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Guidewire Software, Inc (NYSE:GWRE)

Q3 2014 Results Earnings Conference Call

June 02, 2014, 5:00 pm ET

Executives

Karen Blasing - Chief Financial Officer, Treasurer

Marcus Ryu - President, Chief Executive Officer

Analysts

Brent Thill - UBS

Nandan Amladi - Deutsche Bank

Walter Pritchard - Citi

Tom Roderick - Stifel

Sterling Auty - JPMorgan

Operator

Good day, and welcome to the Guidewire third quarter fiscal 2014 financial results conference call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Karen Blasing, Chief Financial Officer. Please go ahead, ma'am.

Karen Blasing

Thank you. Good afternoon, and welcome to the Guidewire Software's earnings conference call for the third quarter of fiscal 2014, which ended on April 30. This is Karen Blasing, Chief Financial Officer of Guidewire, and with me on the call is Marcus Ryu, Guidewire's Chief Executive Officer.

A complete disclosure of our results can be found in our press release issued today, as well as in our related Form 8-K furnished to the SEC. To access the press release and the financial details, please see the Investor Relations section of our website at www.guidewire.com. As a reminder, today's call is being recorded and a replay will be available following the conclusion of the call.

During today's call, we will make statements related to our business that may be considered forward-looking under federal securities laws. These statements reflect our views only as of today and should not be reflected upon as representing our views as of any subsequent date. We disclaim any obligation to update any forward-looking statements or outlook. These statements are subject to a variety of risks and uncertainties that could cause actual results to differ materially from expectations. These risks are summarized in the press release that we issued today.

For a further discussion of the material risks and other important factors that could affect our actual results, please refer to our Annual Report on Form 10-K for the period ended July 31, 2013, and our quarterly report on Form 10-Q for the period ended January 31, 2014, both of which are on file with the SEC.

Also, during the course of today's call, we will refer to certain non-GAAP financial measures. A reconciliation schedule showing GAAP versus non-GAAP results has been provided in our press release issued after the close of market today. Additionally, we are providing detailed reconciliation data as well as recurring revenue calculations, in a supplement posted on our IR website at ir.guidewire.com.

Finally, at times in our prepared comments or responses to your questions, we may offer incremental metrics to provide greater insight into the dynamics of our business or our quarterly results. Please be advised that this additional detail may be one-time in nature and we may or may not provide an update in the future.

With that, let me turn the call over to Marcus for his prepared remarks, and then I will provide details regarding our third quarter financial results and our outlook for the rest of fiscal 2014.

Marcus Ryu

Thanks, Karen. We are pleased that our third quarter results exceeded expectations for both revenue and profitability.

Total revenue of $82 million grew 20% from a year ago, reflecting continued demand for our modern, flexible core system software serving the global P&C insurance industry. Our recurring revenue from term license and maintenance fees on a rolling four quarter basis grew to $165.3 million, an increase of 26% compared to a year ago. We also outperformed relative to our profitability expectations, expanding both gross and operating margins. Based on these results and our view toward the fourth quarter, we are slightly increasing the midpoint of our full-year revenue guidance that Karen will detail later.

Our mission is to build software products that transform the global P&C industry, while ensuring that every customer succeeds in the journey. Strategic competency has served us well over the last 13 years since our founding and we remain singularly focused on the opportunity to serve a huge global industry modernizing its obsolescent core technology. We believe that we are still less than 10% penetrated in this opportunity and we are positioning ourselves to lead the industry through this transformation for many years to come.

Over the last two or three years, we have invested heavily in three areas, sales and marketing, professional services and technology. I would like to take a deeper look at each of these including some examples of third quarter success and describe how our progress will guide our investment strategy with an eye towards fiscal 2015.

