Property and casualty (P&C) insurance is a $2 trillion global industry in the beginning stages of a once-in-a-generation technology transition. Most P&C insurance companies continue to depend on 30-year-old "green screen" software running on COBOL, an outdated programming language which is difficult to upgrade or integrate with today's modern technology. This has become a structural constraint on insurer profitability and competitiveness, and the large technology incumbents have functionally inadequate offerings and custom development is prohibitively costly and risky. The "right" solution is a standard product platform generalized to the entire P&C industry, and the market winner in this space will enjoy very long-term customer relationships and the opportunity to provide many other applications and data services to a secure customer base.
Guidewire Software (GWRE) ("Guidewire" or "the Company") is a leading provider of core systems software to the global P&C insurance industry. The Company's software serves as the mainframe of an insurance company's core operations, enabling the performance of key business functions such as issuing policies, paying claims and billing customers. Guidewire licenses their software on a recurring term license basis and has a $200 million recurring revenue run-rate today. However, the replacement market opportunity represents an estimated $3-5 billion in revenue, and demand for the company's analytics could represent another $3 billion opportunity.
In my view, Guidewire is well positioned to capture a large share of the massive opportunity in P&C software and analytics as it continues to win new customers and expand its penetration of the market. With a nearly perfect license renewal rate, recurring revenues that represent 75% of sales, and solid acquisition trends, earnings downside is extremely limited at this juncture. With an under-penetrated existing customer base, growing sales force, and a large pool of prospective clients, there is a strong case for revenues and market cap tripling in the next 3 years, representing a compelling asymmetrical investment opportunity.
Guidewire, based in Foster City, California, was founded in 2001 by current CEO Marcus Ryu and five other IT industry veterans to essentially transform the global P&C industry. The company has grown to become one of the world's premier providers of modern core software systems to the global P&C insurance industry. In 2013, the company generated over $300 million in revenues across its three segments; Licenses, Maintenance, and Services.
Core Guidewire products include InsuranceSuite™, consisting of PolicyCenter®, ClaimCenter® and BillingCenter® which span the core functional areas in insurance. The InsuranceSuite™ family of software is licensed as an enterprise application (behind the company's firewall) to P&C insurance companies, and serve as an effective "backbone" of the entire insurance sales and service business. The software is typically sold as a 5-year term license, although licenses have been issued on 10, 15, 20-year and perpetual terms as well. Upon contract, roughly 80% of the fee structure is allocated to "license" fees, while the remaining 20% is allocated to "maintenance" fees. Maintenance fees are recognized over the entire 365 day support period. All contracted fees are non-refundable and non-cancellable, giving strong visibility to revenues over the term of the contract.
Guidewire Live® is the Company's cloud-based network service, which allows for a unique marriage of customer and peer data with geophysical information feeds. During catastrophes, such as floods and earthquakes, Guidewire Live enables insurers to map policies they have in the area and the claims received, which allows the insurer to accurately assess how much severe damage there is and if there are certain pockets to which they should farm resources (such as claim representatives).
A Generational Opportunity
"We believe it is still early days in the global P/C insurance industry's generational transition from decades-old legacy systems to flexible, upgradeable platforms for their core operations. We plan to continue to invest in expanding both our product and sale capabilities in fiscal 2014 to capitalize on this significant opportunity."
Marcus Ryu, CEO
It's a strange but true fact that most P&C insurers are still operating on software infrastructures that were created in the 1980's. These legacy "green screen" operating systems, which enable insurers to underwrite policies, pay claims, and bill customers, have failed to keep pace with the vast advances in technology we have witnessed over the past decade. These systems, which were "hard coded" with outdated programming languages like COBOL, are difficult to upgrade and integrate with modern technology and require support by specialized IT staff, many of whom are now retiring.
Industry sources expect that annual spending in support of consolidation/transformation and core system replacement projects will reach annual spending of $5 billion by 2017, up from today's levels of approximately $3 billion. Approximately 80% of P&C insurance industry is still running on legacy core systems, as managements have been reluctant to increase IT spending coming out of the Great Recession. However, with business conditions slowly improving and companies focusing on increasing operational efficiencies, it seems apparent that we have reached an inflection point where the need for a massive replacement cycle is being addressed by cash flush businesses finally willing to invest in the next generation of technology.
Guidewire is well positioned to capitalize on this replacement cycle, and seems to be positioning itself as the go-to solution provider in the space. The company has a nearly perfect client retention rate, and is winning the majority of deals that are up for bid. Facing competition primarily from consulting firms positioning "do-it-yourself" solutions, Guidewire's scalable, integrated, and proven solutions are showing to be highly attractive to potential customers.
Emerging as a leading provider of modern back-office software systems, Guidewire has a huge opportunity to capture a large share of the $3-5 billion recurring opportunity in the P&C insurance industry in the years ahead. While competition from large, incumbent technology firms like Accenture (ACN) may be a concern for investors, it is increasingly evident that the "do-it-yourself" approach they offer is not the long-term solution the insurance industry is looking for.
Market Share Growth Strategy
Guidewire has identified that its addressable customer base is approximately 1,200 insurance providers worldwide. At the end of fiscal year 2013 (July 2013) the Company had 158 customers with at least one InsuranceSuite product under license. So, in a simplified way of looking at the market, Guidewire has about 13% of its addressable customer base under license.
