Guidewire: Greenfield Opportunities

| About: Guidewire Software, (GWRE)
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Summary

Guidewire's shares have been punished for the last several weeks due to poor headline guidance.

On careful examination, the headline guidance turns out not to reflect the underlying results of the company's business.

The company continues to successfully address one of the larger opportunities in the enterprise software universe and it has no real competition.

The company's so-called "greenfield" opportunity is pregnant with major growth potential for the company.

The company's customers (property and casualty insurers) have benefited to a degree from rising rates and have larger budgets for software investments.

A New Year, Same Guidance, Same Guidewire

Guidewire (NYSE:GWRE) has been a frustrating name to own over the past year. The shares are down about 9% over that span while the IGV software/tech index has appreciated by 17%. That is a significant divergence that has left shareholders discomfited.

I first wrote about the name in February and the shares are up 13% since that point. But I take no credit for prescience with regards to this name. I have written about it twice since and the shares are down from 14% since my last article. I called the September article "Guidance Misbehavin'" and so it proved to be. The company has an annoying habit of trying to hide its light under a bushel basket. It almost always guides below the consensus and it winds up beating its guidance. It has made for some confusion among analysts and investors. The average analyst rating as published on First Call is a mediocre 2.4, but the average price target for the shares is a respectable $66. At the moment of the 11 analysts who cover the name, there is one sell, four holds, four buys and a couple of strong buys. The last brokerage opinion revision was that of Piper Jaffray which lowered their rating from Overweight to Neutral.

Is this a good entry point into the shares? I think it is. I have no specific knowledge regarding the progress in the current quarter which will end in three weeks. If it is a typical Guidewire quarter, it will be a beat. The company has beaten expectations by varying amounts four out of the past four quarters and the streak is longer than that. But then the company has often provided very conservative guidance that disheartens investors for some period. This is one of those periods. As I take some pains to portray, I think Guidewire is doing far better than the reported numbers both for earnings and revenues suggest and that it has, relative to its size, a fantastic and under-appreciated market opportunity and the company has no real competitors of scale at this time. Guidewire is not a defensive name (if the market corrects then it will as well) and it is not cheap enough to be defensive. But for long-term growth investors, this is a very decent entry point, I believe.

Part of the problem is that the company is only forecasting 7% growth for the quarter and 15% growth for the year. The company focuses on a metric of four-quarter recurring term license and maintenance revenue in managing its business. That metric increased by 21% last quarter and should increase by 20% or greater this quarter and is a better, although still not perfect, mechanism for assessing growth. In addition, while GWRE uses a significant level of stock based compensation (19% last quarter compared to 18% the prior year), the company has acquired two companies recently. The acquisitions of FirstBest and EagleEye are dilutive in terms of earnings and because of the deferred revenue write-down are not contributing significantly to revenues this current year. The costs of the acquisitions, which were included in the company's earnings reports, caused opex to grow by 25% when revenues showed a 15% increase.

The company has recently (December 19) announced that it will acquire ISCS which is a cloud-based insurance business aimed at the small company insurers. ISCS will be acquired for a consideration of $160 and it apparently has revenues of just less than $20 million. In addition, the company is bearing the costs of what it calls "greenfield digital transformation" venture. This project is one that is taxing the P&L significantly in that it is increasing costs and not recognizing revenues. Last quarter the company deferred $4 million of service revenue which would have been billed and reported as revenue except for the specific circumstances of this project. That item cost the company about $.03-$.04/share in reported EPS.

It appears to this observer that the greenfield project, coupled with the pro-forma revenue recognition method used by the company, is leading many observers and investors to draw investment conclusions regarding Guidewire that are far of the mark.

In looking at the valuation metrics, it is important to note just how much they have been influenced both by the greenfield initiative and by the company's decision not to use pro-forma presentations with regards to its acquisitions. Overall, non-GAAP operating expense showed an increase of 25% compared to the level of the prior fiscal year. The shares have a P/E based on non-GAAP measures that exceeds 50X. The company has a current market capitalization of $3.7 billion. It has cash on the balance sheet of almost $700 million. So, it is an enterprise value of about $3 billion. That means the EV/S for the fiscal year that starts at the end of this month is 5.4X - not precisely cheap, but a lower value than this metric has seen since the company went public in early 2012. The acquisition of ISCS will marginally increase the likely EV/S to 5.5X.

