by our U.S. operating company. We have not designated these forward contracts as hedging instruments and as a result, we record the fair value of the outstanding contracts at the end of the reporting period in our consolidated balance sheet, with any fluctuations in the value of these contracts recognized in other expense (income), net. The fluctuations in the value of these forward contracts recorded in other (expense) income, net, partially offset in net income, the gains and losses from the remeasurement or settlement of the foreign currency denominated accounts receivable, intercompany payables, and cash held by the U.S. operating company recorded in foreign currency transaction loss. We have been primarily exposed to the fluctuation in the British pound and Euro relative to the U.S. dollar. More recently, we have experienced increased levels of exposure to the Australian dollar and Indian rupee. See Note 4 "Derivative Instruments" in the notes to the accompanying consolidated financial statements for discussion on our use of forward contracts. The total change in the fair value of our foreign currency forward contracts recorded in other (expense) income, net, during 2013 and 2012 was a loss of $0.7 million and $1.7 million, respectively. Provision for income taxes The provision for income taxes represents current and future amounts owed for federal, state, and foreign taxes. During 2013 and 2012, we recorded an $18.4 million provision and a $9.1 million provision, respectively, which resulted in an effective tax rate of 32.5% and 29.3%, respectively Our effective income tax rate for 2013 was below the statutory federal income tax rate due to a $2.1 million benefit related to the current period domestic production activities deduction, a $1.2 million benefit related to income generated in foreign jurisdictions that is subject to tax at a rate lower than the U.S. statutory tax rate, and a $1.6 million benefit related to the 2012 and 2013 federal research and experimentation ("R&E") credit. These benefits were partially offset by $1.4 million of permanent differences related to nondeductible meals and entertainment expenses, foreign stock compensation, and transaction costs. Our effective income tax rate for 2012 was below the statutory federal income tax rate due to a $1.2 million benefit related to the domestic production activities deduction and a $1.2 million benefit related to income generated in foreign jurisdictions that is subject to tax at a rate lower than the U.S. statutory rate. These benefits were partially offset by $1 million of permanent differences related to nondeductible meals and entertainment expenses and nondeductible foreign stock compensation. 24-------------------------------------------------------------------------------- Table of Contents The American Taxpayer Relief Act of 2012 (the "Act") was signed into law by President Obama on January 2, 2013. Among other things, the Act retroactively extended the R&E credit through the end of 2013. Under ASC 740, Income Taxes, the effects of new legislation are recognized upon enactment, which means that both the retroactive tax effects for the 2012 R&E credit and the tax effects for the 2013 R&E are recognized in the 2013 financial statements. If we had recognized the effects of the 2012 R&E credit in the 2012 financial statements, the effective tax rate in 2012 would have been lowered by approximately 2.6%. As of December 31, 2013, we had approximately $40.9 million of total unrecognized tax benefits, of which $25.2 million would decrease our effective tax rate if recognized. The remaining $15.7 million of unrecognized tax benefits relate to acquired net operating losses ("NOLs") and R&E credits that are subject to limitations on their use. We expect that the changes in the unrecognized benefits within the next twelve months will be approximately $0.1 million, all of which would reduce our effective tax rate if realized. 2012 Compared to 2011 (Dollars in thousands) Year Ended December 31, Increase 2012 2011 Total revenue $ 461,710 $ 416,675 $ 45,035 11 % Gross profit 304,330 251,877 52,453 21 % Total operating expenses 272,904 241,383 31,521 13 % Income from operations 31,426 10,494 20,932 199 % Income before provision for income taxes 30,945 10,813 20,132 186 % The aggregate value of new license arrangements executed in 2012 was slightly higher than in 2011. The aggregate value of new license arrangements executed fluctuates quarter to quarter. During 2012 and 2011, approximately 74% and 58%, respectively, of new license arrangements were executed with existing clients. We believe the continued demand for our software products and related services is due to the strong value proposition, short implementation period, and variety of licensing models we offer our clients. The increase in gross profit was primarily due to the increase in license revenue and to a lesser extent the increase in maintenance revenue. The increase in operating expenses was primarily due to the increase in selling and marketing expenses and to a lesser extent the increase in research and development expenses, associated with higher headcount. The increase in income from operations and income before provision for income taxes was primarily due to the higher increases in license and maintenance gross profit compared to the increase in operating expenses. Revenue (Dollars in thousands) Year Ended December 31, Increase 2012 2011 License