10-K 1 d272610d10k.htm FORM 10-K Form 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT of 1934

For the fiscal year ended December 31, 2011

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT of 1934

Commission File No. 1-11859

 

 

PEGASYSTEMS INC.

(Exact name of Registrant as specified in its charter)

 

 

Massachusetts

(State or other jurisdiction of incorporation or organization)

(IRS Employer Identification No. 04-2787865)

 

101 Main Street

Cambridge, MA

  02142-1590
(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   Name of Each Exchange on Which Registered
Common Stock, $0.01 par value per share   NASDAQ Global Select Market

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act of 1933.    Yes  ¨    No  x

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes  ¨    No  x

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 and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post such files).    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  x

  Accelerated filer  ¨   Non-accelerated filer  ¨   Smaller reporting company  ¨
    (Do not check if a smaller reporting company)  

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The aggregate market value of the Registrant’s common stock held by non-affiliates of the Registrant based on the closing price (as reported by NASDAQ) of such common stock on the last business day of the Registrant’s most recently completed second fiscal quarter (June 30, 2011) was approximately $783 million.

There were 37,716,783 shares of the Registrant’s common stock, $0.01 par value per share, outstanding on February 20, 2012.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive proxy statement related to its 2012 annual meeting of stockholders to be filed subsequently are incorporated by reference into Part III of this report.


Table of Contents

TABLE OF CONTENTS

 

Item

        Page  
   PART I   

1

  

Business

     3   

1A

  

Risk Factors

     10   

1B

  

Unresolved Staff Comments

     15   

2

  

Properties

     15   

3

  

Legal Proceedings

     15   

4

  

Mine Safety Disclosures

     15   
   PART II   

5

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     16   

6

  

Selected Financial Data

     18   

7

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     19   

7A

  

Quantitative and Qualitative Disclosure about Market Risk

     41   

8

  

Financial Statements and Supplementary Data

     42   

9

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

     77   

9A

  

Controls and Procedures

     77   

9B

  

Other Information

     79   
   PART III   

10

  

Directors, Executive Officers, and Corporate Governance

     79   

11

  

Executive Compensation

     80   

12

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     80   

13

  

Certain Relationships and Related Transactions, and Director Independence

     83   

14

  

Principal Accounting Fees and Services

     83   
   PART IV   

15

  

Exhibits and Financial Statement Schedules

     83   
  

Signatures

     84   

 

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PART I

Forward-looking statements

This Annual Report on Form 10-K contains or incorporates forward-looking statements within the meaning of section 27A of the Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934. 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,” “project,” or variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. We have identified certain risk factors included in Item 1A of this Annual Report on Form 10-K that we believe could cause our actual results to differ materially from the forward-looking statements we make. We do not intend to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

 

ITEM 1. Business

Pegasystems Inc. was incorporated in Massachusetts in 1983. Our stock is traded on the NASDAQ Global Select Market under the symbol PEGA. Our Website address is www.pega.com. We are not including the information contained on our Website as part of, or incorporating it by reference into, this Annual Report on Form 10-K. Unless the context otherwise requires, references in this Annual Report on Form 10-K to “the Company,” “we,” “us” or “our” refer to Pegasystems Inc. and its subsidiaries.

Our business

We develop, market, and license software. We also provide implementation, consulting, training, and technical support services to help our customers maximize the business value they obtain from the use of our software.

Our PegaRULES Process Commander ® (“PRPC”) software provides a unified platform that includes all the necessary elements and technologies to build enterprise applications in a fraction of the time it would take using the disjointed architectures offered by our competitors. 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 in the software and automating the creation of system documentation. Our software delivers multi-channel, cross silo capabilities that bridge front and back-office, and is often used to rejuvenate legacy technology. Our customers use our software to improve their customer service and the customer experience, generate new business, and enhance productivity and profitability.

Our unified technology also allows customers to leverage existing technology investments and create and/or deploy their PRPC applications on premise or through an internet-based cloud computing model, using our Pega Cloud service offerings.

PRPC is complemented by software solutions that we refer to as frameworks. These frameworks provide purpose or industry-specific functionality that allows our customers to quickly implement and easily customize our software to suit their unique requirement.

The integrated capabilities of PRPC and our frameworks make us the leader in the Business Process Management (“BPM”) software market as well as a leader in Customer Relationship Management (“CRM”), Dynamic Case Management, and Decision Management software markets. We focus our sales efforts on target accounts, which are large companies or divisions within companies, and typically leaders in their industry. Our

 

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strategy is to sell initial licenses that are focused on a specific purpose or area of operations, rather than selling large enterprise licenses. A primary objective of this strategy is to have our customers quickly realize business value from our software. Once a customer has realized this initial value, we work with that customer to identify opportunities for follow-on sales. The sales process for follow-on sales is often shorter as a result of our established relationship with the customer. We invest resources in professional services, customer support, and customer and partner enablement to help our customers achieve success.

Our partners

We maintain alliances with global systems integrators and technology consulting firms that also provide consulting services to our customers. Strategic partnerships with technology consulting firms and systems integrators are important to our sales efforts because they influence buying decisions, help us to identify sales opportunities, and complement our software with their domain expertise and services capabilities. These partners may deliver strategic business planning, consulting, project management, and implementation services to our customers. Currently, our partners include well respected, major firms such as Accenture Ltd., Capgemini SA, Cognizant Technology Solutions Inc., Infosys Technologies Limited, Mahindra Satyam, Tata Consultancy Services Limited, International Business Machines Corporation (“IBM”), PricewaterhouseCoopers LLP, Virtusa Corporation, and Wipro Ltd.

Our products

Our primary software solutions are as follows:

PegaRULES Process Commander

PRPC provides a unified platform that includes all the necessary elements and technologies to build enterprise applications in a fraction of the time it would take using our competitors’ products. These elements, which include the direct capture of business objectives, automating programming, reporting, predictive analytics and decisioning, dynamic case management, mobile device access, dynamically generated user interface, process automation, business rules, social media technologies and automating work, are all part of our integrated architecture. 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 in the software and automating the creation of system documentation. Our software is standards-based and can leverage existing technology investments to create new business applications that cross technology silos. Our customers use our software and services to improve their customer service and experience, generate new business, and enhance organizational effectiveness and productivity, which can optionally be created and/or deployed on the cloud using our Pega Cloud service offerings.

Solution Frameworks

We also offer purpose or industry-specific solution frameworks built on the capabilities of our PRPC software. These frameworks allow organizations to quickly implement new customer-facing practices and processes, bring new offerings to market, and provide customized or specialized processing to meet the needs of different customers, departments, geographies or regulatory requirements

Pega CRM

Pega CRM software offers a process-driven, customer-centric business solution in order to optimize the customer experience while reducing costs. The capabilities within Pega CRM automate customer service

 

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inquiries and marketing and apply analytics to predict and adapt customer service processes, which result in the delivery of a personalized customer interaction.

Pega Decision Management

Our decision management products and capabilities are designed to manage processes so that all actions optimize the outcome based on business objectives. Pega Decision Strategy Manager and Next-Best-Action Advisor support cross-channel decision-making for offer management, risk, and other marketing and customer management solutions that optimize customer lifetime value. Our Pega frameworks for cross-sell/up-sell, retention, and collections help marketing professionals build and deploy decision making solutions quickly, while predictive and adaptive analytics support creation and improvement of decision models for outstanding operational performance.

Pega Cloud ®

Pega Cloud is Pegasystems’ service offering that allows customers to create and/or run Pega applications using an Internet-based infrastructure. This offering enables our customers to rapidly build, test, and deploy their applications in a secure cloud environment, while minimizing their infrastructure and hardware costs.

Our services and support

We offer services and support through our professional services group, customer support group, and our training services group. We also utilize third party contractors to assist us in providing services.

Professional services

Our professional services group helps companies and partners implement our software. This enables us to guide our customers through deployment of our software. Many of our customers choose to engage our professional services group for augmentation and expert services to expand their use of our software to additional business or product lines or automate additional processes within existing solutions. In addition, systems integrators and consulting firms, with which we have alliances, also help our customers deploy our products.

Customer support

Our customer support group is responsible for support of our software deployed at customer sites when customer support has been purchased. Support services include automated problem tracking, prioritization and escalation procedures, periodic preventive maintenance, documentation updates, and new software releases.

Training services

The success of our sales strategy for multiple follow-on sales to target customers depends on our ability to train a larger number of partners and customers to implement our technology. We offer training for our staff, customers, and partners. Training is offered at our regional training facilities in Cambridge, Massachusetts, Bedford, New Hampshire, Reading, England, Hyderabad, India, Sydney, Australia, at third party facilities in numerous other locations, and at customer sites. Beginning in 2012, we will also be offering training online through Pega Academy, which will present new ways to learn our software quickly and easily. We expect that the online training will help expand the number of trained experts at a faster pace. Our courses are designed to meet the specific requirements of process architects, system architects, and system administrators.

 

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Our markets and representative customers

Our target customers are large, industry-leading organizations faced with managing transaction intensive, complex and changing processes that seek the agility needed for growth, productivity, customer retention, and compliance. Our customers have typically been large companies in the financial services, healthcare, insurance, government, and communications and media markets. We are expanding our customer base to a broader range of companies within those markets as well as to a broader range of industries, such as manufacturing, energy, travel and entertainment.

Financial services

Financial services organizations require software to improve the quality, accuracy, and efficiency of customer interactions and transactions processing. Pegasystems’ customer process and exceptions management products allow customers to be responsive to changing business requirements. Representative financial services customers of ours include: American Express Company, BBVA Bancomer S.A., BNP Paribas, Citigroup Inc., Charles Schwab Corporation, HSBC Holdings Plc, ING Bank, JP Morgan Chase, MasterCard Worldwide, National Australia Bank Limited, RBC Financial Group, and Toronto-Dominion Bank.

Healthcare

Healthcare organizations seek products that integrate their front and back office initiatives and help drive customer service, efficiency, and productivity. Representative healthcare customers of ours include: Aetna Inc., Amerigroup Corporation, more than 60 percent of the members of the Blue Cross Blue Shield network, Highmark, Medco Health Solutions, Inc., Tenet Healthcare Corporation, United Healthcare Services, Inc., and ViPS/WebMD.

Insurance

Insurance companies, whether competing globally or nationally for customers and channels, need software to automate the key activities of policy rating, quoting, customization, underwriting, and servicing as well as products that improve customer service and the overall customer experience. Representative insurance industry customers of ours include: American National Insurance Group, CARDIF, Chartis, Farmers Insurance Group of Companies, John Hancock Life Insurance Co., Wesfarmers, and Zurich North America.

Communications and Media

Communications and media organizations need to address high levels of customer churn, growing pressure to increase revenue and an ability to respond quickly to changing market conditions. Pega’s unique ability to put the power of innovation into the hands of the business enables organizations to reshape the way they interact with customers, streamline operations and bring new services and products to market. Representative communications and media customers of ours include: Vodafone, Orange, O2, Deutsche Telekom and Cox Communications.

Government

Government agencies need to modernize legacy systems and processes to meet the growing demands for improved constituent service, lower costs and greater levels of transparency. Pegasystems offers a proven, economical and highly effective solution that delivers advanced capabilities to streamline application development and delivery. Representative public sector clients include the State of Texas, ViPS, the FDIC, the Centers for Medicare and Medicaid Services (CMS), and CSC.

 

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Other industries

PRPC offers solutions to a broad range of companies and industries. For example, we sell our BPM technology to customers in energy, life sciences, manufacturing, and travel services. Customers include: Baxter International Inc., Bristol Myers Squibb, ConEdison, Carnival Cruise Lines, GE Energy, Jabil, Novartis International AG, and The British Airport Authority.

Competition

We compete in the BPM, Case Management, CRM, and Decision Management software markets. These markets are intensely competitive, rapidly changing, and highly fragmented, as current competitors expand their product offerings and new companies enter the market. Competitors vary in size and in the scope and breadth of the products and services offered. We encounter competition from:

 

   

BPM vendors including Service-Oriented Architecture (“SOA”) middleware vendors IBM, Oracle Corporation, Software AG, and Tibco Software Inc., and other BPM vendors such as Appian Corporation and the Savvion division of Progress Software;

 

   

Case Management vendors such as the Documentum division of EMC Corporation, the FileNet division of IBM’s Information Management Group, and the BPM/Case Management division of OpenText (following its acquisition of Metastorm and Global 360);

 

   

CRM application vendors such as the Siebel division of Oracle, the Microsoft Dynamics CRM division of Microsoft, and Salesforce.com;

 

   

Decision Management vendors including Business Rules Engine vendors such as the ILOG division of IBM, and the Blaze division of FICO, and vendors of solutions that leverage predictive analytics in managing customer relationships including the Unica Division of IBM;

 

   

Companies that provide application specific software for the financial services, healthcare, insurance and other specific markets such as Guidewire Software, Inc., the Detica NetReveal Division of BAE, SmartStream Technologies Ltd., SunGard, SAP, and The TriZetto Group, Inc.; and

 

   

Current customers’ information technology departments, which may seek to modify their existing systems or develop their own proprietary systems.

We have been most successful competing for customers whose businesses are characterized by a high degree of change, complexity, and size. We believe that the principal competitive factors within our market include:

 

   

Product adaptability, scalability, functionality, and performance;

 

   

Proven success in delivering cost-savings and efficiency improvements;

 

   

Ease-of-use for developers, business units, and end-users;

 

   

Timely development and introduction of new products and product enhancements;

 

   

Establishment of a significant base of reference customers;

 

   

Ability to integrate with other products and technologies;

 

   

Customer service and support;

 

   

Product price;

 

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Vendor reputation; and

 

   

Relationships with systems integrators.

We believe we compete favorably with our competitors on the basis of these competitive factors as our unified Build for Change® technology allows both client business and IT staff, using a single, browser-based user interface, to build enterprise applications in a fraction of the time it would take with the types of disjointed architectures and tools offered by our competitors. We believe we also compete favorably due to our expertise in our target industries and our long-standing customer relationships. We believe we compete less favorably on the basis of some of these factors with respect to our larger competitors, many of which have greater sales, marketing and financial resources, more extensive geographical presence and greater name recognition than we do. In addition, we may be at a disadvantage with respect to our ability to provide expertise outside our target industries.

Sales and marketing

We market our software and services primarily through a direct sales force. Strategic partnerships with consultants and systems integrators are important to our sales efforts because they influence buying decisions, help us to identify sales opportunities, and complement our software with their domain expertise and professional services capabilities.

To support our sales efforts, we conduct a broad range of marketing programs, including targeted solution campaigns, industry trade shows, including our PegaWORLD user conference, solution seminars, industry analyst and press relations, Web marketing, community development, social media, and other direct and indirect marketing efforts. Our consulting staff, business partners, and other third parties also conduct joint and separate campaigns that generate sales leads.

Sales by geography

In 2011, 2010, and 2009, sales to customers based outside of the United States of America (“U.S.”) represented approximately 48%, 41%, and 34%, respectively, of our total revenue. We currently operate in one operating segment — Business Process Solutions. We derive substantially all of our operating revenue from the sale and support of one group of similar products and services. Substantially all of our assets are located within the U.S. See Note 18 “Geographic Information and Major Customers” included in the notes to the accompanying audited consolidated financial statements for further detail.

Research and development

Our development organization is responsible for product architecture, core technology development, product testing, and quality assurance. Our product development priority is to continue expanding the capabilities of our integrator technology. We intend to maintain and extend the support of our existing solution frameworks, and we may choose to invest in additional frameworks which incorporate the latest business innovations. We also intend to maintain and extend the support of popular hardware platforms, operating systems, databases, and connectivity options to facilitate easy and rapid deployment in diverse information technology infrastructures. Our goal with all of our products is to enhance product capabilities, ease of implementation, long-term flexibility, and the ability to provide improved customer service.

During 2011, 2010, and 2009, research and development expenses were approximately $65.3 million, $55.2 million, and $38.9 million, respectively. We expect that we will continue to commit significant resources to our product research and development in the future to maintain our leadership position.

 

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Employees

As of January 31, 2012, we had 1,858 employees worldwide, of which 1,104 were based in the U.S., 346 were based in Europe, 316 were based in India, 33 were based in Australia, 30 were based in Canada and 29 were based in Asia. Our total headcount includes 633 consulting and customer support employees, 474 sales and marketing employees, 537 research and development employees, and 214 administrative employees. In addition, we augmented our research and development and professional services employees with approximately 230 contractors.

Backlog of license, maintenance, and professional services

As of December 31, 2011, we had software license, maintenance, and professional services agreements with customers expected to result in approximately $359.8 million of future revenue, of which we expect approximately $184.8 million to be recognized in 2012. As of December 31, 2010, we had backlog of software license, maintenance, and professional services agreements with customers of approximately $232.1 million. Under some of these agreements, we must fulfill certain conditions prior to recognizing revenue, and there can be no assurance when, if ever, we will be able to satisfy all such conditions in each instance. Business conditions could change and, therefore, backlog may not be a reliable indicator of future financial performance.

