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Pegasystems Inc.

101 Main Street Cambridge, Massachusetts 02142-1590 (617) 374-9600

Ticker Symbol: PEGA Exchange: Nasdaq/NMS Website: www.pegasystems.com 1999 Fiscal Year-End: 12/31/99 Auditor: Arthur Andersen 4/10/00 Close: $10.31 52-Week: $3.63 ­ 26.06 Price/Earnings: N/A Price/Sales: 4.3 Mkt. Cap.: $300 million

Pegasystems Inc. ("PEGA") develops, markets, licenses, and supports customer relationship management (CRM) software designed to enable transaction intensive organization to manage a broad array of customer interactions. PEGA also provides consulting, training, and maintenance and support services to facilitate the installation and use of its solutions.

FINANCIAL SUMMARY ($ mils., except EPS & %) Revenue Gross Profit Operating Income Net Income EPS (Diluted) Cash & Mkt. Securities Total Receivables Total Assets Stockholders' Equity CFFO Depreciation & Amort. Capital Expenditures 3 Mos. 12/99 19.7 10.3 1.0 0.8 $0.03 30.0 77.5 125.0 101.0 1.7 1.7 1.0 3 Mos. 12/98 11.7 1.8 (17.3) (10.6) ($0.37) 24.8 82.5 139.3 101.9 6.4 1.4 1.4 % Change 68% 472% NM NM NM 21% (6%) (10%) NM (73%) 21% (29%) Year 12/99 76.6 41.7 (5.9) (2.4) ($0.08) 30.0 77.5 125.0 101.0 6.3 6.8 2.8 Year 12/98 61.8 31.7 (22.8) (11.6) ($0.41) 24.8 82.5 139.3 101.9 (19.5) 5.6 7.4 % Change 24% 32% NM NM NM 21% (6%) (10%) NM NM 21% 38%

©2000 by the Center for Financial Research and Analysis, Inc. (CFRA)

Update -- Pegasytems Inc. ("PEGA"), 4/11/00: 1999 Annual Report Comments In our May 1997 and August 1998 reports, CFRA expressed concern about PEGA's revenue and earnings boosts stemming from aggressive revenue recognition, as well as a number of deteriorating operational indicators. CFRA remains concerned about these issues based upon the review of the Company's 1999 Annual Report and fourth quarter press release. Collapse in Deferred Revenue PEGA's balance of deferred revenue has collapsed in recent periods. As shown in Table 1a, deferred revenue plunged to $7.7 million in September after a significant decline in the June period. Despite the modest rebound during the December quarter, deferred revenue remains substantially below the year-ago period, both in absolute terms and as a percentage of total revenue. Specifically, while revenue increased by 68.4% year-over-year in the December quarter, the Company's balance of deferred revenue declined by 59.4%. As a result, the Company's deferred revenue amounted to 44.5% of quarterly revenue at December 1999, down from 183.4% in the year-ago period. The Company attributed the declines to the completion of projects on which revenue had previously been deferred. CFRA also notes that the Company may have obtained a boost to reported earnings throughout 1999 as a result of the recognition of deferred revenue without the associated costs related to the service, as such costs appear to have been recorded in previous periods ­ at the time the deferred revenue was recorded. Specifically, PEGA reported in its 1999 10-K filing that the increase in its service gross margin during 1999 was primarily attributable to the recognition of previously deferred services revenue and the allocation of total payments under customer arrangements to services revenue, the associated costs of which were recognized as incurred (i.e. in previous periods). As shown in Table 1b, the services gross margin improved significantly during 1999 causing total Company gross margin to increase, despite the significant increase in service revenue (PEGA's lower-margin revenue category) as a percentage of total Company revenue. If the improvement was indeed the result of the prior-period recognition of costs associated with service revenue recorded at the time of recording the deferred revenue, PEGA would have obtained a boost during 1999.

