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TMCNet:  PEGASYSTEMS INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

[February 20, 2013]

PEGASYSTEMS INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) 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 enables our customers 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. We also provide consulting 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. Our strategy is to sell a series of licenses that are focused on a specific purpose or area of operations, rather than to sell a large enterprise license.

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, energy and government markets.

Our solution frameworks products include customer relationship management ("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 actions optimize the process outcomes 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 create and/or deploy 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, and at customer sites. In 2012, we began offering training online through Pega Academy, which provides an alternative way to learn our software in a virtual environment quickly and easily. We expect that this online training will help expand the number of trained experts at a faster pace.

Our total revenue increased 11% in 2012 compared to 2011 and reflects revenue growth in each of software license, maintenance, and professional services revenue. License revenue increased 18%, primarily driven by the increase in term license revenue. Maintenance revenue increased 14%, primarily due to the increase in the aggregate value of the installed base of our software and continued strong renewal rates. Professional services gross margin increased to 17% in 2012 largely due to lower on-boarding time and expenses associated with reduced hiring as more of our customers became enabled and more implementation projects were led by our partners. In 2012, we generated approximately $43.6 million in cash from operations due to our strong collections, and ended the year with $123 million in cash, cash equivalents, and marketable securities.

We believe our growth and success in 2012 were due to: • Our disciplined and focused global sales strategy to targeted customers; • The return on investment our clients achieve from the use of Pega technology, leading to repeat purchases; 21 -------------------------------------------------------------------------------- Table of Contents • Demand for our industry-leading software solutions and services; • Investment in making our products faster and easier to use; and • Expansion of our solutions frameworks offerings.

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 2013 we plan to: • Extend our product leadership through continued innovation; • 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; • Build-out our sales capacity by hiring additional sales professionals; • Invest in self-study enablement to expand the Pega ecosystem; • Further develop and leverage our partner alliances; and • Develop and increase our solutions frameworks.

RESULTS OF OPERATIONS 2012 Compared to 2011 (Dollars in thousands) Year Ended December 31, Increase 2012 2011 Total revenue $ 461,710 $ 416,675 $ 45,035 11 % Gross profit 304,330 251,877 52,453 21 % Total operating expenses 272,904 241,383 31,521 13 % Income from operations 31,426 10,494 20,932 199 % Income before provision for income taxes 30,945 10,813 20,132 186 % The aggregate value of new license arrangements executed in 2012 was slightly higher than in 2011. The aggregate value of new license arrangements executed fluctuates quarter to quarter. During 2012 and 2011, approximately 74% and 58%, respectively, of new license arrangements were executed with existing customers.

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.

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

The increase in operating expenses was primarily due to the increase in selling and marketing expenses and to a lesser extent the increase in research and development expenses, associated with higher headcount.

The increase in income from operations and income before provision for income taxes was primarily due to the higher increases in license and maintenance gross profit compared to the increase in operating expenses.

22-------------------------------------------------------------------------------- Table of Contents Revenue (Dollars in thousands) Year Ended December 31, Increase 2012 2011 License revenue Perpetual licenses $ 102,438 63 % $ 94,129 68 % $ 8,309 9 % Term licenses 46,638 28 % 34,453 25 % 12,185 35 % Subscription 14,830 9 % 10,225 7 % 4,605 45 % Total license revenue $ 163,906 100 % $ 138,807 100 % $ 25,099 18 % In both 2011 and 2012, more than 50% of the aggregate value of new license arrangements for the fiscal year was executed in our fourth quarter. A large proportion of the value of these arrangements was term licenses that contributed very little to the increase in our term license revenue in 2012, but will be recognized as revenue in future periods. As a result, the aggregate value of future payments due under non-cancelable term licenses increased significantly in both 2011 and 2012 from $90.9 million as of December 31, 2010 to $161.4 million as of December 31, 2011 and to $211.5 million as of December 31, 2012.

The increase in term license revenue for 2012 is a result of the increase in the aggregate value of future payments due under non-cancelable term licenses arrangements from prior years. See the table of future cash receipts by year from these term licenses on page 33.

