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Introduction
Profitless tech firms are having a bad year. Investors who didn’t care about losses when rates were near zero seem to be changing their minds. Many of these stocks have lost more than half their value, but I believe there is further to go. Growth is now slowing, but profits (especially when considering stock compensation) are as elusive as ever.
Pegasystems (NASDAQ:PEGA) is an unprofitable company with single-digit revenue growth. On top of its fundamental challenges, the company is appealing a $2 billion judgment that a competitor won against it. I offer a fundamental valuation perspective on why the shares are overvalued no matter how the legal matter is settled.
Company background
Pegasystems is an enterprise software company that makes software for application development and digital process automation. According to its website, the company sells a “powerful low-code platform that builds agility into the world’s leading organizations, so they can adapt to change.” Clients use its “AI-powered decisioning and workflow automation to solve their most pressing business challenges.” The architecture is “scalable and flexible.” The company was founded in 1983 and has decades of experience in tailoring its offering to market needs. It is headquartered in Cambridge, MA.
The stock has woefully underperformed the market in the last year. The company has been unprofitable this year and in the prior four years.
Pegasystems’ quarterly financial overview
For the latest quarter ending September 30, 2022 (or what the company headlined as “the best quarter of the year”), the company generated $270.7 million in revenue, up 6% YoY. Operating income was a loss of $77.2 million (-28.5% operating margin). This includes stock compensation, which I do not ignore, as I believe it is a real expense.
The company currently has 82 million shares and a market capitalization of $2.9 billion. It has $593 million of debt and $276 million of cash. It thus has an enterprise value of $3.2 billion, amounting to 2.7x its annual revenue.
Analysts expect the company to generate $1.26 billion in revenue this year and growing 10% next year. I would regard this growth estimate as optimistic, since the company’s growth is currently in the mid-single digits. The consensus estimates for $0.10 of EPS this year and $0.57 next year ignore a substantial amount of stock compensation.
The company is shifting to a subscription-based model from selling licenses, and this move is largely complete. I see no evidence of an impending inflection in the growth rate, e.g., a growing deferred revenue balance.
PEGA stock valuation and recommendation
Given the company’s consistent losses, it is hard to determine its value. However, I am offering a scenario where it will make an attempt to drastically cut costs and become profitable. Assuming the company cuts a third of its costs and gets some leverage from growth, I am modeling a 6% GAAP operating margin in the long term.
A 6% margin on $1.26 billion of expected revenue this year would mean normalized annual operating profit of $$76 million. I would assume a 5% tax rate due to the company’s net operating losses over the last few years that can shield taxes. Thus, the company would generate $72 million in after-tax operating income or $0.88 per share. I would apply a generous 25x multiple to arrive at a per share value of $22 for the business. Subtracting net debt of $4 per share on the balance sheet would result in fair value for the shares of $18. Thus, I believe there is a 50% downside from the current share price of $36. There are no meaningful comparables for the company, but a high-quality software company like Microsoft (MSFT) trades at 25x earnings.
In a bull case, the company will surprise to the upside with a 10% operating margin. This would result in a normalized annual operating profit of $126 million or $120 million after tax. I will apply a 30x multiple on the per share profit of $1.46 to come up with a value per share of $44 for the business. Subtracting net debt of $4 per share would result in fair value for the shares of $40. This would represent a 10% upside from the current share price.
I recommend that investors avoid PEGA stock, sell any existing positions or short the stock. The short interest is low at 5%. With a professional account, you can generate more than 3% a year on the proceeds from shorting the stock, from the short rebate that your broker will pay you. The rebate is generated by investing the sale proceeds in the overnight market (less the broker’s fee).
The Appian lawsuit
The company was sued by a competitor, Appian (APPN), in the Circuit Court of Fairfax County, Virginia, alleging that Pegasystems had misappropriated Appian’s trade secrets and violated the Virginia Computer Crimes Act. In May 2022, a jury found that this misappropriation was “willful and malicious,” and awarded Appian damages of $2 billion. In September 2022, the court entered judgment in the amount of $2.06 billion, consisting of the jury award and attorney fees, with post-judgment interest accruing at 6% a year. The company is appealing this result, a process that could take years.
If the judgment is upheld, the consequences could be fatal to the company. It will most likely be able to deduct the payment as an expense against taxable income over time, so with a tax benefit at the 20% statutory rate (and ignoring the interest component), it would amount to $1.6 billion, a little more than the value of $1.5 billion I calculate for the company ($18 for each of the 82 million shares).
On its website, Pegasystems takes a more sanguine view of the situation, stating that it has the financial strength to pay the judgment. It points out that it raised $600 million in February 2020 with a convertible debt offering. My view is that raising $600 million in a placid business environment to retain the cash on one’s balance sheet and fund one’s business is one thing; raising $2 billion in the current tight-money economy without any profits to repay it, in order to pay it out to a competitor, would be virtually impossible.
The most likely scenario would be for the parties to settle the litigation for a lower amount, with Pegasystems issuing stock and some debt to fund it. A $1 billion settlement would be a loss in value of $10 per share, which would hurt, but would allow the company to continue with its business. It would also save the company the current $10 million or so it is spending on legal fees every quarter.
Pegasystems’ convertible problem
During the easy money boom time, many companies issued low-cost convertible debt, since it was almost free money for a period of time. PEGA’s $600 million convertible costs it a mere 0.75% a year. The problem is that all debt eventually comes due, and the company needs to have the cash to repay it or roll over the debt. This convertible is due March 2025. It is unlikely to be converted into shares since the conversion price is $135 a share, increased to $196 with capped calls – a far cry from the current $36 share price.
Even without its legal issues, PEGA would find it hard to roll over the debt at such favorable terms. In fact, it is likely to face a “crush of competition” according to a recent WSJ article about a company looking to get a head-start on dealing with its debt due in the same time frame. Investors are also likely to take a more hard-nosed view on lending money at low rates to unprofitable companies. So the company has a little more than two years to get to profitability and settle its litigation overhang. The clock is ticking!
External ratings
Based on its quantitative analysis, Seeking Alpha helpfully provides a warning in red that PEGA is at high risk of performing badly. It has a composite rating of 1.47, equating to a strong sell, with an F for valuation and C- for profitability, offset by a surprising A for growth. As is usually the case, Wall Street analysts are more positive, with a rating of 3.3, representing a hold. Their price targets have been following the stock lower all year.
Risks are manageable
Shorting a stock has many risks. Rather than repeating them, please refer to one of my prior articles, for instance, the one on Guidewire (GWRE) or GitLab (GTLB). The only company-specific risk here is around the progression of the company’s appeal of the Appian lawsuit verdict.
The company is paying a dividend of 3c per share every quarter, which represents a cost for short positions. Somewhat irresponsibly given its losses and net debt, it was also buying back its stock earlier in the year, although it did not in the most recent quarter.
Conclusion
A position in PEGA is best avoided at the current price. Intrepid investors may short the stock in anticipation of the company’s losses continuing and the chance that the company will have to pay to settle its legal problems.
Pre-emptive disclosure
Writing a short thesis on a stock on a public forum is an invitation for blowback from employees and holders of the stock. I welcome respectful comments from eponymous readers. If you are a holder or employee, you would be better off directing your energies towards having your company become profitable.
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