Description

EXECUTIVE SUMMARY: Guidewire (GWRE) is the market share leader for software solutions focused on the Property and Casualty (P&C) insurance market. GWRE’s valuation today (~70x/~35x FY24E/FY25E consensus EBITDA, respectively) is underpinned by the street’s acceptance of management’s unrealistic FY25E/LT models and stated cloud TAM >1.5-3x 3^rd party estimates. The reality facing GWRE is that – even if it is successful in converting the ~80% of its customer base that remains deployed on-premises to cloud – it is operating a software model with structurally lower margins, exacerbated by >30% of revenue coming from <0% margin professional services + support, all in an increasingly competitive and limited TAM. Further, this cloud conversion is far from certain, with ~10% of new wins choosing to deploy on-prem. Despite all of this, GWRE trades at a premium to more competitively secure and higher growth SaaS comps. Continued profit/FCF margin misses and adjustments to mgmt’s LT model seem likely to drive a N/M-term de-rating. This setup creates a >1.5-1 short risk/reward and a base case FY26E ~30% return: Short Downside Case FY26E price target of $~110 p.s., Base Case of ~$50 p.s., Upside Case of ~$25 p.s..

GWRE SHORT THESIS SUMMARY

1. Structurally inferior financials vs. often-comp’d SaaS due to architecture, services mix, sales efficiency, and other factors
2. Consensus figures largely underwrite management’s FY25E and long-term (~FY28E) targets despite poor execution to date
3. GM expansion – critical to LT model – is predicated on converting >2x as many customers by FY26E vs. FY20-FY23E.
4. S&M efficiency points to “heavy lift” to drive conversion (e.g. GWRE spent 1.6 S&M $ for every net new ARR $ since FY20)
5. Management and sellside consistently overstate viable TAM compared with 3^rd party estimates as well as top-down math
6. Cloud-native competitors (e.g., Duck Creek) have stronger financial profiles, likely allowing them to outspend GWRE in S&M
7. Despite slower growth and worse metrics, GWRE trades at ~15x gross profit, well above vertical software peers (~10x GP)
8. Continued profitability misses (e.g. missed on OCF 7 of the last 8 Qs despite 8/8 rev beats) could catalyze derating

COMPANY OVERVIEW

Introduction: GWRE provides software solutions that support policy, claims, and billing management for the P&C insurance market. The company went public in 2012 at ~$13 p.s.. Founded in San Mateo, CA in 2001, today GWRE serves >500 customers globally and employs 3,376 people.

Business Model / Products:  GWRE generates revenue by marketing software and services supporting policy, claims, and billing management as well as add-on modules for CPQ (configure, price, quote) tooling, data management, and analytics. The company generally prices its software based on the amount of Direct Written Premium that will be processed by the software’s deployment within its client (estimated take rate is 10-20bps of DWP). GWRE segments its revenue and gross profit by:

• Subscription & Support (46% of FY22A Revenue, 27% FY20A-23E CAGR, 27% YoY LTM growth, 51% GAAP GMs)
• InsuranceSuite is comprised of three core modules: PolicyCenter, BillingCenter, and ClaimCenter as well as add-ons
• InsuranceNow is a suite-only product targeted at smaller clients (i.e. tier 3-5 insurers), added via ISCS M&A in 2017
• Cloud licenses are sold for a 3-5 year term and billed annually in advance, with annual renewals afterward
• “Support” (i.e. incremental services) is typically sold as a % of total subscription fees, billed annually in advance
• KPIs: Gross margin, Support % of S&S, Cloud ARR, S&M $ / net new revenue, Rev/Customer
• Licenses (30% of FY22A Revenue, -9% FY20A-23E CAGR, -5% YoY LTM growth, 98% GAAP GMs)
• Term and perpetual (<1% of total) licenses. Licenses are generally sold for two year terms, with annual renewals
• KPIs: Gross margin, Professional services attach rate, ARR, S&M $ / net new recurring revenue, Rev/Customer
• Services (24% of FY22A Revenue, 2% FY20A-23E CAGR, 17% YoY LTM growth, -11% GAAP GMs)
• Implementation and support services for on-prem, privately hosted, and GWRE-hosted cloud. Billed monthly.
• KPIs: Gross margin, attach rate (vs. licenses and vs. S&S + Licenses)

Market and competition: GWRE participates in the P&C Insurance SW market, which Gartner sizes at ~$16bn and expects to grow 11% p.a. through FY25. While GWRE’s traditional offerings target P&C Vertical and Horizontal Applications sub-markets, expansion into hosted cloud offerings allows GWRE to target infrastructure budgets as well.