The increases in the aggregate value of term license arrangements executed in a certain period is not necessarily indicative of the volume level in future periods.

The mix between perpetual and term license arrangements executed in a particular period varies based on customer needs. A change in the mix between perpetual and term license arrangements executed over time may cause our revenues to vary materially from period to period. The increase in perpetual license revenue was primarily due to the increase in the aggregate value of new perpetual license arrangements executed during the fourth quarter of 2012.

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 may limit the amount of revenue that can be recognized in a reporting period. Consequently, our subscription revenue may vary quarter to quarter. The increase in subscription revenue was primarily due to the full year of revenue recognized in 2012 on some arrangements for which we began recognizing revenue in the fourth quarter of 2011.

(Dollars in thousands) Year Ended December 31, Increase 2012 2011 Maintenance revenue Maintenance $ 133,527 $ 117,110 $ 16,417 14 % The increase in maintenance revenue was primarily due to the growth in the aggregate value of the installed base of our software and continued strong renewal rates.

(Dollars in thousands) Year Ended December 31, Increase (Decrease) 2012 2011 Professional services revenue Consulting services $ 157,792 96 % $ 153,919 96 % $ 3,873 3 % Training 6,485 4 % 6,839 4 % (354 ) (5 )% Total Professional services $ 164,277 100 % $ 160,758 100 % $ 3,519 2 % 23 -------------------------------------------------------------------------------- Table of Contents Professional services are primarily consulting services related to new license implementations. Revenue from our Pega Cloud offerings is included in consulting services revenue and was the primary driver for the increase in professional services revenue in 2012. In addition, our consulting services revenue increased due to higher realization rates in 2012 compared to 2011. As more of our customers are becoming enabled and our partners are leading the majority of implementation projects, our consulting services revenue may be lower in future periods.

(Dollars in thousands) Year Ended December 31, Increase 2012 2011 Gross Profit Software license $ 157,567 $ 132,114 $ 25,453 19 % Maintenance 118,740 104,033 14,707 14 % Professional services 28,023 15,730 12,293 78 % Total gross profit $ 304,330 $ 251,877 $ 52,453 21 % Total gross profit % 66 % 60 % Software license gross profit % 96 % 95 % Maintenance gross profit % 89 % 89 % Professional services gross profit % 17 % 10 % As a result of the increased number of customer and partner led implementations, we have slowed the hiring of consulting services personnel, reducing non-billable on-boarding time and increasing utilization rates of our staff, resulting in higher gross profit percentages. If we increase our hiring pace in future periods, we may again incur on-boarding and enablement costs that may result in lower professional services gross profit percentages.

(Dollars in thousands) Year Ended December 31, (Decrease) 2012 2011 Amortization of intangibles: Cost of software license $ 6,189 $ 6,284 $ (95 ) (2 )% Selling and marketing 4,928 4,928 - - General and administrative 20 103 (83 ) (81 )% $ 11,137 $ 11,315 $ (178 ) (2 )% The decrease in amortization expense was due to the amortization in full of our trade name intangible asset in 2011 and our technology designs intangible asset in the first quarter of 2012.

Operating expenses (Dollars in thousands) Year Ended December 31, Increase 2012 2011 Selling and marketing Selling and marketing $ 167,263 $ 147,457 $ 19,806 13 % As a percent of total revenue 36 % 35 % Selling and marketing headcount 520 464 56 12 % 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.

24 -------------------------------------------------------------------------------- Table of Contents We continue to create additional sales capacity by increasing sales headcount to target new accounts in existing industries, as well as to expand coverage in new industries and geographies. The increase in selling and marketing expenses was primarily due to a $19.3 million increase in compensation and benefit expenses associated with higher headcount, partially offset by a $1.1 million decrease in commission expense.

(Dollars in thousands) Year Ended December 31, Increase 2012 2011 Research and development Research and development $ 76,726 $ 65,308 $ 11,418 17 % As a percent of total revenue 17 % 16 % Research and development headcount 727 523 204 39 % 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 India research facility as we have been replacing contractors with employees. The increase in offshore headcount lowered our average compensation expense per employee.