revenue Perpetual licenses $ 102,438 63 % $ 94,129 68 % $ 8,309 9 % Term licenses 46,638 28 % 34,453 25 % 12,185 35 % Subscription 14,830 9 % 10,225 7 % 4,605 45 % Total license revenue $ 163,906 100 % $ 138,807 100 % $ 25,099 18 % 25 -------------------------------------------------------------------------------- Table of Contents In both 2011 and 2012, more than 50% of the aggregate value of new license arrangements for the fiscal year was executed in our fourth quarter. A large proportion of the value of these arrangements was term licenses that contributed very little to the increase in our term license revenue in 2012, but will be recognized as revenue in future periods. As a result, the aggregate value of future payments due under noncancellable term licenses increased significantly in both 2011 and 2012 from $90.9 million as of December 31, 2010 to $161.4 million as of December 31, 2011 and to $211.5 million as of December 31, 2012. The increase in term license revenue for 2012 is a result of the increase in the aggregate value of future payments due under noncancellable term licenses arrangements from prior years. The increases in the aggregate value of term license arrangements executed in a certain period is not necessarily indicative of the volume level in future periods. The mix between perpetual and term license arrangements executed in a particular period varies based on client needs. A change in the mix between perpetual and term license arrangements executed over time may cause our revenues to vary materially from period to period. The increase in perpetual license revenue was primarily due to the increase in the aggregate value of new perpetual license arrangements executed during the fourth quarter of 2012. Subscription revenue primarily consists of the ratable recognition of license, maintenance and bundled services revenue on perpetual license arrangements that include a right to unspecified future products. Subscription revenue does not include revenue from our Pega Cloud® offerings. The timing of scheduled payments under client arrangements may limit the amount of revenue that can be recognized in a reporting period. Consequently, our subscription revenue may vary quarter to quarter. The increase in subscription revenue was primarily due to the full year of revenue recognized in 2012 on some arrangements for which we began recognizing revenue in the fourth quarter of 2011. (Dollars in thousands) Year Ended December 31, Increase 2012 2011 Maintenance revenue Maintenance $ 133,527 $ 117,110 $ 16,417 14 % The increase in maintenance revenue was primarily due to the growth in the aggregate value of the installed base of our software and continued strong renewal rates. (Dollars in thousands) Year Ended December 31, Increase (Decrease) 2012 2011 Services revenue Consulting services $ 157,792 96 % $ 153,919 96 % $ 3,873 3 % Training 6,485 4 % 6,839 4 % (354 ) (5 )% Total Services $ 164,277 100 % $ 160,758 100 % $ 3,519 2 % 26 -------------------------------------------------------------------------------- Table of Contents Revenue from our Pega Cloud® offerings is included in consulting services revenue and was the primary driver for the increase in services revenue in 2012. In addition, our consulting services revenue increased due to higher realization rates in 2012 compared to 2011. As more of our clients are becoming enabled and our partners are leading the majority of implementation projects, our consulting services revenue may be lower in future periods. (Dollars in thousands) Year Ended December 31, Increase 2012 2011 Gross Profit Software license $ 157,567 $ 132,114 $ 25,453 19 % Maintenance 118,740 104,033 14,707 14 % Services 28,023 15,730 12,293 78 % Total gross profit $ 304,330 $ 251,877 $ 52,453 21 % Total gross profit percent 66 % 60 % Software license gross profit percent 96 % 95 % Maintenance gross profit percent 89 % 89 % Services gross profit percent 17 % 10 % As a result of the increased number of client and partner led implementations, we have slowed the hiring of consulting services personnel, reducing non-billable on-boarding time and increasing utilization rates of our staff, resulting in higher gross profit percentages. If we increase our hiring pace in future periods, we may again incur on-boarding and enablement costs that may result in lower services gross profit percentages. (Dollars in thousands) Year Ended December 31, Increase (Decrease) 2012 2011 Amortization of intangibles: Cost of software license $ 6,189 $ 6,284 $ (95 ) (2 )% Selling and marketing 4,928 4,928 - - % General and administrative 20 103 (83 ) (81 )% $ 11,137 $ 11,315 $ (178) (2 )% The decrease in amortization expense was due to the amortization in full of our trade name intangible asset in 2011 and our technology designs intangible asset in the first quarter of 2012. Operating expenses (Dollars in thousands) Year Ended December 31, Increase 2012 2011 Selling and marketing Selling and marketing $ 167,263 $ 147,457 $ 19,806 13 % As a percent of total revenue 36 % 35 % Selling and marketing headcount 520 464 56 12 % 27 -------------------------------------------------------------------------------- Table of Contents We continue to create additional sales capacity by increasing sales headcount to target new accounts in existing industries, as well as to expand coverage in new industries and geographies. The increase in selling and marketing expenses was primarily due