• P&C Insurance Software: GWRE primarily competes for Vertical-Specific and App. SW $s, sized at ~$11bn growing ~12%
• Vertical Competitors (% rev share): GWRE (34%), Duck Creek (10%), Majesco (9%), Sapiens, and others (Per Gartner, note that market share calculations exclude both products offered by ERP suite vendors {e.g., SAP} and in-house SW spend.)

WHY DOES THIS OPPORTUNITY EXIST?

• Cloud conversion narrative: As recently as CQ3 22, three customers chose to buy new on-premises deployments (compared with four new cloud buyers) –disputing mgmt’s claims that it has plans to move all its customers into the “cloud”. The most probable outcome is that GWRE will need to support both on-prem and single-tenant cloud for the foreseeable future, making the ~1,000bps of GM expansion modeled by the street unlikely. Finally – even if ultimately successful – conversion is very likely to take more time than consensus is modeling (e.g., of 79 cloud sales noted during 2022 Analyst Day, only 19 were live as of CYE 2022 – this number increased to 40 by FQ3).
• Inferior business, but comp’d to Vertical SW: Perhaps because there is no operating profitability to put a multiple on, almost every sellside analyst points to relative parity with vertical SW and SaaS peers on a xRevenue basis, ignoring both inferior growth rates and the fact that GWRE’s GAAP GMs are considerably below those generated by this peer set.
• Persistent overstatement of TAM by management and sellside: Always a red flag for vertical software companies trading at a xTAM multiple, GWRE management simultaneously claims to be the leader with 20-30% share and high RMS (probably true) while also identifying a TAM >20x its current revenue. These two claims appear to contradict one another. I believe they do, and that true serviceable TAM is probably somewhere between $3-$5bn and growing mid/high teens p.a.. Comparing various TAM calculations will allow you to make your own decision here:
• Gartner Total P&C Insurance Software TAM: $7bn of annual Application spend (note that this counts ALL SW spending on apps by P&C insurers, including everything from security to expense mgmt., many features of which GWRE does not offer) + $5bn infrastructure SW spend (arguably addressable via the hosted cloud product) + $4bn of vertical specific (core TAM for product) = $16bn total TAM expected to grow 11% p.a.
• Mgmt TAM (Oct 2022 Investor Day): $700mm of “Fully Ramped” ARR + $3bn of Cloud Conversion, Expanded DWP and Cross-sell within GWRE’s existing customer base + $8bn of Analytics and Data Offerings add-ons + $10bn of new customer wins (whitespace and competitive) = $21bn total TAM
• Top-down TAM (base case): $2,700bn of Global P&C DWP * 10bps take rate = $2.7bn TAM  
• Top-down TAM (Bull case): $2,700bn of Global P&C DWP * 20bps take rate = $5.4bn TAM  
• Bottom-up (Reported to Gartner for annual market guide + publicly reported info where available): $2.7bn TAM, note that this is imperfect because it’s mostly self-reported and excludes 1) venders who choose not to participate (like SAP) as well as 2) in-house SW spend, which is probably at least >2-3x this figure.    
• Bottom-up (2022 deals basis, according to Gartner): [1,373 existing deployments + 150 new deals (flattish YoY)] * average 2022 new deal revenue [~$2.2mm] = $3.4bn

WHERE I COULD BE WRONG / BULL CASE

1. Clear market leader (20% of DWP, >2x RMS vs. DCT) in a vertical market wherein share appears to be consolidating
2. There could be a sudden sea change in insurer behavior, leading to a massive shift away from in-house SW/ traditional ERP vendors (i.e., making management’s TAM more “real”)
3. Very sticky product, with historical <1% churn rate; GWRE could be able to sustain this despite cloud conversion challenges
4. Mgmt could prove capable of expanding margins via services optimizations (e.g. plan calls for ~10x cloud support efficiency)
5. Mgmt claims >60% win rates (weighted based on DWP); Gartner estimates GWRE wins ~50% of new logo deployments
6. Expansion into adjacent insurance markets, especially life insurance, could make strategic sense and increase TAM by ~1.5x
7. Taking mgmt’s claims of a 2-3x cloud uplift, converting 100% of the on-prem base would allow GWRE to beat cons. revenue
8. Main competitor, DCT, was recently acquired by a PE sponsor, which could prioritize profitability over growth/share gain
9. A strategic (e.g. Roper) or financial buyer could emerge (note: difficult LBO math and no go-shop bidders for DCT)