Regarding sales and marketing, we have often underscored that our products address highly complex problems, that our sales cycles are very long and demanding and that consequently it takes time to ramp selling teams into effectiveness. Notwithstanding those challenges, we have made considerable investments since going public to broaden our geographic reach, especially in Europe, to target more Tier 1 customer engagements and to develop our sales pipeline through inside sales teams. In the third quarter, we had continued success in all these counts.

For example, during the quarter, we signed our first customer in Switzerland, one of the most profitable but conservative markets in the industry. Basler Insurance is a $2 billion domestic insurer who selected PolicyCenter and BillingCenter and its multilingual deployment will support users in German, French and Italian.

Another international win was with QBE Insurance Group of Australia, the largest insurer in the country and a global Tier 1 with $18 billion in written premiums, who licensed PolicyCenter and BillingCenter to become a full suite customer. QBE also selected our data management tools to further leverage their Guidewire investment.

Here in the States, W. R. Berkley Group is a Tier 1 insurer, operating a family of companies in different niches. Berkley Risk Administrators Company or BRAC is the fourth Berkeley affiliate to become a Guidewire customer in the past two years, selecting ClaimCenter for their $400 million strategic risk management business.

Looking ahead, we believe we can continue our successful sales track record with moderated growth in sales headcount, while continuing to invest in better supporting under-penetrated regions like Europe and Latin America as well as driving adoption of our newer product offerings. While we plan to moderate sales headcount growth, we are focusing on driving sales productivity gains as newer salespeople mature in their Guidewire experience and we expect continued strong results from the team.

Regarding services, a consistent FY14 theme from us has been investment in a healthy ecosystem of system integrator partnerships to handle an increasing portion of customer implementation activity. By design, Guidewire is still involved at some level in all implementations as an elite differentiator and more heavily so for new products and the new geographies. But our SI program is critical to our business model focus on generating recurring license and maintenance revenue.

In concert with our partners, we maintained our 100% success implementation track record with our customers in the third quarter with several significant customer launches and upgrade to the latest version of InsuranceSuite. These included major go lives at American National Property And Casualty, Aviva Canada, GuideOne, Mitsui Direct in Japan, Workplace Safety and Insurance Board in Toronto, and Zurich UK.

We have PolicyCenter launches in the third quarter that included PZU in Poland and CNA, a top 10 commercial lines insurer here in the U.S. CNA was our first PolicyCenter customer in 2004, with an initial go live in 2006, and they have relied on Guidewire to support their evolution for over a decade spanning small commercial to now specialty lines of business.

I turn last to our third investment area, technology, which continues to be distinctively recognized by both insurers and other industry observers. Guidewire has been named a leader in Gartner's first Magic Quadrant for insurance claims management module in their report published in May. Earlier this fiscal year, we successfully delivered Version 8 of InsuranceSuite, as well as new Guidewire Live apps, a selection of portal products extending InsuranceSuite to policyholders and our first version of Guidewire Data Management.

We are encouraged by strong indications that customers who have adopted our core system platform see Guidewire as the logical or even assumptive choice for strategic solutions that leverage that platform. For example, in addition to QBE licensing our data management solutions in the third quarter, Travelers Canada and Wawanesa Mutual both licensed Guidewire Live apps to build on the benefits they are seeing with their deployments of Guidewire's core system software.

Product wise, we believe there are considerable opportunities still in front of us to solidify our leadership position for the core suite and to build a leadership position in the areas of mobile and portal extensions, data management and analytics, all of which represents expansions of our addressable market and enhancements of our value proposition to the industry we know best. Consequently, while year-to-date R&D headcount grew only modestly as we tested the water with new offerings, we are planning to increase our technology investments over the coming quarters with the goal of increasing our R&D team by over 20% in the next several quarters.

We are already underway with heightened R&D investments to extend our leadership position in core systems and to accelerate our development of new products that will expand our TAM. At the same time, we will continue to look for partnerships and acquisitions that could accelerate our development efforts.