The company's fee structure is based on the insurance customer's "Direct Written Premiums" - this metric is a measure of an insurance carrier's gross premium written, adjusted for cancellations, before deducting any premiums paid or ceded to a reinsurer. On the most recent conference call, Guidewire estimates that based on "Addressable DWPs" the Company only has about 8-9% of its target market penetrated. This implies a current valuation of roughly $3.5 billion in potential InsuranceSuite revenues today.
Since 2006, when the first InsuranceSuite products came to market, the Company's strategy has been to lead with a single product (such as PolicyCenter) and eventually up-sell complementary offerings across additional lines of business and geographies. The business model has been successful, but as it stands today many of Guidewire's larger customers are still in early stages of adoption and implementation. While the initial target market was middle market firms with $300 million to $1 billion in revenues, Guidewire has refined and improved its platform to the point it is fully scalable for insurance customers of all sizes.
For example, a Tier 1 customer like American International Group (AIG) has many different lines of business such as Personal Auto, Complex Commercial, Worker's Comp, and Inland Marine insurance. They also operate in many different countries across the world. Their back office systems will have many different moving parts and, as a result of various mergers and acquisitions, their technology infrastructure may be quite different based on line of business or location. A transition to a new platform such as InsuranceSuite requires a significant commitment of resources, and a logical way to tackle this problem is to implement new technology in rollout stages.
Guidewire has captured roughly 9% of its potential InsuranceSuite market in a seven-year period marred by one of the most painful recessions on record. It is my view that GWRE has the potential to eclipse 20% market share in the next 3-4 years based on its superior platform and lack of compelling alternatives.
Recent Financial Performance
Last year was a record year for Guidewire; revenue reached $301 million, EBITDA topped $60 million and GAAP earnings were $15 million or $0.25 per share. Growth over the previous year was strong, as the Company secured several key Tier 1 customer contracts which strongly boosted top line revenue growth. In its most recent earnings release, Guidewire disclosed that first quarter 2014 revenue was $66.5 million, much stronger than the consensus expectation of $62 million. The Company's fiscal year is off to a strong start as 12 new projects went live, two deals closed for new PolicyCenter contracts, and Guidewire secured its first contract for its new Data Hub and Info Center offering. Management has provided initial revenue guidance for fiscal year 2014 of $330-340 million.
In the last 7 years, Guidewire has transformed from a startup player to a dominant force in the market with 9% share of addressable Direct Written Premiums. The Company has invested aggressively in its sales force over the last year, and now has a "SWAT Team" of elite sales reps focused on courting key Tier 1 customers across the globe. I believe the impressive growth we've seen from GWRE is only the tip of the iceberg.
With sales and technology infrastructure in place, I view it as a base case scenario that Guidewire achieves 20% market penetration by 2017 on the strength of its one-of-a-kind suite of products and services and a captive customer base with huge cross-sell and up-sell opportunities. While one may wonder why other competitors aren't coming to market and attempting to garner share of this tremendous opportunity, it is important to realize that there are huge challenges associated with courting the most profitable insurance clientele; timeliness of implementation, high volume of transactions involved, and stringent performance requirements are some of the reasons why there is not a single other provider with both the track record and experience of Guidewire in dealing with this complex technological transition.
Based on studies from Ovum and other industry sources, the addressable market for core InsuranceSuite offerings could top $5 billion by 2017. My expectation of ~20% market share capture would imply that GWRE recurring revenues can approach $1 billion in the next 4 years, a threefold increase from the $301 million in fiscal year 2013. Assuming Guidewire Live revenue growth in-line with recent years, total enterprise revenues could reach $1.3 billion in 2017.
For early lifecycle companies such as Guidewire, EV/Sales is a common and appropriate measure of valuation. Other metrics fail to account for elevated levels of spending, and frankly, as the business scales we could see significant expansion in profit margins and free cash flow. At today's levels, Guidewire trades at roughly 8X current year sales, which is consistent with peers who have similar growth profiles.
The key to understanding the Guidewire story is the realization that this is a multi-year opportunity where a clear winner will emerge in the transition from legacy systems to the next generation of core systems software. Ultimately I feel that this will transpire over the course of 3-4 years given the time required to successfully implement the technology across complex business lines. During this time my view is that GWRE's market share will approximately double to 20%, representing annual revenues in the area of $1.3 billion. Later in the cycle, the valuation multiple will very likely contract to a (more) reasonable level around 6-7X.
Given revenue assumptions for 2017, a 6.5X EV/Sales multiple yields an equity market capitalization of $8.6 billion or roughly $140 per share. At roughly $47.50 today, this would represent almost a tripling of shares over a 3-4 year period.
The Bottom Line
Guidewire has emerged as an elite provider of next generation core software systems to the global P&C industry, as evidenced by near perfect retention rates, growing clientele base, and increasing adoption of its suite of products and services. Facing limited competition, the Company is in a great position to leverage the once-in-a-generation opportunity being created as insurance companies migrate from antiquated COBOL "green-screen" systems to next generation software more conducive to increased business productivity and integration with web, mobile and cloud data services. If the company is able to maintain its strong growth trajectory and continue capturing market share through increased cross-selling opportunities and new client onboarding, shares have the potential to triple in the next 3-4 years with limited revenue downside due to its recurring license revenue model.
Additional disclosure: I am a fiduciary over client accounts that are long GWRE at various prices. While I have no plans to initiate new positions in the next 72 hours, this may change at any time and for any reason. This article is not a solicitation to invest in shares of any company mentioned and should not be construed as bona fide investment advice. You should always conduct your own due diligence and consult your financial advisor before investing.