| PEGASYSTEMS INC ITEM 1A RISK FACTORS Factors that may affect future results 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 revenues In recent years, we have typically licensed our software to new customers pursuant to perpetual licenses rather than term licenses, which has the effect of decreasing the amount of future term license renewal revenue and cash flow, and could reduce our overall future license revenue and cash flow if we are unable to increase the future volume of license transactions |
| In prior years, we typically licensed our software under term licenses requiring the customer to make monthly payments over the license term |
| More recently, we have typically been selling perpetual licenses to our software with a single license fee being payable at the commencement of the license (although our term license revenue exceeded our perpetual license revenue in 2005 due to a few large term licenses) |
| We expect that perpetual licenses for new customers will continue to be a significant portion of 8 ______________________________________________________________________ [31]Table of Contents total license signings, although we expect to enter into new term licenses in certain instances |
| Our use of perpetual licenses has the effect, with respect to such transactions, of increasing our license revenue and cash flow in the short term, but of decreasing the amount of renewal license revenue and cash flow in the future |
| If we are unable to increase the volume of new license transactions, given the anticipated decline in the renewal revenue from term license arrangements, our license revenue and cash flow will likely decline in future periods |
| The volume of our license transactions began to increase in the second half of 2005, and we may not be able to sustain this increased volume of license transactions unless we 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 transactions is likely to increase demand for professional services, training and maintenance relating to our products |
| Given that our volume of license transactions began to increase in the second half of 2005, we anticipate that 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 our customers through training and the creation of “centers of excellence” to create an expanded universe of people that are skilled in the implementation of our products |
| However, if we 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 |
| We are increasingly entering into smaller 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 |
| In 2005, we increasingly entered into small initial licenses with our new customers rather than selling large application licenses, to allow these new customers to realize business value from our software quickly and for a limited up-front investment |
| Once a customer has realized this initial value, we work with the customer to identify opportunities for follow-on sales, which are typically larger than the initial sale |
| 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, and our license revenue will be limited to the smaller initial sale |
| This could lower average transaction size and adversely affect our financial performance |
| Our term license revenue will decrease in the short term if we increasingly enter into term licenses with contract provisions that require the term license revenue to be recognized over the term of the agreement as license payments become due or ratably over the term of the license when paid in advance, or if existing customers do not renew their term licenses |
| A significant portion of our total revenue has been attributable to term licenses, including term license renewals |
| Historically, a significant portion of our term license revenue has been recognized as the present value of the committed future term license fees, as described in the Critical Accounting Policies contained in this Annual Report on Form 10-K In the future, we expect to increasingly enter into term licenses with contract provisions that require the term license revenue to be recognized over the term of the agreement as payments become due, or ratably over the term of the license when payments are made in advance |
| This would have the effect, with respect to a particular agreement, of reducing our term license revenue in the initial period but increasing the amount of recurring future term license revenue during the remainder of the license term, but would not change the expected cash flow |
| In addition, while historically a majority of customers have renewed their term licenses, there can be no assurance that a majority of customers will continue to renew expiring term licenses |
| A decrease in term license renewal revenue absent offsetting revenue from other sources would have a material adverse effect on future financial performance |
| 9 ______________________________________________________________________ [32]Table of Contents Our professional services revenue is dependent to a significant extent on closing license transactions with new customers |
| We derive a substantial portion of our professional services revenue from implementation of software licensed by new customers and the development of applications by our customers using our software |
| Increasingly, we are relying on business partners to provide the implementation services for our customers, thus reducing the amount of professional services revenue we derive relative to a given level of license revenue |
| Accordingly, it is imperative that we close more license transactions with new customers if we are to maintain or grow our services revenue |
| Factors relating to fluctuations in our financial results The timing of our license revenue is difficult to predict accurately, due to the uncertain timing of the completion of implementation services, product acceptance by the customer and closing of additional sales |
| Our quarterly revenue may fluctuate significantly, in part because a large portion of our revenue in any quarter is attributable to product acceptance or license renewal by a relatively small number of customers |
| Fluctuations also reflect our policy of recognizing revenue upon product acceptance or, in the case of term licenses, license renewal |
| In some cases, customers will not accept products until the end of a lengthy sales cycle and an implementation period, typically ranging from six to twelve months |
| Our PegaRULES products typically have a shorter sales cycle and implementation period than our historical application products |
| However, we may experience longer acceptance periods in some cases with respect to these products |
| Any increases in our sales or acceptance cycles may adversely affect our financial performance, due in part to the recognition of sales staff and commission costs in advance of revenue recognition |
| In addition, risks over which we have little or no control, including customers’ budgets, staffing allocation, and internal authorization reviews, can significantly affect the sales and acceptance cycles |
| Changes requested by customers may further delay product implementation and revenue recognition |
| 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, transactions and arrangements made among related parties, 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 |
| 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 |
| Our quarterly operating results have varied considerably in the past and are likely to vary considerably in the future |
| Historically, most of our revenue in a quarter has been attributable to a small number of transactions |
| This has caused our revenue to fluctuate, sometimes significantly |
| These fluctuations could cause us to be unprofitable on an annual or quarterly basis and to fail to meet analysts’ expectations regarding our earnings or revenue |
| Our current strategy to rely more heavily on third party services in support of license sales may increase these fluctuations because we will have less control over the timing of closing sales or customer acceptance of our software |
| While future fluctuations in our quarterly operating results may be buffered to some extent by the increasing percentages of our total revenue from maintenance services and by an increase in the number of license transactions, we expect those fluctuations will continue to be significant at least in the near term |