As we consider our momentum and look out to fiscal 2015, we reaffirm our goal of 20% growth in term license revenue, consistent teens growth in maintenance while expecting that our services revenue growth will moderate. We will share our thoughts in more detail after our fourth quarter results that we will announce in September, but we can share now that we do expect to gain modest financial leverage in gross margins in fiscal 2015 driven by a higher license and maintenance revenue mix.

I will turn the call now over to Karen to discuss our financial results for the quarter and to provide more detail on our outlook. Karen?

Karen Blasing

Thank you, Marcus. We are pleased to report solid results for the third quarter that exceeded our revenue and earnings expectations.

Total revenue was $82 million for the third quarter of fiscal 2014, a 20% increase from a year ago. Within revenue, license revenue was $31.9 million, a 39% increase from third quarter fiscal 2013. Term license revenue increased 58% year-over-year to $28.2 million while perpetual license revenue remained quite small at $3.7 million, compared with $5 million in the third quarter fiscal 2013.

As a reminder, in the second quarter of fiscal 2013, we saw $4.5 million in early payments of our software invoices from our current customers which were expected in the third quarter of fiscal 2013, and in the second quarter of 2014 we saw $1 million in early payments which were expected in the third quarter. There were no significant early payments in the third quarter of 2014. Including these early payments in the respective third quarter results, license revenue growth would have been 20% year-over-year.

Maintenance revenue, which is recognized ratably through the year, was $10.4 million for the third quarter, up 15% from a year ago, reflecting overall license growth trends. Services revenue was $39.7 million, up 10% from a year ago as we continue our strategy to increasingly leverage our SI partners for customer implementations. Geographically, the U.S. represented 59% of revenue in the third quarter, with 41% of revenue coming from outside the U.S.

Turning to expenses. We will discuss our profitability measures on both a GAAP and non-GAAP basis and we have provided a reconciliation of these measures in our earnings release issued today, which is also posted on our website, with the primary difference being stock-based compensation expenses.

Non-GAAP gross profit in the third quarter of $49.3 million represented a gross margin of 60%, a significant increase from 52% a year ago. This improvement from the third quarter of fiscal 2013 was primarily due to the combination of increased service margins and decreased service revenue as a percentage of total revenue, reflecting the longer-term trend leverage we see in our model as SI partners take on more implementation responsibilities.

Non-GAAP license gross margin was 98.6% compared to 99.4% a year ago due to an increase in third-party royalties and the costs of Guidewire Live. Non-GAAP maintenance gross margins of 81.5%, up from 80.6% a year ago. Non-GAAP gross margin for services was 23.5%, which increased from 15.5% in the prior year.

We have managed our services headcount growth in line with our support of our SI partners resulting in a higher utilization of our services team. Our services margins in the prior year were significantly dampened by our investment in new employees who required ramp up time to be billable.

Turning to operating expenses. Total non-GAAP operating expenses were $38.5 million in the third quarter, an increase of 21% compared to a year ago, primarily from investments in R&D and sales and marketing. Despite these continued investments in our growth, operating expenses in total were lower than assumed in our guidance, due primarily to the timing of new hires and tighter management of some discretionary expenses.

Profitability was ahead of expectations in the quarter. We saw higher than anticipated revenue and lower than anticipated expenses resulting in a non-GAAP operating income of $10.9 million and non-GAAP net income of $7.6 million or $0.11 per diluted share, both of which were above our guided ranges.

Turning now to our balance sheet. We ended the third quarter with $600.1 million in cash, cash equivalents and investments, up from $588.4 million at the end of the second quarter. Our increase in cash was driven primarily from operating cash flow of $20.3 million in the third quarter.

Total deferred revenue at the end of the third quarter was $58.3 million, an increase from $51.5 million at the end of the second quarter. As a reminder, we do not believe that deferred revenue is a meaningful indicator of business activity during the quarter since we typically bill term license contracts annually and recognize the full annual payment upon the due date or other contract terms. Further, our multiyear contracts combined with annual payment terms means that a significant amount of our contractually committed fees are not visible on our balance sheet. We believe that the combination of this contracted business and our best in class renewal rates continues to provide us with a high level of visibility into future recurring revenue today.