to a $19.3 million increase in compensation and benefit expenses associated with higher headcount, partially offset by a $1.1 million decrease in commission expense. (Dollars in thousands) Year Ended December 31, Increase 2012 2011 Research and development Research and development $ 76,726 $ 65,308 $ 11,418 17 % As a percent of total revenue 17 % 16 % Research and development headcount 727 523 204 39 % The increase in headcount reflects growth in our India research facility as we have been replacing contractors with employees. The increase in offshore headcount lowered our average compensation expense per employee. The increase in research and development expenses was primarily due to a $9.9 million increase in compensation and benefit expenses associated with higher headcount and a $3.3 million increase in rent and facilities related expenses associated with the build-out of our U.S. and India facilities, partially offset by a $2.3 million decrease in engineering contractor expenses. (Dollars in thousands) Year Ended December 31, Increase 2012 2011 General and administrative General and administrative $ 28,915 $ 28,198 $ 717 3 % As a percent of total revenue 6 % 7 % General and administrative headcount 251 216 35 16 % We completed the move to our new office headquarters in the third quarter of 2012 and ceased use of the former office space in the fourth quarter of 2012, resulting in approximately $0.2 million in lease exit costs. We recorded approximately $5.7 million and $1.9 million of rent expense under the new lease arrangement during 2012 and 2011, respectively. Stock-based compensation We recognize stock-based compensation expense associated with equity awards in our consolidated statements of operations based on the fair value of these awards at the date of grant. (Dollars in thousands) Year Ended December 31, Increase 2012 2011 Stock-based compensation: Cost of services $ 3,655 $ 2,737 $ 918 34 % Operating expenses 7,851 6,291 1,560 25 % Total stock-based compensation before tax 11,506 9,028 $ 2,478 27 % Income tax benefit (3,699 ) (2,854 ) The increase in stock-based compensation expense was primarily due to the higher value of the annual periodic equity grant, the annual executive grant and new hire grants. See Note 15 "Stock-Based Compensation" in the notes to the accompanying audited consolidated financial statements for further information on our stock-based awards. 28 -------------------------------------------------------------------------------- Table of Contents Non-operating income and (expenses), net (Dollars in thousands) Year Ended December 31, Change 2012 2011 Foreign currency transaction gain (loss) $ 780 $ (935 ) $ 1,715 n/m Interest income, net 419 398 21 5 % Other income, net (1,680 ) 856 (2,536 ) n/m $ (481 ) $ 319 $ (800 ) n/m n/m - not meaningful We hold foreign currency denominated accounts receivable, intercompany payables, and cash in our U.S. operating company where the functional currency is the U.S. dollar. As a result, these receivables, intercompany payables, and cash are subject to foreign currency transaction gains and losses when there are changes in exchange rates between the U.S. dollar and the foreign currencies. The fluctuations in foreign currency transaction gains and losses were primarily due to the changes in the value of the British pound and Euro relative to the U.S. dollar during 2012 and 2011. Beginning in the second quarter of 2011, we entered into foreign currency forward contracts to manage our exposure to changes in foreign currency exchange rates affecting the foreign currency denominated accounts receivable, intercompany payables, and cash held by our U.S. operating company. We have not designated these foreign currency forward contracts as hedging instruments and as a result, we record the fair value of the outstanding contracts at the end of the reporting period in our consolidated balance sheet, with any fluctuations in the value of these contracts recognized in other (expense) income, net. The fluctuations in the value of these foreign currency forward contracts recorded in other (expense) income, net, partially offset in net income the gains and losses from the remeasurement or settlement of the foreign currency denominated accounts receivable, intercompany payables, and cash held by the U.S. operating company recorded in foreign currency transaction gain (loss). The total change in the fair value of our foreign currency forward contracts recorded in other (expense) income, net, during 2012 and 2011 was a loss of $1.7 million and a gain of $0.8 million, respectively. Provision (benefit) for income taxes The provision for income taxes represents current and future amounts owed for federal, state, and foreign taxes. During 2012 and 2011, we recorded a $9.1 million provision and a $0.7 million provision, respectively, which resulted in an effective tax rate of 29.3% and 6.5%, respectively Our effective income tax rate for 2012 was below the statutory federal income tax rate due to a $1.2 million benefit related to the current period domestic production activities and a $1.2 million benefit related to lower foreign income tax rates. These benefits were partially offset by $1 million of permanent differences related to nondeductible meals and foreign stock compensation. Our effective income tax rate for 2011 was below the statutory federal income tax rate due to a $2.5 million reduction in liabilities established for