Forward-Looking Statements

This Quarterly Report on Form 10-Q contains or incorporates forward-looking statements within the meaning of section 27A of the Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which we operate and management's beliefs and assumptions. In addition, other written or oral statements that constitute forward-looking statements may be made by us or on our behalf. Words such as "expect," "anticipate," "intend," "plan," "believe," "could," "estimate," "may," "target," "project," or variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict.

We encourage you to carefully review the risk factors we have identified in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2008. We believe these risk factors could cause our actual results to differ materially from the forward-looking statements we make. We do not intend to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

Our products and services

We develop and license rules-based BPM software and provide professional services, maintenance, and training related to our software. We focus our sales efforts on target accounts, which are companies or divisions within companies, and are typically large organizations that are among the leaders in their industry. Our strategy is to sell initial licenses to these target accounts that are focused on a specific purpose or area of operations, rather than selling large enterprise licenses. This strategy allows our customers to quickly realize business value from our software and limits their initial investment. Once a customer has realized this initial value, we work with the customer to identify opportunities for follow-on sales.

Our license revenue is primarily derived from sales of our PegaRULES Process Commander ("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 are built on the capabilities of PRPC and are purpose- or industry -specific collections of best practice functionality to allow organizations to quickly implement new customer-facing practices and processes, bring new offerings to market, and provide customized or specialized processing. These products often require less implementation assistance than prior generations of our software products. In many cases this has resulted in a shorter sales process and implementation period. PRPC and related solution frameworks can be used by a broad range of customers within financial services, insurance and healthcare markets, as well as other markets, such as life sciences and government.

Almost all of our customers also purchase maintenance on our products, which includes rights to upgrades and new releases, incident resolution and technical assistance. Maintenance revenue is a significant portion of our total revenue and is directly attributable to the installed base of our software licenses.

Our customers typically request professional services and training to assist them in implementing our products. Professional services are provided directly by us and through our network of partners. By utilizing these partners, we have increased the supply of skilled service consultants that can assist our customers.

Business overview

We achieved license revenue growth of 58% and 60% during the third quarter and first nine months of 2009 compared to the same periods in 2008, respectively, despite the continued challenging economic conditions. Our perpetual license revenue increased 37% and 61% and our term license revenue increased 80% and 57% during the third quarter and first nine months of 2009 compared to the same periods in 2008, respectively.

We generated approximately $38.8 million and $32.9 million in cash from operations in the first nine months of 2009 and 2008, respectively.

The total value of new license arrangements executed during the third quarter and first nine months of 2009 was higher than in the same periods in 2008, despite a decline in demand from European customers. In addition, the value of new license arrangements executed with new customers in the first nine months of 2009 was greater than in the same period in 2008, evidencing our success with companies across a broader range of industries.

We believe these results reflect our ability to quickly and successfully deliver our versatile Build for Change ® technology to Fortune ® 500 customers across industries and international borders, allowing these customers to reduce operating costs and increase revenues after a short implementation period. These operational efficiencies experienced by our customers are part of the strong value proposition our technology provides to our customers.

We believe the ongoing challenges for our business include continuing to drive revenue growth, continuing to expand our expertise in new and existing industries, and maintaining our leadership position in the BPM market.

To address these challenges, during the first nine months of 2009, we:

- Executed license arrangements with customers in new industries;

- Created and staffed strategic roles within our organization, focused on partners and alliances;

- Enhanced our training curriculum to increase the number of our professional services consultants with the master level of PRPC certification;

- Invested in our research and development efforts by increasing headcount;

- Introduced an agile development and deployment methodology to further reduce time-to-market of product enhancements and new features; and

- Continued to hire sales and marketing professionals.

The recent economic crisis has had an adverse impact on our target markets including, among other things, volatility in security prices, diminished liquidity, and limited access to funding. These conditions could impact the ability and willingness of our financial services and insurance customers, and possibly our customers in other industries, to make investments in technology and pay their trade obligations. Our financial services and insurance customers as a group represent a significant amount of our revenues, including those associated with our future cash receipts from license arrangements as detailed on page 24 and our receivables. We considered these facts and determined they did not have a material adverse impact on our allowances for doubtful accounts and sales credit memos as of September 30, 2009.