Table 1a: Deferred Revenue versus Total Revenue, Quarterly Trend Dec. (Q4) YOY Change (59.4%) 68.4%

($ millions, except %) Deferred Revenue Revenue DeferredRevenue / Revenue

Q4, 12/99 8.7 19.7 44.5%

Q3, 9/99 7.7 20.5 37.4%

Q2, 6/99 14.2 21.3 66.4%

Q1, 3/99 21.0 15.1 139.1%

Q4, 12/98 21.4 11.7 183.4%

©2000 by the Center for Financial Research and Analysis, Inc. (CFRA), 6001 Montrose Road, Suite 902, Rockville, MD, 20852; Phone: (301) 984-1001; Fax: (301) 984-8617. ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, in whole or in part, in any form or by any means, without the prior written permission of CFRA. The information in this report was based on sources believed to be reliable and accurate, principally consisting of required filings submitted by the Company to the Securities and Exchange Commission; but no warranty can be made. No data or statement is or should be construed to be a recommendation for the purchase, retention, or sale of the securities of the company mentioned.

©2000 by the Center for Financial Research and Analysis, Inc. (CFRA)

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Table 1b: Gross Margin by Revenue Source and Total Company, 1999 versus 1998 1999 Service Revenue / Total Revenue Gross Margin - Licenses Gross Margin ­ Services Gross Margin ­ Total Company 63.3% 89.3% 34.2% 54.4% 1998 52.6% 94.7% 12.2% 51.3%

Earnings Boost: Reversal of Allowance for Doubtful Accounts PEGA obtained a significant boost to earnings during the December quarter as a result of the reversal previously established reserves for doubtful accounts. Specifically, the Company reversed $2.6 million of its allowance for doubtful accounts into income during the quarter. Absent the reversal, earnings for the quarter would have been reduced by approximately $1.1 million, or $0.04 ­ to a loss of $0.01 from the reported income of $0.03. (See Table 2a.) The Company attributed the reversal during the period to the resolution of customer projects and increased focus on the collection process initiated during the fourth quarter. CFRA also notes that as a result of the reversal, PEGA's allowance for doubtful accounts fell to 3.0% of gross accounts receivable at December ­ down significantly from 12.4% in the September quarter and 6.0% in the year-ago quarter. (See Table 2b.)

Table 2a: Reported Earnings for Q2 (12/99), Adjusted based on Allowance Percentage of 3.71% ($ millions, except EPS) Net Income EPS Reported 0.8 $0.03 Adjustment (1.1) ($0.04) CFRA-Adjusted (0.3) ($0.01)

Table 2b: Allowance for Doubtful Accounts versus Gross Accounts Receivable (GAR) ($ millions, except %) Allowance GAR Allowance / GAR Q4, 12/99 1,026 78.5 3.0% Q3, 9/99 3,811 78.7 12.4% Q2, 6/99 3,791 81.5 12.1% Q1, 3/99 3,257 88.6 9.0% Q4, 12/98 2,753 95.2 6.0%

Reduction in R&D Spending PEGA may have obtained a boost to earnings for the quarter and year ended December 1999 as a result of a significant reduction in research and development spending. Specifically, despite revenue increases of 68% and 24% for the quarter and year ended December 1999, research and development expenses declined by 23% and 17% for the respective periods. (See Table 3a.) Had PEGA's rate of R&D expenditures remained at prior-period levels in absolute terms (a more conservative assumption than as a

©2000 by the Center for Financial Research and Analysis, Inc. (CFRA)

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percentage of total revenue), the Company's earnings would have been reduced by $0.04 and $0.14 per share for the quarter and year ended December 1999, respectively. (See Table 3b.)