Available Information

We make available free of charge through our Website www.pegasystems.com our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and amendments to these reports, as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission (“SEC”). The SEC maintains a Website that contains reports, proxy, and information statements and other information regarding issuers that file electronically with the SEC at www.sec.gov. We make available on our Website reports filed by our executive officers and Directors on Forms 3, 4, and 5 regarding their ownership of our securities. Our Code of Conduct, and any amendments to our Code of Conduct, is also available on our Website.

 

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ITEM 1A. RISK FACTORS

The following important factors could cause our actual business and financial results to differ materially from those contained in forward-looking statements made in this Annual Report on Form 10-K or elsewhere by management from time to time.

Factors relating to our financial results

The number of our license arrangements has been increasing, and we may not be able to sustain this growth unless we and our partners can provide sufficient high quality professional services, training, and maintenance resources to enable our customers to realize significant business value from our software. Our customers typically request professional services and training to assist them in implementing our products. Our customers also purchase maintenance on our products in almost all cases. As a result, an increase in the number of license arrangements is likely to increase demand for professional services, training, and maintenance relating to our products. Given that the number of our license arrangements has been increasing, we will need to provide our customers with more professional services, training, and maintenance to enable our customers to realize significant business value from our software. Accordingly, we have been hiring additional personnel in these areas and improving our “on-boarding” process to ramp up new personnel in a shorter period of time. We have also been increasingly enabling our partners and customers through training to create an expanded universe of people that are skilled in the implementation of our products. However, if we and our partners are unable to provide sufficient high quality professional services, training, or maintenance resources to our customers, our customers may not realize sufficient business value from our products to justify follow-on sales, which could impact our future financial performance. In addition, the growth required to meet the increased demand for our professional services could strain our ability to deliver our services engagements at desired levels of profitability, thereby impacting our overall profitability and financial results.

We frequently enter into limited scope initial licenses with new customers, which could adversely affect our financial performance if we are not successful in obtaining follow-on business from these customers. We frequently enter into initial licenses with our new customers that are focused on a specific purpose or area of operations, rather than selling large enterprise licenses, to allow these new customers to realize business value from our software quickly and for a limited initial investment. Once a customer has realized this initial value, we work with the customer to identify opportunities for follow-on sales. However, we may not be successful in demonstrating this initial value to some customers, for reasons relating to the performance of our products, the quality of the services and support we provide for our products, or external reasons. For these customers, we may not obtain follow-on sales or the follow-on sales may be delayed, and our license revenue will be limited to the smaller initial sale. This could lower the total value of all transactions and adversely affect our financial performance.

Our professional services revenue is dependent to a significant extent on closing new license transactions with customers. We derive a substantial portion of our professional services revenue from implementation of new software licenses with our customers. Accordingly, it is imperative that we close more license transactions with our customers if we are to maintain or grow our services revenue.

If we are unable to maintain vendor specific objective evidence (“VSOE”) of fair value of our professional services arrangements, we may be required to delay a portion of our revenue to future periods. We have established VSOE of fair value of our professional services in North America and Europe, other than Spain, based on the price charged when these services are sold separately. The weakened economy and significant competition within our industry have created pricing pressure on professional services provided by technology companies. If we elect to discount our professional services pricing or otherwise introduce variability in our professional services arrangements to attract or retain customers, this could lead to an insufficient number of consistently priced professional services arrangements for us to maintain VSOE. If we do not have VSOE of fair value of our professional services, we may be required to recognize all revenue for these professional

 

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services arrangements, including any related license, maintenance, and other services revenue if the professional services are bundled in an arrangement, ratably over the longer of the software maintenance period or the service period.

The timing of our license revenue is difficult to predict accurately, which may cause our quarterly operating results to vary considerably. A change in the number or size of high value license arrangements, or a change in the mix between perpetual licenses, term licenses, and Pega Cloud subscriptions can cause our revenues to fluctuate materially from quarter to quarter. Our decision to enter into term licenses and Pega Cloud subscriptions that require the revenue to be recognized over the license term may adversely affect our profitability in any period due to sales commissions being paid at the time of signing and the corresponding revenue being recognized over time. We budget for our selling and marketing, product development, and other expenses based on anticipated future revenue. If the timing or amount of revenue fails to meet our expectations in any given quarter, our financial performance is likely to be adversely affected because only small portions of expenses vary with revenue. As a result, period-to-period comparisons of our operating results are not necessarily meaningful and should not be relied upon to predict future performance.

Our financial results may be adversely affected if we are required to change certain estimates, judgments, and positions relative to our income taxes. In the ordinary course of conducting a global business enterprise, there are many transactions and calculations undertaken whose ultimate tax outcome cannot be certain. Some of these uncertainties arise as a consequence of positions we have taken regarding valuation of deferred tax assets, transfer pricing for transactions with our subsidiaries, and potential challenges to nexus and tax credit estimates. We estimate our exposure to unfavorable outcomes related to these uncertainties and estimate the probability for such outcomes. Future realization of our deferred tax assets ultimately depends on the existence of sufficient taxable income within the available carryback or carryforward periods. We record a valuation allowance to reduce our deferred tax assets to an amount we believe is more likely than not to be realized. If our taxable income is not consistent with our expectations or the timing of income is not within the applicable carryforward period, we may be required to establish a valuation allowance on all or a portion of these deferred tax assets. Changes in our valuation allowance impact income tax expense in the period of adjustment. Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome of these matters or our current estimates regarding these matters 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, unfavorable or favorable, on our income tax provisions, require us to change the recorded value of deferred tax assets, and adversely affect our financial results.

We are investing heavily in sales and marketing and professional services in anticipation of a continued increase in license arrangements, and we may experience decreased profitability or losses if we are unsuccessful in increasing the value of our license arrangements in the future. We have been increasing our investment in sales and marketing to meet increasing demand for our software by hiring additional sales and marketing personnel. We anticipate that we will need to provide our customers with more professional services, training, and maintenance as a result of this increase in demand, and have been hiring additional personnel in these areas. These investments have resulted in increased fixed costs that do not vary with the level of revenue. If the increased demand for our products does not continue, we could experience decreased profitability or losses as a result of these increased fixed costs.

Factors relating to our products and markets

The continued weakness in the U.S and international economies may negatively impact our sales to, and the collection of receivables from, our financial services and insurance customers and possibly our customers in other industries. Our sales to, and our collection of receivables from, our customers may be impacted by adverse changes in global economic conditions, especially in the U.S., Europe and Asia Pacific. In the past few years, these regions have experienced instability in financial markets, tightening credit, and weak overall economic conditions, which has impacted the financial services and insurance industries in particular. These trends could

 

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impact the ability and willingness of our financial services and insurance customers, and possibly our customers in other industries, to make investments in technology, which may delay or reduce the amount of purchases of our software and professional services. These factors could also impact the ability and willingness of these customers to pay their trade obligations and honor their contractual commitments under their non-cancellable term licenses. These customers may also become subject to increasingly restrictive regulatory requirements, which could limit or delay their ability to proceed with new technology purchases. Our financial services and insurance customers as a group represent a significant amount of our revenues and receivables. Accordingly, their potential financial instability could negatively impact our business, operating results, and financial condition.

We will need to acquire or develop new products, evolve existing ones, and adapt to technology change. Technical developments, customer requirements, programming languages, and industry standards change frequently in our markets. As a result, success in current markets and new markets will depend upon our ability to enhance current products, to acquire or develop and introduce new products that meet customer needs, keep pace with technology changes, respond to competitive products, and achieve market acceptance. Product development requires substantial investments for research, refinement, and testing. There can be no assurance that we will have sufficient resources to make necessary product development investments. We may experience difficulties that will delay or prevent the successful development, introduction, or implementation of new or enhanced products. Inability to introduce or implement new or enhanced products in a timely manner would adversely affect future financial performance.

The market for our offerings is intensely and increasingly competitive, rapidly changing, and highly fragmented. The market for BPM software and related implementation, consulting, and training services is intensely competitive, rapidly changing and highly fragmented. We currently encounter significant competition from internal information systems departments of potential or existing customers that develop custom software. We also compete with large technology companies such as IBM, Oracle and SAP, companies that target the customer interaction and workflow markets, companies focused on business rules engines or enterprise application integration, “pure play” BPM companies, industry-specific application vendors, and professional service organizations that develop custom software in conjunction with rendering consulting services. Competition for market share and pressure to reduce prices and make sales concessions are likely to increase. Many competitors have far greater resources and may be able to respond more quickly and efficiently to new or emerging technologies, programming languages or standards or to changes in customer requirements or preferences. Competitors may also be able to devote greater managerial and financial resources to develop, promote, and distribute products and provide related consulting and training services. There has been recent consolidation in the BPM market whereby larger companies such as IBM, Oracle, OpenText and Progress Software have acquired companies that provide BPM software, which we expect will further increase competition. There can be no assurance that we will be able to compete successfully against current or future competitors or that the competitive pressures faced by us will not materially adversely affect our business, operating results, and financial condition.

We have historically sold to the financial services, insurance and healthcare markets, and rapid changes or consolidation in these markets could affect the level of demand for our products. We have historically derived a significant portion of our revenue from customers in the financial services, insurance, and healthcare markets, and sales to these markets are important for our future growth. Competitive pressures, industry consolidation, decreasing operating margins, regulatory changes, and privacy concerns affect the financial condition of our customers and their willingness to buy. In addition, customers’ purchasing patterns in these industries for large technology projects are somewhat discretionary. The financial services and insurance markets are undergoing intense domestic and international consolidation and financial turmoil, and consolidation has been occurring in the healthcare market. Consolidation may interrupt normal buying behaviors and increase the volatility of our operating results. In recent years, several of our customers have been merged or consolidated, and we expect this to continue in the near future. Future mergers or consolidations may cause a decline in revenues and adversely affect our future financial performance. All of these factors affect the level of demand for our products from customers in these industries, and could adversely affect our business, operating results and financial condition.

 

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We rely on certain third-party relationships. We have a number of relationships with third parties that are significant to sales, marketing and support activities, and product development efforts. We rely on software and hardware vendors, large system integrators, and technology consulting firms to provide marketing and sales opportunities for the direct sales force and to strengthen our products through the use of industry-standard tools and utilities. We also have relationships with third parties that distribute our products. There can be no assurance that these companies, most of which have significantly greater financial and marketing resources, will not develop or market products that compete with ours in the future or will not otherwise end or limit their relationships with us.

We face risks from operations and customers based outside of the U.S. Sales to customers located outside of the U.S. represented approximately 48% of our total revenue in 2011, 41% of our total revenue in 2010, and 34% of our total revenue in 2009. We, in part through our wholly owned subsidiaries, market products and render consulting and training services to customers based outside of the U.S. including, for example, customers based in Canada, the United Kingdom, France, Germany, Spain, Italy, the Netherlands, Belgium, Switzerland, Austria, Ireland, Finland, Hungary, Poland, Sweden, Turkey, Russia, Mexico, Australia, China, Hong Kong, and Singapore. We have established offices in Canada, Europe, Asia and Australia. We believe that growth will necessitate expanded international operations, requiring a diversion of managerial attention and increased costs. We anticipate hiring additional personnel to accommodate international growth, and we may also enter into agreements with local distributors, representatives, or resellers. If we are unable to do one or more of these things in a timely manner, our growth, if any, in our foreign operations may be restricted, and our business, operating results, and financial condition could be materially and adversely affected.

In addition, there can be no assurance that we will be able to maintain or increase international market demand for our products. Several of our international sales are denominated in U.S. dollars. Accordingly, any appreciation of the value of the U.S. dollar relative to the currencies of those countries in which we sell our products may place us at a competitive disadvantage by effectively making our products more expensive as compared to those of our competitors. Additional risks inherent in our international business activities generally include unexpected changes in regulatory requirements, increased tariffs and other trade barriers, the costs of localizing products for local markets and complying with local business customs, longer accounts receivable patterns and difficulties in collecting foreign accounts receivable, difficulties in enforcing contractual and intellectual property rights, heightened risks of political and economic instability, the possibility of nationalization or expropriation of industries or properties, difficulties in managing international operations, potentially adverse tax consequences (including restrictions on repatriating earnings and the threat of “double taxation”), increased accounting and internal control expenses, and the burden of complying with a wide variety of foreign laws. There can be no assurance that one or more of these factors will not have a material adverse effect on our foreign operations, and, consequentially, our business, operating results, and financial condition.

We are exposed to fluctuations in currency exchange rates that could negatively impact our financial results and cash flows. Because a significant portion of our business is conducted outside the U.S., we face exposure to adverse movements in foreign currency exchange rates. These exposures may change over time as business practices evolve, and they could have a material adverse impact on our financial results and cash flows. Our international sales have increasingly become denominated in foreign currencies. The operating expenses of our foreign operations are primarily denominated in foreign currencies, which partially offset our foreign currency exposure. Our U.S. operating company invoices most of our foreign customers in foreign currencies, so it holds cash and receivables valued in these foreign currencies, which are subject to foreign currency transaction gains or losses. A decrease in the value of foreign currencies, particularly the British pound and the Euro relative to the U.S. dollar, could adversely impact our financial results and cash flows.

 

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Factors relating to our internal operations and potential liabilities

We depend on certain key personnel, and must be able to attract and retain qualified personnel in the future. The business is dependent on a number of key, highly skilled technical, managerial, consulting, sales, and marketing personnel, including our Chief Executive Officer. The loss of key personnel could adversely affect financial performance. We do not have any significant key-man life insurance on any officers or employees and do not plan to obtain any. Our success will depend in large part on the ability to hire and retain qualified personnel. The number of potential employees who have the extensive knowledge of computer hardware and operating systems needed to develop, sell, and maintain our products is limited, and competition for their services is intense, and there can be no assurance that we will be able to attract and retain such personnel. If we are unable to do so, our business, operating results, and financial condition could be materially adversely affected.

We may experience significant errors or security flaws in our product and services, and could face privacy, product liability and warranty claims as a result. Despite testing prior to their release, software products frequently contain errors or security flaws, especially when first introduced or when new versions are released. Errors in our software products could affect the ability of our products to work with other hardware or software products, or could delay the development or release of new products or new versions of products. The detection and correction of any security flaws can be time consuming and costly. Errors or security flaws in our software could result in the inadvertent disclosure of confidential information or personal data relating to our customers, employees, or third parties. Software product errors and security flaws in our products or services could expose us to privacy, product liability and warranty claims as well as harm our reputation, which could impact our future sales of products and services. Our license agreements typically contain provisions intended to limit the nature and extent of our risk of product liability and warranty claims. There is a risk that a court might interpret these terms in a limited way or could hold part or all of these terms to be unenforceable. Also, there is a risk that these contract terms might not bind a party other than the direct customer. Furthermore, some of our licenses with our customers are governed by non-U.S. law, and there is a risk that foreign law might give us less or different protection. Although we have not experienced any material product liability claims to date, a product liability suit or action claiming a breach of warranty, whether or not meritorious, could result in substantial costs and a diversion of management’s attention and our resources.

We face risks related to intellectual property claims or appropriation of our intellectual property rights. We rely primarily on a combination of copyright, trademark and trade secrets laws, as well as confidentiality agreements to protect our proprietary rights. We have obtained patents from the U.S. Patent and Trademark Office relating to the architecture of our systems. We cannot assure that such patents will not be invalidated or circumvented or that rights granted thereunder or the claims contained therein will provide us with competitive advantages. Moreover, despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain the use of information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the U.S. There can be no assurance that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology.

There can be no assurance that third parties will not claim infringement by us with respect to current or future products. Although we attempt to limit the amount and type of our contractual liability for infringement of the proprietary rights of third parties, these limitations often contain certain exclusions, and we cannot be assured that these limitations will be applicable and enforceable in all cases. Even if these limitations are found to be applicable and enforceable, our liability to our customers for these types of claims could be material in amount given the size of certain of our transactions. We expect that software product developers will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays, or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could have a material adverse effect upon our business, operating results, and financial condition.

 

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If our security measures are breached and/or unauthorized access is obtained to a customer’s confidential information from our cloud computing service offering, we may be exposed to significant legal and financial liabilities. Our cloud computing service offering allows customers to create and run PRPC-based applications using an internet-based infrastructure. This offering involves the hosting of customers’ applications which may contain confidential information, including personal and financial data regarding their end customers on the servers of a third-party technology provider. We also rely on third party systems including encryption, virtualized infrastructure and support. Because we do not control the transmissions between our customers and our third-party infrastructure providers, the processing of data on the servers of the third-party technology providers, or the internal controls maintained by the third-party technology providers that could prevent unauthorized access and provide appropriate data encryption, we cannot ensure the complete integrity or security of such transmissions, data or processing. Our security measures may be breached as a result of third-party action, including intentional misconduct by computer hackers, system error, human error or otherwise. Because the techniques used to obtain unauthorized access or to sabotage systems change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. While we have invested in the protection of our customers’ data to reduce these risks, there can be no assurance that our efforts will prevent breaches in our systems. Security breaches could expose us and our customers to a risk of loss or misuse of this information. Any security breach could result in a loss of confidence in the security of our service, damage our reputation, disrupt our business, lead to legal liability and negatively impact our future sales. We carry data breach insurance coverage to potentially mitigate the financial impact of such potential legal liability.