Now I would like to turn to our outlook for the fourth quarter and full year fiscal 2014. Based on the third quarter performance and our anticipated new sales, we remain confident in our fourth quarter outlook. As stated on our last call, we continue to expect growth in services revenue to moderate this year as our system integrator partners continue to gain traction and our customers increase their engagements with our partners.

We expect our term license and maintenance revenue growth rates to outpace our services growth. This trend will gradually shift a larger percentage of our revenue to license and maintenance.

With that backdrop, we expect fourth quarter revenue to be in the range of $109.5 million to $113.5 million, representing year-over-year growth of 15% at the midpoint. We expect license revenue to be in the range of $62.5 million to $64.5 million, maintenance revenue of approximately $11 million and services revenue in the range of $36 million to $38 million.

For the fourth quarter, we anticipate non-GAAP operating income of between $30 million and $33 million and non-GAAP net income of between $19.7 million and $21.7 million or $0.27 to $0.30 per share, based on a fully diluted share count of 73.1 million shares.

Our non-GAAP operating income and net income expectations for the fourth quarter exclude approximately $14.5 million in stock-based compensation expense and $0.4 million in amortization of intangible assets. Including these non-cash expenses, we anticipate GAAP operating income of between $15.1 million and $18.1 million for the fourth fiscal quarter. We anticipate GAAP net income between $8.5 million and $10.3 million or a profit of $0.12 to $0.14 per share, based on a fully diluted share count of 73.1 million shares. We anticipate an effective non-GAAP tax rate of approximately 34% and a GAAP tax rate of approximately 40.6% in the fourth quarter.

For the full year fiscal 2014, we anticipate total revenue to be in the range of $341.5 million to $345.5 million. This represents an increase of $5 million at the midpoint from our prior guidance range of $334.5 million to $342.5 million and a total revenue increase of 14% from fiscal 2013 at the midpoint.

Within revenue, we believe that license revenue will be in the range of $148.5 million to $150.5 million, an increase of 20% to 22% from fiscal 2013. We believe perpetual license revenue will be roughly equivalent to or slightly higher in fiscal year 2014 than fiscal 2013. We expect maintenance revenue to be in the range of $40.5 million to $41.5 million, an increase of 8%to 10% from fiscal 2013. Keep in mind that we expect maintenance revenue growth to lag license revenue growth and is recognized ratably over the support period. We anticipate services revenue to be in the range of $152 million to $154 million, an increase of 9% to 10% from fiscal 2013.

Turning to profitability. We anticipate full year non-GAAP operating income in the range of $54.5 million to $57.8 million, an increase from our prior guidance range of $35.5 million to $39.5 million reflecting upside in the third quarter and representing a non-GAAP operating margin of 16% at the midpoint of our revenue and operating income guidance. As we anticipate non-GAAP net income in the range of $36.8 million to $39.1 million or $0.51 to $0.55 per share, based on a fully diluted share count of 71.6 million shares. We anticipate an effective non-GAAP tax rate of approximately 34% for the full year.

On a GAAP basis, which includes approximately $62 million of stock-based compensation expense and approximately $1.4 million in amortization of intangible assets, we anticipate a fiscal 2014 operating loss of between $9 million and $5.7 million, a net loss of $4.6 million to $2.5 million or a loss per share of $0.07 to $0.04 per share, based on an estimated weighted average basic share count of 65.8 million shares. We anticipate an effective GAAP tax rate of approximately 40.6%$ for the full year.

Looking beyond fiscal 2014. While we plan to share more detail in conjunction with our fourth quarter results in September, we are anticipating that in fiscal 2015 we can continue to deliver term license revenue growth of approximately 20% and deliver mid to high teens maintenance revenue growth. We expect to achieve this strong term license revenue growth next year even as we see it as more challenging period-over-period comparisons with the term license revenue base that is now significantly larger than it was two years ago.