The increase in research and development expenses was primarily due to a $9.9 million increase in compensation and benefit expenses associated with higher headcount and a $3.3 million increase in rent and facilities related expenses associated with the build-out of our U.S. and India facilities, partially offset by a $2.3 million decrease in engineering contractor expenses.

(Dollars in thousands) Year Ended December 31, Increase 2012 2011 General and administrative General and administrative $ 28,915 $ 28,198 $ 717 3 % As a percent of total revenue 6 % 7 % General and administrative headcount 251 216 35 16 % 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.

We completed the move to our new office headquarters in the third quarter of 2012 and ceased use of the former office space in the fourth quarter of 2012, resulting in approximately $0.2 million in lease exit costs. We recorded approximately $5.7 million and $1.9 million of rent expense under the new lease arrangement during 2012 and 2011, respectively.

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 2012 2011 Stock-based compensation: Cost of services $ 3,655 $ 2,737 $ 918 34 % Operating expenses 7,851 6,291 1,560 25 % Total stock-based compensation before tax 11,506 9,028 $ 2,478 27 % Income tax benefit (3,699 ) (2,854 ) 25 -------------------------------------------------------------------------------- Table of Contents The increase in stock-based compensation expense was primarily due to the higher value of the annual periodic equity grant, the annual executive grant and new hire grants. See Note 14 "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 2012 2011 Foreign currency transaction gain (loss) $ 780 $ (935 ) $ 1,715 n/m Interest income, net 419 398 21 5 % Other (expense) income, net (1,680 ) 856 (2,536 ) n/m $ (481 ) $ 319 $ (800 ) n/m n/m - not meaningful We hold foreign currency denominated accounts receivable, intercompany payables, and cash in our U.S. operating company where the functional currency is the U.S.

dollar. As a result, these receivables, intercompany payables, and cash are subject to foreign currency transaction gains and losses when there are changes in exchange rates between the U.S. dollar and the 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 2012 and 2011.

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

The total change in the fair value of our foreign currency forward contracts recorded in other (expense) income, net, during 2012 and 2011 was a loss of $1.7 million and a gain of $0.8 million, respectively.

Provision for income taxes The provision for income taxes represents current and future amounts owed for federal, state, and foreign taxes. During 2012 and 2011, we recorded a $9.1 million provision and a $0.7 million provision, respectively, which resulted in an effective tax rate of 29.3% and 6.5%, respectively Our effective income tax rate for 2012 was below the statutory federal income tax rate due to a $1.2 million benefit related to the current period domestic production activities and a $1.2 million benefit related to lower foreign income tax rates. These benefits were partially offset by $1 million of permanent differences related to nondeductible meals and foreign stock compensation.

26-------------------------------------------------------------------------------- Table of Contents The American Taxpayer Relief Act of 2012 (the "Act") was signed into law by President Obama on January 2, 2013. Among other things, the Act retroactively extends the research and experimentation ("R&E") credit through the end of 2013.

Under ASC 740, Income Taxes, the effects of new legislation are recognized upon enactment, which in the U.S. federal jurisdiction is the date the president signs a tax bill into law. For the Company this means that both the retroactive tax effects for the 2012 R&E credit and the tax effects for the 2013 R&E credit will be recognized in the 2013 financial statements. If the Company had recognized the effects of the 2012 credit in 2012, the effective tax rate in 2012 would have been lowered by approximately 2.6%.

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

As of December 31, 2012, the Company had approximately $26.3 million of total unrecognized tax benefits, of which $16 million would decrease the Company's effective tax rate if recognized. However, approximately $9.2 million of these unrecognized tax benefits relate to acquired NOLs and research tax credits, which are subject to limitations on use. The Company expects that the changes in the unrecognized benefits within the next twelve months will be approximately $0.6 million, which would reduce the Company's effective tax rate if realized.

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.

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.

27-------------------------------------------------------------------------------- Table of Contents 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.

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.

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.

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 % 28 -------------------------------------------------------------------------------- Table of Contents 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 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.