The acquisition of other businesses and technologies may present new risks. We have undertaken a significant acquisition during the past two years and may continue to evaluate and consider other potential strategic transactions, including acquisitions of businesses, technologies, services, products and other assets in the future. These acquisitions, if undertaken, may involve significant new risks and uncertainties, including distraction of management attention away from our current business operations, insufficient new revenue to offset expenses, inadequate return on capital, integration challenges, new regulatory requirements, and issues not discovered in our due diligence process. No assurance can be given that such acquisitions will be successful and will not adversely affect our profitability or operations.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

 

ITEM 2. Properties

Our principal administrative, sales, marketing, support, and research and development operations are located at 101 Main Street, Cambridge, Massachusetts in an approximately 105,000 square foot leased facility. The lease for this facility expires in 2013. We expect all of these functions will move to One Charles Park and One Rogers Street, Cambridge, Massachusetts, in the second half of 2012, where our leases for approximately 163,000 square feet expire in 2023, subject to our option to extend for two additional five-year periods. We also lease space for our other offices in the U.S., Australia, Canada, India, the United Kingdom and in other European and Asian countries under leases that expire at various dates through 2020. We believe that additional or alternative space will be available as needed in the future on commercially reasonable terms.

 

ITEM 3. Legal Proceedings

None.

 

ITEM 4. Mine Safety Disclosures

Not applicable.

 

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PART II

 

ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information

Our common stock is quoted on the NASDAQ Global Select Market (“NASDAQ”) under the symbol “PEGA.” The following table sets forth the range of high and low sales prices of our common stock on NASDAQ for each quarter in the years ended December 31:

 

     Common Stock Price  
     2011      2010  
     High      Low      High      Low  

First Quarter

   $ 41.15       $ 30.82       $ 39.65       $ 32.25   

Second Quarter

   $ 47.14       $ 34.30       $ 39.66       $ 26.33   

Third Quarter

   $ 47.55       $ 30.54       $ 33.94       $ 20.36   

Fourth Quarter

   $ 40.67       $ 26.87       $ 37.81       $ 23.92   

Holders

As of February 10, 2012, we had approximately 36 stockholders of record and approximately 29,200 beneficial owners of our common stock.

Dividends

In July 2006, we began paying a quarterly cash dividend of $0.03 per share of common stock. Quarterly cash dividends are expected to continue at $0.03 per share to stockholders of record as of the first trading day of each quarter, subject to change or elimination at any time by our Board of Directors.

Issuer Purchases of Equity Securities

The following table sets forth information regarding our repurchases of our common stock during the fourth quarter of 2011.

 

Period

   Total Number
of Shares
Purchased
     Average Price
Paid per
Share
     Total Number of
Shares
Purchased as Part
of Publicly
Announced Share
Repurchase
Program (1)
     Approximate Dollar
Value of Shares That
May Yet Be  Purchased
Under Publicly
Announced Share
Repurchased Programs (1)
(in thousands)
 

10/1/11 – 10/31/11

     7,405       $ 32.54         7,405       $ 9,454   

11/1/11 – 11/30/11

     24,904         29.57         24,904         14,308   

12/1/11 – 12/31/11

     11,624         29.74         11,624         13,963   
  

 

 

          

Total

     43,933       $ 30.12         
  

 

 

          

 

(1)

Since 2004, our Board of Directors has approved stock repurchase programs that have authorized the repurchase, in the aggregate, up to $86.3 million of our common stock. On November 9, 2011, we announced that our Board of Directors approved a $5.6 million increase in the remaining funds available under the program expiring on December 31, 2011, and an extension of the expiration date to December 31, 2012. Under this program, purchases may be made from time to time on the open market or in privately

 

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  negotiated transactions. Shares may be repurchased in such amounts as market conditions warrant, subject to regulatory and other considerations. We have established a pre-arranged stock repurchase plan, intended to comply with the requirements of Rule 10b5-1 under the Securities Exchange Act of 1934, as amended, and of Rule 10b-18 of the Exchange Act (the “10b5-1 Plan”). All share repurchases under the Current Program during closed trading window periods will be made pursuant to the 10b5-1 Plan.

Stock Performance Graph and Cumulative Total Stockholder Return

The following performance graph represents a comparison of the cumulative total stockholder return (assuming the reinvestment of dividends) for a $100 investment on December 31, 2006 in our common stock, the Total Return Index for the NASDAQ Composite (“NASDAQ Composite”), a broad market index, and the Standard & Poors (“S&P”) North Software-Software Index™ (“S&P NSSI”), a published industry index. We paid dividends of $0.12 per share during 2011, 2010, 2009, 2008, and 2007. The graph lines merely connect measurement dates and do not reflect fluctuations between those dates.

 

LOGO

 

             
     12/31/2006     12/31/2007     12/31/2008     12/31/2009     12/31/2010     12/31/2011  

Pegasystems Inc.

  $ 100.00      $ 122.60      $ 128.33      $ 354.64      $ 383.50      $ 308.81   

NASDAQ Composite

  $ 100.00      $ 110.65      $ 66.42        $96.54      $ 114.06      $ 113.16   

S&P NSSI

  $ 100.00      $ 116.24      $ 71.83        $106.24      $ 132.96      $ 123.85   

 

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ITEM 6. Selected Financial Data

The selected financial data presented below has been derived from our audited consolidated financial statements. This data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, the consolidated financial statements and accompanying notes.

 

     Year Ended December 31,  
             2011                      2010                     2009                      2008                      2007          
     (in thousands, except per share amounts)  

Consolidated Statements of Operations Data:

             

Total revenue

   $ 416,675       $ 336,599      $ 264,013       $ 211,647       $ 161,949   

Income (loss) from operations

     10,494         (2,580 )     41,819         14,479         1,951   

Income (loss) before provision (benefit) for income taxes

     10,813         (6,197 )     47,415         15,672         9,942   

Net income (loss)

     10,108         (5,891     32,212         10,977         6,595   

Net earnings (loss) per share:

             

Basic

   $ 0.27       $ (0.16 )   $ 0.89       $ 0.30       $ 0.18   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Diluted

   $ 0.26       $ (0.16 )   $ 0.85       $ 0.29       $ 0.18   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Cash dividends declared per common share

   $ 0.12       $ 0.12      $ 0.12       $ 0.12       $ 0.12   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 
     Year Ended December 31,  
     2011      2010     2009      2008      2007  
     (in thousands)  

Consolidated Balance Sheet Data:

             

Total cash, cash equivalents, and marketable securities

   $ 111,432       $ 87,251      $ 202,653       $ 167,229       $ 149,981   

Working capital

     89,716         73,606        188,552         159,080         159,547   

Long-term license installments, net of unearned interest income

             1,223        2,976         5,413         8,267   

Intangible assets, net of accumulated amortization

     69,369         80,684        336         479           

Goodwill

     20,451         20,451        2,391         2,141         1,933   

Total assets

     381,711         337,475        279,585         245,850         243,307   

Stockholders’ equity

     208,756         195,670        205,219         173,114         172,944   

The following items impact the comparability of our consolidated financial data:

 

   

Our acquisition of Chordiant in April 2010. During the first quarter of 2011, the Company recorded adjustments to the purchase price allocation of its acquisition of Chordiant. As required by applicable business combination accounting rules, these adjustments were applied retrospectively. Therefore, other current assets, long-term other assets, goodwill, accrued expenses, and deferred tax assets were revised as of December 31, 2010 to reflect these adjustments. These revisions did not have any impact on the Company’s previously reported results of operations or cash flows. See Note 9 “Acquisition, Goodwill, and Other Intangible Assets” for further discussion of these adjustments.

 

   

Foreign currency transaction (losses) gains of $(0.9) million, $(5.6) million, $2.1 million, $(4.5) million, and $0.3 million, during the years ended December 31, 2011, 2010, 2009, 2008, and 2007, respectively. See Item 7A. “Quantitative and Qualitative Disclosure about Market Risk” for further discussion of our foreign currency exchange risk.

 

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ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Business overview

We develop, market, license, and support software, which allows organizations to build, deploy, and change enterprise applications easily and quickly. Our unified software platform includes all the necessary elements and technologies to build enterprise applications in a fraction of the time it would take with competitive disjointed architectures, by directly capturing business objectives, automating programming, and automating work. Our customers use our software to improve their customer service and the customer experience, generate new business, and enhance productivity and profitability. We also provide professional services, maintenance, and training related to our software.

We focus our sales efforts on target accounts, which are large companies or divisions within companies and typically leaders in their industry. We also focus our sales efforts on existing and targeted new industries. Our strategy is to sell initial licenses that are focused on a specific purpose or area of operations, rather than selling large enterprise licenses. Once a customer has realized the value of our software, we work with the customer to identify opportunities for follow-on sales.

Our license revenue is primarily derived from sales of our PRPC software and related solution frameworks. PRPC is a comprehensive platform for building and managing BPM applications that unifies business rules and business processes. Our solution frameworks, 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 solution frameworks can be used by a broad range of customers within financial services, insurance, healthcare, communications and government markets, as well as other markets such as energy and media.

We develop and license 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 all actions optimize the outcome 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 customers to optionally create and/or run Pega applications using an Internet-based infrastructure. This offering enables our customers 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.

We offer training for our staff, customers, and partners at our regional training facilities, at third party facilities in numerous other locations, and at customer sites. Beginning in 2012, we will also be offering training online through Pega Academy, which will provide new ways to learn our software quickly and easily. We expect that this online training will help expand the number of trained experts at a faster pace. Our online training may result in lower training revenues.

Our total revenue increased 24% in 2011 compared to 2010 and reflects revenue growth in each of software license, maintenance, and professional services revenue. Maintenance revenue increased 40% primarily due to the increase in the aggregate value of the installed base of our software and a full year of maintenance revenue attributed to license arrangements executed by Chordiant prior to the acquisition. In 2011, we generated approximately $39.8 million in cash from operations, primarily driven by our net income, and ended the year with $111.4 million in cash, cash equivalents, and marketable securities.

We believe our growth and success in 2011 were due to:

 

   

Our disciplined and focused global sales strategy to targeted customers;

 

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The return on investment our clients achieve from the use of Pega technology leading to repeat purchases;

 

   

Expansion of our customer base through sales to customers within new industries;

 

   

Demand for our industry-leading software solutions and services;

 

   

Investment in making our products faster and easier to use;

 

   

Expansion of our solutions frameworks offerings; and

 

   

Collaboration and continued development of our partner alliances.

We believe that the ongoing challenges for our business include our ability to drive revenue growth, expand our expertise in new and existing industries, remain a leader in CRM and the decision management markets, and maintain our leadership position in the BPM market.

To support our growth and successfully address these challenges through 2012 we plan to:

 

   

Expand our expertise across targeted industries;

 

   

Improve the end user experience with enhanced user interface;

 

   

Maintain our focused global sales strategy to targeted customers;

 

   

Invest in our research and development by significantly increasing headcount;

 

   

Hire additional sales and marketing professionals;

 

   

Invest in self-study enablement to expand the Pega ecosystem;

 

   

Further develop our partner alliances; and

 

   

Develop and increase our solutions frameworks.

RESULTS OF OPERATIONS

2011 Compared to 2010

 

(Dollars in thousands)    Year Ended December 31,          Increase (Decrease)      
     2011                  2010                  

Total revenue

   $     416,675       $       336,599       $ 80,076             24

Gross profit

     251,877         207,865         44,012         21

Acquisition-related costs

     482         5,924         (5,442)         (92)

Restructuring costs

     (62)         8,064         (8,126)         n/m   

Other operating expenses

     240,963         196,457         44,506         23

Total operating expenses

     241,383         210,445         30,938         15

Income (loss) before provision (benefit) for income taxes

     10,813         (6,197)         17,010         n/m   

n/m – not meaningful

The aggregate value of license arrangements executed in 2011 was significantly higher than in 2010 or in any prior year. 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 customers. In addition, our significant investment in hiring sales personnel has generated license sales to customers in new and existing industries and geographies.

 

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The increase in gross profit was primarily due to the increase in maintenance revenue and to a lesser extent the increase in license revenue.

The increase in operating expenses was primarily due to the increase in selling and marketing expenses associated with higher headcount and higher sales commissions related to the increase in the value of license arrangements executed.

The increase in income (loss) before provision (benefit) for income taxes was primarily due to the increase in maintenance and license gross profit and the decrease in foreign exchange losses in 2011 compared to 2010, partially offset by the increase in total operating expenses.

Revenue

 

(Dollars in thousands)    Year Ended December 31,    

            Increase             

 
     2011     2010        

License revenue

               

Perpetual licenses

   $ 94,129         68   $ 79,041         66   $ 15,088         19

Term licenses

     34,453         25     31,940         27     2,513         8

Subscription

     10,225         7 %     8,858         7     1,367         15
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

Total license revenue

   $     138,807         100   $     119,839         100   $       18,968         16
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

The aggregate value of license arrangements executed in 2011 was significantly higher than in 2010 or any prior year. The aggregate value of license agreements executed in the fourth quarter of 2011 set a quarterly record for the Company primarily due to a significant increase in the value of term license arrangements executed. A change in the mix between perpetual and term license arrangements executed in a period varies based on customer needs, which may cause our revenues to vary materially quarter to quarter. If we continue to execute a higher proportion of term license arrangements, our license revenue may be recognized over longer periods.

The increase in perpetual license revenue was primarily due to an increase in the aggregate value of perpetual license arrangements executed. Many of our perpetual license arrangements include extended payment terms and/or additional rights of use that delay the recognition of revenue to future periods. The aggregate value of payments due under these licenses was $48.4 million as of December 31, 2011 compared to $32.8 million as of December 31, 2010. See the table of future cash receipts by year from these perpetual licenses and certain subscription licenses on page 33.

We recognize revenue for our term license arrangements over the term of the agreement as payments become due or earlier if prepaid. The increase in our term license revenue was primarily due to revenue from the increased aggregate value of term license arrangements executed during 2011, partially offset by higher prepayments in 2010. Prepayments can cause our term license revenue to vary quarter to quarter. Total future payments due under term licenses increased to $161.4 million as of December 31, 2011 compared to $90.9 million as of December 31, 2010 and includes approximately $37.7 million of term license payments that we expect to recognize as revenue in 2012. Our term license revenue in 2012 could be higher than $37.7 million as we complete new term license agreements in 2012 or if we receive prepayments from existing term license agreements. See the table of future cash receipts by year from these term licenses on page 33.

 

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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 customer arrangements determines the amount of revenue that can be recognized in a reporting period. Consequently, our subscription revenue may vary quarter to quarter.

 

(Dollars in thousands)      Year Ended December 31,        Increase  
       2011        2010                    

Maintenance revenue

                   

Maintenance

     $   117,110         $   83,878         $     33,232           40
    

 

 

      

 

 

      

 

 

      

The increase in maintenance revenue was primarily due the continued increase in the aggregate value of the installed base of our software and a full year of maintenance revenue attributed to license arrangements executed by Chordiant prior to the acquisition.

 

(Dollars in thousands)      Year Ended December 31,         Increase      
       2011     2010        

Professional services revenue

                       

Consulting services

     $ 153,919           96   $ 126,283           95   $ 27,636           22

Training

       6,839           4     6,599           5     240           4
    

 

 

      

 

 

   

 

 

      

 

 

   

 

 

      

Total Professional services

     $     160,758           100   $   132,882           100   $   27,876           21
    

 

 

      

 

 

   

 

 

      

 

 

   

 

 

      

Professional services are primarily consulting services related to new license implementations. The increase in consulting services revenue was primarily due to higher demand for these services as a result of the significant increase in the number of license arrangements executed in the fourth quarter of 2010 and in 2011.

 

(Dollars in thousands)      Year Ended December 31,     Increase (Decrease)  
       2011     2010              

Gross Profit

          

Software license

     $     132,114      $     115,536      $     16,578        14

Maintenance

       104,033        72,837        31,196        43

Professional services

       15,730        19,492        (3,762     (19 )% 
    

 

 

   

 

 

   

 

 

   

Total gross profit

     $ 251,877      $ 207,865      $ 44,012        21
    

 

 

   

 

 

   

 

 

   

Total gross profit percent

       60     62    

Software license gross profit percent

       95     96    

Maintenance gross profit percent

       89     87    

Professional services gross profit percent

       10     15    

The decrease in software license gross profit percent was primarily due to the full year of amortization expense in 2011 for the technology intangibles we acquired as part of the Chordiant acquisition in April 2010.

The increase in maintenance gross profit percent was primarily due to the increase in maintenance revenue.

 

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During 2010, we continued to hire professional services employees to support our growth and expand our expertise across various industries. The decrease in professional services gross profit percent was primarily due to lower utilization as a result of an increased number of newly hired personnel that required training before they could be assigned to customer projects. It was also due to the participation of an increased number of existing professional services personnel in expert training programs. These advanced training programs are part of our strategy to increase the pool of expertly trained professional services personnel to fulfill increased demand for these services. The lower utilization was partially offset by an increase in our overall realization rates in 2011 compared to 2010.