In addition, international customers are increasingly key to our continued growth. The sales cycle of new territories are inherently longer and less certain with respect to timing. We are anticipating that most of our license revenue will come from term contracts and that perpetual license revenue will decrease from fiscal 2014.

I would like to reiterate that with the success we are seeing transitioning more of our implementation effort to our SI partners, we expect services revenue and hiring to be flat next fiscal year and we expect to start seeing a positive impact on overall gross margins as a result of the more favorable mix of license and maintenance as a percentage of total revenue.

As Marcus mentioned, our heavier sales and marketing investments over the past two fiscal years are yielding good results. Our focus is shifting to further productivity improvements while continuing to build our sales presence in geographies like EMEA and in sales support of new products.

Responding to customer appetite for new products from Guidewire, we will increase our investments in R&D. We expect those increased investments to decline in FY operating margins relative to FY14 levels which have been above expectations but we are confident this will allow us to offer more products and expand our TAM.

In summary, we are pleased with our third quarter results and are confident in the remainder of the fiscal year as reflected in our guidance and the momentum we are seeing in the marketplace across the combination of both new and existing customers.

Operator, can you now open the call for questions?

Question-and-Answer Session

Operator

(Operator Instructions). We will go first to Brent Thill with UBS.

Brent Thill - UBS

Good afternoon. Marcus, you mentioned a number of pretty high profile wins outside the U.S. I am curious if you could just talk a little bit about the pace of those wins. Any changes you are seeing? I know Karen noted that some of the sales cycles continue to be pretty long there. But anything notable from your perspective as you look at the international sales volume?

Marcus Ryu

I wish I could report an acceleration. Brent, every one of these cycles are really arduous and they come sometimes in clusters, just with no specific pattern when we finally take a long conversation and get it converted. We are pretty pleased with what we are seeing internationally, in that there is a consistency of demand. We have a lot of confidence in our platform being generalized enough to serve the needs of a very diverse and global industry and we think that we have the only platform that's proven, that it can serve that totality of the market.

Any P&C insurer of any size writing business in any language and that's a pretty unique market position to have. I don't think any of our competitors do. That has been pretty compelling. And over time, that's allowed us to penetrate some very difficult places, including a lot of organizations, like one of the names I mentioned, Basler Insurance in Switzerland that is really unaccustomed to buying packaged applications because they never believed that one would be able to meet their needs. So those kinds of confirmations are very encouraging to us. But the cycles remain very, very difficult and I think that's just the nature of the business we have and will always have.

Brent Thill - UBS

Okay, and just a quick follow-up. You mentioned in R&D, you are going to open up your investments a little bit faster than you have. And given that it sounds like you have some proof points in the new products. Can you give us a little more granularity in terms of where you have been pleasantly surprised on the R&D side that now gives you confidence to step back on the investments area?

Marcus Ryu

Yes. So as a refresher, we really have three additional vectors of new product development beyond the core suite, which of course is still the bulk of our business and is essential to our strategic plan. We have to win the core system battle and new product offerings really leverage the value proposition of that core system once it's been implemented. But those three vectors build on top of it and they are data management, which is an operational data store and conventional data warehousing technology, but very specific for P&C insurers and integrated to our suite, mobile and portal technology that extends our platform to external constituents and then analytics where the primary asset that we have today is Guidewire Live, but we have other aspirations as well.

In each of those areas, over the last 18 months, we brought new offerings to market and the goal, as with any new software offerings is, can you get those early customers excited, can you get them engaged and prove that you have something interesting to them, get them to actually pay you and prove value that then is the basis for the next wave of customers and eventually, hopefully not to long from then really bringing it to the mass market. And we feel really good about all three of those efforts, all three of those dimensions. We have got a lot of great customer engagement and excitement about them. And now we have more product to build to fulfill the opportunity in each of those areas. It is very satisfying to get license from existing customers in each of those who now recognize we can do more beyond just that core suite.

