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Morningstar | Faster-Than-Expected Subscription Ramp Is a Double-Edged Sword for Guidewire; Lowering FVE to $110

Wide-moat Guidewire Software reported material upside for its third quarter, offset by weak guidance for next quarter. We see the thesis as evolving positively, as customer interest in subscriptions is picking up appreciably. Just last quarter, management was expecting 40%-60% of new sales to be driven by subscriptions this year, whereas now it believes it will be closer to the high end. While we view this as favorable since revenue will become more stable and Guidewire will be less susceptible to large perpetual license deals that can swing a quarter, we acknowledge the pressure such a transition puts on near-term revenue and margins. As such, we are lowering our fair value estimate to $110 from $117. Our view of the company’s competitive position is unchanged, and we continue to view it as leading the way in the modernization of the slow-moving P&C insurance industry. We view today’s sell-off mostly as investor frustration over unexpectedly muted ARR growth, coupled with a series of issues from the last few quarters, including the services business, Cyence customer churn, and now the high contract renewals on shorter durations and lower guidance.

For the quarter, revenue grew 16% year over year to $163 million, with one large license deal driving most of the $7 million upside, which in turn drove material EPS upside versus our model. This deal was pulled from the July quarter and therefore contributed to lower guidance for next quarter. Ramping subscription revenue should offer less quarterly volatility, which investors have generally cheered as these model transitions have become better understood. Guidewire also adopted ASC 606 this quarter, which led to significant contract renewals ahead of schedule, and on one-year terms, versus multi-year deals previously—and even several with pricing concessions. This will depress ARR growth in the near term but ultimately not have a meaningful impact on the business, in our opinion.

A faster ramp in subscription revenue implies lower growth, as revenue is recognized ratably over a year, rather than up front as it is in perpetual license deals. Lower revenue also imply lower margins. This dynamic is offset by other moving parts from the quarter and the outlook. Management now believes system integrator partners are better equipped to take on more implementation work, and therefore relieve the company from the slower growth and lower margin business of installing software at client sites. This is not the company’s first round of issues with implementation partners, but we are in favor of software companies limiting services revenue as much as possible.

Our revised longer-term now incorporates a more rapid shift to subscriptions and a step down in services revenue. We prefer the subscription model, and we believe investors overwhelmingly do as well. We also think that the economics could be better than normal, as management indicates that the revenue opportunity is two to three times as large in a subscription deal compared with a perpetual license deal.

Lastly, we are pleased that management upped its outlook for InsuranceSuite deals for the year to 7-8, from 5-8 previously, as this lends support to our view of Guidewire as the industry leader even in a quarter with more bad news than good.