As of September 30, 2009, our cash, cash equivalents, and marketable securities totaled $198.4 million, a $31.2 million increase compared to December 31, 2008. We believe that our current cash, cash equivalents, marketable securities, and cash flow from operations will be sufficient to fund our operations and our share repurchase program for at least the next 12 months. We also evaluate acquisition and other strategic opportunities from time to time, which if pursued, could require use of our funds. Material risks to cash flow from operations include delayed or reduced cash payments accompanying sales of new licenses or a decline in our overall business.

Critical accounting policies and estimates

Management's Discussion and Analysis of Financial Condition and Results of Operations is based upon the condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"). 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. The significant accounting policies that we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

- Revenue recognition,

- Allowance for doubtful accounts and sales credit memos,

- Stock-based compensation, and

- Accounting for income taxes.

There have been no changes in our critical accounting policies or significant accounting estimates as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2008. For more information regarding our critical accounting policies, we encourage you to read the discussion contained in Item 7 under the heading "Critical Accounting Policies and Estimates" and Note 2. "Significant Accounting Policies" included in the notes to the Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2008.

Results of Operations



                                 Three Months Ended        Increase         Nine Months Ended         Increase
                                   September 30,                              September 30,
(Dollars in thousands)            2009         2008                         2009        2008
Total revenue                  $    64,821   $ 52,698   $ 12,123    23%   $ 191,066   $ 152,295   $  38,771    25%

Gross profit                        40,761     32,142      8,619    27%     124,883      91,414      33,469    37%

Total operating expenses            33,296     28,701      4,595    16%      93,253      83,223      10,030    12%

Income before provision for
income taxes                        $8,526     $2,717     $5,809   214%     $36,652     $10,923     $25,729   236%

Despite the continued challenging economic conditions, we continue to experience an increase in demand for our software products and related services, which we believe is due to the strong value proposition, short implementation period, and flexible licensing terms we offer our customers. Our success is also due to the growth in the BPM sector and our position as leader in this market space.

The increases in gross profit during the third quarter and first nine months of 2009 compared to the same periods in 2008 were primarily due to the increase in license revenue and to a lesser extent due to the increase in maintenance revenue, partially offset by a decrease in our professional services gross profit. The increases in income before provision for income taxes during the third quarter and first nine months of 2009 compared to the same periods in 2008 were primarily due to the higher growth rate of our license and maintenance revenue compared to the lower growth rate of our operating expenses. Due to credit market turmoil and adverse changes in the economy during 2008, we changed the mix of our investment portfolio to increase our holdings of pre-refunded municipal bonds, which resulted in $0.4 million and $1.7 million of lower interest income during the third quarter and first nine months of 2009, respectively, compared to the same periods in 2008. Our income before provision for income taxes was positively impacted by a $2.3 million and $4.1 million increase in foreign currency transaction gains during the third quarter and first nine months of 2009, respectively, compared to the same periods in 2008.

A small number of high value license arrangements or the mix between perpetual and term licenses can cause our revenues to fluctuate materially from quarter to quarter. The revenue growth rate achieved in any historical period is not necessarily indicative of the results expected for future periods.

Revenue



                                                     Three Months Ended                        Increase                         Nine Months Ended                         Increase
                                                        September 30,                                                             September 30,

(Dollars in thousands)                          2009                     2008                                             2009                     2008
License revenue

Perpetual licenses                          $ 13,666    48 %          $9,958    56 %         $  3,708    37 %         $ 47,284    58 %         $ 29,346    57 %         $ 17,938   61 %

Term licenses                                 12,006    42 %           6,666    37 %            5,340    80 %           29,794    36 %           19,005    37 %           10,789   57 %

Subscription                                   2,686    10 %           1,286     7 %            1,400   109 %            4,967     6 %            2,863     6 %            2,104   73 %


Total License revenue                       $ 28,358   100 %         $17,910   100 %         $ 10,448    58 %         $ 82,045   100 %         $ 51,214   100 %         $ 30,831   60 %

The increases in perpetual license revenue during the third quarter and first nine months of 2009 compared to the same periods in 2008 were driven by increases in the number of perpetual licenses. The mix between perpetual and term license arrangements fluctuates based on customer circumstances and the intended use of our software. For the first nine months of 2009, new perpetual license arrangements comprised a higher portion of our total license arrangements as compared to the first nine months of 2008. Many of the 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 perpetual and certain subscription licenses was $45.8 million as of September 30, 2009 compared to $19.8 million as of September 30, 2008. See the table of future cash receipts by year from these perpetual licenses and certain subscription licenses on page 24.