 

(Dollars in thousands)            Year Ended December 31,                     Increase (Decrease)        
     2011      2010               

Amortization of intangibles:

          

Cost of software license

   $ 6,284       $ 4,231       $ 2,053        49

Selling and marketing

     4,928         3,285         1,643        50

General and administrative

     103         185         (82     (44 )% 
  

 

 

    

 

 

    

 

 

   
   $     11,315       $     7,701       $     3,614            47
  

 

 

    

 

 

    

 

 

   

The increase in amortization expense was due to a full year of amortization in 2011 associated with $88 million of intangible assets we acquired as part of the Chordiant acquisition in April 2010. The decrease in amortization expense included in general and administrative expense was due to the Chordiant trade name intangible asset being fully amortized in 2011.

Operating expenses

 

(Dollars in thousands)   

            Year Ended December 31,         

     Increase  
             2011                      2010                 

Selling and marketing

           

Selling and marketing

   $     147,457       $     116,230       $     31,227         27

As a percent of total revenue

     35      35      

Selling and marketing headcount

     464         377         87         23

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.

We continue to increase sales headcount to target new accounts in new and existing industries and across expanded geographies and to create additional sales capacity for future periods. The increase in selling and marketing expenses was primarily due to a $15.1 million increase in compensation and benefit expenses associated with higher headcount, a $7.6 million increase in commissions expense associated with the record value of license arrangements executed in 2011, a $1.6 million increase in amortization expense related to the acquired Chordiant customer related intangibles, a $2.1 million increase in partner commissions expenses, a $1.7 million increase in travel expenses, and a $1.2 million increase in sales and marketing program expenses, including our PegaWORLD user conference.

 

(Dollars in thousands)   

        Year Ended December 31,         

     Increase  
     2011      2010         

Research and development

           

Research and development

   $     65,308       $     55,193       $     10,115         18

As a percent of total revenue

     16      16      

Research and development headcount

     523         397         126         32

 

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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 Indian research facility. The increase in offshore headcount lowered our average compensation expense per employee.

The increase in research and development expenses was primarily due to an $8.9 million increase in compensation and benefit expenses associated with higher headcount, a $2.1 million increase in rent expense, partially offset by a $2.5 million decrease in engineering contractor expenses. We plan to continue investing in our research and development in 2012 in order to make it easier and faster for our customers to create applications using our software.

 

(Dollars in thousands)   

        Year Ended December 31,         

    Increase  
             2011                     2010                

General and administrative

         

General and administrative

   $     28,198      $     25,034      $     3,164         13

As a percent of total revenue

     7     7     

General and administrative headcount

     216        180        36         20

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 a $1.1 million increase in compensation and benefit expenses associated with higher headcount and a $1.8 million increase in accounting fees and tax consulting and legal fees primarily related to the expansion of our international operations.

As a result of our lease arrangement for our new office headquarters, we expect to cease use of our current offices in the second half of 2012. Accordingly, in June 2011, we revised the remaining useful lives of certain leasehold improvements and furniture and fixtures and recorded incremental depreciation expense of approximately $0.9 million during 2011. We recorded approximately $1.9 million of rent expense under the new lease arrangement during 2011. We recorded approximately $0.8 million of this rent and depreciation in cost of services and approximately $2 million in operating expenses.

Acquisition-related costs

Acquisition-related costs are expensed as incurred and include direct and incremental costs associated with an impending or completed acquisition. During 2011, the $0.5 million of acquisition-related costs were primarily legal fees associated with litigation assumed from our acquisition of Chordiant. During 2010, the $5.9 million of acquisition-related costs consisted of approximately $3.1 million of due diligence costs and advisory and legal transaction fees, approximately $0.8 million of valuation and tax consulting fees, approximately $1.6 million of legal costs associated with acquired litigation, and approximately $0.4 million of integration and other expenses related to our acquisition of Chordiant.

Restructuring costs

Restructuring costs included approximately $6.5 million of severance and related benefit costs recognized during the second and third quarters of 2010 for the reduction of personnel within redundant roles as a result of our integration of Chordiant.

 

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In connection with our evaluation of our combined facilities, we ceased use of space within a redundant facility during the fourth quarter of 2010 and recorded approximately $1.6 million of restructuring expenses, consisting of future lease payments and demising costs, net of estimated sublease income for this space. During the first quarter of 2011, we incurred an additional $0.1 million of exit costs related to this space and as a result of signing a sublease for this space during the third quarter of 2011, we revised our estimate of exit costs and recorded a $0.2 million reduction of restructuring costs.

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  
       2011      2010         

Stock-based compensation:

               

Cost of services

     $       2,737       $         1,825       $         912           50

Operating expenses

       6,291         4,920         1,371           28
    

 

 

    

 

 

    

 

 

      

Total stock-based compensation before tax

       9,028         6,745       $ 2,283           34
          

 

 

      

Income tax benefit

       (2,854      (2,185        

The increase in stock-based compensation expense was primarily due to the higher headcount and the related expense associated with the December 2010 periodic grant and 2011 new hire stock-based 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  
       2011      2010         

Foreign currency transaction loss

     $ (935    $ (5,569    $ 4,634         n/m   

Interest income, net

                     398               1,138         (740      (65 )% 

Other income, net

       856         814                     42         5
    

 

 

    

 

 

    

 

 

    
     $ 319       $ (3,617 )    $ 3,936         n/m   
    

 

 

    

 

 

    

 

 

    

n/m – not meaningful

We hold foreign currency denominated accounts receivable and cash in our U.S. operating company where the functional currency is the U.S. dollar. As a result, these receivables and cash are subject to foreign currency transaction gains and losses when there are changes in exchange rates between the U.S. dollar and 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 2011 and 2010.

Beginning in the second quarter of 2011, we have entered into forward foreign currency contracts to manage our exposure to changes in foreign currency exchange rates affecting the foreign currency denominated accounts receivable and cash held by our U.S. operating company. We have not designated these forward foreign currency 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 income, net. The fluctuations in the value of these forward foreign currency contracts recorded in other income, net, partially offset in net income the gains and losses from the remeasurement or settlement of the foreign currency denominated accounts receivable and cash held by the U.S.

 

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operating company recorded in foreign currency transaction (loss) gain. During 2011, the total change in the fair value of our forward foreign currency contracts recorded in other income, net, was a net gain of $0.8 million. The impact on net income of the gains recorded on the forward foreign currency contracts and the foreign currency transaction losses recorded on the remeasurement and settlement of the foreign currency denominated assets, was a net loss of approximately $1.2 million for the year ended December 31, 2011. This net loss was primarily due to the timing of settlement of intercompany balances and foreign currency denominated cash held as of the end of the period, for which we did not have forward currency contracts.

The decrease in interest income was primarily due to lower yields earned and a lower weighted-average value of marketable securities held throughout the year ended December 31, 2011 compared to the same period in 2010.

Provision (benefit) for income taxes

We account for income taxes at each interim period using our estimated annual effective tax rate. The provision for income taxes represents current and future amounts owed for federal, state, and foreign taxes.

The provision (benefit) for income taxes represents current and future amounts owed for federal, state, and foreign taxes. During 2011 and 2010, we recorded a $0.7 million provision and a $0.3 million benefit, respectively, which resulted in an effective tax rate of 6.5% and (4.9%), respectively

Our effective income tax rate for 2011 was below the statutory federal income tax rate due to a $2.5 million reduction in 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.

During 2010, we recorded a valuation allowance against state credits and a discrete item related to the nondeductible portion of acquisition-related costs we incurred during 2010, which reduced our tax benefit by approximately $2.3 million and $0.7 million, respectively. The consolidation of Chordiant’s operations had a significant impact on our consolidated state apportionment factors. As a result of this change, we recorded a valuation allowance against certain state credits.

As of December 31, 2011, unrecognized tax benefits totaled approximately $25.3 million, of which $18.2 million, if recognized, would decrease our effective tax rate. However, approximately $11.1 million of these unrecognized tax benefits relate to acquired net operating losses (“NOLs”) and research tax credits, which if recognized, would be subject to limitations on use. We expect that the changes in the unrecognized benefits within the next twelve months will be approximately $0.2 million and would reduce our effective tax rate.

2010 Compared to 2009

 

(Dollars in thousands)    Year Ended December 31,                Increase (Decrease)           
     2010      2009           

Total revenue

   $     336,599       $     264,013         $         72,586        27

Gross profit

     207,865         173,076           34,789        20

Acquisition-related costs

     5,924                   5,924        n/m   

Restructuring costs

     8,064                   8,064        n/m   

Other operating expenses

     196,457         131,257           65,200        50

Total operating expenses

     210,445         131,257           79,188        60

(Loss) income before (benefit) provision for income taxes

     (6,197      47,415           (53,612     (113 )%

n/m – not meaningful

 

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We continued to experience demand for our software solutions and related services in 2010, which we believe was due to the strong value proposition, short implementation period, and variety of licensing models we offer our customers.

The increase in gross profit was primarily due to the increase in maintenance and license revenue.

The increase in operating expenses during 2010 was primarily due to the continued expansion of our sales force and our research and development operations. It was also due to the acquisition-related expenses and restructuring costs associated with our acquisition of Chordiant.

The decrease in (loss) income before (benefit) provision for income taxes during 2010 compared to 2009 was primarily due to the higher growth rate in operating expenses and lower total gross profit percent in 2010. The lower total gross profit percent was due to lower software license gross profit percent in 2010 as a result of the amortization of acquired Chordiant technology intangible assets. The decrease in (loss) income before (benefit) provision for income taxes was also due to the $5.6 million foreign currency transaction loss in 2010 compared to a gain of $2.1 million in 2009.

Revenue

 

(Dollars in thousands)    Year Ended December 31,     Increase (Decrease)  
     2010     2009        

License revenue

              

Perpetual licenses

   $ 79,041         66   $ 71,678         62   $ 7,363        10

Term licenses

     31,940         27     36,638         32     (4,698     (13 )% 

Subscription

     8,858         7 %     7,618         6     1,240        16
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

   

Total license revenue

   $     119,839         100   $         115,934         100   $         3,905        3
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

   

License revenue was primarily due to new license arrangements executed in the period. Through the first three quarters of 2010, the aggregate value of new license arrangements executed was lower compared to the same periods in 2009. However, we executed a record aggregate value of new license arrangements during the fourth quarter of 2010, and as a result, the aggregate value of new license arrangements executed for the year exceeded that of 2009. Consistent with our strategy to focus on follow-on sales to our targeted customers, approximately 75% of the aggregate value of new license arrangements executed during 2010 was from existing customers.

The increase in perpetual license revenue during 2010 compared to 2009 was driven by an increase in the number and value of new perpetual license arrangements. Many of our perpetual license arrangements include extended payment terms and/or additional rights of use that delay the recognition of revenue to future periods. The aggregate value of payments due under these perpetual and certain subscription licenses was $32.8 million as of December 31, 2010 compared to $57.1 million as of December 31, 2009.

We recognize revenue for our term license arrangements over the term of the agreement as payments become due or earlier if prepaid. Our term license revenue decreased in 2010 compared to 2009 primarily due to more prepayments of term licenses by a few customers in 2009 and the expiration of one term license in 2009. While term license revenue decreased in 2010, the aggregate value of new term license arrangements executed in 2010 was significantly higher than in 2009. As a result, the aggregate value of future payments due under term licenses increased to $90.9 million as of December 31, 2010 compared to $76.3 million as of December 31, 2009 and includes approximately $30.9 million of term license payments that we expect to recognize as revenue in 2011. Our term license revenue in 2011 could be higher than $30.9 million as we complete new term license agreements in 2011 or if we receive prepayments from existing term license agreements. A change in the mix between perpetual and term license arrangements executed, which varies based on customer needs, can cause our revenues to vary materially quarter to quarter.

 

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Table of Contents

Subscription revenue primarily relates to our arrangements that include a right to unspecified future products and is recognized ratably over the term of the arrangement. The increase in subscription revenue during 2010 compared to 2009 was due to a new customer arrangement that began in the third quarter of 2009 and continued through all of 2010. The timing of scheduled payments under customer arrangements and a change in a customer’s selection of a renewal option can cause our subscription revenue to vary quarter to quarter.

 

(Dollars in thousands)    Year Ended December 31,      Increase  
               2010                 2009                

Maintenance revenue

           

Maintenance

   $   83,878       $   50,099       $         33,779         67
  

 

 

    

 

 

    

 

 

    

The increase in maintenance revenue during 2010 compared to 2009 was primarily due to the $12.1 million in maintenance revenue attributable to the recognition of the fair value of deferred maintenance revenue acquired from Chordiant and the continued increase in the aggregate value of the installed base of our software.

 

(Dollars in thousands)    Year Ended December 31,     Increase  
     2010     2009        

Professional services revenue

               

Consulting services

   $     126,283         95   $   93,910         96   $     32,373         34

Training

     6,599         5     4,070         4     2,529         62
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

Total Professional services

   $ 132,882         100   $ 97,980         100   $ 34,902         36
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

Professional services are primarily consulting services related to new license implementations. The increase in consulting services and training revenue during 2010 compared to 2009 was primarily due to a higher demand for these services in North America associated with new license arrangements executed in the later part of 2009 and includes approximately $3.6 million of revenue associated with professional services arrangements existing at the acquisition date of Chordiant.

 

(Dollars in thousands)    Year Ended December 31,     Increase  
     2010     2009              

Gross Profit

        

Software license

   $     115,536      $     115,813      $ (277     n/m   

Maintenance

     72,837        43,896        28,941        66

Professional services

     19,492        13,367        6,125        46
  

 

 

   

 

 

   

 

 

   

Total gross profit

   $ 207,865      $ 173,076      $     34,789        20
  

 

 

   

 

 

   

 

 

   

Total gross profit percent

     62     66    

Software license gross profit percent

     96     100    

Maintenance gross profit percent

     87     88    

Professional services gross profit percent

     15     14    

n/m – not meaningful

The decrease in software license gross profit percent during 2010 compared to 2009 was due to the amortization of acquired technology intangibles related to Chordiant.

 

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Gross profit percent for maintenance and professional services during 2010 were relatively unchanged compared to 2009.

 

(Dollars in thousands)   

        Year Ended December 31,         

     Increase  
             2010                      2009                        

Amortization of intangibles:

           

Cost of software license

   $             4,231       $             121       $       4,110         n/m   

Selling and marketing

     3,285                 3,285         n/m   

General and administrative

     185         20         165         n/m   
  

 

 

    

 

 

    

 

 

    
   $ 7,701       $ 141       $ 7,560         n/m   
  

 

 

    

 

 

    

 

 

    

n/m – not meaningful

The increase in amortization expense during 2010 compared to 2009 was due to the amortization associated with $88 million of acquired intangible assets recognized as a result of the purchase price allocation of Chordiant. The identifiable intangible assets are expected to be amortized over a weighted-average period of 8.4 years on a straight-line basis.

Operating expenses

 

(Dollars in thousands)   

        Year Ended December 31,         

     Increase  
     2010      2009         

Selling and marketing

           

Selling and marketing

   $     116,230       $         74,378       $     41,852         56

As a percent of total revenue

     35      28      

Selling and marketing headcount

     377         253         124         49

We significantly increased sales hiring in the first half of 2010 in order to target new accounts across expanded geographies and to create additional sales capacity for future periods. The increase in selling and marketing expenses was primarily due to a $23.3 million increase in compensation and benefit expenses associated with higher headcount, a $3.3 million increase in amortization expense related to the acquired Chordiant customer related intangibles, a $3.9 million increase in travel expenses, a $3.2 million increase in expenses related to marketing programs, including our 2010 PegaWORLD user conference. We did not host a PegaWORLD conference in 2009. The increase was also due to a $1.0 million increase in contractor services, a $1.0 million increase in telecom expenses, a $0.5 million increase in training expenses and a $0.3 million increase in agency and recruiting expenses.

 

(Dollars in thousands)   

         Year Ended December 31,         

     Increase  
     2010      2009         

Research and development

           

Research and development

   $         55,193       $     38,862       $     16,331         42

As a percent of total revenue

     16      15      

Research and development headcount

     397         222         175         79

The increase in headcount reflected growth in our Indian research facility as well as new employees from the Chordiant acquisition. The increase in offshore headcount lowered our average compensation expense per employee.

 

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The increase in research and development expenses during 2010 compared to 2009 was due to an $11.0 million increase in compensation and benefit expenses associated with higher headcount, a $1.4 million increase in engineering contractor expenses, a $0.6 million increase in travel expenses, and a $0.5 million increase in depreciation and equipment related expenses.

 

(Dollars in thousands)   

        Year Ended December 31,         

     Increase  
             2010                      2009                 

General and administrative

           

General and administrative

   $     25,034       $     18,017       $     7,017         39

As a percent of total revenue

     7      7      

General and administrative headcount

     180         144         36         25

The general and administrative expenses during 2010 included $1.1 million of compensation and benefit expenses for Chordiant employees who were in transitional roles that ended by the end of the third quarter of 2010.