GWRE shares have been valued at premium multiples since the company went public. Since the company went public in 2012, the shares have appreciated by about 3X while reported revenues have doubled, although the current sales metric has seen a significant shift from perpetual to term based licenses which has tended to understate the real growth of this company. Guidewire's fiscal Q2 comes to an end in a few weeks (1/31/2017). In the wake of the latest acquisition, said by the company's CFO, Richard Hart, to be the last acquisition for a while, I thought it might be appropriate to update some expectations and valuation metrics for the company.

Looking Backward

Fiscal Q1 was not considered by many observers to be a halcyon quarter for Guidewire. Earnings were released after the close on 11/29/16. The shares fell by about 9% in the next few days and have drifted downward since that point. To be fair, the IGV index lost about 5% of its value in the same span, but it has recovered most of that ground and Guidewire has not.

Despite the company's over-attainment in Q1, the company suggested that the year would be back-end loaded in terms of bookings because the pipeline had larger but fewer potential transactions. To the extent that it happens that way, services revenues might be impacted because of projects starting later. Overall, the company is now forecasting revenues of $479 million at the mid-point with non-GAAP EPS of $.75. The company's prior forecast for revenues had been $478 million with EPS of $.74. Since the first quarter was $8 million ahead of the forecast for that period with an EPS beat of $.07, the guidance provided was taken as a disappointment and has led to the share price under-performance since the results and the guidance were released. To be sure, $4 million of the reduction in guidance has been a function of the strengthening of the dollar. So, the reduction in revenue guidance based on the forecast provided by the company was around 1%. Again, based on a significant amount of history with this company, I would be surprised to see it play out that way and, indeed, management spoke to being conservative because of the difficulty there is in forecasting the timing of larger transactions coupled with revenue recognition policies that will have to be analyzed on an individual basis for each large transaction.

Revenues for the quarter were $94 million, a beat of 10% more or less. The company reported almost $39 million in license revenues compared to prior guidance that at its mid-point had been $36 million. Guidance for this company, while not perhaps an exercise in deliberate obfuscation, often is puzzling because large perpetual license deals, which turn up with some regularity are never forecast. In the past quarter, management indicated it had received a $4 million-plus perpetual license deal from an existing customer but was still maintaining that for the full year, perpetual license revenues would show no increase. Perhaps it will turn out that way or more likely at some point the company will be surprised by another such deal. I think that investors should look at the performance of term license revenue as a reasonable growth proxy and then add-on some recognition of the Greenfield project and the deferred revenue write down the company is taking from its acquisitions.

When investors evaluate valuation metrics, to compare apples with apples between this company and other enterprise software companies, it is necessary to at least try to make some assumptions for these factors. Management is less transparent regarding these measures than one might wish for reasons that are not really clear to this writer. Management spoke to the deferred revenue write-down being $4-$6 million this year and it spoke to a service revenue deferral from the greenfield initiative of another $4 million. I am reasonably confident that the company is deferring some license revenues from the project as well, but this has not been in any company press release and I doubt that it will be.

In addition, in Q1, the company won a major transaction with National Indemnity Insurance, part of the Berkshire Hathaway Group (NYSE:BRK.A) (NYSE:BRK.B). The commercial terms of this agreement were apparently more complex and distinctive than is the case for other Guidewire customers. As a result, and atypically, none of the revenues from this deal will be recognized in the current fiscal year despite payments being received on a typical milestone basis. The CFO declined to quantify the impact of this transaction on reported numbers, although typically deals like this produce seven-figure revenue streams in terms of both license and services revenues even in their initial year. Viewed holistically, I think it is fair to suggest that reported revenue growth for this company during its fiscal 2017 year will be understated by at least 500 basis points due to what I can only describe as a singular approach to revenue recognition.

