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

I'm Kevin Kumar. I cover software here at Goldman. And I'm pleased to have Jeff Cooper, CFO from Guidewire. Thank you for being here.

Thank you for having me.

So I thought, Jeff, maybe a good place to start would be just a brief overview of Guidewire. Obviously, a lot of change over the last couple of years as you transition to cloud. So maybe a brief rundown of the business on read.

Sure. Yes. So Guidewire is a vertically focused software company, 100% focused on serving the needs of the property and casualty insurance industry. We sell a suite of applications that kind of make up the core functions of an insurance company, policy administration, claims management, billing systems, that are part of what we call our insurance suite product set. And then we also sell a suite of digital and data applications that surround the core, primarily sold on-premise for the history of the company, always sold at a term license model, more recently have moved to a cloud-delivered model, so have been working to transition our software to be cloud delivered and then working to move the industry to adopt cloud core systems of record. So that's been a big focus over the last 5 years or so and going through a period of time where a lot of emphasis on building out that platform also an environment where the industry we serve is pretty conservative and so reticent to buy emerging platforms to a period of time where we are now, which is growing confidence in the maturity of the platform that we are -- we have to sell. And so that's where we are.

Yes. That's great. And I definitely want to touch on the cloud transition there, but maybe to start with you recently reported earnings, and 4Q historically has been a big, big quarter for Guidewire. So maybe any key takeaways in terms of the quarter, how it kind of turned out relative to expectations and kind of the demand trends you're seeing there?

Yes. Really strong quarter for us. So we were thrilled with our sales activity, saw healthy demand across what we call cloud migration. So cloud migration would be an on-premise Guidewire customer making the decision to transition to our cloud, in addition to new modernization activity. So that would be an insurer that's running on a legacy IT stack, making the decision to buy Guidewire. So kind of new logos. So broad adoption -- broad demand across different types of cohorts pretty healthy demand environment, really positive progress on the financial model as well. We've been -- I think the first step of our cloud transition was building out the platform and then making sure that all the early adopters were successful and spending a fair amount ahead of the demand curve to ensure that no early insurers had major hiccups with adopting cloud because referenceability in our industry is paramount. And now we've transitioned a bit to kind of focusing on driving efficiency of the platform. So that's manifesting itself in the gross margin line. We had an over 10 percentage point increase in the subscription and support gross margins in fiscal year '24, which is tremendous and a little bit ahead of where I expected to be. And then that kind of then also flowing down to the bottom line and cash flow just had a really strong cash flow quarter. So that was great to see.

Yes. And we'll definitely dig into some of those dynamics. Maybe to start with just macro. We get the question around what are the macro dynamics within P&C? Kind of where are we in that cycle? It seems like there's a lot of change to COVID, and we've kind of come out of that. The carriers are raising rates. And maybe just how you think about kind of the willingness and readiness for these carriers to do these larger commitments and larger modernizations? Where are we in terms of that?

Yes. I always try to distill it between -- I still think the primary driver of adoption and the willingness to buy and consume our products today is more micro driven than macro driven. It's kind of where the maturity of the platform is. And coming out of a period of time where we actually saw pretty soft demand because this is such a conservative industry and wanted to see more reference points. And we've been working hard to build those reference points. And so in terms of where we are with the maturity of the platform, I think that's the biggest driver in terms of why we're seeing some acceleration in demand. The macro backdrop has certainly improved as insurers are taking rate in a meaningful way, given where we were a year or so or 2 years ago because there is a lag factor in terms of how many within especially personal lines are able to raise their rates. So sometimes the claims cost goes up faster than the rates can go up and it takes a little while for those models to resolve themselves, but we're seeing kind of healthy rate taking amongst the insurance industry. And that's probably helping as well in terms of the overall willingness to take on big projects like this.

Yes. And in terms of -- you talked about the cloud maturity. But when you think about kind of buying patterns across your customer base, can you talk about -- have there been any changes? Like obviously, Tier 1s buy differently than perhaps Tier 2, Tier 3. Can you maybe run through those buyer dynamics and if there's been any change over the last, say, 1 or 2 years?