We recognize revenue for our term license arrangements over the term of the agreement as payments become due or earlier if prepaid. The increases in term license revenue during the third quarter and first nine months of 2009 compared to the same periods in 2008 were primarily due to significant prepayments of certain term licenses during the third quarter. In addition, the increase in term license revenue during the first nine months of 2009 compared to the same period in 2008 was due to the increase in the aggregate value of payments for non-cancellable term licenses signed during 2008 and 2007 for which a portion of these agreements was recognized as revenue during the first nine months of 2009. The remainder of these agreements will be recognized as revenue in future periods. The aggregate value of payments due under these term licenses was $70.2 million as of September 30, 2009 compared to $74.6 million as of September 30, 2008. See the table of future cash receipts by year from these term licenses on page 24. The aggregate value of future payments due under non-cancellable term licenses as of September 30, 2009 includes $5.3 million of term license payments that we expect to recognize as revenue during the remainder of 2009. However, we expect our actual term license revenue for the remainder of 2009 could be higher than $5.3 million as we complete additional term license agreements during the remainder of 2009 or if we receive prepayments from existing term license agreements.

Subscription revenue primarily relates to our arrangements that include a right to unspecified future products and is recognized ratably over the economic life or term of the arrangement. The increases in subscription revenue during the third quarter and first nine months of 2009 compared to the same periods in 2008 were primarily due to a new customer arrangement.

                                      Three Months Ended        Increase        Nine Months Ended       Increase
                                        September 30,                             September 30,
 (Dollars in thousands)                2009         2008                         2009        2008
 Maintenance revenue
 Maintenance                        $    12,489   $ 10,045   $  2,444   24%   $   36,608   $ 29,027   $ 7,581   26 %

The increases in maintenance revenue during the third quarter and first nine months of 2009 compared to the same periods in 2008 were due to the continued increase in the aggregate value of the installed base of our software.

                                                       Three Months Ended                                                      Nine Months Ended                        Increase
                                                         September 30,                        (Decrease)                         September 30,                         (Decrease)
 (Dollars in thousands)                           2009                    2008                                            2009                    2008
 Professional services revenue
 Consulting Services                         $ 23,371    97 %        $ 23,685    96 %        $ (314)    (1 )%        $ 69,652    96 %        $ 68,094    95 %         $1,558      2%
 Training                                         603     3 %           1,058     4 %          (455)   (43 )%           2,761     4 %           3,960     5 %        (1,199)   (30)%


 Total Professional services                 $ 23,974   100 %        $ 24,743   100 %        $ (769)    (3 )%        $ 72,413   100 %        $ 72,054   100 %           $359      0%

Professional services are primarily consulting services related to new license implementations. During the third quarter and first nine months of 2009, our professional services revenue was negatively impacted by pricing pressures associated with a weaker global economy and the decline in the value of the Euro relative to the U.S. dollar in 2009 compared to the same periods in 2008. Our training revenues continue to be negatively impacted by a weak global economy.

                                            Three Months Ended       Increase (Decrease)           Nine Months Ended       Increase (Decrease)
                                               September 30,                                         September 30,
     (Dollars in thousands)                  2009         2008                                     2009         2008
     Gross Profit
     Software license                        $28,330     $17,880         $10,450        58 %       $81,955     $51,150         $30,805        60 %
     Maintenance                              10,931       8,591           2,340        27 %        32,156      25,021           7,135        29 %
     Professional services                     1,500       5,671         (4,171)      (74) %        10,772      15,243         (4,471)      (29) %

     Total gross profit                      $40,761     $32,142          $8,619        27 %      $124,883     $91,414         $33,469        37 %



     Maintenance gross profit percent            88%         86%                                       88%         86%

     Professional services gross profit
     percent                                      6%         23%                                       15%         21%

The increases in software license gross profit during the third quarter and first nine months of 2009 compared to the same periods in 2008 were due to the increases in our license revenue, which had no significant incremental associated direct costs. The increases in maintenance gross profit during the third quarter and first nine months of 2009 compared to the same periods in 2008 were due to higher maintenance revenue and lower incremental direct costs.