FINANCIAL OVERVIEW AND BASE CASE: My base case assumes that GWRE is able to convert (this means sell, not necessarily have deployed and in the P&L – this is an important distinction because new cloud sales have historically shown up in ARR almost a year before they show up fully in the P&L) ~75% of its base by FY26 without meaningful churn. Then, I assume that mgmt is able to effectively reverse the damage they’ve done to gross and operating margins during the conversion, getting to a ~56% GAAP / ~60% non-GAAP GM and a ~16% Adj. EBITDA margin by FY26E. I think this is pretty generous for all the reasons described above and gets you to $150-$200mm of EBITDA by FY26E (from ~$0 today).  

RISK/REWARD: What multiple to put on this $175mm of FY26E EBITDA? Given the current multiple on that figure is >30x, this deserves some serious thought. Fundamentally I think that this business– having exited its conversion and thereby growing with the cloud P&C SW market of low-mid teens – should be trading around a LSD FCF yield given its (presumably) still dominant position in a smallish TAM. Assuming sustainable LFCF conversion in the ~85% range and that buybacks roughly offset dilution from SBC, putting a 3% FCF yield on this profile gets you to a $50 FY26 PT, equivalent to 20-25x EBITDA. This sort of squares with where a comps analysis gets you, with a fair set of vertical SW comps (median topline growth rate of 18%, median GM of 65%) trading at ~x30 fwd EBITDA today. Given even this fairly optimistic picture of the future GWRE, I’d say that 5-10x of EBITDA multiple is a fair discount for its relatively inferior financial profile and smaller market opportunity vs. the average vertical SW company.

It’s fairly easy to paint an upside case where everything goes perfectly (i.e. mgmt. hits its LT targets early) and the company is doing >$200mm of EBITDA by FY26E and somehow still earns an-above peer multiple that gets you to a $100-$130 PT in FY26E. There is also an easily imaginable scenario wherein GWRE either 1) stumbles during the transition of its remaining ~80% of customers not currently in the cloud and churn ticks up, 2) faces increased competition from DCT and Majesco, owned by the two best software private equity operators on the planet, 3) Isn’t able to expand gross margins by >1,000 basis points because it continues to operate higher-touch, single-tenant deployments and/or can’t convert private cloud deployments, 4) is unable to double sales efficiency like consensus is calling for. Any combination of these factors could result in FY26E EBITDA <$100mm. Pick your multiple for a software company facing any of these headwinds and perennially underperforming management targets and you probably get to a $20-30 FY26E PT. This all sets up for a good return in a reasonable operating and valuation base case, with a nice risk-reward comparing the bull and bear cases.  

CATALYSTS: Upcoming catalysts in FY23E earnings (FYE 7/30 call typically early September) which is likely to show downside to consensus profitability and/or another reset of management’s FY25E and long-term models. I think there is limited likelihood of an upward reset to management’s LT model during FY earnings or the Fall Analyst day, but these are likely to be key catalysts, one way or another.

APPENDICES TABLE OF CONTENTS

1. Market Overview and Competition
2. Product Overview
3. Industry Research Excerpts
4. Management Overview
5. Board Overview
6. Top Holders
7. Management’s LT Model from October 2022 Analyst Day

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APPENDIX A: MARKET OVERVIEW AND COMPETITION

APPENDIX B: PRODUCT OVERVIEW

APPENDIX C: INDUSTRY RESEARCH EXCERPTS^[1]

APPENDIX D: MANAGEMENT OVERVIEW

APPENDIX E: BOARD OVERVIEW

APPENDIX F: TOP HOLDERS

APPENDIX G: MGMT FY25 AND LT TARGETS

^[1] Gartner.

Catalyst

CATALYSTS: Upcoming catalysts in FY23E earnings (FYE 7/30 call typically early September) which is likely to show downside to consensus profitability and/or another reset of management’s FY25E and long-term models. I think there is limited likelihood of an upward reset to management’s LT model during FY earnings or the Fall Analyst day, but these are likely to be key catalysts, one way or another.