Guidewire Software, Inc. (GWRE) Earnings Call Transcript & Summary

Good afternoon, everyone. This is Pete Heckmann with D.A. Davidson. Thank you for participating today in our Software and Internet Virtual Conference. For this session, we have Guidewire Software. We have Jeff Cooper, the CFO; and Alex Hughes, who runs Investor Relations. Gentlemen, thank you for participating today.

Yes. No, thanks so much for having us.

Yes. It's great. Well, your Guidewire is relatively newer name for me, but I've been watching from the sidelines and have attended your Investor Day several times in the past. But at a very high level, it's a vertically focused enterprise software company, exclusively focused on property and casualty insurance. And that's an industry that not everyone knows a lot about. Can you talk about how you look at that industry, adjust the -- or think about the market opportunity? And how do you judge Guidewire's progress within the industry?

Yes, sure. So Guidewire exclusively focuses on the P&C insurance industry, and we sell core systems of record that P&C insurers rely upon to run their business. So this includes policy administration systems, claims management systems, billing systems and a variety of other capabilities. And then we surround those core systems with systems of engagement, which we call our digital products in addition to data and analytics products. Globally, the P&C insurers manage approximately $2.5 trillion in direct written premiums. And insurers on average typically spend about 4% of their DWP on IT initiatives in a given year. So it's a pretty huge market that we operate within. We estimate the overall market for core system software that we sell is around $12 billion to $13 billion market, with significant TAM upside as we further penetrate the data and analytics opportunity that exists within the P&C insurance sector. So a lot of opportunity in front of us as we continue to tackle this market. And we think about our penetration in a variety of ways. Of the $2.5 trillion today, we manage to touch approximately $540 billion of the DWP with at least one of our core systems. And so that's about 20% of the global DWP we touch in some capacity. But our overall revenue penetration is closer to 5%, meaning that we often have significant expansion opportunity with our -- within our customer base. So as a market leader in an attractive vertical market, we're excited that there's still a lot of work to be done and a lot of modernization activities still to do within this industry.

Got it. On last week's call, your quarterly earnings call, you discussed some of the key themes that Guidewire is hearing from customers who are looking to upgrade their technology. And that includes the importance of a unified core platform, the strong product road map from their vendors as well as they're looking to gain the ability to innovate faster than they have been under their legacy systems. Can you talk a little bit about the areas? Or what would be sort of the priorities, I guess, is -- what you're seeing, core system upgrades, analytics, digital engagement, where are the areas that are really the hot buttons today?

So this market is evolving. Guidewire's founding vision was to help this industry modernize and bring a more modern approach to their core system framework, help drive efficiencies, allow insurers to be more innovative. And that's been consistent throughout the history of Guidewire. What we're seeing now is a shift to cloud-delivered software. I view that as an evolution of a lot of the themes that were driving our original founding vision. If we think back 30, 40 years ago when a lot of the original legacy systems were put in place, there was a build once and then patch and manage those systems, and that was the mentality. The innovation that Guidewire really brought to the market was delivering modern software that was upgradable. And in an on-premise context, our customers would typically take a major upgrade every 4 to 6 years, and we would release a major upgrade every 2 years. Now we're shifting the industry to the cloud, which is just further accelerating that vision to allow us to deliver innovation capabilities to our customers in a much more rapid cadence. So in the cloud context, we can deliver an upgrade every 6 months, and our customers should be able to relatively seamlessly take those upgrades every single time rather than skipping an upgrade. So faster access to innovation, simplifying the overall IT framework. A lot of the pain points that our customers have today is just the overall maintenance and management of these systems that they are doing within their premises. This can be quite complex and difficult. So the value proposition of the cloud helps them simplify, gain faster access to innovation. And one of the key drivers that's really impacting business today are some of the digital initiatives and digital capabilities. And especially in a COVID world where you need -- it's an imperative to have an app to be able to touch your customers' digital first, a lot of these legacy systems are holding people back in their ability to interact with their customers in a modern way. So the cloud is a much more open system with much more robust API frameworks to enable more sophisticated digital capabilities. And we have some really exciting early examples of this. One of our customers recently updated their cloud software from the Aspen release to the Banff release, and they did that in 4 days versus what would have taken months to take a major upgrade in an on-premise context. So starting to see some exciting proof points as customers are making this decision to go cloud.