Yes. We service a pretty diverse customer set within the P&C insurance industry. So that can include insurers that have $100 million of direct written premium to very large Tier 1 insurers that have [ '23 ] or even in some cases, larger than that in terms of billions of direct written premium that they manage. So it's -- the buying patterns vary. Smaller insurers will typically buy a full suite and make a decision and kind of go all in with 1 vendor. The larger insurers have very complicated IT stack. Some of them grew through acquisition. There may be 30 or 40 different core system vendors that exist in that overall landscape. And they tend to buy in a more piece male, modular fashion. I think one of the themes that we've seen more recently -- 2 years ago, we were seeing a willingness to do some test and learn in the cloud, maybe bring a small line of insurance into the cloud, see how that goes and then build on success. And I think what we've seen in the last 2 Q4s in particular, is an increasing willingness to make big commitments. There was a customer that we signed in Q4 that was a claim center migration opportunity. The sales team did a good job of selling the whole suite and the value of the whole suite. Their original intention was just to do a claim center migration. But then ultimately, you said, "Hey, we're likely going to go all in with Guidewire eventually. And so why don't I just make the decision and buy the whole thing now and then create a road map where all ultimately move to policy center and billing center." And we're seeing more willingness to do that today than 2 years ago. So that's been the biggest theme in terms of the buying behavior that we've seen. Tier 1s, I think the large Tier 1s expect to buy in a more modular fashion. We are working with some of them around how do we create a framework style agreement where maybe you don't need to negotiate every single time you want to buy, you have a kind of an understanding of how that would work. And so we are kind of actively working on some of those negotiations.

Maybe taking a step back and just looking at cloud. I mean it feels like the debate over whether to go into cloud or not is pretty much over most of the new deals being done across the industry or cloud. I guess in the past, you've talked about a pricing uplift 2 to 3x. I guess what are the benefits to the customers? Why are they going down the cloud route? Why -- how do you think about like total cost of ownership and why they're willing to be the premium for cloud?

Yes. foundationally, I mean, we went down this cloud path because we think this is the best way to deliver software to the industry, right? And so if you go back in time, on-prem, we would typically do a major version upgrade of our software, release of our software every 2 years. And a customer would usually skip a release or 2, and so take an update or an upgrade every 4 to 6 years, which is not necessarily best-in-class in terms of delivering innovation to our customers base. So the cloud flips that dynamic pretty significantly. We now do 3 releases a year. Our customers are able to take those releases in an increasingly frictionless fashion, so staying very current. It also -- managing these environments is pretty complex. And so we unburdened our customers of that. Many large insurers kind of had armies of SIs that were in there managing these environments on their behalf. It's quite expensive. And so the overall total cost of ownership of moving to our cloud, even though they're paying Guidewire a fee that is 2 to 3x higher than what they would have been paying on-prem, the division of labor has changed such that it should result in a lower total cost of ownership. We work -- each case is very different, and we do business cases with our customers to try to model this out. I don't think there's a kind of a perfect formula. But in general, by the time you kind of get through a 5-year program, you were exiting in a much better total cost of ownership please.

And Jeff, you talked about migration activity being healthy. I guess maybe walk through -- are you noticing any themes? Or is there a certain catalyst that kind of incentivize the customer to transition and I think there's eventually going to be an end of life the on-premise customer base. So how are they thinking through the time line? And do you see this happening in kind of waves or what's kind of the cadence?

