Shares of Pegasystems (PEGA) have been on a steady path higher over the past year. So far this year, shares are up an impressive 116%, and are set to continue their run higher as the company continues to make a name for itself in automating business processes for corporations. In this particular niche, Pegasystems is number two in the market, behind only IBM (IBM). In the past eight years, the company has grown revenues 24% annually. Over the next five years, the company is forecast to grow earnings at a 25% annual clip.
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PegaRULES!
The company's PegaRULES Process Commander (PRPC) software provides a unified platform that enables customers to build enterprise applications in a fraction of the time it would take using the disjointed architectures offered by other software providers. This allows organizations to build, deploy, and change enterprise applications easily and quickly. It also eliminates the time and expense required to create lengthy policy manuals and system specifications by unifying business rules with business processes. The software delivers multi-channel, cross silo capabilities that bridge front and back-office, and is often used to rejuvenate legacy technology.
The PRPC applications are able to be deployed via the Pega Cloud or on premise. The company then utilizes frameworks that allow customers to customize their software to fit their unique needs. The integration of the PRPC and frameworks allows Pegasystems to target Business Process Management (BPM), Customer Relationship Market (CRM), Dynamic Case Management (DCM), and Decision Management software markets.
Another quarter, another big beat
Pegasystems crushed expectations in 3Q with a $0.16 beat on EPS. Revenues came in $5.47 million higher than expectations. Overall, revenues grew 22% Y/Y. This was driven by a 56.8% jump in licensing revenue. Pegasystems has beaten estimates in each of the last four quarters by a wide margin.
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So far this year, the company has delivered operating cash flow of $83.4 million. This is 187% higher than last year. Overall, net income for the first nine months of 2013 was $22.5 million, or $0.58 per diluted share, compared to net income of $1.5 million, or $0.04 per diluted share, for the first nine months of 2012.
The other notable move last quarter was Pegasystems' acquisition of Antenna Software in October. This puts Pegasystems in the fast-growing mobility market. In order for Pegasystems to compete, its applications must be prepared for multiple mobile platforms and more than 250 different screen sizes. The goal for any company is to deliver business software to any channel and with the Antenna acquisition, Pegasystems is one step closer to that goal. According to the company, a few key benefits to this acquisition include:
- Faster time-to-market and increased flexibility in end-to-end mobile application development
- Powerful mobile application and device management
- Mobile Backend-as-a-Service coupled with industry-leading BPM, case management, and advanced decisioning
- Proven expertise of two industry leaders in delivering enterprise solutions to a global clientele
Product innovation and partnerships drive market share gains
Even with the stock on a tear of late, there could still be further room to the upside. This comes as the company just released Pega 7. This is the latest major version upgrade of the company's unified model-driven platform. This new version should greatly improve ease-of-use for its customers as well as increase market share.
And thanks to this product innovation and superior products, Pegasystems has managed to partner with every major global system integrator and IT consulting firm. These strategic partnerships help boost sales and allow Pegasystems to be a core product offering. Its major partners include Accenture, Capgemini, Cognizant Technology, Infosys Technologies, PricewaterhouseCoopers, and Wipro. These industry leading partners, such as the management consulting leader, Accenture, and top accounting firm, PricewaterhouseCoopers, have given Pegasystems a new level of clout and "street cred" when it comes to growing its market share.
These market share gains were evident at the first Pega Developer Conference that was held last month in Hyderabad, India. This conference was oversold with over 1,700 attendees from 52 organizations to learn about Pega 7 software. On the company's earnings call, CEO Alan Trefler highlighted two responses heard at the event (emphasis ours).
"Here are 2 telling quotes from conference attendees. The head of a partner's global BPM practice said, "everyone here, their eyes are lighting up when they see what they're able to do with the new technology ." And from a customer Vice President, he said, "Pega 7 is going beyond boundaries. It's giving a different perspective to the development and building of applications ." These are representative of the comments we now hear about Pega 7, which brings speed and simplicity to the building of serious build business apps."
Broadening its horizons increases its addressable market
Pegasystems has thrust itself into the heart of a $30 billion market opportunity. Pega 7 and its solution frameworks allow the combination of Business Process Management, case management and various vertical application segments. Pegasystems is one of the few companies offer a combined solution and company's IT departments are realizing that they need to adapt to this changing market. According to CEO Alan Trefler:
"Both business and IT organizations know they need something different. But until now the enterprise software market definitions have not given them a name for this new requirement. Now we're seeing industry analysts, pundits, systems integration firms and customers asking aggressively for this new approach. Some call it "systems of differentiation." Some call it smart process applications. We can sometimes hear it referred to as dynamic case management through systems of agility. But regardless of the label, this confluence of market segments for a new type of business application is upon us. And increasingly, customers, partners and analysts are recognizing Pegasystems as the market leader and the best solution to this new emerging set of needs."
Thanks to this new combined solutions offering, Pegasystems is able to service many different industries. The company is seeing strong customer demand in:
- Telecommunications - Pega 7 improves order management and Next-Best-Action marketing improves efficiency and increases cross-sell capabilities.
- Healthcare - as these companies look to save money, Pega 7 allows health care companies to change their business practices based on new products, new processes and most important of all, the new regulations hitting healthcare companies from the Affordable Care Act.
- Financial services - allows financial firms to cut costs, streamline their operations, and facilitate transaction processing.
- Public sector - allows organizations on both the Federal and State levels to accomplish more with their lower budgets. In 3Q, Pegasystems got new contracts for licensing applications, citizen service delivery and exceptions management.