Well, certainly, with fourth quarter results, it seems that the transition to cloud is accelerating and you saw more core deals year-over-year, both fourth quarter and for the year. You saw -- your guidance certainly implies an acceleration of annual recurring revenue, including subscription revenue. And do you feel like that's catalyzed by anything? Or is it just a realization that competitors that have already upgraded are getting a competitive advantage, and so now there's a catch-up cycle?

I think we're still in the early phases of this cloud adoption curve, and the realization of these systems to drive material competitive advantage is still pretty early days. I think what we're seeing is just the steady progression and traction of what has really been years of hard work that Guidewire has been working on for the last 2.5 years to set ourselves up to have a quarter like we had in Q4, where we were able to sell 17 cloud deals in a single quarter. And we expect that to continue to gain momentum and gain traction. We like to talk about this as just more steady progression rather than massive inflections, but -- because this is an industry that is quite conservative and we have a lot of people that are looking at some of these early reference points and trying to assess when would be the right time for them to go to the cloud. A lot of the decision-making is a timing decision, looking at the IT investments that an insurer has made, how they can sequence a shift to the cloud in their budget plans and other activities. And so a lot of those conversations are ongoing. But we feel really good about where we are today, how this market is evolving and the investments that we've made to put us on track to continue to be the leader in this segment.

Right, right. And as you say, as a leader, I think you cite over 400 customers, P&C insurance carriers. And correct me if I'm mistaken, but I think somewhere like 75% of those are still running primarily on-prem installations. Can you talk about the pace of migration to the cloud and some of the implications for revenue growth and margins as that occurs?

Yes. Still the vast majority of our customer base is on-premise. We did discuss our cloud ARR, which is growing quite significantly. And we define cloud ARR as those that have bought our cloud products, even though they may not have fully completed the transition, so there's often a fairly significant transition period. But that ended the year at just over $230 million and around 40% of our total ARR. Now the price points in the cloud tend to be higher. So that wouldn't mean that we're at 40% of our customers in the cloud, but 40% of the ARR is now being driven by our cloud products. 89% of our overall new sales activity in Q4 was cloud. So it's clear that this is now the future. We are a cloud company, right? And this will be the driver of our business going forward.

Yes, yes. And then you've done, I think, a really nice job of breaking down some of the piece parts and the related margin. But this migration to the cloud has required a substantial investment in infrastructure and capabilities that have weighed on than the margins for subscription revenue. But on last week's call, you had said that you feel like you're reaching a trough year with the potential for subscription gross margins to move from the low 20s close to the 30% above over the next period of time. And so as that goes, how do we see that margin migration and the mix shift? Can you talk -- and certainly, you've talked longer term. But where might we expect to see margins, let's say, 3, 4, 5 years from now?

Yes. So our subscription margins, we've made big investments in our cloud operations function to put the pieces in place to be able to support a quarter where we're adding 17 cloud customers in a quarter and kind of continuing to see that growth. So we feel really good about those investments that we've made over the last 2 years. As we look ahead to this year, you're going to see continued growth on the cost of goods sold for the subscription line going into next year. But a lot of that is the full year effects of investments we made in fiscal '21. And we expect to start tapering those investments quite aggressively on the COGS side, and that will have a margin impact over the years to come. So as we think ahead to some of the targets we put forth in the Analyst Day, we identified what we call the midterm target at about $1 billion of ARR, and we'll give some more insights into this at our Analyst Day later on this month. But the subscription and support margin target that we set out for that period was kind of 66% to 68%. And we feel good about those targets. I mean that's material margin expansion from where we are today. We start to see the subscription margin move up meaningfully in fiscal '22. And those will be some pretty healthy step-ups year after year as the subscription revenue growth will be quite durable. And we feel like a lot of the investments we've made we can leverage for the next few years. So kind of within that 4- to 5-year time period, marching up towards that margin target is very attainable in our perspective.

Great. Great. And Guidewire generates a fairly material amount of revenue outside of the U.S., roughly 1/3. Can you compare and contrast international markets versus North America and where you might be having some success internationally? And are there any notable differences in what those international customers are trying to accomplish versus the domestic customers?