Professional services gross profit during the third quarter and first nine months of 2009 compared to the same periods in 2008 was adversely impacted by lower realization rates globally due to the challenging economic conditions. In addition, the direct costs associated with the professional services bundled with a certain license arrangement recognized on a subscription basis were recorded in the third quarter of 2009, but the related revenue will be recognized over the term of the subscription period. The bundled professional services for this license arrangement were completed during the third quarter of 2009.

In addition, during the third quarter of 2009, a significant number of our professional services consultants completed our enhanced training curriculum to achieve the master level of PRPC certification, which resulted in lower billable hours and an increased use of contractors. We expect additional professional services consultants will complete this training in the fourth quarter of 2009, which may continue to negatively impact professional services gross profit. We intend to continue our investment in the professional services organization to support our license implementations.

Operating expenses

                                        Three Months Ended                           Nine Months Ended
                                           September 30,            Increase           September 30,            Increase
    (Dollars in thousands)               2009          2008                           2009         2008

    Selling and marketing

    Selling and marketing             $    19,568    $ 15,698    $ 3,870    25%    $   51,663    $ 45,036    $ 6,627    15%

    As a percent of total revenue             30%         30%                             27%         30%

    Selling and marketing headcount                                                       230         184         46    25%

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. The increase in selling and marketing expenses during the third quarter of 2009 compared to the same period in 2008 was primarily due to $2.1 million higher sales commissions mainly associated with the increase in our new license arrangements and $1.6 million increase in compensation and benefit expenses associated with higher headcount. The increase in selling and marketing expenses during the first nine months of 2009 compared to the same period in 2008 was primarily due to $4.2 million higher sales commissions mainly associated with the increase in our new license arrangements, and a $3.0 million increase in compensation and benefit expenses associated with higher headcount, partially offset by a $0.5 million decrease in travel expenses and a $0.3 million decrease in recruiting agency fees.

                                     Three Months Ended                          Nine Months Ended
                                       September 30,            Increase           September 30,            Increase
    (Dollars in thousands)            2009         2008                           2009         2008
    Research and development

    Research and development       $    9,930    $  7,936    $ 1,994    25%    $   28,198    $ 22,832    $ 5,366    24%

    As a percent of total
    revenue                               15%         15%                             15%         15%

    Research and development
    headcount                                                                         219         153         66    43%

Research and development expenses include compensation, benefits, contracted services, and other headcount-related expenses associated with research and development. During the first three quarters of 2008, the research and development center in India was not operational and therefore associated start-up expenses were classified as general and administrative expenses. Subsequent to becoming operational in October 2008, all expenses associated with our development center are classified as research and development. The change in classification of these expenses resulted in a $0.7 million and a $2.1 million increase in research and development expenses during the third quarter and first nine months of 2009, respectively, compared to the same periods in 2008.

The increase in research and development expenses during the third quarter of 2009 compared to the same period in 2008 was also due to a $0.9 million increase in compensation and benefit expenses associated with higher headcount and $0.2 million of training expenses associated with our agile deployment methodology. The increase in research and development expenses during the first nine months of 2009 compared to the same period in 2008 was also due to a $3.1 million increase in compensation and benefit expenses associated with higher headcount, partially offset by a $0.2 million decrease in recruiting expenses.

                                             Three Months Ended                                   Nine Months Ended
                                               September 30,             (Decrease)               September 30,             (Decrease)
    (Dollars in thousands)                    2009         2008                                2009           2008
    General and administrative

    General and administrative             $    3,798    $  5,067    $ (1,269 )    (25)%    $    13,392    $    15,355    $ (1,963 )    (13)%

    As a percent of total revenue                  6%         10%                                    7%            10%

    General and administrative headcount                                                            138            126          12        10%

General and administrative expenses include compensation, benefits, and other headcount-related expenses associated with the finance, legal, corporate governance, and other administrative headcount, as well as accounting, legal, and other administrative fees.

The change in classification of the expenses related to our research and development center in India resulted in a $0.7 million and a $2.1 million decrease in general and administrative expenses during the third quarter and first nine months of 2009, respectively, compared to the same periods in 2008. During the third quarter and first nine months of 2009 compared to the same . . .