Pegasystems Helps Streamline Customers' Business Processes

Senior Equity Analyst

Dan Romanoff

Associate Equity Analyst

Jack Keegan

We believe Pegasystems is well established in the business process management, or BPM, software niche and further benefits from related customer relationship management, or CRM, applications. We expect the company to remain a leading provider for enterprise users in the coming years as it moves customers to its new Pega Infinity platform, which unifies customer engagement with automation. The company’s revenue model transition was messy at times but is largely complete and we expect Pegasystems to emerge leaner and more focused. With that said, we still believe that Pegasystems demonstrates high customer switching costs as evidenced by its long customer relationships and strong annual contract value, or ACV, metrics.

BPM software allows customers to produce more efficient operations by automating business processes. Pegasystems’ no- and low-code platform importantly allows the business user, rather than a software engineer, to automate the workflow in a way that matches the business need. There is a library of templates for common uses that customers can draw from to further expedite the automation. Users can also draw from any previous work their company has done on the platform, employing chunks of code many times over. This allows for common processes to be written once and used repeatedly, thereby lowering costs and decreasing the time between process or application updates. While customer engagement remains the primary driver behind the proliferation of BPM uses, there are increasing amounts of complicated business processes that benefit from BPM solutions. Lastly, the software allows for users to “build for change,” meaning once software-driven processes are in place, they can be changed quickly on the fly so that all similar uses are also updated.

Pegasystems has long been considered a leader in BPM and a smaller player within CRM. Management sizes the market at $60 billion-$70 billion, which includes both CRM and BPM. We further note that the Pega platform is a high-end solution that larger enterprises with a high level of customer interactions would undertake.

Business Strategy & Outlook

We assign Pegasystems a no-moat rating as we do not expect the company to generate excess returns on invested capital over the next decade, mostly because of its elongated revenue model transition and uncertainty arising from the Appian award from litigation that remains under appeal.

We do believe Pegasystems benefits from high customer switching costs on both the customer relationship management and business process management solutions. Additionally, Pegasystems has enjoyed good customer retention throughout its cloud transition and is experiencing solid annual contract value growth. However, Pegasystems has displayed inconsistencies on the top line as a result of a messy model transition. We also see uncertainty around the company’s ability to meet its debt obligations in a rising rate environment, and the company was hit with a $2 billion legal judgment, which lessens our confidence that Pegasystems can generate the economic profits necessary to warrant a narrow economic moat rating.

Pegasystems operates in two categories of software: customer relationship management, or CRM, and business process management, or BPM. CRM solutions include marketing, customer services, and sales automation. Its low-code BPM solutions include robotic automation and case management software designed to work across multiple applications to create workflow connectivity. Both markets are broad and growing and feature a wide range of ever-increasing competitors. Management believes the company’s total addressable market is approximately $60 billion-$70 billion and will grow to over $100 billion in the coming years. For comparison, Pegasystems has posted revenue of north of $1 billion since fiscal 2020. While an opportunity this large implies a significant growth runway, we do not see the company’s growth materially outstripping the expansion of the underlying markets based on well-established competition.

Pegasystems’ foundation comes from BPM solutions that were adopted by enterprise customers for case management within customer service applications. Most notably, American Express was an early adopter of its software to automate processes within contact centers, such as providing the same user experience regardless of how the customer engages with the company, notifying supervisors automatically if approval is need for raising a credit limit, populating all data fields and alerting all necessary areas of the business when a new customer has been onboarded, among many other actions. Such seemingly simple and critical tasks may have initiated dozens of business processes across a variety of systems and were likely to even have involved the use of hard copies at one point.

In subsequent years, Pegasystems has transformed into a low or no-code application development platform. Key to Pegasystems’ software is that the solutions are conducted by the employee who is directly involved with the business process and controls the workflow automation, as opposed to an IT professional. The no-code platform enables the employee in charge of the workflow to drag and drop interfaces from a comprehensive library of existing code blocks to establish a set of rules for a specific process.