Yes. I think -- If you're a customer on-prem, the most natural time to think about making a migration to our cloud is when you were thinking about doing a major upgrade. So let's say, we had 10 versions of our on-prem software. If you're on version 8, you were thinking about doing an update. It's like, well, do I update the version 10 or I go directly to cloud and just skip that step. So that's the most logical time. And then now we're seeing a bit more -- early on, there was maybe a hesitancy around being an early adopter. Now we're into the middle part of the demand curve. And I think that's also increasing some appetite to buy and maybe they don't want to be a late adopter either. And we are generally pushing through price increases each year. I mean the early customers took a bigger risk. The later customers, the platform is much more mature, and it's been derisked quite a bit. And so we're raising prices as we go through these releases. So there's a lot of different things that a customer will think through. I think what we're seeing today a bit more is this kind of recognition that, okay, I get it now. I'm comfortable with the innovation that Guidewire is delivering, I'm comfortable with the maturity of the platform, I'm likely going to go there, and so I should probably start getting organized. We're seeing that a lot more today, but there's still a lot of work to do. And we still haven't -- if you look at about 66% of our overall ARR is now coming from our cloud products. But on the core side, still over half of our customers are on-prem. So we still have a lot of work to do to migrate our customers.

That's helpful. Maybe just a little bit about competition, especially maybe compare and contrast what the competitive dynamics were in the on-prem world and if that's changed kind of in the cloud world, most of the other vendors have also gone through a similar transition and Obviously, Guidewire is focused on the higher end of the market. But maybe talk about some of the dynamics you're seeing in terms of competitive dynamics?

Yes. So Guidewire did a really good job carving out a market leadership position on-prem and delivering our suite of applications to the industry. It's always been a competitive marketplace. So there's a number of vendors that operate in the space that we've been the largest of those -- that cohort of vendors. We did see -- for Guidewire, there was always this debate internally about what -- when is the right time to really think about transitioning our investments in R&D towards the cloud. Because we know once you do that, you somewhat disrupt your pipeline because once you said, hey, we're now going to focus our efforts on building cloud, you're going to create a chill over those that were planning to buy on-prem, right? So it was a very considered decision for us. And we did see some of our competitors, I think, differentiate from Guidewire by posturing cloud first or earlier than we did. And I think that, that was helpful for us to some extent because it kind of caused us to kind of move a little faster and challenge ourselves. And I think that the early part of the shift to the cloud, we saw some competitors put up some nice wins, that was still very much like any one or warm-up for what was the ultimate cloud journey. And then when you kind of went through this process of being pretty introspective, heads down, focused on building. It happened to align a little bit with COVID and a time in the marketplace when there probably wasn't a lot of buying appetite anyway and have now emerged and feel very confident in the cloud platform that we've built. The win rates we're experiencing today are at parity or higher than what our on-prem win rates were. Our thesis all along has been that market leadership is going to matter even more in the cloud domain than it mattered on-prem. It's one thing to buy software from a vendor and put it behind your 4 walls and run that software, especially mission-critical software. It's another thing to entrust a vendor to run your kind of core suite of applications as a cloud service. And we felt very strongly that market leadership would matter more in the cloud. And I was kind of part of the big investment cycle that we put in place to make sure that we distance ourselves in the cloud, not just kind of meet the moment, but also kind of distance ourselves from competitors. And we think we feel very confident in the progress that we've made.

Yes. The interesting dynamic has been maybe some competitive displacements that, historically, that's not been the case, right? It's usually net new going after custom solutions. But it feels like you're seeing a little bit more traction with competitive displacements. Is that a durable trend? Is it too early to tell, any thoughts there?

Yes, there's a unique element of our market that is a little bit different because when you go into a competitive situation and you lose, you -- our old paradigm is that you've lost that customer for 20 years because the complexity around taking a mainframe-based system and recodifiing all that business logic into a new modern system. And the program you put in place to kind of get that instantiated, it's such a big effort that the kind of the friction to move off of that is so high. So you kind of have to have that mentality when you go into competitive environments. And what we're seeing now, which is kind of interesting, is the things that we would have deemed as previously modernized as insurers are thinking about their cloud strategy, maybe they kind of modernized on-prem 10 years ago, and are saying, "Hey, well, now I want to revisit that and I want to revisit the vendor decision that I've made." So some of that stuff that we kind of mentally have put in the box is no longer in our TAM is coming back into our TAM, which is great to see. The big part is still the massive amount of the industry that still runs on mainframe. So it's nice to see these competitive displacements. But -- and I think they make good reference points and proof points, but the part of the opportunity is still that mainframe workloads that are out there.