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 % 29 -------------------------------------------------------------------------------- Table of Contents 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 % The increase in headcount reflects growth in our India 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.

(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 % 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 ceased use of our former offices in the fourth quarter of 2012. In June 2011, because of our expectation that we would cease use of our former offices, 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.

30 -------------------------------------------------------------------------------- Table of Contents 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.

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 14 "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 2010Foreign 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, intercompany payables, and cash in our U.S. operating company where the functional currency is the U.S.

dollar. As a result, these receivables, intercompany payables, 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.

31 -------------------------------------------------------------------------------- Table of Contents During 2011, the total change in the fair value of our foreign currency forward 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 foreign currency forward 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 foreign currency forward 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 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 related to acquired net operating losses ("NOLs") and research tax credits, which if recognized, would be subject to limitations on use.

LIQUIDITY AND CAPITAL RESOURCES (in thousands) Year Ended December 31, 2012 2011 2010 Cash provided by (used in): Operating activities $ 43,579 $ 39,815 $ 18,414 Investing activities (19,238 ) (45,388 ) 6,841 Financing activities (8,091 ) (6,312 ) (13,251 ) Effect of exchange rate on cash 922 1,111 (4,734 ) Net increase (decrease) in cash and cash equivalents $ 17,172 $ (10,774 ) $ 7,270 As of December 31, 2012 2011 2010 Total cash, cash equivalents, and marketable securities $ 122,985 $ 111,432 $ 87,251 We believe that our current cash, cash equivalents, and cash flow from operations will be sufficient to fund our operations and our share repurchase program for at least the next 12 months.

32-------------------------------------------------------------------------------- Table of Contents In June 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 completed the move to our new office headquarters in the third quarter of 2012 and ceased use of the former office space in the fourth quarter of 2012, resulting in approximately $0.2 million in lease exit costs. The remaining $0.5 million of lease payments for this space will be paid by the end of the second quarter of 2013.

We invested approximately $12.8 million in 2012, net of our landlord tenant improvement allowance for furniture, fixtures, IT equipment, and leasehold improvements for our new office headquarters.

We evaluate acquisition opportunities from time to time, which if pursued, could require use of our funds. Approximately $51.5 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 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 primary drivers of cash provided by operating activities during 2012 were net income of $21.9 million and a $24.8 million increase in deferred revenue primarily resulting from the difference in timing of billings and revenue recognition for annual maintenance.

The primary drivers of cash provided by operating activities during 2011 were $10.1 million of net income and a $14.6 million increase in deferred revenue primarily resulting from the difference in timing of billings and revenue recognition for annual maintenance.

Cash used in operating activities during 2010 was primarily due to our net loss of $5.9 million and a $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 $255 million as of December 31, 2012 compared to $209.9 million as of December 31, 2011. The future cash receipts due as of December 31, 2012 are summarized as follows: Contractual Other contractual payments for term license payments not licenses not recorded on recorded on the As of December 31, (in thousands) the balance sheet (1) balance sheet (2) Total 2013 $ 55,170 $ 18,161 $ 73,331 2014 54,529 12,194 66,723 2015 48,272 5,793 54,065 2016 38,544 7,389 45,933 2017 and thereafter 14,980 - 14,980 Total $ 211,495 $ 43,537 $ 255,032 (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.

33 -------------------------------------------------------------------------------- Table of Contents Cash (used in) provided by investing activities During 2012, we invested $23.6 million primarily in leasehold improvements, furniture and fixtures and equipment for the build-out of our U.S. and India offices.

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.