Yes. It's -- the market -- and I'm -- I've been with Guidewire now 4 years, and I feel like I'm learning every day about the insurance market. There are unique differences in different geographies. Europe is an area where we've had some really good success. We're starting to see more cloud momentum in Europe, which is exciting. There are investments that are required to support the regulatory environment in a particular country. And there tends to be, in each geo, kind of 1 or 2 competitors that have a good handle on the unique components to support a particular country, and they pretend to offer more bespoke systems. And we think our approach is superior to leverage a more standardized software approach and then kind of build country layer content on top of that. And so we're seeing good success. It's been a little bit slower to adopt cloud. I would say, sales cycles in Europe are a little bit longer just as they go through -- going through their evaluation process for cloud, but seeing positive momentum there. And I'm looking forward to Europe being a meaningful contributor as we look at fiscal '22. In Asia Pac, it's also an interesting market. The insurance market tends to be more consolidated there. A handful of very large insurers dominate the market, both in Australia and the Japan region, which -- where we're pretty active. We're starting to see a little bit more innovation in newer insurers. We announced a deal at a company called Hollard, which is a fast growing insurer in Australia and New Zealand, which was an exciting win for us in Q4. But we're also very focused on some of the larger players there. A lot of those players are customers of ours in some capacity and engaging with those folks as they're starting to think about what their cloud journey will look like. But international business is a big part of our overall TAM and a big part of how we think about the market opportunity in front of us.

Got it. Got it. And so yes, in terms of M&A, you completed a handful of acquisitions over the last decade. Cyence was your largest at close to $300 million in purchase price. Can you talk about some of the goals of the M&A program, talk -- Cyence was relatively larger and really contributed some capabilities in data analytics. But how do you think about your M&A program and some of the hurdle -- the return hurdles that you think about when evaluating deals?

So you've seen us be a little bit more conservative on M&A over the last 3 years as we focused our efforts on making sure that the cloud transition is going well. That's a big execution story for us, and we didn't want to take on any incremental distraction. I also think as we architect and really attack the foundational architectural layer of our products, that's going to help us create a platform that will be easier for us to then plug in acquisitions in the future. And so HazardHub, which was a recent acquisition we did, really fit the bill for that data and analytics play, API-first model, have a good product that's starting to see product market fit, but could benefit from our distribution engine. So really, that one was kind of a perfect example of what I would call a tuck-in type acquisition where we can meaningfully accelerate what the company was trying to do. So that was an exciting kind of smaller tuck-in. There are a number of tuck-in opportunities that exist that can be quite interesting. I think you'll see us evaluate those. And then there's certainly potential for larger acquisitions. We -- as you noted, Cyence is our largest, and that's $300 million. So we haven't done anything super material to this point, but something that could really accelerate the value proposition and help us address certain parts of the TAM, whether it's in data analytics or other segments that would be somewhat adjacent. Still within P&C is my sense. We often are asked about transitioning to adjacencies such as the life market, and those are things that we do evaluate and assess from time to time, but we still think there's so much work to be done in P&C.

Okay. Okay. And then with the HazardHub acquisition, it raised a question in my mind about owning proprietary data. Certainly, specialty underwriters need a lot of data for marine, property, different types of risks. How do you feel about owning the proprietary data versus partnering? And should we maybe expect some other deals like HazardHub come down the pike?

We want to take a pretty comprehensive approach. We want to open. And I think the cloud enables us to more elegantly partner with technology providers. And so we do intend to partner aggressively. We want to build an ecosystem in a marketplace that sits around our core. And over time, I think that, that could create a logical M&A pipeline for Guidewire. But typically, as we kind of start, my sense is it's partner first, but if there are things that are interesting out there that we would like to own, we will certainly look at those as well.

Okay. Okay. And you recently gave guidance for fiscal 2022 where you formalized your guidance for fiscal 2022. And we talked about strong ARR growth and what appears to be certainly another year of 45%, 50% growth in subscription revenue. But that model is sensitive to several variables. Can you talk about some of those key variables in terms of revenue mix and things that we might want to think about that could create some headwinds or tailwinds for the year?