Yes. Understood. I wanted to talk about kind of some of the growth trends. You ended the year at ARR, 14% growth, ramped ARR was 19%. I guess how do you interpret that dynamic? And maybe just touch on kind of the ramp dynamics of the business and what that 19% means in terms of kind of maybe durability or even visibility of growth over the next, call it, year or 2?

Yes. Yes. So we have this construct that we call fully ramped ARR. We disclosed that on an annual basis. fully ramped ARR looks at our customer contracts and the fee tables in our customer contracts and looks at the terminal year of each of those and then calculate that, right? And so we benefit from pretty long-durated contracts and in many cases, they ramp during the initial contract period. And what -- we first disclosed this back in 2019 when we had a couple whole large wins in the American Family and USAA, where the fully ramped events were really quite compelling, but the incremental year-1 ARR was not that big. And so it was kind of a view through into the selling activity that occurred that may not manifest itself in ARR. And then we -- it also gives the visibility into this concept of -- we have this ARR backlog that is very clearly spelled out in contracts that will come to the company over time. And that is time derated, if not success, it's not based on any success criteria. And the dynamic has been pretty interesting. What we saw early on was there was a couple of large commitments. And then we moved into COVID, and we moved into a point in time when we were very actively building Guidewire Cloud platform. And we saw a little bit residents to make big commitments. So we saw people doing testing the water, they're making smaller commitments, they're not making the big commitments. And so the amount of fully ramped ARR was a little bit lower and some of those events that ARR backlog that was coming into our ARR actually became a bit of a headwind versus tailwind. And then that started to reverse itself last year when we started to see insurers have an increasing willingness to make big commitments. And now that's turning into a tailwind. So fully ramped ARR last year grew 17%. This year, it grew 19%, and that benchmarks to overall ARR growing in the 14% range. So it's becoming a bit of a tailwind, and that gives us just visibility into future ARR growth coming from these accounts. So that's a little bit of why we disclose that metric. It's a little bit unique.

Yes. Another dynamic that's come up is some of the GWP true-up that you're seeing in the contract. So maybe walk through, I think you talked about a couple of points of tailwind for that in the business. So maybe just talk about like is that a durable trend? Is that -- how staggered is that in terms of when customers come up for renewal? And how do you see that kind of playing out from a growth tailwind perspective?

Yes. So we have a wide variety of customer contracts. But foundationally, we price our software on basis points of direct written premium. So we don't sell seats. It's not like this is just how the company has always priced their software and aligns with how the insurance industry thinks about their cost structure and their income statement. So it's been a model that's worked very well for us. A customer will very often have -- so they have what's called a baseline direct written premium in their contract. And then we have rights to, if they go over that baseline to charge true-ups. And in this environment where we're seeing inflation and insurers taking rate, we are seeing more true-ups than normal. And so that added -- we said about 2 percentage points to growth this year over a normal year. We're seeing a little bit more on our on-prem base, although the overall gross dollars was pretty balanced, but on a percentage basis, more on our on-prem base, those contracts are all pretty old. And a new contract that's not uncommon for customer to buy a bit direct written premium and they're currently managing to give them some growth or some room, a buffer, before they hit a true-up. But we are seeing more true-ups. And we do expect the true-ups to be kind of durable. It takes a little while for insurers to take rate and for that to flow through their models. And then it also takes a little while for it to flow through our model in terms of when the renewal hits or when they go through some buffer that was built into the baseline. So as we look ahead to next year, maybe not quite as much of a tailwind as this year, but we do still expect it to be a tailwind vis-a-vis a typical year.

Yes. That's helpful. Maybe a question on your noncore products. I think the focus has been on cloud, rightfully so. And the transition and selling the core systems. But you have a broad portfolio, you have analytics, you have other products you can sell. I guess what's kind of the -- is that a meaningful contributor to growth? How is that evolving? It feels like the attach rates for AI -- excuse me, analytics is pretty compelling. So how do you think through kind of that as a growth driver?

