Pegasystems Earnings: Strong Quarter as Customer Conversations on AI Ramp; Maintain $52 Fair Value

No-moat Pegasystems PEGA reported third-quarter results above our estimates on the top and bottom line as the firm had outsize subscription revenue along with improved operating efficiency as a result of headcount reductions and restructuring earlier in the year. Management noted high customer interest in generative AI, and we view Pegasystems as well positioned to benefit due to its history with integrating AI into its platform and natural fit with process automation. Our model adjustments are minor given the results, and we maintain our fair value estimate of $52 per share. Shares are trading near $40 and we view the stock as undervalued. However, due to heightened uncertainty arising from its ongoing litigation with Appian, we prefer other software names in our coverage with less overhang.

Third-quarter revenue grew 24% year over year to $335 million as subscriptions revenue outpaced our estimates driven by stronger than normal expansion from existing customers, which we are not yet convinced is a durable trend. Pega Cloud ACV growth was up 17% year over year and continues to be its largest and fastest growing segment, brought on by investments in automation, Kubernetes implementation, and multi-tenancy.

Pegasystems generated a non-GAAP operating margin of 6.4% in the quarter, compared with negative 15.7% a year ago, which was better than we anticipated. Restructuring actions taken within the quarter helped, as did better revenue. These same factors contributed to good cash flow generation. Management reiterated its ‘Rule of 40′ goal for ACV growth and free cash flow margin to exceed 40%. This quarter it produced 13% free cash flow margin and a sequentially lower 12% ACV growth.