Yes. So we -- as a business internally, we have very much focused our efforts and how we think about our momentum as a business on ARR because ARR will normalize for all the different revenue patterns that we have in our customer base. So we sell primarily now subscription arrangements. Most of our legacy customers are on term license arrangements. And so they pay us an annual license fee and maintenance fee that is ratable. So the annual license fee is recognized annually as they -- as that contract renews and then the maintenance portion is recognized ratably. Duration has a very significant impact on that because sometimes initial deals are 2 or 3 years in duration, and that kind of causes the revenue to be pulled forward on the thing. So modeling the revenue line over the last 3 or 4 years in the midst of the transition has been quite complicated. ARR really helps normalize for the different revenue patterns and understand the organic growth of the business. That will start to lessen as we shift almost all of our new bookings activity to cloud and as term license arrangements that were multiyear in duration eventually transition into annual renewals or shift to cloud migrations as well, then that will start to kind of normalize. But right now, ARR is the real measure of how we think about things. And there's a variety of variables that go into how we model ARR. First is, is how much new business do we sell in a period and then how does that translate to ARR? Second is, is a lot of our arrangements are multiyear in nature and have ramped components. And so the ARR will grow naturally as we execute to the contract, and it will grow on -- usually on the annual anniversary of the contract start date. And then we also monitor and measure quite actively any ARR attrition or churn activities. And so those are the key variables that we look at and we model. We have a really good sense, very low churn. We talked about kind of 3% or lower ARR attrition within our core business. And we obviously have a very good sense of what's flowing into our ARR from previously sold deals from these ramped arrangements. And so that gives us good predictability on the ARR line, and that will just continue to grow as we grow more and more into this cloud model.

Right, right. Okay. And -- yes. On the balance sheet, the company has about approximately $1 billion in net cash. And the company, I think, directed maybe around $160 million to share buybacks over the last fiscal year. Can you talk about how you think about those share buybacks and -- versus kind of keeping your powder dry for potentially acquisitions?

Yes. At the last Analyst Day, we highlighted that given the industry that we serve and the conservative nature, there is a comfort level when you're making a 10-, 20-year investment on a core system provider that there is a bit of cash on the balance sheet. So we like to kind of think about that as $600 million, $700 million that run the business cash that gives comfort to our customers. And then having a fair amount of cash available to be opportunistic to pursue acquisitions to make sure that we can pursue the strategic vectors that we want to pursue. And when we looked at that, we felt like there's probably a bit of excess cash that we could give back to shareholders through a share repurchase program. So we put a $200 million share repurchase program in place. We're working through that. And my expectation is, is we'll be largely through that by the end of Q1. And then we'll revisit with the Board whether or not we want to put something else in place or kind of let that ride out and be a bit more aggressive on the M&A front. So that's an active discussion that we'll have going forward.

Got it. Got it. And we only have 2 -- a couple of minutes left. And so just, again, the P&C insurance industry is just a little bit maybe less well known by technology investors. And so could you outline maybe 2, 3 bigger picture dynamics that are going to roll out over the next, let's say, 3, 4, 5 years, things like usage-based insurance or more automated claims handling, the dynamics that we should be watching? And to the extent that regulation is one of those, I'd love to hear your thoughts.

Yes. I mean some of the new capabilities that we've announced in our cloud product is something called Advanced Product Designer, which really helps and ensure bringing new insurance lines to market and a more rapid cadence in a more seamless way. And you mentioned usage-based insurance. We announced a solution to address that need very specifically -- And the other thing we're seeing is claims automation. I think touchless claims is a desired endpoint for a lot of insurers. So those are some of the efforts that we're working on. But I think the real element that is attractive for our cloud product is managing these core systems on their behalf in a seamless way so that they can take the fruits of our R&D efforts in a rapid cadence. And so building out that architecture layer, that infrastructure layer to support our cloud products has been a huge emphasis for us over the last 2 years, and that's a big part of the value proposition as well.

That's helpful. Okay. Well, unfortunately, we're out of time. I would love to keep talking about the business, but we will look forward to the Investor Day at the end of this month. I thank you, Jeff and Alex, again for participating and for everyone else listening in.

Yes. No, thanks so much, Pete.

Thank you.