Downgrading Our Pegasystems Moat Rating Largely on Concerns About Appian Lawsuit

Pegasystems PEGA reported strong fourth-quarter results and provided investors with healthy first-quarter guidance. However, we have reassessed the company’s moat rating and are downgrading Pegasystems to a no-moat rating from narrow, as we remain concerned about potential value destruction arising from the outstanding $2 billion legal judgment awarded to Appian. Litigation aside, our long-term outlook for Pegasystems’ products has not changed, as we still see strong evidence of high customer switching costs and view it as a potential candidate for a moat reconsideration hinging on the final settlement of the legal affair with Appian. Despite our moat downgrade, we are maintaining our $55 fair value estimate on the back of the strong results and guidance. We view the shares, trading up to $45 after hours, as slightly undervalued but would prefer to invest in cleaner stories, given the uncertainty involved.

Fourth-quarter revenue grew 25% year over year to $396 million, significantly outpacing our estimate of $343 million. More encouraging is the significant backlog for Pega Cloud and a slight uptick in the Pega Cloud annual contract value growth rate from the prior quarter. Pegasystems closed out its year on a strong note, with ACV growing 16% year over year in constant currency to $1.1 billion, while remaining performance obligations were up 4% in constant currency to $1.4 billion. We are encouraged by the continued adoption of Pega Cloud, where ACV growth improved again, growing 25% from the prior year, while its backlog grew 54% year over year.

Non-GAAP operating margin was 16.2%, compared with negative 1.5% a year ago. The improvement was the result of management’s cost-cutting measures and stronger Pega Cloud gross margins as the platform continues to scale. We view Pega Cloud as a critical profitability lever for the company and were pleased to see its gross margin improving 300 basis points to 70% as the product scales.