Guidewire: It Has Built A Better Mousetrap, And The Property/Casualty Insurers Are Coming

| About: Guidewire Software, (GWRE)

Summary

Guidewire reported very strong results for its fiscal Q2 on the evening of March 1st.

The company did not choose to raise guidance materially.

The shares responded modestly to the strong quarter, rising 4% on the day.

Sub-headline numbers such as operating cash flow and a 28% growth in subscription licenses were significantly stronger than the headline numbers.

Marcus Ryu, the company's CEO, gave a cogent and persuasive commentary about how Guidewire would be able to grow its license revenues by 20% or more for the foreseeable future.

The Facts

Guidewire (NYSE:GWRE) reported a strong quarter that beat expectations in most categories. The shares were up about 4% on the earnings release and guidance, and now stand 11% higher than the day I wrote my initial report on the company. I have included some specifics of the release here for the convenience of the reader.

Top line: Total revenues were up 14% to $102 million, license revenues were up by 22% to $53 million, and professional services revenues up by 3% to $34.5 million.

Earnings: GAAP operating income more than doubled to $7.7 million. GAAP net income per share was $.01, as compared to $.06/share in the year-ago quarter. Non-GAAP earnings per share rose by 40% to $.24, up from $.17 in the year-ago period.

Balance sheet: Operating cash flow quadrupled in the quarter to $27.9 million. Free cash flow for this company is essentially equivalent to operating cash flow. Deferred revenue growth, which is considered by the company as less important than it is for other subscription revenue companies, was $12 million this quarter, compared to $6 million in the year-ago period. Guidewire has a far smaller balance of deferred revenues than many other companies with subscription models. The company bills one year in advance on multi-year deals and recognizes the revenue when it is received. In addition, during the quarter, there was a substantial fall in DSO, which had a significant impact on the cash flow for the period. Stock-based compensation was $16.6 million for the period, up from $12.4 million in the year-ago period. Stock-based comps represented 41% of operating cash flow in this past quarter and was substantially greater than the total operating cash flow in the prior-year quarter. This is often a metric that is ignored, but it shows just how powerful the company's operating leverage was in the just-reported quarter.

Guidance changed its guidance, but minimally so, despite the significant beat on both the top line and bottom line during its fiscal Q2. Revenues are now projected to be $412 million for the year. The prior consensus had been $412 million. The company is now projecting non-GAAP EPS in a range of $.64-.71, compared to the prior consensus EPS forecast of $.64.

Some Commentary on the Commentary

Despite what I might consider to be a rather tepid forward guidance, much of the call this quarter can best be described as a love-in. Analysts have loved GWRE shares for a long time now, and one of the best things that companies can do to make analysts look good is to have a significant beat, such as the one Guidewire just announced. There are 7 buys and strong buys out of 9 published ratings on the name. There is no reason I have to believe that anyone is going to change their rating as a result of this quarter.

There were several points of interest during the course of the conference call. One of those was the growth in term license revenues, up by 28% in the quarter, significantly above the rate of the published growth in license revenue and one of the strongest growth rates in that metric that GWRE has seen in a long time. Some of this was a function of deals closing earlier than the company had forecast, and since the company bills upfront, on an annual basis, the earlier closes drove the license revenue upside. On the other side of the ledger, perpetual license revenue was trivial during the quarter and put a crimp in the growth of reported license revenue. The CFO commented that perpetual licenses were less than $1 million in the quarter, but that he felt the pipeline was such that the level of perpetual licenses would be significantly greater in the second half of the fiscal year.

The strong margin performance was both the result of above-plan revenue and below-plan expenses, most particularly in the hiring area. It was surprising to see that the sales and marketing line grew just over 10% year on year in the wake of such strong sales performance. Management is forecasting that both R&D, which saw a 14% increase in spend during the quarter, and sales and marketing would be growing at higher rates during the last 6 months of the fiscal year.

Guidewire announced just a single Tier 1 win during the quarter with Nationwide Insurance for that company's digital portal, which in and of itself is not a huge deal, but may lead to significant additional business down the road. For the most part, bookings were spread out amongst a host of Tier 2 and Tier 3 insurers. While it is always nice to brag about Tier 1 wins, the company has more than enough proof points at this juncture that winning a particular deal with a large Tier 1 customer is a bit less important in the grand scheme of things than the fact that the growth in term licenses was 28%.