unrecognized tax benefits and a corresponding reduction in income tax expense related to uncertain tax positions of prior years for which the statute of limitations expired, a $1.5 million benefit related to the current period domestic production activities and a $0.6 million benefit related to tax credits from our continued investment in research and development activities. These benefits were partially offset by a $0.3 million increase in our valuation allowances and $0.6 million of permanent differences related to nondeductible meals. As of December 31, 2012, the Company had approximately $26.3 million of total unrecognized tax benefits, of which $16 million would decrease the Company's effective tax rate if recognized. However, approximately $9.2 million of these unrecognized tax benefits relate to acquired NOLs and research tax credits, which are subject to limitations on use. 29-------------------------------------------------------------------------------- Table of Contents LIQUIDITY AND CAPITAL RESOURCES (in thousands) Year Ended December 31, 2013 2012 2011 Cash provided by (used in): Operating activities $ 80,703 $ 43,579 $ 39,815 Investing activities (63,997 ) (19,238 ) (45,388 ) Financing activities (14,567 ) (8,091 ) (6,312 ) Effect of exchange rate on cash 567 922 1,111 Net increase (decrease) in cash and cash equivalents $ 2,706 $ 17,172 $ (10,774 ) As of December 31, 2013 2012 2011 Total cash, cash equivalents, and marketable securities $ 156,692 $ 122,985 $ 111,432 We believe that our current cash, cash equivalents, and cash flow from operations will be sufficient to fund our operations and our share repurchase program for at least the next 12 months. There can be no assurance that changes in our plans or other events affecting our operations will not result in materially accelerated or unexpected cash requirements. We evaluate acquisition opportunities from time to time, which if pursued, could require use of our funds. On October 9, 2013, we acquired Antenna for $27.7 million in cash, inclusive of cash acquired and a preliminary working capital adjustment. During 2013, we incurred $1.3 million, primarily in professional fees to affect this acquisition and expect to incur an additional estimated $0.4 million in such fees. As of December 31, 2013, approximately $43.3 million of our cash and cash equivalents is held in our foreign subsidiaries. If it became necessary to repatriate these funds, we may be required to pay U.S. tax, net of any applicable foreign tax credits, upon repatriation. We consider the earnings of our foreign subsidiaries to be permanently reinvested and, as a result, U.S. taxes on such earnings are not provided. It is impractical to estimate the amount of U.S. tax we could have to pay upon repatriation due to the complexity of the foreign tax credit calculations and because we consider our earnings permanently reinvested. Cash provided by operating activities The primary drivers of cash provided by operating activities during 2013 were net income of $38.0 million and a $26.4 million increase in deferred revenue primarily resulting from the difference in timing of billings and revenue recognition for annual maintenance. The primary drivers of cash provided by operating activities during 2012 were $21.9 million of net income and a $24.8 million increase in deferred revenue primarily resulting from the difference in timing of billings and revenue recognition for annual maintenance. Cash used in operating activities during 2011 was primarily due to our net income of $10.1 million and an $18.5 million increase in accounts receivable. 30 -------------------------------------------------------------------------------- Table of Contents Future Cash Receipts from License Arrangements Total contractual future cash receipts due from our existing license agreements was approximately $264.3 million as of December 31, 2013 compared to $255 million as of December 31, 2012. The future cash receipts due as of December 31, 2013 are summarized as follows: Contractual Other contractual payments for term license payments not licenses not recorded on recorded on the As of December 31, (in thousands) the balance sheet (1) balance sheet (2) Total 2014 $ 69,287 $ 22,947 $ 92,234 2015 62,978 4,652 67,630 2016 50,037 3,128 53,165 2017 28,459 - 28,459 2018 and thereafter 22,829 - 22,829 Total $ 233,590 $ 30,727 $ 264,317 (1) These amounts will be recognized as revenue in the future over the term of the agreement as payments become due or earlier if prepaid. (2) These amounts will be recognized as revenue in future periods and relate to perpetual and subscription licenses with extended payment terms and/or additional rights of use. Cash used in investing activities During 2013, cash used in investing activities was primarily for purchases of marketable debt securities for $60.6 million, partially offset by the proceeds received from the maturities and called marketable debt securities of $27.8 million. We paid $25.6 million to acquire Antenna, net of cash acquired and a preliminary working capital adjustment. We also invested $5.6 million primarily in leasehold improvements and computer equipment for the build-out of our U.S. and India offices. During 2012, we invested $23.6 million primarily in leasehold improvements, furniture and fixtures and equipment for the build-out of our U.S. and India offices. During 2011, cash used in investing activities was primarily for