The increase in general and administrative expenses during 2010 compared to 2009 was primarily due to a $2.2 million increase in compensation and benefit expenses associated with higher headcount, a $1.3 million increase in contractor expenses, a $1.2 million increase in professional fees, and a $1.2 million increase in our non-income tax reserves.

Acquisition-related costs

During 2010, we incurred $5.9 million of acquisition-related costs associated with the Chordiant acquisition. These costs consisted of approximately $3.1 million of due diligence costs and advisory and legal transaction fees, approximately $0.8 million of valuation and tax consulting fees, approximately $1.6 million of legal costs associated with acquired litigation, and approximately $0.4 million of integration and other expenses.

Restructuring costs

Restructuring costs included approximately $6.5 million of severance and related benefit costs recognized during the second and third quarters of 2010 for the reduction of approximately 50 personnel as a result of the integration of Chordiant. These personnel were in redundant roles, primarily in general and administrative functions.

In connection with our evaluation of our combined facilities, we approved a plan to eliminate one redundant facility. We ceased use of this space during the fourth quarter of 2010 and recorded approximately $1.6 million of restructuring expenses, consisting of future lease payments and demising costs, net of estimated sublease income for this space.

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  
               2010                  2009             

Stock-based compensation:

               

Cost of services

     $ 1,825       $ 1,096       $ 729           67

Operating expenses

       4,920         3,577         1,343           38
    

 

 

    

 

 

    

 

 

      

Total stock-based compensation before tax

       6,745         4,673       $ 2,072           44
          

 

 

      

Income tax benefit

       (2,185      (1,688        

 

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The increase in stock-based compensation expense in 2010 compared to 2009 was primarily due to an increase in the number of employees electing to receive 50% of their corporate incentive compensation plan (“CICP”) in RSUs and in the number of new hire stock-based grants. As of December 31, 2010, we had approximately $9.5 million of unrecognized stock-based compensation expense, net of estimated forfeitures, related to the unvested portion of our equity awards that is expected to be recognized over a weighted-average period of approximately 2.3 years. 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  
             2010                      2009                   

Foreign currency transaction (loss) gain

   $ (5,569    $ 2,083         $ (7,652      n/m   

Interest income, net

     883         3,144           (2,261      (72 )% 

Installment receivable interest income

     255         347           (92      (27 )% 

Other income, net

     814         22           792         n/m   
  

 

 

    

 

 

      

 

 

    
   $ (3,617 )    $       5,596         $ (9,213      n/m   
  

 

 

    

 

 

      

 

 

    

n/m – not meaningful

Foreign currency transaction losses in 2010 compared to gains in 2009 were due to the significant decrease in the value of the British pound and the Euro relative to the U.S. dollar and the higher total amount of foreign currency denominated net assets held in the U.S. during 2010, consisting primarily of cash and receivables. As a result of our acquisition of Chordiant, we expanded our international operations. We hold U.S. dollars in these foreign operations whose functional currency is the Euro, which partially offsets our exposure to foreign currency transaction losses related to foreign currencies held by our U.S. operating company. See Item 7A. “Quantitative and Qualitative Disclosure about Market Risk” for further discussion of our foreign currency exchange risk.

The decrease in interest income during 2010 compared to 2009 was due to the sale of our marketable securities we used to pay for the Chordiant acquisition.

Other income during 2010 includes a $0.6 million realized gain on the sale of shares of a closely-held private company.

(Benefit) provision for income taxes

The (benefit) provision for income taxes represents current and future amounts owed for federal, state, and foreign taxes. During 2010 and 2009, we recorded a $0.3 million benefit and a $15.2 million provision, respectively, which resulted in an effective tax rate of (4.9%) and 32.1%, respectively.

During 2010, we recorded a valuation allowance against state credits and a discrete item related to the nondeductible portion of acquisition-related costs we incurred during 2010, which reduced our tax benefit by approximately $2.3 million and $0.7 million, respectively. The consolidation of Chordiant’s operations had a significant impact on our consolidated state apportionment factors. As a result of this change, we recorded a valuation allowance against certain state credits.

Our effective income tax rate for 2009 was below the statutory federal income tax rate due to a $0.8 million benefit related to the current period domestic operating activities, a $0.9 million benefit from tax-exempt income, and a $0.8 million reduction in the Company’s reserve for uncertain tax positions related to the settlement of the Company’s income tax audit with the United Kingdom government and tax positions of prior years for which the statute of limitations had expired. These benefits were partially offset by $0.4 million of permanent differences, primarily related to nondeductible meals and entertainment expenses.

 

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As of December 31, 2010, unrecognized tax benefits totaled approximately $20.3 million, all of which if recognized, would decrease our effective tax rate. However, approximately $11.1 million of these unrecognized tax benefits relate to acquired NOLs and research tax credits, which if recognized, would be subject to limitations on use. We expected that the changes in the unrecognized benefits within the next twelve months would be approximately $2 million and would reduce our effective tax rate.

LIQUIDITY AND CAPITAL RESOURCES

 

(in thousands)    Year Ended December 31,  
     2011      2010      2009  

Cash provided by (used in):

        

Operating activities

   $       39,815       $       18,414       $       49,581   

Investing activities

     (45,388      6,841         (18,163

Financing activities

     (6,312      (13,251      (5,049

Effect of exchange rate on cash

     1,111         (4,734      1,401   
  

 

 

    

 

 

    

 

 

 

Net (decrease) increase in cash and cash equivalents

   $ (10,774    $ 7,270       $ 27,770   
  

 

 

    

 

 

    

 

 

 
     As of December 31,  
     2011      2010      2009  

Total cash, cash equivalents, and marketable securities

   $ 111,432       $ 87,251       $ 202,653   
  

 

 

    

 

 

    

 

 

 

We have funded our operations primarily from cash provided by operations and we expect to continue funding our operations in this manner in 2012.

The increase in cash, cash equivalents, and marketable securities in 2011 compared to 2010 was primarily due to $39.8 million of cash provided by operations partially offset by $11.1 million of repurchases of our common stock. The decrease in cash, cash equivalents, and marketable securities in 2010 compared to 2009 was primarily due to our acquisition of Chordiant, for which we paid $109.2 million in cash, net of approximately $47.6 million of cash acquired. Working capital was $89.7 million as of December 31, 2011 compared to $73.6 million as of December 31, 2010.

On June 29, 2011, we entered into a lease arrangement for our new office headquarters in Cambridge, Massachusetts commencing on July 1, 2011 and terminating on December 31, 2023, subject to our option to extend for two additional five-year periods. We will continue to pay our monthly rent under the lease for our current offices in Cambridge, Massachusetts, through the remaining term of that lease, which is scheduled to expire on May 31, 2013. The new lease arrangement provides us with a rent-free period for the remaining term of the current lease, for the same amount of space covered by the current lease. The future rental payments due under the new lease arrangement total $75.8 million. We invested approximately $4.6 million in 2011 and we expect to invest approximately $10.9 million in the first half of 2012 for furniture, fixtures, IT equipment, and leasehold improvements for our new office headquarters.

We paid approximately $3.8 million in severance and related benefit costs and lease payments in 2011 in connection with our restructuring. The remaining $1 million in severance and related benefit costs and lease payments will be paid by the end of 2013.

We believe that our current cash, cash equivalents, marketable securities, and cash from operations in 2011 will be sufficient to fund our operations and our share repurchase program for at least the next 12 months. Approximately $26.4 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

 

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have to pay upon repatriation due to the complexity of the foreign tax credit calculations and because we consider our earnings permanently reinvested. There can be no assurance that changes in our plans or other events affecting our operations will not result in materially accelerated or unexpected expenditures.

Cash provided by operating activities

The $21.4 million increase in cash provided by operating activities in 2011 compared to 2010 was primarily due to the increase in our net income and the $14.6 million increase in deferred revenue, partially offset by the $18.5 million increase in accounts receivable resulting from the increase and timing of billings, and revenue recognition. The $31.2 million decrease in cash provided by operating activities in 2010 compared to 2009 was primarily due to the decrease in our net income and the $23.4 million increase in accounts receivable.

Future Cash Receipts from License Arrangements

Total contractual future cash receipts due from our existing license agreements was approximately $209.9 million as of December 31, 2011 compared to $123.7 million as of December 31, 2010. The future cash receipts due as of December 31, 2011 are summarized as follows:

 

As of December 31, (in thousands)        

     Contractual
payments for term
licenses not recorded on

      the balance sheet (1)      
       Other contractual
license payments not
recorded on the

balance sheet (2)
       Total  

2012

     $ 37,741         $ 22,590         $ 60,331   

2013

       36,701           6,681           43,382   

2014

       33,737           8,319           42,056   

2015

       29,511           4,601           34,112   

2016 and thereafter

       23,737           6,256           29,993   
    

 

 

      

 

 

      

 

 

 

Total

     $ 161,427         $ 48,447         $ 209,874   
    

 

 

      

 

 

      

 

 

 

 

(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) provided by investing activities

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.

During the first quarter of 2010, we sold our marketable securities to pay for the Chordiant acquisition. During the second quarter of 2010, we paid $109.2 million, net of cash acquired, to complete the Chordiant acquisition. During 2010, we invested $3.6 million in computer equipment, leasehold improvements and furniture and fixtures primarily for our Cambridge location and $1.2 million in capitalized software primarily related to our implementation of an accounting system.

During 2009, cash used in investing activities was primarily for purchases of marketable debt securities for $79.4 million, partially offset by the proceeds received from the sales, maturities and called marketable debt securities of $67.3 million.

 

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Cash used in financing activities

Net cash used in financing activities during 2011, 2010, and 2009, 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 $86.3 million of our common stock. As of December 31, 2011, approximately $65.9 million has been repurchased, approximately $13.9 million remains available for repurchase and approximately $6.4 million expired. Purchases under these programs have been made on the open market.

Common stock repurchases

The following table is a summary of our repurchase activity under all of our stock repurchase programs during 2011, 2010, and 2009:

 

(Dollars in thousands)    2011      2010      2009  
     Shares      Amount      Shares      Amount      Shares      Amount  

Prior year authorizations at January 1,

      $         13,237          $         15,779          $         12,862   

Authorizations

        5,590            5,750            15,000   

Repurchases paid

     137,429         (4,815      294,059         (8,272      673,066         (11,947

Repurchases unsettled

     1,688         (49      538         (20      3,898         (136
     

 

 

       

 

 

       

 

 

 

Authorized dollars remaining as of December 31,

      $ 13,963          $ 13,237          $ 15,779   
     

 

 

       

 

 

       

 

 

 

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 2011 and 2010, equity holders net settled their equity awards representing the right to purchase a total of 704,000 and 889,000 shares, respectively, of which only 426,000 and 493,000 shares respectively, were issued. The balance of the shares was surrendered to us to pay for the exercise price and the applicable taxes. During 2011 and 2010, instead of receiving cash from these equity holders, we withheld shares with a value of $6.2 million and $7.0 million, respectively, for payment of taxes, and $4.3 million and $6.7 million, respectively, for payment of the exercise price. The value of share repurchases and shares withheld for net settlement of our employee stock option exercises and vesting of RSUs offset the proceeds received under our various share-based compensation plans during 2011, 2010, and 2009.

Dividends

We declared a cash dividend of $0.12 per share for each of the years ended December 31, 2011, 2010, and 2009, and paid cash dividends of $4.5 million, $4.4 million, and $4.3 million, in 2011, 2010, and 2009, respectively. It is our current intention to pay a quarterly cash dividend of $0.03 per share to shareholders of record as of the first trading day of each quarter, however, the Board of Directors may terminate or modify this dividend program at any time without notice.

Contractual obligations

As of December 31, 2011, we had material purchase obligations for customer support and consulting services 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 non-cancelable operating leases that expire at various dates through 2020.

 

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As of December 31, 2011, our known contractual obligations, including future minimum rental payments required under operating leases with non-cancelable terms in excess of one year were as follows:

 

          Payment due by period  

Contractual obligations:

(in thousands)

  Total     2012     2013 &
2014
    2015 &
2016
    2017 &
Thereafter
    Other  

Purchase obligations (1)

  $ 1,683      $ 1,683      $ —        $ —        $ —        $ —     

Liability for uncertain tax positions (2)

    9,468        —          —          —          —          9,468   

Operating lease obligations (3)

    100,794        10,802        18,570        16,755        54,667        —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $       111,945      $       12,485      $       18,570      $       16,755      $       54,667      $       9,468   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Represents the fixed or minimum amounts due under purchase obligations for customer support and consulting services.

 

(2) As of December 31, 2011, our recorded liability for uncertain tax positions was approximately $9.5 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 $1.4 million included in accrued expenses and approximately $3.3 million in other long-term liabilities in the accompanying audited consolidated balance sheet as of December 31, 2011.

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 professional services. Our license arrangements, whether involving a perpetual license or a term license, generally contain multiple elements, including professional 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.

 

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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.

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 signed by the customer for software licenses and a statement of work for professional services. In the event the customer 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.

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 software license agreements do not include a right of return.

Collection of fee is probable—We assess the probability of collecting from each customer at the outset of the arrangement based on a number of factors, including the customer’s payment history, its current creditworthiness, economic conditions in the customer’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 support, and all other revenue recognition criteria are met.

Term software license fees are generally payable on a monthly basis under license agreements that typically have a three to five-year term and may be renewed for additional terms at the customer’s option.

As a result of our focus on frequent sales to our targeted customers, our strategy to sell initial term licensing agreements to those customers with the goal to generate follow-on sales, and as a result of extended payment terms, 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.

Until 2005, the majority of our term license arrangements were larger agreements with extended payment terms that did not typically result in follow-on license agreements. We have a history of successfully collecting payments under the original payment terms for these arrangements, therefore, we recognized the present value of the future term license payments upon customer acceptance, provided that no significant obligations or contingencies exist related to the software, other than maintenance support, and provided all other criteria for revenue recognition had been met. A portion of the license fees payable under these agreements (equal to the difference between the total license payments and the discounted present value of those payments) was initially deferred and recognized as installment receivable interest income (and is not part of total revenue) over the license term. We no longer utilize this business model for software license transactions. As of December 31, 2011, the remaining balance of these installment receivables totaled approximately $1.3 million.

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.

 

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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.

Professional services revenues

Our professional services revenue is comprised of fees for consulting services, including software implementation, training, reimbursable expenses and sales of our Pega Cloud as-a-platform offering (“Pega Cloud”). Consulting services may be provided on a “stand-alone” basis or bundled with a license and software maintenance services.

Revenue from “stand-alone” 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 and Europe, other than Spain.

Consulting services may 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 customer, we account for these services separately from our Pega Cloud offering. 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 customers 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 customers 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 customers generally require us to indemnify the customer 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, 2011, we had not experienced any material losses related to these indemnification obligations and no material claims were outstanding. See Note 13 “Commitments and

 

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Contingencies” in the accompanying notes to the audited consolidated financial statements for a discussion of the settlement of claims assumed in the acquisition of Chordiant related to certain software that was sold by Chordiant.

Deferred revenue

Deferred software license revenue typically results from customer 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 professional services revenue represents advanced billings for consulting and training services that are recognized as the services are performed.

Allowance for doubtful accounts and allowance for sales credit memos

We record allowances for estimates of sales credit memos for services rendered. We base these estimates on historical analyses of sales credit memos and assumptions about future events and experience with customer disputes. If we used different assumptions in calculating the allowance, adjustments would be reflected as changes to revenue.

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Our estimates are based on the composition of the accounts receivable aging, historical bad debts, changes in payment patterns, customer creditworthiness and current economic trends. If we used different assumptions, or if the financial condition of customers were to deteriorate that resulted in their inability to make required payments, additional provisions for doubtful accounts would be required and would increase bad debt expense.

Goodwill and Intangible Assets Impairment

Goodwill represents the residual purchase price paid in a business combination after all identified assets and liabilities have been recorded. Goodwill is not amortized, but prior to the Company’s adoption of the Financial Accounting Standards Board “FASB” Accounting Standards Update (“ASU”) No. 2011-08, “Intangibles-Goodwill and Other (Topic 350)” (“ASU 2011-08”), was tested annually in the fourth quarter for impairment or between annual tests if indicators of potential impairment exist. We adopted ASU 2011-08 in the fourth quarter of 2011, performed our qualitative assessment and concluded it was not more likely than not that the fair value of our single reporting unit was less than its carrying value. In 2010 and 2009, we compared the carrying value of our reporting unit to its fair value. Had the fair value of the reporting unit been less than its carrying amount, we would have determined the implied fair value of the goodwill and evaluated it for impairment.

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.