Yes. So we have a nice kind of recurring revenue engine with our digital products. There's some rearchitecting of how we're doing that, that I think can make that were compelling over time and more easy to adopt. We have a broad suite of analytics products that include reporting capabilities. We have a predictive analytics capabilities. We have some data products that help insurers drive better underwriting outcomes. And so a fairly robust suite of analytics products. In general, I think with where we are in the cloud, those kind of ancillary products haven't been an accelerant to growth because the cloud is kind of at this adoption curve. And we think over time as the cloud becomes more instantiated, those products will be a bit more compelling. The first step for insurers to get live on the cloud, and then we see them pop their head up and look at some of these ancillary products. But we're excited about the potential there. And especially around on-prem, all of our customers adopted our software in quite different ways and utilize maybe different database technologies that are [indiscernible], there's just a variety of different ways that they ran the software in the cloud, it's very standardized. And so it enables us to more easily kind of sell-through and also more easily create a marketplace that is something we're excited about. So this is -- it's becoming a focus more and more as we now feel that the cloud is in a really healthy place. How do we start thinking through some of these new product areas that we can drive forward.

That's great. I wanted to ask about the partner ecosystem, and that's been -- it feels like that's a key part of the strength of the Guidewire platform is the extensive partner ecosystem. It felt like Guidewire was doing more of the heavy lifting in the early days of the cloud it feels like you've gotten more comfortable offloading more work. I guess what needs to be -- what's left to be done in terms of partner enablement. And what are the ramifications, I guess, for kind of the services side of your business and kind of the overall revenue mix going forward?

Yes. Yes. So when we talk about partners, there's really 2 categories of partners. There's our SI partners who do a lot of the implementation work. And then there's our solutions partners that kind of tap into our marketplace and create some innovation in [ interesting ways ]. So on the SI side, early on in the cloud transition, we felt it was important to lead a lot of the programs to, one, we were early -- we had to figure out how to run these programs, right, where we could train our SIs. We had to figure out how to do them ourselves. And we wanted to be really intimate to the programs from a product perspective. So we are driving a lot of the early programs the intention all along was to make sure that, over time, the SIs do the majority of that work. We've tried to do all the work ourselves, we'll not be able to do this many cloud deals because without building a massive, massive services organization, and so we've done a really good job. That team has been focused on it. I'm thrilled with the investment that the SIs have made to kind of drive certification. I was -- I saw the guy who runs the PWC program recently, and he was kind of touting about this social media campaign about how when the latest release came out, how quickly they all got certified on it, and they were sharing it on LinkedIn. And so kind of that's been really positive to see that. And as a result, our services revenue has come down, which is great because the software revenue is continuing to be very strong, which is emblematic of the fact that our partners are taking a lot of this work, and that's what we need to do in order to address this modernization of an industry together.

Yes. I wanted to touch on March, specifically cloud gross margins. You talked about the improvement there this year. I think the guidance for fiscal '25 implies a pretty healthy incremental gross margin. So is it just a function of more scale now as you get more customers on board? Like what -- maybe that's part of the question. And the second part would be just how high can gross margins get without kind of current architecture that you have at Guidewire?

Yes. I told Diego, I'm super disappointed because we're not doing a third year of over 100% [indiscernible] our margins. I mean, we've -- there's been a lot of work to drive efficiency into the platform, and we are seeing the benefit of that. So -- and the accounting can get quite complex in terms of cloud migration accounting and ASC 606 and the impact on subscription revenue. But what I try to look at is kind of looking at our margins on a cash basis, on an ARR basis to get confidence in how we think about the long-term targets. And there's so much movement in terms of the efficiencies we've delivered to the platform. that it can get a little bit cloudy from an overall investor looking at the financials to try to understand because over 100% incremental margins is not kind of sustainable, but as we kind of look at the cash margins and think about how that compares to our long-term targets, it gives us confidence that we should be normalizing some of those model impacts, delivering incremental margins in line with or slightly better than some of those targets that we have that should kind of allow the model to continue to march up towards those targets.