Table 3a: Research & Development Expenses versus Revenue ($ millions, except %) Research & Development Revenue R & D / Revenue Q4, 12/99 4.4 19.7 22.6% Q4, 12/98 5.7 11.7 48.6% Change (22.8%) 68.4% Yr. 1999 19.8 76.6 25.9% Yr. 1998 23.8 61.8 38.5% Change (16.8%) 24.0%

Table 3b: Reported Earnings for the Quarter and Year ended December 1999, Adjusted to Increase R&D Expenditure Level to Absolute 1998 Levels ($ millions, except EPS) Net Income EPS Reported 0.8 $0.03 Adjustment (1.3) ($0.04) CFRAAdjusted (0.5) ($0.01) Reported (2.4) ($0.08) Adjustment (4.0) ($0.14) CFRAAdjusted (6.4) ($0.22)

Aggressive Revenue Recognition Despite a number of required earnings restatements, PEGA continues to record revenue in what CFRA considers an aggressive manner. Specifically, the Company records the bulk of its license revenue immediately despite receiving payments over the extended term of the agreements. Background. PEGA recognizes a significant portion of its total revenue (34% and 37% for the quarter and year ended December) from licensing agreements upon acceptance, despite receiving monthly payments throughout the extended life of the agreement (typically five years). Specifically, PEGA records as software license revenue, upon customer acceptance, the discounted value of all payments scheduled to be received in future periods. The excess of the payments over the discounted present value is recognized ratably as interest income throughout the term of the licensing agreement. Commentary. CFRA considers it aggressive to "front-end load" revenue related to agreements in which the preponderant portion of the payment stream extends considerably beyond the date of recognition (as would clearly be the case for PEGA, with 80% of the cash inflows received beyond one year). In PEGA's case specifically, we find the issue particularly exacerbated given the number of required priorperiod earnings restatements the Company has had to make. Specifically, during the two-year period ended December 1998, the Company restated its quarterly or annual financial statements on three separate occasions. In addition, in August 1999, PEGA restated its financial statements for the three-month period ended March 1999 and the year-ended December 1998. Sequential Revenue Decline PEGA's revenue fell sequentially for the second straight quarter during December. As shown in Table 4a, revenue fell by 3.9% sequentially during both the December and September periods. In addition, future revenue growth may be hampered as evidenced by lack of growth displayed in the Company's backlog of license and maintenance revenue. Specifically, total Company backlog (which represents

©2000 by the Center for Financial Research and Analysis, Inc. (CFRA)

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agreements expected to result in revenue in the current year) amounted to $36 million at December 1999 ­ essentially flat from the year-ago period. (See Table 4b.) CFRA also notes that future revenue may also be dampened as a result of the recent period depletion of deferred revenue as mentioned previously in the report.

Table 4a: Revenue and Sequential Growth, Quarterly Trend Q4, 12/99 Revenue Sequential Growth 19.7 (3.9%) Q3, 9/99 20.5 (3.9%) Q2, 6/99 21.3 41.7% Q1, 3/99 15.1 28.3% Q4, 12/98 11.7 (33.4%) Q3, 9/98 17.6

Table 4b: Backlog ($millions), 1999 36.0 1998 35.0

High Level of Receivables Although PEGA's level of receivables, as measured in days sales outstanding (DSO), has dropped significantly in recent periods, the Company's DSO remained high at December 1999. Specifically, DSO amounted to 359 days at December 1999 ­ almost a year to collect on its receivables. (See Table 5.)

Table 5: Accounts Receivable, in Days Sales Outstanding (DSO), Based on Quarterly Revenue ($ mils., except DSO) Revenue Trade and Current Installment A/R Long-Term Installment A/R Total A/R DSO ­ Total A/R Q4 12/99 19.7 32.8 44.6 77.5 359 Q3 9/99 20.5 27.0 48.0 74.9 333 Q2 6/99 21.3 27.5 50.2 77.7 332 Q1 3/99 15.1 33.1 52.3 85.4 517 Q4 12/98 11.7 43.5 49.0 92.5 718 Q3, 9/98 17.6 35.3 58.1 93.4 483

©2000 by the Center for Financial Research and Analysis, Inc. (CFRA)

Pegasystems Inc. (4/11/00)

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