Cash used in financing activities Net cash used in financing activities during 2012, 2011, and 2010, 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 $92.4 million of our common stock. As of December 31, 2012, approximately $71.2 million has been repurchased, approximately $14.8 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 2012, 2011, and 2010: (Dollars in thousands) 2012 2011 2010 Shares Amount Shares Amount Shares Amount Prior year authorizations at January 1, $ 13,963 $ 13,237 $ 15,779 Authorizations 6,036 5,590 5,750 Repurchases paid 181,803 (5,130 ) 137,429 (4,815 ) 294,059 (8,272 ) Repurchases unsettled 3,399 (76 ) 1,688 (49 ) 538 (20 ) Authorized dollars remaining as of December 31, $ 14,793 $ 13,963 $ 13,237 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 2012 and 2011, option and RSU holders net settled stock options and vested RSUs representing the right to purchase a total of 548,000 shares and 704,000 shares, respectively, of which only 319,000 shares and 426,000 shares, respectively, were issued to the option and RSU holders and the balance of the shares were surrendered to us to pay for the exercise price and the applicable taxes. During 2012 and 2011, instead of receiving cash from the equity holders, we withheld shares with a value of $4.4 million and $6.3 million, respectively, for withholding taxes, and $2.7 million and $4.3 million, respectively, for 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 2012, 2011 and 2010.

34 -------------------------------------------------------------------------------- Table of Contents Dividends We declared $0.12 per share for the year ended December 31, 2012, but our Board of Directors authorized us to accelerate the payment of the fourth quarter dividend to be paid in December 2012 rather than in January 2013. Therefore, we paid $5.7 million in dividends in 2012. For the years ended December 31, 2011 and 2010, we declared $0.12 per share and paid cash dividends of $4.5 million, and $4.4 million, respectively. It is our current intention to pay a quarterly cash dividend of $0.03 per share, however, the Board of Directors may terminate or modify this dividend program at any time without notice.

Contractual obligations As of December 31, 2012, we had purchase obligations for customer support and marketing programs 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.

As of December 31, 2012, 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: 2014 & 2016 & 2018 & (in thousands) Total 2013 2015 2017 Thereafter Other Purchase obligations (1) $ 685 $ 685 $ - $ - $ - $ - Liability for uncertain tax positions (2) 13,606 - - - - 13,606 Operating lease obligations (3) 90,864 8,929 17,919 17,032 46,984 - Total $ 105,155 $ 9,614 $ 17,919 $ 17,032 $ 46,984 $ 13,606 (1) Represents the fixed or minimum amounts due under purchase obligations for customer support and marketing programs.

(2) As of December 31, 2012, our recorded liability for uncertain tax positions was approximately $13.6 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 $1.1 million included in accrued expenses and approximately $8.4 million in other long-term liabilities in the accompanying audited consolidated balance sheet as of December 31, 2012.

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.

35 -------------------------------------------------------------------------------- Table of Contents Revenue recognition Our revenue is derived primarily from software licenses, maintenance fees related to our software licenses, and consulting services. Our license arrangements, whether involving a perpetual license or a term license, generally contain multiple elements, including 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.

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 or purchase order signed by the customer for software and maintenance and a statement of work for consulting 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. Services, including maintenance, are considered delivered as the work is performed or, in the case of maintenance, over the contractual service period.

• 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 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, and all other revenue recognition criteria are met.

Term software license fees are payable on a monthly, quarterly, or annual 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 and other factors, such as the risk of concessions, 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.

36-------------------------------------------------------------------------------- Table of Contents 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 no longer utilize this business model for software license transactions and as of December 31, 2012 and 2011, the remaining balance of these installment receivables totaled zero and $1.3 million, respectively.

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 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 offering ("Pega Cloud"). Consulting services may be provided on a "stand-alone" basis or bundled with a license and software maintenance services.

Revenue from 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, Australia, and Europe.

Consulting services may occasionally 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 as described earlier. Stand-alone value is established through the customer's ability to buy these services from many trained partner system integrators and from transactions sold independently from the sale of Pega Cloud. 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.

37-------------------------------------------------------------------------------- Table of Contents 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, 2012, we had not experienced any losses related to these indemnification obligations and no claims were outstanding.

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.

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") in the fourth quarter of 2011, was tested annually in the fourth quarter for impairment or between annual tests if indicators of potential impairment exist. We performed our qualitative assessment in the fourth quarter of 2012 and 2011 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, 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.

38-------------------------------------------------------------------------------- Table of Contents 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 $113.2 million remained available as of December 31, 2012. 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.

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 of 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 15 "Income Taxes" in the notes to the accompanying audited consolidated financial statements for further information.

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