Guidewire is seeing a more rapid uptake of its new digital products than it had planned on. This will probably constrain the growth in services margins a bit as the company will need to use higher-cost GWRE personnel to do many of the early implementations until the partner ecosystem has a stable of trained and proficient consultants.

One of its chief goals in the coming years is to drive down the Total Cost of Ownership (TCO) of its solutions. While it is not particularly visible in the company's numbers, the Guidewire ecosystem generates a huge amount of service costs that the company's customers pay because of the extensive customization of all of its solutions. Historically, it has taken Guidewire users at least 12-18 months, and sometimes longer, to get their systems up and running. Thus, it is probably more significant than might be apparent for this company to announce that it had gotten a small component of its large State Farm win into production in just 7 months.

This significant customization that has been required for most Guidewire installations has raised the TCO calculus and lengthens paybacks, such that many projects do not get funded or are postponed. To the end of reducing TCO, Thunderhead Solutions and Guidewire have signed a reseller agreement. While I would not usually comment on individual reseller agreements, Thunderhead is supposed to be the prototype of future deals whereby resellers bring product type integration and pre-built document templates to Guidewire customers, significantly reducing the cost of implementing the company's solutions. If Guidewire can really reduce some of the TCO variables, it will almost inevitably see greater growth. The huge commitments in terms of personnel resources that have been required to implement its products have almost certainly been a significant growth constraint.

Guidewire spoke about a single cloud deployment in its customer base. The company is facilitating the deployment of a solution in the cloud from AAA Carolinas. As I mentioned in my prior report, it is taking a far more measured approach in moving its software to the cloud than is the case with many other vendors. Given the competitive alternatives to GWRE at this time, using a measured approach to dealing with the cloud makes sense.

The Big Question

Many readers and some of the interlocutors on last night's call continued to be concerned, I suppose, about how this company can sustain license revenue growth of 20% and greater in a world where many economic indicators outside the US are deteriorating, and in which growth in this country is just around 2%. CEO Marcus Ryu attempted to answer the question, but since I believe it is central to the investment thesis regarding this company, I will try my own hand at trying to answer the concern.

It is my belief that most large software projects are bought and not sold. By that I mean any company which buys a multi-million dollar software solution has determined that the solution is something without which it simply cannot survive. There are good software salesman and those who are ineffective, but one thing for sure is that no salesman can really influence the corporate judgment of necessity.

In the case of the insurance industry, massive changes are underway to try to lower administrative cost so that the companies can better compete on price. Earlier this week, Metropolitan Life announced that it was selling its remaking cohort of agents to Mass Mutual. Now, of course, those companies both sell life insurance, and the agents in question are going to have to learn how to sell a suite of financial products to consumers. But much the same thing is happening in the property and casualty insurance company. The companies simply have to find ways to lower their high-cost, high-touch models of dealing with policyholders. There are huge costs involved in getting quotes for prospective customers, putting policies together and then in processing claims.

The other side of the equation is that most insurance vendors provide their policyholders with an unsatisfactory experience in getting quotes, in buying policies and in paying claims. The companies know that and are struggling with ways in which they can dramatically improve user satisfaction with the process of buying insurance and processing claims.

The management of most insurance vendors is far more aware of these facts than I am. They are faced with a seeming conundrum of trying to cut back office costs and improve the customer experience at the same time. To do that, they have turned to adopting digital technologies to both reduce the time and cost involved with acquiring insurance and paying claims, and to reduce the person hours necessary to process an application or to pay a claim.

In most cases, the really large deals in the IT Insurance segment that are supposed to be transformative in nature are driven by CEOs and chief marketing officers, and sometimes by CFOs. The CIOs, who might never of their own volition tackle these large projects, are told to go evaluate alternatives and to acquire something.

So far, Guidewire has had a unique capability in helping its customers to bring about transformational changes. Sooner or later, insurance vendors who lack the digital capabilities such as those offered by the company are going to be severely competitively disadvantaged. Their costs will be higher, reducing their pricing flexibility and their customer satisfaction, and ultimately, their customer retention will be lower. Insurance companies buy Guidewire these days as much to respond to competitive pressure as for any other single reason. That is a really nice place to be when selling software, and that is why, in my opinion, the company can sustain 20% license revenue growth in what is, overall, a mediocre market in which to sell IT products and services.