purchases of marketable debt securities for $57.2 million, partially offset by the proceeds received from the sales, maturities and called marketable debt securities of $21.7 million. We also invested $9.8 million in property and equipment, primarily leasehold improvements, computer equipment and furniture and fixtures for our U.S. and UK offices. Cash used in financing activities Net cash used in financing activities during 2013, 2012, and 2011, was primarily for repurchases of our common stock and the payment of our quarterly dividend. Since 2004, our Board of Directors has approved annual stock repurchase programs that have authorized the repurchase up to $104.5 million of our common stock. As of December 31, 2013, approximately $83.7 million has been repurchased, approximately $14.4 million remains available for repurchase and approximately $6.4 million expired. Purchases under these programs have been made on the open market. 31 -------------------------------------------------------------------------------- Table of Contents Common stock repurchases The following table is a summary of our repurchase activity under all of our stock repurchase programs: Year ended December 31, (Dollars in thousands) 2013 2012 2011 Shares Amount Shares Amount Shares Amount Prior year authorizations at January 1, $ 14,793 $ 13,963 $ 13,237 Authorizations 12,164 6,036 5,590 Repurchases paid 386,629 (12,370 ) 181,803 (5,130 ) 137,429 (4,815 ) Repurchases unsettled 3,141 (154 ) 3,399 (76 ) 1,688 (49 ) Authorized dollars remaining as of December 31, $ 14,433 $ 14,793 $ 13,963 In addition to the share repurchases made under our repurchase programs, we net settled the majority of our employee stock options exercised and RSUs vested. During 2013 and 2012, option and RSU holders net settled stock options and vested RSUs representing the right to purchase a total of 861,000 shares and 548,000 shares, respectively, of which only 432,000 shares and 319,000 shares, respectively, were issued to the option and RSU holders and the balance of the shares were surrendered to us to pay for the exercise price with respect to stock options and the applicable taxes for both options and RSUs. During 2013 and 2012, instead of receiving cash from the equity holders, we withheld shares with a value of $7.4 million and $4.4 million, respectively, for withholding taxes, and $9.0 million and $2.7 million, respectively, for the exercise price. Dividends We declared quarterly dividends totaling $0.12 per share for each of the years ended December 31, 2013, 2012, and 2011. Our Board of Directors authorized us to accelerate the payment of the fourth quarter 2012 dividend otherwise payable in January 2013 to December 2012. Therefore, we paid $5.7 million in dividends in 2012. For the years ended December 31, 2013 and 2011, we paid cash dividends of $3.4 million, and $4.5 million, respectively. It is our current intention to pay a quarterly cash dividend of $0.03 per share, however, the Board of Directors may terminate or modify this dividend program at any time without notice. Contractual obligations As of December 31, 2013, we had purchase obligations for customer support and marketing programs and payments under operating leases. Our lease arrangement for our new office headquarters expires in 2023, subject to our option to extend for two additional five-year periods. We also lease space for our other offices under noncancellable operating leases that expire at various dates through 2021. 32 -------------------------------------------------------------------------------- Table of Contents As of December 31, 2013, our known contractual obligations, including future minimum rental payments required under operating leases with noncancellable terms in excess of one year were as follows: Payment due by period Contractual obligations: 2015 & 2017 & 2019 & (in thousands) Total 2014 2016 2018 Thereafter Other Purchase obligations (1) $ 1,114 $ 1,114 $ - $ - $ - $ - Liability for uncertain tax positions (2) 19,154 - - - - 19,154 Operating lease obligations (3) 95,429 11,947 22,625 19,427 41,430 - Total $ 115,697 $ 13,061 $ 22,625 $ 19,427 $ 41,430 $ 19,154 (1) Represents the fixed or minimum amounts due under purchase obligations for customer support and marketing programs. (2) As of December 31, 2013, our recorded liability for uncertain tax positions was approximately $19.2 million. We are unable to reasonably estimate the timing of the cash outflow due to uncertainties in the timing of the effective settlement of tax positions. (3) Includes deferred rent of approximately $0.7 million included in accrued expenses and approximately $11.1 million in other long-term liabilities in the accompanying audited consolidated balance sheet as of December 31, 2013. CRITICAL ACCOUNTING POLICIES, SIGNIFICANT JUDGMENTS AND ESTIMATES Management's discussion and analysis of the financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. and the rules and regulations of the SEC for annual 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 related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions and beliefs of what could occur in the future given available information. We consider the following accounting policies to be both those most important to the portrayal of our financial condition and those that require the most subjective judgment. If actual results differ significantly from management's estimates and projections, there could