Brent Thill - UBS

Okay. Thank you.

Operator

And next we will move to Nandan Amladi with Deutsche Bank.

Nandan Amladi - Deutsche Bank

Hi. Good afternoon. Thanks for taking my question. So, Marcus, first question for you on the system integration partnerships. Clearly they are moving in a direction that you had stated a couple of years ago. But services mix has always been a bit of a leading indicator for large contracts that you might have signed. As this mix shifts in the stated direction, how should investors look at or what should they look at as other leading indicators for new business might have brought in?

Marcus Ryu

Right. Service engagements are still an indicator in the sense that we have heavier services involvement on the newer frontiers of our business so that would be newer products and newer geographies. Of course, that's all blended in with the total services book in our total portfolio of customers. So I appreciate the question of what else can you look to, to have a sense of how license sales might be going in and what could be anticipated for the future?

I think other very useful indicators are progress in countries, right. Because one of the biggest gating factors for a non-U.S. customer to buy our software is to feel comfortable that we meet their specific needs in Germany, in the U.K., in France, et cetera and the single best thing that we can do to win more customers in the geography is to win some customers in the geography. So that's a very useful indicator.

I think the same applies to newer products and next quarter we will be giving a more detailed profile of the new wins that we have had over the year for our newer products. And obviously the more traction we have there, the same logic applies and we go up the adoption curve and I think just generally the kind of confidence in the nature of the guidance that we deliver in every one of these calls is the other quantitative measure. I think in aggregate they should give a pretty declarative picture of how we feel about the future.

Nandan Amladi - Deutsche Bank

Thank you. Then perhaps a follow-up on the previous question. Your increased investments in sales and marketing, how are you targeting them in terms of certain geographies, certain product areas?

Marcus Ryu

Right. So consistent with the answer I just gave to your prior question, we are directing the investments towards those other frontiers of our business that we see more work to be done. One of those is geographic expansion, primarily in Europe, where we have made a lot of progress. We have some really great wins this year. But we need a little bit of heavier coverage than we have right now. So if you were to look at the territories of our average European rep, compared to our average North American rep, you would see that they are really spread out over many more relationships that are aspiring relationship and so we need a bit more coverage.

And then as we bring new products there, there are more conversations to be had, more constituents at our prospect that we have to persuade. And so that takes more focus and in some cases, especially with something like data management, and we anticipate more and more with analytics, we want to bring some domain expertise, very specific to those areas to bear as well. So that's where our investments in sales and marketing you will see directed.

Nandan Amladi - Deutsche Bank

Thank you.

Operator

Our next question comes from Walter Pritchard with Citi.

Walter Pritchard - Citi

I have two questions. One, Marcus, on your end, with SIs doing more of the go live, or I guess more of the [inaudible] you are still involved in a lot of those deals, can you talk about whether the go lives, they happen faster or slower than when you had primary involvement in that? And how you are tracking that, getting track of that?

Marcus Ryu

Right. I appreciate the question. First an important clarification is that we really demand to be involved in all of our projects, not just some of them. In some cases, at a very modest level, at least by headcount but it's very important and it's precisely to ensure that all of the promises and expectations of the customer are being fulfilled. I would not report any difference in project duration or in success rate or anything of the sort between us and our SI partners.

That's a very important part of the pledge that we make to customers that we stand behind our estimates jointly with our partners, arm-in-arm and that it will make them successful together and own it equally. We are not passing off any responsibility or accountability, but we are just bringing more resource to bear and in some cases, more cost efficiently than we could do on our own.