Overall, across all segments, the combination of business process automation, cross-channel customer experience, dynamic case management and verticals solutions really helps organizations improve agility and responsiveness. This is the core of what Pegasystems' software can accomplish.
Competition remains the greatest threat
The threat to Pegasystems' business is competition. The company competes with IBM, Oracle, SAP, Tibco Software, EMC, OpenText, Salesforce, Microsoft and many other software vendors in one way or another. Some of those are very large and resource-heavy (in terms of cash and ability to borrow) companies. In any case, CEO Alan Trefler summed up why he sees his company as more innovative than the larger competitors.
A big difference between us and Oracle and IBM - I call them the Frankenstack vendors because Frankenstein was the monster that was stitched together from many dead bodies and Frankenstack is products made up of many dead software companies. If you look under the cover, you will see some 15-20 products glued together. This culture of acquisition is very bad for innovation. Companies like Oracle, instead of innovating, became investment banks. They were innovative earlier, now they are just trying to buy up everything so the customer cannot escape.
Further debunking the worry of competitive pressures is Gartner's latest Magic Quadrant for the CRM Customer Engagement Center. In this Magic Quadrant, Pegasysems is behind only salesforce.com when it comes to the completeness of vision. Pegasystems is only one of three companies that's considered a leader in Gartner's Magic Quadrant. Pegasystems also outranks Oracle on both ability to execute and completeness of vision.
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Gartner goes on to say that "in the CRM space overall, Pegasystems has the best ability to model and predict a customer's behavior, create a workflow to support that customer, and to then associate the best action to execute with (and for) the customer." To help counter the competitive pressures, Pegasystems has invested a combined $197.2 million in R&D over the past three years. The company has a 740 employees working on R&D efforts.
The valuation is very appealing, suggesting 50% upside
In looking at shares of Pegasystems, we see several things we like. License backlog continues to grow. It has grown from $226 million last year to $268 million as of the end of September. The company's cash balance has grown at an even faster rate. In the past year, total cash has increased 69% to $188 million. Total cash per share is now $4.97. Pegasystems has no debt.
In looking at earnings, shares trades at 32x next year's earnings. With the company continuing to beat estimates, and the potential for the company to beat next year's EPS, we think its forward P/E is actually lower.
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Next year, the consensus is for EPS to come in at $1.50. We think this is low and forecast EPS to come in at $1.60 based on the company's strengths discussed above and its pattern of beating estimates. EPS of $1.60 puts its forward multiple at 30x. This is very reasonable considering the growth potential ahead for the company.
On the other hand, EPS could come in even higher with margin improvement. Current gross margin is 69% and operating margin is 12%. There is definite room for margin expansion heading into next year. In the base case, if we assume that next year's (2014) EPS comes in at $1.60, and we get no multiple expansion (45x current p/e), that's still nearly 50% upside to $70.
Prime beneficiary of the Affordable Care Act
We see Pegasystems as a key component to solving the issues related to the implementation of the Affordable Care Act. We all know that a main issue with the program has been the website and getting insured persons signed up. Pegasystems has successfully allowed Fallon Community Health Plan to implement and meet the requirements of the Affordable Care Act. According to the company (emphasis ours):
"By using Pega, FCHP was able to turn the October 1, 2013 federal deadline into an opportunity to improve business operations and provide better service . FCHP used Pega to help comply with ACA's mandates for member-level rating and execute Health Insurance Exchange requirements. They successfully exchanged HIPAA-based electronic information with the Massachusetts Health Connector within four months of selecting Pega, and released a new broker portal called QuoteNow, just one month later. While consumers across the country have experienced difficulties using sales and enrollment portals for the Federal Exchange, Healthcare.gov, FCHP has been accepting applications and enrolling members, since open enrollment officially started. QuoteNow streamlines health insurance application and enrollment activities, provides best practice quoting, rating and underwriting and offers many new features to FCHP's broker community."
Susan Taylor, Pegasystems' VP further added:
"The scope of the Affordable Care Act is so immense that the glitches which have arisen so far are not a surprise. Fallon Community Health Plan's approach, embracing Pega's technology to use the changes as an opportunity to help improve their business operations, has been brilliant. Fallon Community Health Plan embodies how an agile organization can adapt for growth when using the benefits of Pega."
As more health plans become aware of Pegasystems' solutions for implementation of the Affordable Care Act, we see Pegasystems signing up more health plans and growing its top- and bottom-lines. More health plan signups would cause us to raise our EPS estimate of $1.60 next year and provide further upside for shares.
Bottom line
Pegasystems is an undiscovered gem in the software space. Even though it has a market cap of $1.8 billion, there are only 4 analysts covering the stock. We think the lack of coverage keeps many institutions out of the stock. They simply are not aware of the company and its potential. Even we were surprised that there have only even been 2 articles on Seeking Alpha about Pegasystems.
Part of the explanation could be that 54% of the company is held by insiders. Average daily volume is only about 100k. The largest shareholder is Founder and CEO Alan Trefler. His 19.8 million share stake makes him a near billionaire. Most notable is that he is not on an automatic sell program and is holding onto his stake. Another billionaire that is invested in the company is Ken Fisher. His firm, Fisher Asset Management, has a 2% stake.
Overall, it's tough to argue with the results Pegasystems has posted and with a strong balance sheet and plenty of tailwinds ahead, we see shares continuing their up and to the right trajectory.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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