 

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Valuation of Acquired Intangible Assets

In connection with our acquisition of Chordiant, we recorded $88 million of intangible assets, relating principally to customer related intangible assets and acquired technology. The valuation process used to calculate the values assigned to these acquired intangible assets was complex and involved significant estimation relative to our financial projections. The principal component of the valuation process was the determination of discounted future cash flows, which was based on a number of estimates and assumptions. There was inherent uncertainty involved with this estimation process. The estimates and assumptions that are most sensitive include, but are not limited to:

 

   

the selection of an appropriate discount rate;

 

   

the required return on all assets employed by the valued asset to generate future income;

 

   

our projected overall revenue growth and mix of revenue from a market participant’s perspective;

 

   

our gross margin estimates (which are highly dependent on our mix of revenue);

 

   

our technology life cycles;

 

   

the attrition rate of our customers;

 

   

our planned level of operating expenses.

Accounting for Income Taxes

We recognize deferred tax assets and liabilities due to temporary differences between the book and tax bases of recorded assets and liabilities. 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 future reversals of existing taxable temporary differences, future taxable income, taxable income in prior carryback years, and tax planning strategies. 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.

We determined that we may utilize approximately $150.8 million of acquired Chordiant federal and foreign net operating losses (“NOLs”), of which approximately $127.2 million remained available as of December 31, 2011. The acquired federal NOLs are subject to annual limitations through 2029. As a result of the purchase price allocation, we recorded deferred tax assets of approximately $52.3 million related to these acquired NOLs. If our taxable income is not consistent with our expectations or the timing of income is not within the applicable carryforward period, we may be required to establish a valuation allowance on all or a portion of these deferred tax assets.

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.

 

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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 for 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.

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. Stock-based compensation is recognized over the requisite service period, which is generally the vesting period of the equity award, and is adjusted each period for anticipated forfeitures. We recognize stock-based compensation using the ratable method, which treats each vesting tranche as if it were an individual grant.

We periodically grant stock options and RSUs for a fixed number of shares to employees and non-employee Directors. RSUs deliver to the recipient a right to receive a specified number of shares of our common stock upon vesting, net of tax withholding. Unlike stock options, there is no cost to the employee at share issuance. We value our RSUs at the fair value of our common stock on the grant date, which is the closing price of our common stock on the grant date, less the present value of expected dividends as the employee is not entitled to dividends during the requisite service period. The exercise price for stock options is greater than or equal to the fair market value of the shares at the date of the grant.

We estimate the fair value of stock options using the Black-Scholes option valuation model, which requires us to make estimates of key assumptions including the expected term of the option, the expected volatility of our stock price over the option’s expected term, the risk-free interest rate over the option’s expected term, and our expected annual dividend yield. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. The expected volatility is based on the historical volatility of our stock price. The expected annual dividend yield is based on the expected annual dividend of $0.12 per share divided by the average stock price. The risk-free interest rate is based on the yield of zero-coupon U.S. Treasury securities for a period that is commensurate with the expected option term at the time of grant. If factors change and we employ different assumptions in future periods, the compensation expense that we record may differ significantly from what we have recorded in the current period.

The choice of a valuation model, and the underlying assumptions used in applying that model, involves significant judgment. Our judgment reflects our assessment of the most accurate method of valuing the stock options we issue based on our historical experience, knowledge of current conditions, and beliefs of what could occur in the future given available information. Our judgment could change over time as additional information becomes available to us, or the facts underlying our assumptions change over time, and any change in our judgments could have a material effect on our financial statements.

See Note 15 “Stock-Based Compensation” in the notes to the accompanying audited consolidated financial statements for further information.

 

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ITEM 7A. Quantitative and Qualitative Disclosure about Market Risk

Market risk represents the risk of loss that may affect us due to adverse changes in financial market prices and rates. Our market risk exposure is primarily related to fluctuations in foreign exchange rates and interest rates.

Foreign currency exposure

We derived approximately 48%, 41%, and 34%, of our total revenue from sales to customers based outside of the U.S. in 2011, 2010, and 2009, respectively. Our international license and professional services sales have increasingly become denominated in foreign currencies. However, the operating expenses of our foreign operations are also primarily denominated in foreign currencies, which partially offset our foreign currency exposure. A decrease in the value of foreign currencies, particularly the British pound and the Euro relative to the U.S. dollar, could adversely impact our revenues and operating results.

Beginning in the second quarter of 2011, we have entered into forward foreign currency contracts to manage our exposure to changes in foreign currency exchange rates affecting foreign currency denominated accounts receivable and cash held by our U.S. operating company.

Our U.S. operating company invoices most of our foreign customers in foreign currencies, so it holds cash and receivables denominated in these foreign currencies. Our U.S. operating company’s functional currency is the U.S. dollar. Therefore, when there are changes in the foreign currency exchange rates versus the U.S. dollar, we recognize a foreign currency transaction gain or (loss) in our consolidated statements of operations. In addition, we have intercompany accounts that are eliminated in consolidation, but that expose us to foreign currency exchange rate fluctuation, which are recorded as foreign currency transaction gains or (losses) in our consolidated statements of operations.

We are primarily exposed to changes in the value of the Euro and British pound relative to the U.S. dollar. We have not designated the forward foreign currency contracts as hedging instruments and as a result, we record their fair value at the end of each reporting period in our consolidated balance sheet as other current assets for unrealized gains and accrued expenses for unrealized losses, with any fluctuations in the value of these contracts recognized in other income, net, in our consolidated statements of operations. Generally, we enter into contracts with terms of 60 days or less.

The fluctuations in the value of these forward foreign currency contracts partially offset the gains and losses from the remeasurement or settlement of the foreign currency denominated accounts receivable and cash held by the U.S. operating company, thus mitigating the volatility.

During 2011, we entered into and settled forward foreign currency contracts to sell 28.5 million Euros and 19.5 million British pounds and to receive $71.4 million. As of December 31, 2011, we did not have any forward foreign currency contracts outstanding. During 2011, the total change in the fair value of our forward foreign currency contracts recorded in other income, net, was a net gain of $0.8 million.

The impact on net income of the gains recorded on the forward foreign currency contracts, which is included in other income, net, in the accompanying consolidated statements of operations, and the foreign currency transaction losses recorded on the remeasurement and settlement of the foreign currency denominated assets, which is included in foreign currency transaction (loss) gain in the accompanying consolidated statements of operations, was a net loss of approximately $1.2 million for the year ended December 31, 2011. This net loss was primarily due to timing of settlement of intercompany balances and foreign currency denominated cash held as of the end of the period, for which we did not have forward currency contracts.

Interest rate exposure

As of December 31, 2011, we had $51.1 million of marketable debt securities, which consisted of government sponsored enterprise bonds, corporate bonds, and municipal bonds. Due to the overall short-term remaining maturities of our marketable debt securities, our interest rate exposure is not significant. As of December 31, 2011, a 200 basis point increase in market interest rates would have reduced the fair value of our fixed rate marketable debt securities by approximately $1.2 million.

 

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ITEM 8. Financial Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page  

Report of Independent Registered Public Accounting Firm

     43   

Consolidated Balance Sheets as of December 31, 2011 and 2010

     44   

Consolidated Statements of Operations for the years ended December 31, 2011, 2010, and 2009

     45   

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the years ended December 31, 2011, 2010, and 2009

     46   

Consolidated Statements of Cash Flows for the years ended December 31, 2011, 2010, and 2009

     47   

Notes to Consolidated Financial Statements

     48   

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of Pegasystems Inc.

Cambridge, Massachusetts

We have audited the accompanying consolidated balance sheets of Pegasystems Inc. and subsidiaries (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Pegasystems Inc. and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2011, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 29, 2012 expressed an unqualified opinion on the Company’s internal control over financial reporting.

/s/ DELOITTE & TOUCHE LLP

Boston, Massachusetts

February 29, 2012

 

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PEGASYSTEMS INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

 

     As of December 31,  
     2011      2010  
ASSETS      

Current assets:

     

Cash and cash equivalents

   $ 60,353       $ 71,127   

Marketable securities

     51,079         16,124   
  

 

 

    

 

 

 

Total cash, cash equivalents, and marketable securities

     111,432         87,251   

Trade accounts receivable, net of allowance of $926 and $1,159

     98,293         79,896   

Deferred income taxes

     9,826         4,770   

Income taxes receivable

     7,545         9,266   

Other current assets

     4,865         7,473   
  

 

 

    

 

 

 

Total current assets

     231,961         188,656   

Property and equipment, net

     14,458         11,010   

Long-term deferred income taxes

     43,286         33,769   

Long-term other assets

     2,186         2,905   

Intangible assets, net

     69,369         80,684   

Goodwill

     20,451         20,451   
  

 

 

    

 

 

 

Total assets

   $     381,711       $     337,475   
  

 

 

    

 

 

 
LIABILITIES AND STOCKHOLDERS’ EQUITY      

Current liabilities:

     

Accounts payable

   $ 10,899       $ 6,286   

Accrued expenses

     18,336         24,736   

Accrued compensation and related expenses

     39,170         27,125   

Deferred revenue

     73,840         56,903   
  

 

 

    

 

 

 

Total current liabilities

     142,245         115,050   

Income taxes payable

     9,547         5,783   

Long-term deferred revenue

     15,367         17,751   

Other long-term liabilities

     5,796         3,221   
  

 

 

    

 

 

 

Total liabilities

     172,955         141,805   
  

 

 

    

 

 

 

Commitments and contingencies

     

Stockholders’ equity:

     

Preferred stock, $0.01 par value, 1,000 shares authorized; no shares issued and outstanding

               

Common stock, $0.01 par value, 70,000 shares authorized; 37,712 shares and 37,250 shares issued and outstanding

     377         372   

Additional paid-in capital

     129,701         122,607   

Retained earnings

     77,029         71,431   

Accumulated other comprehensive income:

     

Net unrealized gain (loss) on available-for-sale marketable securities

     57         (36

Foreign currency translation adjustments

     1,592         1,296   
  

 

 

    

 

 

 

Total stockholders’ equity

     208,756         195,670   
  

 

 

    

 

 

 

Total liabilities and stockholders’ equity

   $ 381,711       $ 337,475   
  

 

 

    

 

 

 

See notes to consolidated financial statements.

 

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PEGASYSTEMS INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

 

     Year ended December 31,  
     2011     2010     2009  

Revenue:

      

Software license

   $ 138,807      $   119,839      $ 115,934   

Maintenance

     117,110        83,878        50,099   

Professional services

     160,758        132,882        97,980   
  

 

 

   

 

 

   

 

 

 

Total revenue

     416,675        336,599        264,013   
  

 

 

   

 

 

   

 

 

 

Cost of revenue:

      

Cost of software license

     6,693        4,303        121   

Cost of maintenance

     13,077        11,041        6,203   

Cost of professional services

     145,028        113,390        84,613   
  

 

 

   

 

 

   

 

 

 

Total cost of revenue

     164,798        128,734        90,937   
  

 

 

   

 

 

   

 

 

 

Gross profit

     251,877        207,865        173,076   
  

 

 

   

 

 

   

 

 

 

Selling and marketing

     147,457        116,230        74,378   

Research and development

     65,308        55,193        38,862   

General and administrative

     28,198        25,034        18,017   

Acquisition-related costs

     482        5,924          

Restructuring costs

     (62     8,064          
  

 

 

   

 

 

   

 

 

 

Total operating expenses

     241,383        210,445        131,257   
  

 

 

   

 

 

   

 

 

 

Income (loss) from operations

     10,494        (2,580     41,819   

Foreign currency transaction (loss) gain

     (935     (5,569     2,083   

Interest income, net

     398        1,138        3,491   

Other income, net

     856        814        22   
  

 

 

   

 

 

   

 

 

 

Income (loss) before provision (benefit) for income taxes

     10,813        (6,197     47,415   

Provision (benefit) for income taxes

     705        (306     15,203   
  

 

 

   

 

 

   

 

 

 

Net income (loss)

   $   10,108      $ (5,891   $   32,212   
  

 

 

   

 

 

   

 

 

 

Net earnings (loss) per share

      

Basic

   $ 0.27      $ (0.16   $ 0.89   
  

 

 

   

 

 

   

 

 

 

Diluted

   $ 0.26      $ (0.16   $ 0.85   
  

 

 

   

 

 

   

 

 

 

Weighted-average number of common shares outstanding

      

Basic

     37,496        37,031        36,208   

Diluted

     39,404        37,031        38,113   

Cash dividends declared per share

   $ 0.12      $ 0.12      $ 0.12   
  

 

 

   

 

 

   

 

 

 

See notes to consolidated financial statements.

 

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PEGASYSTEMS INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND

COMPREHENSIVE INCOME (LOSS)

(in thousands, except per share amounts)

 

    Common Stock     Additional
Paid-In
Capital
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income
    Total
Stockholders’
Equity
 
    Number
of Shares
    Amount                          

Balance at December 31, 2008

    35,810      $ 358      $ 117,926      $ 53,935      $ 895      $ 173,114   

Repurchase of common stock

    (677     (7     (12,076         (12,083

Issuance of common stock for share-based compensation plans

    1,645        17        (4,140                   (4,123

Issuance of stock under Employee Stock Purchase Plan

    15               335                      335   

Exercise of common stock warrants

    7                                      

Issuance of stock awards

    18               454            454   

Stock-based compensation expense

                  4,219                      4,219   

Tax benefit from exercise or vesting of equity awards, net of deferred tax asset deficiencies of $740

                  14,671                      14,671   

Cash dividends declared ($0.12 per share)

                         (4,371            (4,371

Comprehensive income:

           

Foreign currency translation adjustments

                                1,314        1,314   

Net unrealized holding gain on investments available-for-sale, net of tax of $45

                           (523     (523
           

 

 

 

Net income

                         32,212               32,212   
           

 

 

 

Total comprehensive income

            $ 33,003   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2009

    36,818      $ 368      $ 121,389      $ 81,776      $ 1,686      $ 205,219   

Repurchase of common stock

    (295     (3     (8,289         (8,292

Issuance of common stock for share-based compensation plans

    690        7        (4,720                   (4,713

Issuance of stock under Employee Stock Purchase Plan

    22               595                      595   

Issuance of stock awards

    15               420                      420   

Stock-based compensation expense

        6,325            6,325   

Value of stock options issued for acquisition of Chordiant

                  3,519                      3,519   

Tax benefit from exercise or vesting of equity awards, net of deferred tax asset deficiencies of $351

                  3,368            3,368   

Cash dividends declared ($0.12 per share)

                         (4,454            (4,454

Comprehensive loss:

           

Foreign currency translation adjustments

                                149        149   

Unrealized loss on securities:

           

Net unrealized holding loss on investments available-for-sale, net of tax of $19

                                (338     (338

Less: reclassifications adjustment for gains included in net loss, net of tax of $5

                                (237     (237

Net loss

                         (5,891            (5,891
           

 

 

 

Total comprehensive loss

            $ (6,317
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2010

    37,250      $ 372      $ 122,607      $ 71,431      $ 1,260      $ 195,670   

Repurchase of common stock

    (139     (1     (4,863         (4,864

Issuance of common stock for share-based compensation plans

    575        6        (4,293                   (4,287

Issuance of stock under Employee Stock Purchase Plan

    18               647                      647   

Issuance of stock awards

    8               350                      350   

Stock-based compensation expense

             8,678                      8,678   

Tax benefit from exercise or vesting of equity awards, net of deferred tax asset deficiencies of $83

                  6,575                      6,575   

Cash dividends declared ($0.12 per share)

                         (4,510            (4,510

Comprehensive income:

           

Foreign currency translation adjustments

                                296        296   

Unrealized gain on securities:

           

Net unrealized holding gain on investments available-for-sale, net of tax of $5

                                93        93   

Net income

                         10,108               10,108   
           

 

 

 

Total comprehensive income

            $ 10,497   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2011

            37,712      $         377      $         129,701      $         77,029      $       1,649      $       208,756   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See notes to consolidated financial statements.