It is the self-imposed constraints on reporting revenue that have led to a decline in gross margins of 150 basis points and to an increase in operating expense ratios this past quarter. Another peculiarity of this company's reporting is that it does not record long-term contracts in its long-term deferred revenue account. The company has been pivoting toward larger contracts with larger customers and those tend to be multi-year. The company sadly does not provide a derived booking metric that might be used to record its sales trajectory. The company noted that it had significant success in selling its predictive analytics solutions to existing customers. Many software vendors have begun to offer predictive analytics or AI - they are basically the same technology. This company has been able to use its capabilities in that technology to help improve the sales efficiency of its users and to drive business a bit faster than most other vendors. The company is forecasting that the up-take of predictive analytics will continue at the same percentage in terms of growth this current fiscal year as in fiscal 2016. Of course, given that the revenue base of predictive analytic products is much larger now than a year ago, this implies that dollar revenue growth and the contribution of predictive analytics to the overall Guidewire business will accelerate noticeably.

The current fiscal year has the potential to see Guidewire breakthrough in terms of Tier I insurance companies purchasing Guidewire solutions. The company already has major contracts with such household name vendors as State Farm and Allstate. (Allstate's Esurance web car insurance runs on Guidewire software). The Allstate reference led Guidewire to a win with another web based auto insurer called Metromile which has recently gone live. Most large companies that offer auto insurance are going to have to offer a discounted product that more or less mimics what is being sold today by Esurance and Metromile to remain competitive.

Again, despite what appears to have been a guide down for the balance of fiscal 2017, I do not think there has been any slowdown in terms of demand for the company's solutions and my own sense, based on anecdotal checks, is that it appears that even on an organic basis, growth for Guidewire is accelerating.

What's the real growth story for Guidewire?

On occasion, I have read both articles on this platform and research reports regarding the extent to which Guidewire has been or may be overvalued. Part of this is a product of the large slug of share-based compensation that this company uses. In Q1, more than all of the reported non-GAAP income for the period was a function of stock- based comp. The company does not and will not likely earn much money this year on a GAAP basis, although if it chose to report some of its business in a manner that is used by comparable IT vendors, it would actually have a significant level of earnings.

But I think many negative observers fail to appreciate just how large and complex is the opportunity for Guidewire. I think it is worth quoting one of the answers on this most recent conference call that CEO Marcus Ryu provided in response to a question regarding the likely evolution of Guidewire's business. "And third, to your point, if you're a very, very large insurer, you have a history of building all your own systems, given it's a very complex legacy environment, than as you contemplate the enormous effort that it will take the transition to a more appropriate, modern digitally engaged kind of platform, you naturally look to your peer group and you want to know who else has done this, who have they done it with, what are their bona fides, have they proven their scalability, have they proven their worthiness in these large-scale transformation programs. And so, the success that we've been able to achieve with some very, very large insurers among out customer base has been absolutely essential to establishing our credential to serve other insurers. And as in every industry, companies are rated with different degrees of risk appetites."

Guidewire, perhaps unique in the IT space amongst companies that dominate a vertical, has yet to be successful with the very largest insurance companies, other than the special case of Allstate owned Esurance. When looking at the growth potential for this company it is important to understand that most analysis do not factor in the enormous potential there is for Guidewire to achieve dramatic scale if its digital solution becomes an industry standard.

During the course of the earnings conference call and at other investor conferences, the CEO has talked about how users want to bring down the TCO of their solutions. The TCO is very high because of how customized solution sets are in within different vendors. The obvious solution is cloud and that is the goal of the greenfield initiative. Guidewire is going to be responsible for the successful implementation and deployment of the software and is going to get paid based on the volume of premiums that will written using its solutions. If this cracks the TCO barrier, it will become a "need to have" solution across the industry.

The insurance industry has resisted third-party vendors supplying the "guts" of their business processes based both on the overall conservatism of typical insurance company management and fear of losing control of their processes to a third party. But if one insurer starts to have costs that are materially lower than peers because of an innovative IT solution, much of this industry's IT history will have to go by the wayside. When investors look at Guidewire they typically look at the high levels of stock-based comp and a growth rate that is certainly not in the forefront when compared to other subscription based vertical software vendors. It is my view (pun not really intended) that they need new glasses that might better identify the opportunity that this company is addressing and which does show up in the numbers if one looks hard enough.

