Guidewire Software, Inc. (GWRE) is transforming not only itself, but the entire Property and Casualty insurance industry by convincing insurers to upgrade their legacy systems to Guidewire’s SaaS-based solutions.
Guidewire is well-positioned for this transformation. According to Morningstar, Guidewire has a wide economic moat and the company wins more deals than its largest competitors combined.
(Source: Guidewire Software)
While I believe that Guidewire has a very promising future, I find that the future is already baked into the stock price. Furthermore, the shift to SaaS is causing suppression of near-term performance due to deferred revenue recognition and lower revenue retention as customers decide whether to make the change to a subscription model which is more expensive than a perpetual license. Given the lofty share price and expectation for soft financial performance this year, I have given Guidewire a neutral rating.
Guidewire provides an ecosystem and tools for more than 350 companies in the Property and Casualty insurance business and includes software and services that allow customers to grow and differentiate their offerings. The company sells to the global market and includes national and regional carriers.
(Source: Guidewire Software)
According to Morningstar, Guidewire has a wide economic moat:
Our wide moat rating for Guidewire Software is driven by higher customer switching costs and, to a lesser extent, intangible assets. Our position is that switching costs for software are driven by several factors. The most obvious would be the direct time and expense of implementing a new software platform. Additionally, there are indirect costs along those same lines, mainly lost productivity as employees move up a learning curve on the new system and the distraction of employees involved with the function where the change is occurring. Perhaps most important, there is operational risk, including loss of data during the changeover, project execution, and potential business disruption. The more critical the function and the more touch points across an organization a software vendor has, the higher the switching costs will be.”
Shift to SaaS
There are two basic issues that confront analysts as a company transforms into SaaS. The first issue is that conversions from perpetual license to SaaS revenue show up on the company financials as a slowdown in revenues. Subscription revenue is spread across the length of the contract instead of upfront as would occur with a perpetual license.
The second issue is high churn rate as customers deliberate whether to make the jump to subscription. This typically results in the loss of some customers and of those customers that endorse the new platform, some will downgrade services in order to compensate for the costlier subscription model. Guidewire is suffering from both of these issues.
Because of these issues, I expect that Guidewire's fundamentals will be soft for the remainder of this year and if this company is like other SaaS stocks, analysts probably won't pick up on the cause.
The good news is that Guidewire’s shift to SaaS appears to be a success in the making as the new customer mix is now approximately 60% subscription.
(Source: Guidewire Software)
Relative Stock Valuation
I determine stock valuation on a relative basis and on the belief that high-growth companies should be valued more highly than slow-growth companies. To illustrate this point, I created a scatter plot of forward gross profit/enterprise value versus estimated YoY sales growth for the 82 stocks in my digital transformation stock universe. The forward gross profit is calculated as follows:
Next Year’s Estimated Sales * Gross Margin TTM
The gross margin is assumed to be the same in the future as it is in the most recent trailing twelve months.
(Source: Portfolio123/MS Excel)
The sales multiple in the vertical direction is calculated using the EV, "next year's sales estimate" mean value based on all analysts from the Portfolio123 database and the most recent gross margin TTM. The estimated YoY sales growth is calculated using "current year's sales estimate" and "next year's sales estimate" also provided by Portfolio123.
The reason for using analysts' estimates as opposed to historical data is because SaaS stocks tend to make a lot of acquisitions, which can muddy the results of the scatter plot. The analyst estimates account for these acquisitions, and the estimates are updated frequently. This makes for a cleaner chart. The sales estimates, unlike EPS estimates, are usually quite accurate for most SaaS companies, except that they tend to be on the conservative side. Keep this in mind when looking at the plot.
I use a linear best-fit trend line. As sales growth goes up, the EV tends to go up and gross profit/EV declines. The trend line was calculated using MS Excel. I consider the stocks sitting above the trend line to be undervalued, while stocks lying under the trend line are overvalued.
As can be seen from this scatter plot, Guidewire is significantly below the trend line, suggesting that its forward gross profits/EV are much lower than its peers, given its estimated future revenue growth rate. My interpretation is that Guidewire is overvalued relative to the average stock in my digital transformation universe.
When it comes to software companies, I don't rely on traditional value factors; instead, I focus on other measures, such as the "Rule of 40," free cash flow margin and cash burn.
The Rule Of 40
A rule of thumb often applied to software companies is the Rule of 40. This metric helps software companies balance growth and profitability. There are different ways of calculating the Rule of 40:
Growth - The standard growth metric is to use the Annual Recurring Revenue (ARR) growth rate. For my Rule of 40 calculation, I use percentage sales growth TTM. There are three reasons for this: (1) ARR is not always available; (2) most SaaS companies grow not only organically but also by acquisition; and (3) many companies are in the middle of a transformation to SaaS and have a significant amount of product sales.
Profit - I have seen many variants for the profit metric. Some analysts use EBITDA margin, others use operational cash flow margin or free cash flow margin. I use the free cash flow margin, as I believe that is the most meaningful factor from an investor perspective.
The Rule of 40 is interpreted as follows: If a company's growth rate plus profit adds up to 40% or more, then the company has balanced growth and profit and is financially healthy.
Guidewire's revenue grew by 26.7% for the most recent twelve months, increasing from 5% in 2016.
Free Cash Flow Margin
Guidewire has a free cash flow margin TTM of 10.7%. The free cash flow was over 25% at the start of 2018 but has been declining since. This is primarily the result of the shift to a SaaS business model.
Rule Of 40 Applied To Guidewire
Guidewire's YoY revenue growth was 26.7%, while free cash flow margin for the trailing twelve months was 10.7%. Therefore:
Revenue Growth + FCF margin = 26.7% + 10.7% = 37.4%
The Rule of 40 calculation comes out slightly lower than 40%. Although Guidewire marginally fails the Rule of 40, I don't see this as a major problem considering that revenues and margins are suppressed during the transformation. In all likelihood, Guidewire will score well on the Rule of 40 next year.
If a company doesn't score well on the Rule of 40, I like to make sure it is at least not burning cash. I determine this by looking at the historical SG&A expenses relative to total revenue.
Note that SG&A includes Sales & Marketing, General & Administrative, and R&D.
SG&A relative to sales was 53% for the most recent twelve months. This figure is quite good for a high-growth stock. I have to conclude that Guidewire is not reckless in its use of cash.
The next scatter plot shows forward operating income/EV versus forward sales growth for all of the stocks in my digital transformation stock universe. The forward operating income for my purposes is before depreciation and amortization and is calculated as follows:
Forward Gross Profit - SG&A Expense TTM
The forward gross profit was calculated earlier in this article. The forward SG&A expense is assumed to be the same as the SG&A expense for the most recent twelve months.
(Source: Portfolio123/MS Excel)
From the above plot, you can see the effect that the SG&A expense has on operating income for Guidewire. The operating income is pretty much in line with its peers. Therefore, I conclude that although Guidewire missed slightly on the Rule of 40 the company is still in pretty good shape relative to its peers.
Guidewire is a solid company with a wide economic moat and good fundamentals. I expect that company performance will be somewhat subdued this year due to the continuing transformation to SaaS.
Guidewire marginally fails the Rule of 40 but I don't see this as a major problem, given the ongoing transformation and conservative SG&A expenses. The only issue that I have with Guidewire is that the stock is expensive relative to its SaaS peers. For this reason, I give the company a neutral rating. I look forward to reviewing this rating in early 2020.
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.