Pegasystems Earnings: ACV Speed Bump as Cash Flow Shines During Continued Cloud Transition

No-moat Pegasystems PEGA was in line with our top-line expectations for the second quarter, primarily driven by the strength of its Cloud business. Shares are down on the report given the sequential decline in annual contract value, or ACV, for which we struggle to recall a precedent throughout our experience. Management pointed to various contract changes, types of new contracts signed, and client churn as driving this anomaly. We consider this a red flag that can be removed next quarter with a return to normal linear progression in ACV. On the flip side, the company generated substantial free cash flow during the quarter which, once sequential ACV growth resumes, we assume investors will applaud. We maintain our fair value estimate of $52 per share given no material guidance update, macro headwinds fueled by uncertainty in customer budgets, and the ongoing litigation process with Appian. After the selloff, we view shares as fairly valued.

Second-quarter revenue grew 9% year over year to $298 million, predominantly driven by growth in Pega Cloud, which grew 23% year over year. We remain focused primarily on Pegasystems’ ACV and backlog instead of revenue, given the ongoing model transition. ACV grew 13% year over year, driven by Pega Cloud ACV at $499 million. Pega Cloud backlog also grew by 23% year over year and now makes up 68% of Pegasystems’ backlog.

Pegasystems produced a negative 1.4% non-GAAP operating margin in the quarter, compared with negative 19.2% a year ago, and below our expectations. Relatedly, we were impressed with the company’s substantial improvement of free cash flow generation, which was well above our expectations. Pegasystems generated $123 million in free cash flow in the first half of the year, compared with guidance of $150 million for the full year. We see continued signs of progress on the company’s march to Rule of 40, which examines the relationship between ACV growth and free cash flow margins.