The strategy of Guidewire is simple enough. Focus on securing customers in the very top tier of the insurance industry. Focus on getting those customers live so they can serve as references. And beat down the cost of customization, these days based on digital transformations that involve transferring workloads to a cloud managed by Guidewire.

Investors can reasonably speculate as to whether Guidewire can pull of all the elements of its strategy, but if it can, and I think it will, then expectations as they have been generally accepted for Guidewire, significantly understate its likely growth trajectory.

As compared to many other verticals in the IT world, Guidewire has far less competition and a far larger potentially addressable market. While Gartner is probably not the only valid source for research in the space, its current rating showing Guidewire alone by a large margin in the leader component of its Magic Quadrant is highly unusual and depicts just how significant an advantage Guidewire has in its industry. Other than Duck Creek, the other potential competitors in the space are described as niche players and are companies not well known outside of the niche in which they compete.

At this point, the company's only significant competitor for Tier I deployments is Duck Creek. Duck Creek belonged to Accenture (NYSE:ACN) for five years and given how service intensive the solutions are in the insurance space, that was a major potential advantage and kept Accenture from becoming a Guidewire partner. Last April, ACN announced that it was selling 60% of the equity in Duck Creek to a private equity firm, Apax Partners. The basic reason for the sale was that operating as a subsidiary of Accenture had apparently constrained operations at Duck Creek and had led to significant share losses over the past several years. It will be harder for Duck Creek to sell to the largest Tier 1 vendors without the imprimatur of ACN and particularly without having complete access to Accenture's international support capabilities. And since CAN no longer owns Duck Creek outright, it has become willing to partner with Guidewire, particularly internationally.

The market dynamics strongly favor Guidewire's attempt to sell the functionality it offers to the larger insurers. It will always face competition from internally built and supported solutions, but my expectation is that over time TCO comparisons will increasingly show savings based on cloud deployments based on third-party products.

Valuation

I commented at the start of this article that looked at traditionally Guidewire shares are not cheap. Using analyst speak, the shares have a premium valuation. It would be surprising to me if a company with such a formidable moat that dominates its space to such an extent did not have a premium valuation. The subscriptions that it sells are incredibly sticky and the amount of renewal business it will ultimately achieve is an asset that is difficult to quantify but which ought to be of some significance in the company's valuation. The value of the greenfield initiative is also not totally knowable at this point other than it is potentially an enormous opportunity to expand the scope of Guidewire.

I do not make a habit of recommending companies that have an EV/S of greater than 5X if there is any reason, other than the way data is presented, to think that they have a longer-term growth expectations of 14%. And the fact is that the company's P/E is high as well, particularly when considering the impact of stock based comp.

Last year Guidewire generated $100 million in operating cash flow (CFFO). Its capex was minimal at $7 million. Most of the cash flow for this company comes in its Q4 (50% last year). The company doesn't forecast cash flow, but CFFO is likely to do better than reported earnings this year because it will not be impacted by the deferred revenue write-down and because the commercial arrangements for the Greenfield deal and other large procurements probably include some form of ratable payments. I think it is reasonable to think that free cash flow will be at least flat and most likely will increase a bit depending on the payment terms for contracts whose revenue cannot be recognized but for which costs are not insubstantial. Last year CFFO grew by more than 50%, far outstripping the growth in reported non-GAAP earnings. Some of that was related to the balance sheet and more was related to the increase in deferred revenues and of stock based comp. That being said, no one is buying these shares for their free cash flow yield that might perhaps be 3%.

Q1 cash burn was slightly greater than the cash burn the prior fiscal year. On the other hand, it tracked better than reported non-GAAP profits. The company will generate most of its cash in the back half of the year.

Last year turned out poorly for Guidewire shareholders. The company has lowered expectations which are for less growth than historical levels coupled with an earnings decline. That has set up a very favorable risk/reward paradigm. I think this will turn out to be a stronger year both for the company and for its shares.

Disclosure: I am/we are long GWRE.

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.