be a material effect on our financial statements. Revenue recognition Our revenue is derived primarily from software licenses, maintenance fees related to our software licenses, and consulting services. Our license arrangements, whether involving a perpetual license or a term license, generally contain multiple elements, including consulting services, training, and software maintenance services. Software revenue recognition requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence ("VSOE") of fair value exists for those elements. The amount of arrangement consideration allocated to undelivered elements is based on the VSOE of fair value for those elements and recognized as those elements are delivered. Any remaining portion of the total arrangement fee is allocated to the software license, the first delivered element. Revenue is recognized for each element when all of the revenue recognition criteria have been met. Changes in the mix of the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product's estimated life cycle could materially impact the amount of earned and unearned revenue. 33-------------------------------------------------------------------------------- Table of Contents Before we can recognize revenue, the following four basic criteria must be met: • Persuasive evidence of an arrangement-As evidence of the existence of an arrangement, we use a contract or purchase order signed by the client for software and maintenance and a statement of work for consulting services. In the event the client is a reseller we ensure a binding agreement exists between the reseller and end user of the software. • Delivery of product-Software is delivered electronically or shipped via disk media. Services, including maintenance, are considered delivered as the work is performed or, in the case of maintenance, over the contractual service period. • Fee is fixed or determinable-We assess whether a fee is fixed or determinable at the outset of the arrangement. In addition, we assess whether contract modifications to an existing term arrangement constitute a concession. Our agreements do not include a right of return. • Collection of fee is probable-We assess the probability of collecting from each client at the outset of the arrangement based on a number of factors, including the client's payment history, its current creditworthiness, economic conditions in the client's industry and geographic location, and general economic conditions. If in our judgment collection of a fee is not probable, revenue is recognized as cash is collected, provided all other conditions for revenue recognition have been met. Software license revenues Perpetual software license fees are recognized as revenue when the software is delivered, any acceptance required by contract that is not perfunctory is obtained, no significant obligations or contingencies exist related to the software, other than maintenance, and all other revenue recognition criteria are met. Term software license fees are payable on a monthly, quarterly, or annual basis under license agreements that typically have a three to five-year term and may be renewed for additional terms at the client's option. As a result of our focus on frequent sales to our targeted clients, our strategy to sell initial term licensing agreements to those clients with the goal to generate follow-on sales, and as a result of extended payment terms and other factors, such as the risk of concessions, we recognize term license revenue over the term of the agreement as payments become due or earlier if prepaid, provided all other criteria for revenue recognition have been met. Subscription revenue primarily consists of license, maintenance and bundled services revenue recognized on our license arrangements that include a right to unspecified future products, which is recognized ratably over the term of the subscription period. Maintenance revenues First-year maintenance typically is sold with the related software license and renewed on an annual basis thereafter. Maintenance revenue is deferred and recognized ratably over the term of the support period, which is generally one year and subject to annual renewals. Perpetual license maintenance obligations are based on separately stated renewal rates in the arrangement that are substantive and therefore represent VSOE of fair value. Term license arrangements include separately stated maintenance fees and we use separate sales to determine VSOE of fair value. Services revenues Our services revenue is comprised of fees for consulting services, including software implementation, training, reimbursable expenses and sales of our Pega Cloud® offering ("Pega Cloud®"). Consulting services may be provided on a "stand-alone" basis or bundled with a license and software maintenance services. 