Walter Pritchard - Citi

Got it, and then Karen, just on seasonality here, we understand you have been giving us guidance here for this year for quite a while. So we understand, I guess you have quite a bit of confidence in that. Could you just help us understand though, as we look forward at seasonality, your business does attribute to getting more seasonal, especially weighted towards the fourth quarter and I am wondering like it was 30% a year in terms of license revenue in 2012 and then 40% a year in 2013 and this year it is looking like it is going to be above that a little of 40%. What's driving that? And should we expect that trend to continue in terms of back end loading of the years?

Karen Blasing

Thanks, Walter. That's absolutely right. Our sales team has signed more contracts in the back half of the year than in any other time. So the customer base of those annual invoice payments which triggers the license revenue for us, this preponderance of them in the fourth quarter for the existing customers, and you can see that in the pattern that you have described. And then historically, new business has come in much heavier in that back half of the year with it as well, particularly in the fourth quarter. So it continues to just be a higher mountain range in each of the four periods. But a good portion of that, of the revenue that's recognized in that fourth quarter is already booked on existing contracts.

Walter Pritchard - Citi

So we should expect that to become even more the case in 2015?

Karen Blasing

If history repeats itself, yes, that will be the case.

Walter Pritchard - Citi

Okay. Thank you very much.

Operator

And Tom Roderick with Stifel has our next question.

Tom Roderick - Stifel

Hi, guys. Good afternoon. Marcus, my first question is for you. You talked a little bit about the adoption of non-modules beyond the core suite. I am interested in learning a little bit more about product demand or customer demand out there some of the Millbrook assets you picked up a while back and how customers are embracing and adopting data integration and analytics that you have built up around that acquisition?

Marcus Ryu

Right. So Millbrook was a contributing asset to our data management offering and it was a great accelerant to our own efforts in that space. I think, if you would ask any one on the team here, we were really enthusiastic about the way that that's gone. As a matter of integrating the organization in to Guidewire, that wasn't that challenging. It was quite a small acquisitions. There were less than 25 employees, but it really was a definitive, an important step for the company to expand its footprint into a very well established and high IT spend domain for an insurer which is aggregating their data into an operational store, often across many systems and using that as an integration point to a lot of downstream systems, which is just a universal problem. It is not one that we invented or brought any particularly novel approach to, but we think we can bring a lot of efficiency for those customers that have implemented our suite.

So in terms of demand, there is actually more than we can meet right now. It would be the most forthright way to describe it. There are a lot of customers who, or pretty much any customer who has implemented the suite has a set of needs there and we want to be very judicious, as we always been in our history, not to take on more than we can successfully implement and fulfill every promise to and that's one of the motivations for us to step up investment in data management, because we see such evidence of demand and have been reasonably well validated pricing now, even though it's an early product.

Tom Roderick - Stifel

Great. Thanks. Second question. You have talked a lot about the Tier 1 pipeline for a while. You have been overly enthusiastic about what that pipeline holds and named a number of Tier 1 international wins this quarter or expansions with Tier 1 customers. But as you look back in that pipeline, particularly in some the proof of concepts that might be getting closer to going live and becoming something more formal, how do you think about what that pipeline looks like and should we expect to see some acceleration in these big deals in 2015?

Marcus Ryu

That could happen. But one nuance that we have always taken pains to underscore is that even if a Tier 1 company chooses to license Guidewire, they may do it with only a fraction of their business. In fact, that's the more likely mode that it will be some fraction of their business that they will commit to us to begin with, and that may be as a matter of just of implementation bandwidth, what they feel they can take on, our capital investment bandwidth or it may be because they want to really validate that this is a platform worthy of serving their enterprise, and that's a decision that a very large conservative organization like to take in steps as opposed to in one big leap, no matter how well validated our technology is from references and a lengthy evaluation cycle.

So I think we feel great about the number of those Tier 1 dialogues we are in and I think we have more proof points than ever to validate that we are the right platform for them. But just as a matter of buying preference, we still expect that the majority, not necessarily the totality, but the majority of them will still choose to buy one application for one portion of their business or a suite for a small portion of their business. And as it impacts our bookings and our revenue, that may be comparable to a bigger, more enterprise decision by a smaller, say a Tier 2 company. And that's an important nuance to understand.