A final point. At the moment, Esurance is one of the more unique providers of auto insurance in that it is totally web-based and operates without agents. The insurance is cheap because the overhead costs are a fraction of those of other insurance companies. I haven't compared insurance rates between Allstate, which is the parent of Esurance, and Esurance itself for coverage, but I believe the difference is significant. To be sure, Esurance sells car insurance, and property/casualty insurance is far more complex than is auto insurance. But that said, the point is that the future of the industry, as Millenials become their largest cohort of customers, is going to be to figure out how to offer self-service for as many things as possible.

I have no specific idea if Guidewire or some other company in the space is trying to build a product or a platform that will facilitate auto insurers or other kind of insurers in building self-service offerings. But it is almost surely going to happen, and I imagine Guidewire will wind up in the forefront of that trend. It is a huge and underappreciated business opportunity to keep the company's growth rate above its 20% goal, should it embark on such a project.

Valuation

GWRE shares are not cheap even after the pullback they have been through in recent months. The estimates are probably not going to change significantly despite the company's strong fiscal Q2. If I were handicapping the likely financial performance for Guidewire or building an independent earnings model, my guess would be that financial performance would at least be on the high side of the guidance ranges that they provided. The most likely scenario is that Guidewire will continue to print above-guidance quarters for the balance of the year, for most of the reasons I discussed above. But I think it is prudent to just consider the numbers that management presented in looking at the valuation.

Guidewire has an EV/S of about 7X, based on calendar year 2016 revenue estimates. That number will go to about 6.2X for calendar year 2017. It is important to note that this company, unlike most others with a subscription-based revenue model, has no metric for billings. Obviously, most of the deals it signs are for two years or more. If the typical customer takes a year to get his application deployed, it wouldn't make much sense to sign less than a 2-year deal. It is realistic to imagine that most of Guidewire's solutions being sold these days will have, at a minimum, a 5-year life, and probably significantly more. But the company really doesn't have a model that builds deferred revenue or reflects the value of the subscription agreements it has signed. Its renewal rate thus far has been very high. One does not often go in and try to rip out an insurance system that is handling customer-facing applications. So, I am not inclined to think that the very high EV/S ratios are particularly useful in valuing this company.

Guidewire's P/E, based on current projections for calendar year 2016, is about 71X. That ratio will come down to about 56X for calendar year 2017, based on current consensus projections. After a quarter in which earnings beat the consensus by 60%, it is hard to be too attached to either the company's guidance or the consensus forecast. The beat this past quarter was no less than $.09, or 60%, of the prior consensus estimate. The P/E figure would be substantially reduced if Guidewire continues to beat estimates.

The company reported cash flow and free cash flow of about $38 million for the first half of its fiscal year. Cash flow for the period was more than 2X reported non-GAAP earnings. Assuming these relationships do not change, free cash flow for the year is going to be about $80 million, providing a free cash flow return of about 2.6% for the current fiscal year and about 3% for the current calendar year.

I think investors need to evaluate the raw statistics carefully, giving due weight to both the unusual revenue model the company currently uses and the likelihood of sustaining a 20% growth in license and maintenance revenues for 5 years or more.

Summary

Guidewire printed a very strong quarter for its fiscal period that ended 1/31/16. Subscription revenue growth of 28% was far beyond what it has been able to achieve for some years now. EPS was significantly greater than prior estimates, as a result of both higher license revenues and lower-than-anticipated costs. The company changed guidance almost imperceptibly, based on the fact that some of the deals that supported the Q2 beat had come in sooner than expected. That being said, to a certain extent, that factor was balanced by the absence of any perpetual license deals in the quarter. I believe Guidewire is more likely than not to beat its guidance and the published consensus this year.

Management commented that it had seen no signs that any of the macro factors weighing on the results of other Enterprise IT companies had impacted its results or were likely to impact its results in the foreseeable future. I suspect this is a valid judgment, based on what the company sells and the value it offers users. There is no way that the property/casualty insurance industry is going to avoid the digital age, and customer-facing applications will have to be automated.

While notional valuation is undoubtedly high, there are a number of factors that should be considered by investors in evaluating the real valuation of these shares. I believe GWRE shares offer investors a favorable risk/reward profile even in the wake of the share price recovery seen in the last couple of weeks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.