34 -------------------------------------------------------------------------------- Table of Contents Revenue from training services and consulting services under time and materials contracts is recognized as services are performed. We have VSOE of fair value for our training services and consulting services under time and materials contracts in North America, Australia, and Europe. Consulting services may occasionally be provided on a fixed-price basis. We do not have VSOE of fair value for fixed-price services or time and materials services in certain geographical regions. When these services are part of a multiple element arrangement, and the services are not essential to the functionality of the software, and when services, including maintenance, are the only undelivered element, we recognize the revenue from the total arrangement ratably over the longer of the software maintenance period or the service period. Revenue from fixed-price services that are not bundled with a software license is generally recognized ratably during the service period, which is typically less than four months. Revenue from stand-alone sales of Pega Cloud® is recognized ratably over the term of the service. When implementation services are sold together with our Pega Cloud® offering and these services have stand-alone value to the client, we account for these services separately from our Pega Cloud® offering as described earlier. Stand-alone value is established through the client's ability to buy these services from many trained partner system integrators and from transactions sold independently from the sale of Pega Cloud®. Since these multiple-element arrangements are not software license sales, we apply a selling price hierarchy. Under the selling price hierarchy, third-party evidence of selling price ("TPE") will be considered if VSOE does not exist, and estimated selling price ("ESP") will be used if neither VSOE nor TPE is available. Generally, we are not able to determine TPE as our sales strategy is customized to the needs of our clients and our products or services are dissimilar to comparable products or services in the marketplace. In determining ESP, we apply significant judgment as we weigh a variety of factors, based on the facts and circumstances of the arrangement. We typically arrive at an ESP for a service that is not sold separately by considering company-specific factors such as geographies, competitive landscape, and pricing practices used to establish bundled pricing and discounting. Warranties and Indemnification We warrant to our clients that our software products will conform to documented specifications for a limited period. We have not experienced significant claims related to software warranties beyond the scope of maintenance support, which we are already obligated to provide, and consequently we have not established reserves for warranty obligations. Our agreements with clients generally require us to indemnify the client against claims that our software infringes third party patent, copyright, trademark or other proprietary rights. Such indemnification obligations are generally limited in a variety of industry-standard respects, including our right to replace an infringing product. As of December 31, 2013, we had not experienced any losses related to these indemnification obligations and no claims were outstanding. Deferred revenue Deferred software license revenue typically results from client billings for which all of the criteria to recognize revenue have not been met. Deferred maintenance revenue represents software license updates and product support contracts that are typically billed in advance and are recognized ratably over the support periods. Deferred services revenue represents advanced billings for consulting, hosting, and training services that are recognized as the services are performed. 35 -------------------------------------------------------------------------------- Table of Contents Goodwill and Intangible Assets Impairment Our goodwill and intangibles assets result from our business acquisitions. Goodwill and intangible assets with indefinite useful lives are not amortized, but are tested for impairment at least annually or as circumstances indicate their value may no longer be recoverable. We do not carry any intangible assets with indefinite useful lives other than goodwill. We perform our annual goodwill impairment during the fourth quarter of the fiscal year. With the acquisition of Antenna, we have determined our business has two operating segments, which are our two reporting units. To assess if goodwill is impaired, we first perform a qualitative assessment to determine whether further impairment testing is necessary. If, as a result of the qualitative assessment, we consider it more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, we perform a quantitative impairment test in a two-step process. For the first step, we screen for impairment, and if any possible impairment exists, we undertake a second step of measuring such impairment by performing discounted cash flow analyses. These analyses are based on cash flow assumptions that are consistent with the plans and estimates being used to manage our business. In the first step, we review the carrying amount of our reporting unit compared to the "fair value" of the reporting unit. An excess carrying value to fair value would indicate that goodwill may be impaired. If we determined that goodwill may be impaired, then we would compare the "implied fair value" to the carrying value of the goodwill. We periodically re-evaluate our business and have determined that we have two operating segments, which are our two reporting units. If our assumptions change in the future, we may be required to record impairment charges to reduce the carrying value of our goodwill. Changes in the valuation of goodwill could materially impact our operating results and financial position. We evaluate our intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. In evaluating potential impairment of these assets, we specifically consider whether any indicators of impairment are present, including, but not limited to: • whether there has been a significant adverse change in the business climate that affects the value of an asset; • whether there has been a significant change in the extent or manner in which an asset is used; and • whether there is an expectation that the asset will be sold or disposed of before the end of its originally estimated useful life. If indicators of impairment are present, we compare the estimated undiscounted cash flows that the specific asset is expected to generate to its carrying value. These estimates involve significant subjectivity. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value. As of December 31, 2013, we had $37.5 million of goodwill and $56.6 million of acquired intangible assets. If our estimates or the related assumptions change in the future, we may be required to record impairment charges to reduce the carrying value of these assets. Changes in the valuation of long-lived assets could materially impact our operating results and financial position. To date, there have been no impairments of goodwill or intangibles assets. Accounting for Income Taxes We use the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on temporary differences between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. 36-------------------------------------------------------------------------------- Table of Contents We regularly assess the need for a valuation allowance against our deferred tax assets. Future realization of our deferred tax assets ultimately depends on the existence of sufficient taxable income within the available carryback or carryforward periods. Sources of taxable income include taxable income in prior carryback years, future reversals of existing taxable temporary differences, tax planning strategies, and future taxable income. We record a valuation allowance to reduce our deferred tax assets to an amount we believe is more likely than not to be realized. Changes in our valuation allowance impact income tax expense in the period of adjustment. Our deferred tax valuation allowances require significant judgment and uncertainties, including assumptions about future taxable income that are based on historical and projected information. As of December 31, 2013, we had approximately $127.5 million of acquired Chordiant federal NOLs that are subject to annual use limitations under section 382 of the Internal Revenue Code. Based on those limitations we anticipate using $101.7 million of the remaining NOLs by 2029. In addition, we had $0.9 million of deferred tax assets related to state NOLs as of December 31, 2013. We acquired approximately $52 million and $58.1 million of federal and foreign NOLs, respectively, in the Antenna transaction. We have preliminarily determined that we may utilize $18.4 million of the acquired Antenna federal NOLs under the applicable section 382 limitation, and these losses are scheduled to expire in 2032. A valuation allowance is recorded on the deferred tax assets in excess of the federal NOLs that are deemed recoverable under the preliminary limitation. With regard to the acquired foreign NOLs, a full valuation allowance has been recorded as of December 31, 2013 due to uncertainty regarding the availability of these NOLs to offset future income generated by the related foreign businesses due to limitations under local country change in control provisions. We assess our income tax positions and record tax benefits based upon management's evaluation of the facts, circumstances, and information available at the reporting date. For those tax positions where it is more-likely-than-not that a tax benefit will be sustained, we record the largest amount of tax benefit with a greater than 50 percent likelihood of being realized upon ultimate settlement with a taxing authority having full knowledge of all relevant information. For those income tax positions where it is not more-likely-than-not that a tax benefit will be sustained, no tax benefit is recognized in the financial statements. We classify liabilities for uncertain tax positions as non-current liabilities unless the uncertainty is expected to be resolved within one year. We classify interest and penalties on uncertain tax positions as income tax expense. As a global company, we use significant judgment to calculate and provide for income taxes in each of the tax jurisdictions in which we operate. In the ordinary course of our business, there are transactions and calculations undertaken whose ultimate tax outcome cannot be certain. Some of these uncertainties arise as a consequence of transfer pricing for transactions with our subsidiaries and nexus and tax credit estimates. In addition, the calculation of acquired tax attributes and the associated limitations are complex. We estimate our exposure to unfavorable outcomes related to these uncertainties and estimate the probability of such outcomes. Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome will not be different from what is reflected in our historical income tax provisions, returns, and accruals. Such differences, or changes in estimates relating to potential differences, could have a material impact on our income tax provision and operating results in the period in which such a determination is made. See Note 16 "Income Taxes" in the notes to the accompanying audited consolidated financial statements for further information. |