Yes. Any questions from the audience? Maybe one on -- I think the cash flow generation of the business, it really inflected this year. I guess what's -- how do you think about -- you touched on the gross margins, which is a pretty critical piece of it, but I think investors often ask about like it's a vertical model, how high can kind of margins get. And I think a big part of that is free cash flow generation. And so I guess what was the drivers of the inflection this year? And I think you put a pretty healthy kind of guidance for next year as well. So maybe just walk through kind of the free cash flow generation of the business and the levers to kind of get that in line with maybe some other vertical software names out there.

Yes. I mean we were thrilled with the -- the biggest element is the work that Diego has done in delivering gross margin with the platform. There are some nuances there in terms of like the timing of rev rec and how it compares to invoicing that has caused cash flow from operations and free cash flow to run kind of meaningfully ahead of operating margins or operating cash flow or operating profit. But the biggest driver is that we've now built machine that can add customers without needing to add headcount and can do it in a way that's highly efficient from an overall AWS workload perspective. And that's -- that was a huge part of the investment that we made over the last 2 years. and that's coming to fruition. That's what's driving it. And we have a relatively efficient go-to-market motion. It's a vertical that there's not that many insurers out there. We know all of them. So we don't have to kind of throw a bunch of money at sales and marketing, trying to get G&A more efficient as well. And so you take all those things together and the model is starting to play out the way we knew it would. And there's nothing that I see that kind of gives me pause to say that, hey, we can't achieve what some of the best-in-class vertical software names out there have achieved.

Yes. on that point, I think you talked about some incremental investments, particularly in the R&D. So maybe walk through kind of where you're investing. I think you kept your kind of EBIT targets kind of -- or you alluded to perhaps having the EBIT margins kind of being on track with your prior kind of targets? And so maybe why now in terms of those investments, how do you think about that balance going forward?

Yes. It's the right time for us, for the last 3 or 4 years, we were just so downward focused on driving cloud execution. And now we feel that, that's in a very healthy place. And we are very aware of the opportunity that exists once we aggregate a meaningful part of the industry on a common cloud platform. to sell through real value-added stuff on the data side, and we have a ratings engine that's been maybe under invested in that we want to reinvest in there's kind of areas in pricing that we think are super interesting. There's a lot of opportunity within GenAI for -- there's numerous use cases there. So there's a lot to invest in, and there's a lot of opportunity. And now that we have the foundation set, it's the right time for us to start making those bets. We are -- in Diego, I mean Diego, from an engineering perspective, Diego manages the biggest part of our R&D line. He has a lot of investment to just kind of tweak some of the allocations, right? So he's shifting more of his effort away from platform and infrastructure and more towards the application layer. And then there's also some incremental investment we're making to drive some of these product investments that we think will pay off years from now and kind of allow us to kind of maintain an exciting kind of durable grower within this industry.

Yes. Great. And maybe last one for me on just capital allocation. I think you're close to $1 billion in cash in the balance sheet. How do you think about -- I think in the past, Guidewire did more M&A, but curious kind of uses of cash, M&A strategy, you did a buyback a while ago. So maybe just kind of update on the capital allocation.

Yes. We're probably going to talk a little bit more about this at the Analyst Day in October. The framework we've had out there historically is conservative industry. I like to see a vendor that is doing a mission-critical service for them, have a well-capitalized balance sheet. And so we've talked about $400 million minimum run the business cash we think we've earned the right to be a long-term consolidator, acquirer in the industry. And so I want to make sure we preserve strategic capital for M&A. We haven't done a lot of M&A because we've been so focused on making sure we've got the cloud transition right and didn't want to take on incremental distraction when we were in the medius part of that transition. But now kind of looking ahead, I think we feel more confident that inorganic should be part of our growth story. And then we also want to do some building. We have a convert that is maturing in March. And our expectation is that we will pay that down in cash and net share settle, so we're kind of making sure we preserve the right balance sheet to be ready for that as well.

Yes. Great. Well, I think we're just out of time. Thanks, everyone. Jeff, thank you so much.

Thank you.