 

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PEGASYSTEMS INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Year ended December 31,  
     2011     2010     2009  

Operating activities:

      

Net income (loss)

   $ 10,108      $ (5,891 )   $ 32,212   

Adjustment to reconcile net income (loss) to cash provided by operating activities:

      

Excess tax benefits from exercise or vesting of equity awards

     (6,658     (3,719     (15,411

Deferred income taxes

     (15,269     (1,574     1,413   

Depreciation and amortization

     17,073        10,838        2,801   

Amortization of investments

     849        994        3,910   

Stock-based compensation expense

     9,028        6,745        4,673   

Foreign currency transaction loss

     977        4,753          

Other

     58        (95     113   

Change in operating assets and liabilities:

      

Trade accounts receivable

     (18,504     (23,365     6,021   

Income taxes receivable and other current assets

     10,519        (1,217     (4,544

Accounts payable and accrued expenses

     9,041        4,515        16,311   

Deferred revenue

     14,595        23,927        639   

Other long-term assets and liabilities

     7,998        2,503        1,443   
  

 

 

   

 

 

   

 

 

 

Cash provided by operating activities

     39,815        18,414        49,581   
  

 

 

   

 

 

   

 

 

 

Investing activities:

      

Purchases of marketable securities

     (57,249     (73,619     (79,447

Proceeds from maturities and called marketable securities

     20,648        34,426        67,327   

Sale of marketable securities

     1,048        161,260          

Payments for 2010 acquisition, net of cash acquired

            (109,228       

Contingent consideration paid for a 2008 acquisition

            (250       

Investment in property and equipment

     (9,835     (5,748     (6,043
  

 

 

   

 

 

   

 

 

 

Cash provided by (used in) investing activities

     (45,388     6,841        (18,163
  

 

 

   

 

 

   

 

 

 

Financing activities:

      

Issuance of common stock for share-based compensation plans

     2,622        2,863        4,808   

Excess tax benefits from exercise or vesting of equity awards

     6,658        3,719        15,411   

Dividend payments to shareholders

     (4,495     (4,441     (4,346

Common stock repurchases for tax withholdings for net settlement of equity awards

     (6,262     (6,984     (8,596

Common stock repurchases under share repurchase programs

     (4,835     (8,408     (12,326
  

 

 

   

 

 

   

 

 

 

Cash used in financing activities

     (6,312     (13,251     (5,049
  

 

 

   

 

 

   

 

 

 

Effect of exchange rate on cash and cash equivalents

     1,111        (4,734     1,401   
  

 

 

   

 

 

   

 

 

 

Net (decrease) increase in cash and cash equivalents

     (10,774     7,270        27,770   

Cash and cash equivalents, beginning of year

     71,127        63,857        36,087   
  

 

 

   

 

 

   

 

 

 

Cash and cash equivalents, end of year

   $     60,353      $     71,127      $     63,857   
  

 

 

   

 

 

   

 

 

 

Supplemental disclosures:

      

Income taxes paid

   $ 2,566      $ 1,582      $ 7,024   

Non-cash investing and financing activity:

      

Dividends payable

   $ 1,132      $ 1,118      $ 1,105   

See notes to consolidated financial statements.

 

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Table of Contents

PEGASYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1. BASIS OF PRESENTATION

(a) Business

The Company develops, markets, licenses, and supports software to automate complex, changing business processes. The Company provides implementation, consulting, training, and technical support services to facilitate the use of its software.

(b) Management estimates and reporting

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S.”) requires management to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates. Accounts with reported amounts based on significant estimates and judgments include revenue, allowance for sales credit memos, deferred income taxes, income taxes payable, intangible assets, goodwill, accrued expenses, deferred revenue, and stock-based compensation.

On June 29, 2011, the Company entered into a lease arrangement for its new office headquarters in Cambridge, Massachusetts. The Company expects to cease the use of its current offices in Cambridge, Massachusetts, in the second half of 2012 and abandon certain leasehold improvements and furniture and fixtures. Accordingly, in June 2011 the Company revised the remaining useful lives of these fixed assets and recorded incremental depreciation expense of approximately $0.9 million during the year ended December 31, 2011, as a result of this change in estimate. The Company expects to record approximately $0.4 million of additional depreciation expense per quarter through mid-2012. See Note 13 “Commitments and Contingencies” for further discussion of the new lease terms and its impact on the financial statements.

(c) Principles of consolidation

The consolidated financial statements include Pegasystems Inc. and its wholly owned subsidiaries. All inter-company accounts and transactions have been eliminated in consolidation.

(d) Purchase price adjustments and reclassifications

During the first quarter of 2011, the Company recorded adjustments to the purchase price allocation of its acquisition of Chordiant. As required by applicable business combination accounting rules, these adjustments were applied retrospectively. Therefore, other current assets, long-term other assets, goodwill, accrued expenses, and deferred tax assets have been revised as of December 31, 2010 to reflect these adjustments. These revisions did not have any impact on the Company’s previously reported results of operations or cash flows. See Note 9 “Acquisition, Goodwill, and Other Intangible Assets” for further discussion of these adjustments.

The Company combined certain captions within the consolidated balance sheet, consolidated statements of operations and consolidated statements of cash flows to conform to the current period presentation. The combining of these captions did not have any impact on total assets, total liabilities, net income (loss), total cash provided by operating activities or total cash used in investing activities.

 

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Table of Contents

PEGASYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

2. SIGNIFICANT ACCOUNTING POLICIES

(a) Revenue recognition

The Company’s revenue is derived primarily from software licenses, maintenance fees related to the Company’s software licenses, and professional services. The Company’s license arrangements, whether involving a perpetual license or a term license, generally contain multiple elements, including professional 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. 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 signed by the customer for software licenses and maintenance, and a statement of work for professional services. In the event the customer is a reseller the Company ensures 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.

 

   

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 software license agreements do not include a right of return.

 

   

Collection of fee is probable—We assess the probability of collecting from each customer at the outset of the arrangement based on a number of factors, including the customer’s payment history, its current creditworthiness, economic conditions in the customer’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 support, and all other revenue recognition criteria are met.

Term software license fees are generally payable on a monthly basis under license agreements that typically have a three to five-year term and may be renewed for additional terms at the customer’s option.

As a result of the Company’s focus on frequent sales to its targeted customers, the Company’s strategy is to sell initial term licensing agreements to those customers with the goal to generate follow-on sales, and as a result of extended payment terms, the Company recognizes 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.

Until 2005, the majority of the Company’s term license arrangements were larger agreements with extended payment terms that did not typically result in follow-on license agreements. The Company has a history of successfully collecting payments under the original payment terms for these arrangements, therefore, the

 

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PEGASYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Company recognized the present value of the future term license payments upon customer acceptance, provided that no significant obligations or contingencies exist related to the software, other than maintenance support, and provided all other criteria for revenue recognition had been met. A portion of the license fees payable under these agreements (equal to the difference between the total license payments and the discounted present value of those payments) was initially deferred and recognized as installment receivable interest income (and is not part of total revenue) over the license term. The Company no longer utilizes this business model for software license transactions. As of December 31, 2011, the remaining balance of these installment receivables totaled approximately $1.3 million.

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 the Company uses separate sales to determine VSOE of fair value.

Professional services revenues

The Company’s professional services revenue is comprised of fees for training, consulting services including software implementation, reimbursable expenses, and sales of its Pega Cloud as-a-platform offering (“Pega Cloud”). Consulting services may be provided on a “stand-alone” basis or bundled with a license and software maintenance services.

Revenue from “stand-alone” training services and consulting services under time and materials contracts is recognized as services are performed. The Company has VSOE of fair value for our training services and consulting services under time and materials contracts in North America and Europe, other than Spain.

Consulting services may be provided on a fixed-price basis. The Company does 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, the Company recognizes 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 the Company’s Pega Cloud offering and these services have stand-alone value to the customer, the Company accounts for these services separately from its Pega Cloud offering. Since these multiple-element arrangements are not software license sales, the Company applies 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, the Company is not able to determine TPE as its sales strategy is customized to the needs of its customers and the Company’s products and services are dissimilar to comparable products or services in the

 

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marketplace. In determining ESP, the Company applies significant judgment as it weighs a variety of factors, based on the facts and circumstances of the arrangement. The Company typically arrives 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

The Company warrants to its customers that its software products will conform to documented specifications for a limited period. The Company has not experienced significant claims related to software warranties beyond the scope of maintenance support, which it is already obligated to provide, and consequently it has not established reserves for warranty obligations.

The Company’s agreements with customers generally require it to indemnify the customer against claims that the Company’s 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 the Company’s right to replace an infringing product. As of December 31, 2011, the Company had not experienced any material losses related to these indemnification obligations and no material claims were outstanding. See Note 13 “Commitments and Contingencies” for a discussion of the settlement of claims assumed in the acquisition of Chordiant related to certain software that was sold by Chordiant.

Deferred revenue

Deferred software license revenue typically results from contractual 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 professional services revenue represents advanced billings for consulting and training services that are recognized as the services are performed.

Allowance for doubtful accounts and allowance for sales credit memos

The Company records allowances for estimates of sales credit memos for services rendered. The Company bases these estimates on historical analyses of sales credit memos and assumptions about future events and experience with customer disputes. If the Company experienced actual results that were different than those used in determining the assumptions in calculating the allowance, adjustments to the allowance would be reflected as changes to revenue.

The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of the Company’s customers to make required payments. The Company’s estimates are based on the composition of the accounts receivable aging, historical bad debts, changes in payment patterns, customer creditworthiness and current economic trends. If the financial condition of the Company’s customers were to deteriorate resulting in their inability to make required payments, additional provisions for doubtful accounts would be required and would increase bad debt expense.

(b) Fair value of financial instruments

The principal financial instruments held by the Company consist of cash equivalents, marketable securities, accounts receivable, and accounts payable. The carrying value of these instruments approximates their fair value due to their short maturities. See Note 4 “Marketable Securities” and Note 6 “Fair Value Measurements” for further discussion of financial instruments that are carried at fair value on a recurring basis.

 

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(c) Derivative instruments

The Company uses forward foreign currency contracts to manage its exposures to changes in foreign currency exchange rates associated with its foreign currency denominated accounts receivable and cash. The forward foreign currency contracts utilized by the Company are not designated as hedging instruments and as a result, the Company records the fair value of these contracts at the end of each reporting period in its consolidated balance sheet as other current assets for unrealized gains and accrued expenses for unrealized losses, with any fluctuations in the value of these contracts recognized in other income net, in its consolidated statement of operations. The fluctuations in the value of these forward foreign currency contracts partially offset the gains and losses from the remeasurement or settlement of the foreign currency denominated accounts receivable and cash held by the U.S. operating company, thus partly mitigating the volatility. Generally, the Company enters into forward foreign currency contracts with terms of 60 days or less.

(d) Property and equipment

Property and equipment are recorded at cost. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets, which are three years for equipment and five years for furniture and fixtures. Leasehold improvements are amortized over the lesser of the term of the lease or the useful life of the asset. Repairs and maintenance costs are expensed as incurred.

The Company capitalizes and amortizes certain direct costs associated with computer software developed or purchased for internal use. The Company amortizes capitalized software costs generally over three to five years commencing on the date the software is placed into service. During 2011, the Company did not capitalize any costs for computer software developed for internal use. During 2010 and 2009, the Company capitalized $0.7 million and $0.5 million of computer software costs related to the Company’s implementation of an accounting system for internal use.

(e) Goodwill

Goodwill represents the residual purchase price paid in a business combination after all identified assets and liabilities have been recorded. Goodwill is not amortized, but prior to the Company’s adoption of the Financial Accounting Standards Board “FASB” Accounting Standards Update (“ASU”) No. 2011-08, “Intangibles-Goodwill and Other (Topic 350)” (“ASU 2011-08”), was tested annually in the fourth quarter for impairment or between annual tests if indicators of potential impairment exist. The Company adopted ASU 2011-08 in the fourth quarter of 2011, performed its assessment and concluded it was not more likely than not that the fair value of its single reporting unit was less than its carrying value. In 2010 and 2009, the Company compared the carrying value of the reporting unit to its fair value. Had the reporting unit’s carrying value exceeded its fair value, the Company would have recorded an impairment loss to the extent that the carrying value of goodwill exceeded its implied fair value. The Company performed its annual impairment evaluations in 2010 and 2009 and determined that goodwill was not impaired.

(f) Intangible Assets

All of the Company’s intangible assets are amortized using the straight-line method over their estimated useful life. The Company evaluates its intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Impairment is assessed by comparing the undiscounted cash flows expected to be generated by the intangible asset to its carrying value. If impairment exists, the Company calculates the impairment by comparing the carrying value of the intangible asset to its fair value as determined by discounted expected cash flows. The Company has not recorded any impairment in 2011, 2010, or 2009.

 

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(g) Research and development and software costs

Research and development costs are expensed as incurred. Capitalization of computer software developed for resale begins upon the establishment of technological feasibility, generally demonstrated by a working model or an operative version of the computer software product. Such costs have not been material to date as technological feasibility is established within a short timeframe from the software’s general availability and, as a result, no costs were capitalized during 2011, 2010, or 2009.

(h) Stock-Based Compensation

The Company recognizes stock-based compensation expense associated with equity awards based on the fair value of these awards at the grant date. Stock-based compensation is recognized over the requisite service period, which is generally the vesting period of the equity award, and is adjusted each period for anticipated forfeitures. The Company recognizes stock-based compensation using the ratable method, which treats each vesting tranche as if it were an individual grant. See Note 15 “Stock-based Compensation” for discussion of the Company’s key assumptions included in determining the fair value of its equity awards at grant date.

(i) Acquisition-related costs

Acquisition-related costs are expensed as incurred and include direct and incremental costs associated with an impending or completed acquisition. During 2011, the $0.5 million of acquisition-related costs were primarily legal fees associated with litigation assumed in our acquisition of Chordiant Software, Inc. (“Chordiant”). During 2010, the $5.9 million of acquisition-related costs consisted of approximately $3.1 million of due diligence costs and advisory and legal transaction fees, approximately $0.8 million of valuation and tax consulting fees, $1.6 million of legal costs associated with the assumed litigation, and $0.4 million of integration and other expenses related to Chordiant. See Note 9 “Acquisition, Goodwill and Intangibles” for further discussion of the acquisition.

(j) Restructuring costs

Restructuring costs include severance and related benefit costs for the reduction of personnel during the second and third quarter of 2010 related to the Chordiant acquisition. They also include future lease payments and demising costs, net of estimated sublease income, for the elimination of space within one facility. See Note 12 “Accrued Restructuring Costs” for further detail.

(k) Foreign currency translation

The translation of assets and liabilities for the majority of the Company’s foreign subsidiaries is made at period-end exchange rates, while revenue and expense accounts are translated at the average exchange rates during the period transactions occurred. The resulting translation adjustments are reflected in accumulated other comprehensive income. Our India subsidiary uses the U.S. dollar as its functional currency, therefore, its monetary assets and liabilities are remeasured at current rates and its non-monetary assets are recorded at historical exchange rates. Realized and unrealized exchange gains or losses from transactions and remeasurement adjustments are reflected in foreign currency transaction (loss) gain, in the accompanying consolidated statements of operations.

(l) Accounting for Income Taxes

The Company recognizes deferred tax assets and liabilities due to temporary differences between the book and tax bases of recorded assets and liabilities. Future realization of the Company’s deferred tax assets ultimately

 

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depends on the existence of sufficient taxable income within the available carryback or carryforward periods. Sources of taxable income include future reversals of existing taxable temporary differences, future taxable income, taxable income in prior carryback years, and tax planning strategies. The Company records a valuation allowance to reduce its deferred tax assets to an amount it believes is more-likely-than-not to be realized. Changes in the valuation allowance impacts income tax expense in the period of adjustment. The Company’s deferred tax valuation allowance requires significant judgment and uncertainties, including assumptions about future taxable income that are based on historical and projected information. The Company recognizes excess tax benefits when they are realized, through a reduction in income taxes payable using the with and without stock option method.

The Company assesses its income tax positions and records 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, the Company records 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. The Company classifies liabilities for uncertain tax positions as non-current liabilities unless the uncertainty is expected to be resolved within one year. The Company classifies interest and penalties on uncertain tax positions as income tax expense.

As a global company, the Company uses significant judgment to calculate and provide for income taxes in each of the tax jurisdictions in which it operates. 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 the Company’s subsidiaries and nexus and tax credit estimates. In addition, the calculation of acquired tax attributes and the associated limitations are complex. See Note 16 “Income Taxes” for further information.

 

3. NEW ACCOUNTING PRONOUNCEMENTS

Disclosures About Offsetting Assets and Liabilities: In December 2011, the Financial Accounting Standards Board “FASB” issued Accounting Standards Update (“ASU”) No. 2011-11, “Balance Sheet (Topic 210): Disclosures About Offsetting Assets and Liabilities” , which creates new disclosure requirements regarding the nature of an entity’s rights of setoff and related arrangements associated with its financial instruments and derivative instruments. Certain disclosures of the amounts of certain instruments subject to enforceable master netting arrangements or similar agreements would be required, irrespective of whether the entity has elected to offset those instruments in the statement of financial position. This ASU is effective for the Company on January 1, 2013 with retrospective application required. The adoption of this standard will not impact the Company’s financial position or results of operations as this accounting standard only requires enhanced disclosure.

Testing Goodwill for Impairment: In September 2011, the FASB issued ASU No. 2011-08, “Intangibles-Goodwill and Other (Topic 350)” (“ASU 2011-08”), which allows an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under the amendments in ASU 2011-08, an entity is not required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The Company elected to adopt the provisions of this ASU early as allowed by the FASB. The adoption of this standard did not have an impact on the Company’s consolidated financial statements.

Presentation of Comprehensive Income: In June 2011, the FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220)” (“ASU 2011-05”), and in December 2011 issued ASU No. 2011-12,

 

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Deferral of the Effective Date for Amendments to the Presentation of Reclassification of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update (Topic 220 (“ASU 2011-12”). These standards (1) eliminate the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity; (2) require the consecutive presentation of the statement of net income and other comprehensive income; and (3) require an entity to present reclassification adjustments on the face of the financial statements from other comprehensive income to net income. The amendments in these ASUs do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income nor do the amendments affect how earnings per share is calculated or presented. This ASU is required to be applied retrospectively and is effective for fiscal years and interim periods within those years beginning after December 15, 2011, which is the Company’s fiscal year 2012. The adoption of this standard will not impact the Company’s financial position or results of operations as this accounting standard only requires enhanced disclosure.