Tom Roderick - Stifel

Great, and Karen, one last quick one for you. I want to make sure I understand the thinking on the gross margin discussion for next year. You talked about that, you expect it to go up modestly. Is that strictly a revenue mix shift issue? In other words, as term license outpaces services, that will drive the entirety of the gross margin increase? Or is there room for greater efficiencies even within each of the lines?

Karen Blasing

It's mostly mix shift. As you noticed, the gross margin that the services margin that we achieved this third quarter was pretty good, in excess of 20%. So there is not a lot more to squeeze out of those gross margins in services. The big benefit to total gross margin will come from the higher mix of license and maintenance.

Tom Roderick - Stifel

Great, perfect. Thank you, guys. Nice job.

Operator

Our next question comes from Sterling Auty with JPMorgan.

Sterling Auty - JPMorgan

Hi, thanks. Two questions, guys. First one, just to make sure I understand it, if you look at services revenue in the quarter, how would you say they came in relative to your expectations? It came in a little bit better than we would have thought. I am just wondering if there is anything in particular that drove that strength in services revenue.

Karen Blasing

It did come in a little better than we thought. We start out every quarter with an estimate of how much project work is going to be completed, particularly at some of the larger engagements that we have and sometimes the pace of work actually outpaces what our expectation was. So thus we ended up with higher service revenue in the third quarter.

Marcus Ryu

Yes. It was a little bit of a utilization uptick, I would say, relative to expectations. And then, it's also the case that sometimes our services are billable in a sales engagement and sometimes they are not, depending on the dynamics of the sales cycle and how much -- there is a lot of factors that can go into whether it's billable or not, and that's another element that's a little bit less predictable than the conventional services utilization, but it counts towards services revenue too. So those are other factors.

Karen Blasing

(inaudible). Most of our services revenues is related to kind of materials billing. There is a small proportion of things that sometimes are more billed build based on milestone rather than this direct number of hours or billable days in that. And that can have some influence over the amount of billings in there for revenue and anyone in the periods. So there is small fluctuations, really, between the quarters for that.

Marcus Ryu

Right.

Sterling Auty - JPMorgan

Okay. And a separate question, maintenance revenue, I still think there's some confusion out there from people, in terms of how much of that maintenance revenue comes from perpetual license? What, if any, comes from term or the subscription contract? And how should we think about that trend going forward?

Karen Blasing

So both perpetual licenses and term license carry maintenance or post contract support maintenance contract with them as well. And both of them are roughly 20% of the license value but as the perpetual revenue has continued to come down over time, the amount of nominal maintenance revenue, most of the components of the maintenance revenue today is from term licenses with very little leftover from the old residual perpetual licenses of years gone by. So the pace of maintenance revenue has definitely slowed and a part of it is the transition from perpetual to term as well.

Marcus Ryu

And one clarification, Sterling, it's not that the maintenance revenue from existing perpetual relationship has gone away. It's just that that has declined as a percentage of total maintenance that we get because most of the maintenance now comes from term licenses as opposed to from perpetual.

Karen Blasing

That's correct.

Sterling Auty - JPMorgan

And it's 20%, just like it is for perpetual. There's no other difference. So we should see this hit a baseline and then grow in correlation to term license?

Karen Blasing

Absolutely.

Sterling Auty - JPMorgan

All right. Perfect. Thank you, guys.

Operator

That does conclude today's question-and-answer session. Mr. Marcus Ryu, I would like to turn the call back to you for any additional or closing remarks.

Marcus Ryu

No other remarks. Thank you all for participating on our call and good bye.

Operator

Once again, that does conclude today's conference. We appreciate your participation.

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Source: Guidewire Software's (GWRE) CEO Marcus Ryu on Q3 2014 Results - Earnings Call Transcript

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