Over the years automation capabilities have been increasingly incorporated into modern business applications. For example, Salesforce famously reinvented the CRM as salesforce automation. For context, both ServiceNow and Salesforce boast no and low-code solutions, albeit for specific and more limited use cases than Pegasystems. We view competition for no and low-code applications to increase in quantity and quality as companies look to scale automated processes more efficiently. Pegasystems is the clear leader in no and low-code BPM with room to grow, in our opinion.

Within CRM, the largest competition is from CRM titan Salesforce and Microsoft, followed by other notable players such as Oracle, SAP, ServiceNow, Zendesk, and Atlassian among other smaller companies. While the BPM market has been flourishing since its inception and we expect it to continue to grow more than 10% annually, we believe CRM is the smaller opportunity for Pegasystems, as many applications have built in automation functionality for specific functions, such as customer relationship management, human resources, and marketing. There is significant overlap in the CRM and BPM landscape with competition from Microsoft, Salesforce, Oracle, ServiceNow, Atlassian, and others.

Customer switching costs are frequently associated with software companies, which we see as consistent with Pegasystems. One of the main factors driving switching costs is the direct time and expense of implementing a new software package while maintaining the existing platform. A large portion of Pegasystems’ customers are enterprise-size, and a major implementation is likely to involve a system integrator and can take several years. Additionally, there are indirect costs along those same lines, mainly lost productivity as customers move up a learning curve on the new system along with the distraction of users involved in the function where the change is occurring. Lastly, and perhaps most importantly, there is the operational risk, including loss of data during the changeover, project execution, and potential operational disruption. The more critical the function and the more touch points across an organization a software vendor has, the higher the switching costs will be.

While we see no difference with Pegasystems as to the presence of high customer switching costs, we view other operational mishaps and inconsistencies as outweighing any moatiness. To wit, historical returns on invested capital do not suggest that an economic moat is present. More important, as we look ahead, we see too high a frequency of business uncertainties—including a messy business model transition; looming debt obligations; and a $2 billion legal judgment awarded against Pegasystems, in favor of Appian—to have confidence that the core business can quickly rebound.

The recent history of poor adjusted returns on invested capital can largely be explained with Pegasystems’ model transition. Beginning in 2017, management changed the business model from a predominantly perpetual license to a software as a service, or SaaS, one, to avoid large quarterly swings in revenue and offer customers the cloud-based delivery users prefer. The transition artificially dampened revenue as well as margins, while increasing research and development expenses in tandem as Pegasystems had to port its products to the cloud. While the transition was messy, with a conclusion pushed out several times, we view the journey as being largely over.

While the engineering and financial impacts were challenging, we view the transition as a requirement for a modern software provider, especially as Pegasystems seeks to remain a leader in BPM and compete against its larger rivals. With the transition largely complete, we return a keen eye to its ability to grow annual contract value, which can face significant headwinds in periods of macrouncertainty when budgets are more highly scrutinized. This factor particularly pertains to Pegasystems, as it has one of the higher price points in the market. Even with existing customers, the firm may struggle to drive meaningful contract expansion with existing customers.

Additionally, Pegasystems lost its lawsuit brought on by Appian and faces a potentially catastrophic $2.036 billion in damages for trade secret misappropriation. Pegasystems is currently appealing the judgment and has maintained its innocence throughout proceedings. The full amount of damages represents a significant portion of Pegasystems’ market capitalization, and if the $2 billion judgment stands, Pegasystems could be forced into bankruptcy. Pegasystems is currently appealing the verdict and we have modeled a consequential $1 billion payout in 2026 financed entirely by an equity raise. We note there is significant uncertainty around the lawsuit but believe the conduct as damaging enough to have further uncertainty around how Pegasystems operates and its prospects. We also have a strong conviction that Pegasystems will need to access the capital markets soon simply to fund normal operations, further adding to its balance sheet uncertainty.

None

Economic Moat

Pegasystems

Pegasystems, Inc. engages in the development, market, license, and support of software, which allows organizations to build, deploy, and change enterprise applications. Its product Pega Infinity helps connect enterprises to their customers in real-time across channels, streamline business operations, and adapt to meet changing requirements. The company was founded by Alan Trefler in 1983 and is headquartered in Cambridge, MA.

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