Disclosure of Supplementary Pro Forma Information for Business Combinations: In December 2010, the FASB issued ASU No. 2010-29, “Disclosure of Supplementary Pro Forma Information for Business Combinations (Topic 805)Business Combinations” (“ASU 2010-29”), to improve consistency in how the pro forma disclosures are calculated. Additionally, ASU 2010-29 enhances the disclosure requirements and requires description of the nature and amount of any material, nonrecurring pro forma adjustments directly attributable to a business combination. ASU 2010-29 is effective for the Company in fiscal year 2012 and should be applied prospectively to business combinations for which the acquisition date is after the effective date. The adoption of this standard will not impact the Company’s financial position or results of operations as this accounting standard only requires enhanced disclosure.

 

4. MARKETABLE SECURITIES

 

(in thousands)    December 31, 2011  
      Amortized
Cost
     Unrealized
Gains
     Unrealized
Losses
    Fair Value  

Marketable securities:

          

Municipal bonds

   $ 27,968         74         (2   $       28,040   

Corporate bonds

     15,058         16         (34     15,040   

Government sponsored enterprise bonds

     8,001         2         (4     7,999   
  

 

 

    

 

 

    

 

 

   

 

 

 

Marketable securities

   $     51,027               92         (40   $ 51,079   
  

 

 

    

 

 

    

 

 

   

 

 

 
(in thousands)    December 31, 2010  
      Amortized
Cost
     Unrealized
Gains
     Unrealized
Losses
    Fair Value  

Marketable securities:

          

Government sponsored enterprise bonds

   $ 5,601         1         (9   $       5,593   

Corporate bonds

     5,468                 (49     5,419   

Commercial paper

     2,999                 (1     2,998   

Municipal bonds

     2,114                        2,114   
  

 

 

    

 

 

    

 

 

   

 

 

 

Marketable securities

   $     16,182                   1         (59   $ 16,124   
  

 

 

    

 

 

    

 

 

   

 

 

 

The Company considers debt securities with maturities of three months or less when purchased, to be cash equivalents. Interest is recorded when earned. All of the Company’s investments are classified as available-for-sale and are carried at fair value with unrealized gains and losses recorded as a component of accumulated other comprehensive income, net of related income taxes.

 

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As of December 31, 2011, remaining maturities of marketable debt securities ranged from February 2012 to November 2014, with a weighted-average remaining maturity of approximately 14 months.

 

5. DERIVATIVE INSTRUMENTS

Beginning in the second quarter of 2011, the Company uses forward foreign currency contracts to manage its exposure to changes in foreign currency exchange rates associated with its foreign currency denominated accounts receivable and cash. The U.S. operating company invoices most of its foreign customers in foreign currencies, which results in cash and receivables held at the end of the reporting period denominated in these foreign currencies. Since the U.S. operating company’s functional currency is the U.S. dollar, the Company recognizes a foreign currency transaction gain or (loss) on the foreign currency denominated cash and accounts receivable held by the U.S. operating company in its consolidated statements of operations when there are changes in the foreign currency exchange rates versus the U.S. dollar. The Company is primarily exposed to changes in the value of the Euro and British pound relative to the U.S. dollar. The forward foreign currency contracts utilized by the Company are not designated as hedging instruments and as a result, the Company records the fair value of these contracts at the end of each reporting period in its consolidated balance sheet as other current assets for unrealized gains and accrued expenses for unrealized losses, with any fluctuations in the value of these contracts recognized in other income, net, in its consolidated statement of operations. However, the fluctuations in the value of these forward foreign currency contracts partially offset the gains and losses from the remeasurement or settlement of the foreign currency denominated accounts receivable and cash held by the U.S. operating company, thus partly mitigating the volatility. Generally, the Company enters into forward foreign currency contracts with terms of 60 days or less.

During 2011, the Company entered into and settled forward foreign currency contracts to sell 28.5 million Euros and 19.5 million British pounds and to receive $71.4 million. As of December 31, 2011, the Company did not have any forward foreign currency contracts outstanding. During 2011, the change in the fair value of the Company’s forward foreign currency contracts recorded in other income, net, was a net gain of $0.8 million.

 

6. FAIR VALUE MEASUREMENTS

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 observable inputs that are observable either directly or indirectly; and (Level 3) significant unobservable inputs in which there is little or no market data, which requires 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. On a recurring basis, the Company records its marketable securities at fair value.

The Company’s investments classified within Level 1 of the fair value hierarchy are valued using quoted market prices. The Company’s investments classified within Level 2 of the fair value hierarchy are valued based on matrix pricing compiled by third party pricing vendors, using observable market inputs such as interest rates, yield curves, and credit risk.

 

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The fair value hierarchy of the Company’s cash equivalents and marketable securities at fair value is as follows:

 

                    Fair Value Measurements at  Reporting        
Date Using
 
(in thousands)    December 31, 2011      Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs

(Level 2)
 

Money market funds

   $             3,067       $                 3,067       $   
  

 

 

    

 

 

    

 

 

 

Marketable securities:

        

Municipal bonds

   $ 28,040       $ 6,110       $           21,930   

Corporate bonds

     15,040         15,040           

Government sponsored enterprise bonds

     7,999         2,001         5,998   
  

 

 

    

 

 

    

 

 

 

Total marketable securities

   $ 51,079       $ 23,151       $ 27,928   
  

 

 

    

 

 

    

 

 

 

 

                    Fair Value Measurements at  Reporting        
Date Using
 
(in thousands)    December 31, 2010      Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs

(Level 2)
 

Money market funds

   $             14,342       $                 14,342       $   
  

 

 

    

 

 

    

 

 

 

Marketable securities:

        

Government sponsored enterprise bonds

   $ 5,593       $       $           5,593   

Corporate bonds

     5,419         5,419           

Commercial paper

     2,998                 2,998   

Municipal bonds

     2,114                 2,114   
  

 

 

    

 

 

    

 

 

 

Total marketable securities

   $ 16,124       $ 5,419       $ 10,705   
  

 

 

    

 

 

    

 

 

 

Assets Measured at Fair Value on a Nonrecurring Basis

Assets not recorded at fair value on a recurring basis, such as property and equipment, and intangible assets are recognized at fair value when they are impaired. During 2011, 2010, and 2009, the Company did not recognize any nonrecurring fair value measurements from impairments. The Company recorded assets acquired and liabilities assumed related to its acquisition of Chordiant at fair value as described in Note 9 “Acquisition, Goodwill, and Other Intangible Assets.”

 

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7. TRADE ACCOUNTS RECEIVABLE, NET OF ALLOWANCES

Unbilled trade accounts receivable relate to services earned under time and material arrangements, maintenance and license arrangements that had not been invoiced as of December 31, 2011 and December 31, 2010, respectively.

 

(in thousands)    December 31,
2011
    December 31,
2010
 

Trade accounts receivable

   $ 77,123      $ 65,373   

Unbilled accounts receivable

     22,096        15,682   
  

 

 

   

 

 

 

Total accounts receivable

     99,219        81,055   
  

 

 

   

 

 

 

Allowance for sales credit memos

     (895     (1,027

Allowance for doubtful accounts

     (31     (132
  

 

 

   

 

 

 

Total allowance

     (926     (1,159
  

 

 

   

 

 

 
   $         98,293      $         79,896   
  

 

 

   

 

 

 

The Company records an allowance for estimates of potential sales credit memos when the related revenue is recorded and reviews this allowance periodically. The following reflects the activity of the allowance for sales credit memos for each of three years ended December 31:

 

(in thousands)    2011     2010     2009  

Balance at beginning of year

   $ 1,027      $ 540      $ 1,125   

Provision for credit memos

     2,877        3,050        2,600   

Credit memos issued

     (3,009     (2,563     (3,185
  

 

 

   

 

 

   

 

 

 
   $         895      $         1,027      $         540   
  

 

 

   

 

 

   

 

 

 

 

8. PROPERTY AND EQUIPMENT

 

(in thousands)    December 31,
2011
    December 31,
2010
 

Leasehold improvements

   $ 12,778      $ 7,242   

Computer equipment

     8,951        8,550   

Furniture and fixtures

     3,495        2,736   

Computer software purchased

     3,186        3,079   

Computer software developed for internal use

     721        721   

Fixed assets in progress

     451        626   
  

 

 

   

 

 

 
     29,582        22,954   

Less: accumulated depreciation and amortization

     (15,124     (11,944
  

 

 

   

 

 

 

Property and equipment, net

   $         14,458      $         11,010   
  

 

 

   

 

 

 

Depreciation and amortization expense was approximately $6.1 million, $4.3 million, and $2.8 million for the years ended December 31, 2011, 2010, and 2009, respectively.

 

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9. ACQUISITION, GOODWILL, AND OTHER INTANGIBLE ASSETS

Chordiant Acquisition

On April 21, 2010, the Company acquired all of the outstanding shares of common stock of Chordiant, a leading provider of customer relationship management (“CRM”) software and services with a focus on improving customer experiences through decision technology. The aggregate purchase price for Chordiant was approximately $160.3 million, consisting of $156.8 million in cash and the issuance of stock options with a fair value of $3.5 million. The Company issued approximately 241,000 stock options as replacement of outstanding Chordiant stock options at the acquisition date. The majority of the fair value of these stock options was recorded as purchase price based on the portion of the awards related to pre-combination services. The compensation expense associated with the portion of the replacement awards related to post-combination services totaled $0.2 million and was recognized as compensation expense over the remaining service period. The Company has expensed all transaction costs, as described in Note 2 “Significant Accounting Policies.” These costs were included in acquisition-related costs in the accompanying consolidated statement of operations. The operations of Chordiant were included in the Company’s operating results from the date of acquisition.

During the third quarter of 2010, the Company preliminarily determined that it may utilize approximately $146 million of acquired Chordiant federal net operating losses (“NOLs”), which are subject to annual limitations through 2029. As a result of this determination and other tax related adjustments, the Company updated its purchase price allocation in the third quarter of 2010 and recorded a $31.5 million increase in net deferred tax assets, a $0.3 million decrease in accrued federal income taxes, a decrease of $2.4 million in acquired intangible assets, and a $29.4 million decrease in goodwill. During the fourth quarter of 2010, the Company recorded a valuation adjustment on certain acquired foreign NOLs, preliminarily determined it may utilize a total of $150.8 million of acquired Chordiant federal and foreign NOLs, and recorded additional assumed liabilities. As a result of these changes, the Company recorded a $1.8 million increase in net deferred tax assets, a $3.4 million increase to accrued liabilities, and a $0.6 million decrease to long-term liabilities, which resulted in a $1.0 million net increase to goodwill.

During the first quarter of 2011, the Company recorded adjustments to the purchase price allocation to reflect the Company’s final determination of other accrued liabilities, acquired tax assets and uncertain tax liabilities. As a result of this determination, the Company recorded a $1.8 million decrease to other accrued liabilities, a $0.4 million increase to net deferred tax assets, and a corresponding $2.2 million decrease to goodwill. These purchase price adjustments were also reflected retrospectively as of December 31, 2010 in the accompanying consolidated balance sheet as required by the business combination accounting rules.

 

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As of December 31, 2011 and 2010, as a result of the final purchase price allocation, the Company had approximately $18.1 million of goodwill, which was primarily due to the expected synergies of the combined entities and the workforce in place. The goodwill created by the transaction is nondeductible for tax purposes. A summary of the final purchase price allocation for the acquisition of Chordiant was as follows:

 

(in thousands)       

Total purchase consideration:

  

Cash

   $ 156,832   

Stock options

     3,519   
  

 

 

 

Total purchase consideration

   $ 160,351   
  

 

 

 

Allocation of the purchase consideration:

  

Cash

   $ 47,604   

Accounts receivable, net of allowance

     14,231   

Other assets

     2,659   

Property and equipment

     753   

Deferred tax assets, net

     26,927   

Identifiable intangible assets

     88,049   

Goodwill

     18,060   

Accounts payable

     (5,303)   

Accrued liabilities

     (12,053)   

Deferred maintenance revenue

     (17,863)   

Long-term liabilities

     (2,713)   
  

 

 

 

Net assets acquired

   $             160,351   
  

 

 

 

The valuation of the assumed deferred maintenance revenue was based on the Company’s contractual commitment to provide post-contract customer support to Chordiant customers. The fair value of this assumed liability was based on the estimated cost plus a reasonable margin to fulfill these service obligations. The majority of the deferred revenue was recognized in the 12 months following the acquisition.

The valuation of the acquired intangible assets is inherently subjective and relies on significant unobservable inputs. The Company used an income approach to value the acquired customer related intangible assets, technology and trade name. The valuation for each of these intangible assets was based on estimated projections of expected cash flows to be generated by the assets, discounted to the present value at discount rates commensurate with perceived risk. The valuation assumptions took into consideration the Company’s estimates of contract renewal, technology attrition and revenue growth projections.

The acquired intangibles are being amortized over a weighted-average period of 8.4 years on a straight-line basis. The values for specifically identifiable intangible assets, by major asset class, are as follows:

 

(in thousands)          

Amortization
period

(in years)

Customer related intangible assets

   $             44,355             9

Technology

     43,446             8

Trade name

     248            1
  

 

 

    
   $ 88,049            
  

 

 

    

 

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PEGASYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Pro forma Information

The following pro forma financial information presents the combined results of operations of the Company and Chordiant as if the acquisition had occurred on January 1, 2009 after giving effect to certain pro forma adjustments. The pro forma adjustments reflected herein include only those adjustments that are directly attributable to the Chordiant acquisition, factually determinable, and expected to have a continuing impact on the Company. These pro forma adjustments include a reduction of historical Chordiant revenue for fair value adjustments related to acquired deferred revenue and elimination of deferred costs associated with revenue, a net increase in amortization expense to eliminate historical amortization of Chordiant intangible assets and to record amortization expense for the $88 million of acquired identifiable intangibles, and a decrease in interest income as a result of the cash paid for the acquisition. The pro forma financial information for 2010 includes approximately $8.5 million of acquisition-related costs, including transaction costs incurred by the Company and Chordiant. The pro forma financial information does not reflect any adjustments for anticipated synergies resulting from the acquisition and is not necessarily indicative of the operating results that would have actually occurred had the transaction been consummated as of January 1, 2009.

 

     Pro Forma
Year Ended
December 31,
 
     2010      2009  

Revenue

   $         355,433       $     323,478   

Net (loss) income

     (21,890)         5,490   

Net (loss) income per basic share

   $ (0.59)       $ 0.15   
  

 

 

    

 

 

 

Net (loss) income per diluted share

   $ (0.59)       $ 0.14   
  

 

 

    

 

 

 

Goodwill and Intangibles

As discussed in Note 18 “Geographic Information and Major Customers”, the Company operates in one operating segment, business process solutions. The Company has one reporting unit, the fair value of which is evaluated annually to determine whether goodwill is impaired.

The following table presents the changes in the carrying amount of goodwill:

 

(in thousands)    2011      Recasted
2010

(1)
 

Balance as of January 1,

   $       20,451       $       2,391   

Goodwill acquired during the year

             20,227   

Purchase price adjustments to goodwill retrospectively applied

             (2,167)   
  

 

 

    

 

 

 

Balance as of December 31,

   $ 20,451       $ 20,451   
  

 

 

    

 

 

 

 

(1) The purchase price adjustments related to the Chordiant acquisition identified during the first quarter of 2011 were retrospectively applied as of December 31, 2010.

 

61


Table of Contents

PEGASYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Intangible assets are recorded at cost and are amortized using the straight-line method over their estimated useful life, which range from four to nine years. The technology designs and non-compete agreements are being amortized over their estimated useful lives of four and five years, respectively.

 

(in thousands)    Cost      Accumulated
Amortization
    Net Book
Value
 

As of December 31, 2011

       

Customer related intangibles

   $ 44,355       $ (8,214   $ 36,141   

Technology

     43,446         (10,269     33,177   

Trade name

     248         (248       

Technology designs

     490         (463     27   

Non-compete agreements

     100         (76     24   

Intellectual property

     1,400         (1,400       
  

 

 

    

 

 

   

 

 

 

Total

   $ 90,039       $ (20,670   $ 69,369   
  

 

 

    

 

 

   

 

 

 

As of December 31, 2010

       

Customer related intangibles

   $ 44,355       $ (3,286   $ 41,069   

Technology

     43,446         (4,108     39,338   

Trade name

     248         (165     83   

Technology designs

     490         (340     150   

Non-compete agreements

     100         (56     44   

Intellectual property

     1,400         (1,400       
  

 

 

    

 

 

   

 

 

 

Total

   $     90,039       $ (9,355   $     80,684   
  

 

 

    

 

 

   

 

 

 

For the years ended December 31, 2011, 2010 and 2009, amortization expense of acquired intangibles was reflected in the Company’s consolidated statements of operations as follows:

 

(in thousands)    2011      2010      2009  

Amortization expense:

        

Cost of software license

   $ 6,284       $