| We plan selling and marketing expenses, product development and other expenses based on anticipated future revenue |
| If revenue falls below expectations, 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 operating results are not necessarily meaningful and should not be relied upon to predict future performance |
| 10 ______________________________________________________________________ [33]Table of Contents We are investing heavily in sales and marketing and professional services in anticipation of increased license signings, and we may experience decreased profitability or losses if we are unsuccessful in increasing the value of license signings in the future |
| Demand for our products began to increase in the second half of 2005, which resulted in an increase in the value of new license signings in the second half of 2005 compared to the first half of 2005 |
| We anticipate that the demand for our products will continue to increase in 2006 compared to 2005 |
| Consequently, we have been increasing our investment in sales and marketing by hiring additional sales and marketing personnel |
| We also anticipate that we will need to provide our customers with more professional services, training and maintenance as a result of this anticipated increase in demand, and have been hiring additional personnel in these areas |
| If the anticipated demand for our products does not materialize, or if we are unsuccessful in increasing the value of new license signings, we could experience decreased profitability or losses as a result of these increased fixed costs, and our financial performance and results of operations could be adversely affected |
| Factors relating to our products and markets We will need to 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 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 |
| Our products are complex and may contain errors |
| Errors in products could cause the loss of or delay in market acceptance or sales and revenue, the diversion of development resources, injury to our reputation, or increased service and warranty costs which would have an adverse effect on financial performance |
| The market for our offerings is increasingly and intensely competitive, rapidly changing, and highly fragmented |
| The market for business process management software and related implementation, consulting and training services is intensely competitive 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 companies that target the customer interaction and workflow markets 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 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 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 and healthcare markets, and sales to these markets are important for our future growth, although we have been increasing our sales to other markets |
| 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 market is undergoing intense domestic and international consolidation, and consolidation has been increasing in the healthcare market |
| Consolidation may interrupt normal buying behaviors and increase the 11 ______________________________________________________________________ [34]Table of Contents volatility of our operating results |
| In recent years, several of our customers have been merged or consolidated |
| 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 |
| 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 relational database management system applications and development tool vendors, 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 their relationships with or support of us |
| We face risks from operations and customers based outside of the US Sales to customers headquartered outside of the United States represented approximately 35prca of our total revenue in 2005, 32prca in 2004, and 20prca in 2003 |
| We, in part through our wholly-owned subsidiaries based in the United Kingdom, Singapore, Canada, and Australia, market products and render consulting and training services to customers based in Canada, the United Kingdom, France, Germany, the Netherlands, Belgium, Switzerland, Austria, Ireland, Sweden, South Africa, Mexico, Australia, Hong Kong, and Singapore |
| We have established offices in Europe and Australia |
| 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 will 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 |
| Many of our international sales are denominated in US dollars |
| Accordingly, any appreciation of the value of the US 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 |
| Furthermore, we conduct a portion of our business in currencies other than the United States dollar |
| Our revenues and operating results are adversely affected when the dollar strengthens relative to other currencies and are positively affected when the dollar weakens |
| Changes in the value of major foreign currencies, particularly the British Pound and the Euro relative to the United States dollar, could adversely affect our revenues and operating results |
| 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 Mr |
| Alan Trefler, our Chief Executive Officer |
| The loss of key personnel could 12 ______________________________________________________________________ [35]Table of Contents 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 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 |
| Software product errors and security flaws in our products or services could expose us to product liability or 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-US 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 United States 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 United States |
| 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 |
| We are not aware that any of our products infringe the proprietary rights of third parties |
| There can be no assurance, however, 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 |
| Investor confidence and share value may be adversely impacted if our management is unable to provide an unqualified assessment regarding the effectiveness of our internal control over financial reporting, or if our independent registered public accounting firm is unable to provide us with an unqualified attestation regarding management’s assessment, for our 2006 fiscal year or beyond, as required by Section 404 of the Sarbanes-Oxley 13 ______________________________________________________________________ [36]Table of Contents Act of 2002 |
| The Securities and Exchange Commission, as directed by Section 404 of the Sarbanes-Oxley Act of 2002, adopted rules requiring public companies to include a report of management on the company’s internal control over financial reporting in its annual reports on Form 10-K that contains an assessment by management of the effectiveness of the company’s internal control over financial reporting |
| In addition, the company’s independent registered public accounting firm must attest to and report on management’s assessment of the effectiveness of the company’s internal control over financial reporting |
| For the year ended December 31, 2005, management’s assessment is included on page 37 of this Annual Report on Form 10-K and our independent registered public accounting firm’s attestation is included on page 38 of this Annual Report on Form 10-K For 2005, management’s assessment, and our registered public accounting firm’s attestation, concluded that our internal control over financial reporting as of December 31, 2005 was not effective due to a material weakness in our ability to properly apply generally accepted accounting principles as they relate to the recognition of revenue on transactions that contain complex and non-standard terms and a material weakness relating to our ability to make accurate estimates impacting our tax provision |
| For future periods, although we intend to diligently and regularly review and update our internal control over financial reporting in order to ensure compliance with the Section 404 requirements, our management may not be able to provide an unqualified assessment for our 2006 fiscal year or beyond, and our independent registered public accounting firm may not be able to provide unqualified opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting for any of these years |
| Any such event could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of our financial statements, which ultimately could negatively impact the market price of our shares |