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Morningstar | Guidewire Continues to Stake Its Claim as a Wide-Moat, Mission-Critical Software Vendor; $105 FVE. See Updated Analyst Note from 09 Aug 2018

After transferring coverage of Guidewire Software to a new analyst, we have maintained our wide moat, stable moat trend, and medium uncertainty ratings, along with our $105 fair value estimate. We still see shares as modestly undervalued and still see this as an attractive entry point to own a wide-moat stock, with some of the strongest switching costs in our coverage.

Guidewire Software creates solutions for property and casualty insurers, which we believe have historically updated their outdated IT systems at a glacial pace. As insurers look to shore up operational efficiency, data integrity, and policyholder engagement, Guidewire has prospered as its modern software systems have started to replace P&C insurers' clunky, decades-old mainframes. We think this value proposition, coupled with the subpar returns of P&C insurers since the financial crisis, has served as a catalyst for Guidewire’s growth. Today, Guidewire has emerged as the global leader in replacing these legacy systems with its InsuranceSuite application, which manages claims, billings, and the entire policy life cycle.

We believe Guidewire’s applications result in meaningful cost savings by increasing underwriting and billing efficiency, shortening the claims cycle, and limiting claims leakage, which yields diminished operating costs for the customer. Due to the lengthy implementation process (anywhere from 12 to 36 months), many customers see Guidewire as a long-term strategic partner, giving us confidence in durable switching costs.

The firm has 350 total customers, with Guidewire modeling its pricing on the amount of premiums tied to licensed applications. Guidewire’s products are scalable to the largest insurance organizations in the world, and its suite is deployable either on-premises or in the cloud by way of partnerships with major public cloud vendors such as Amazon Web Services.

The firm’s customers write $0.5 trillion in direct written premiums annually, and Guidewire has relationships with more than 25 of the roughly 70 global Tier 1 insurers, yielding a strong revenue base. Newer data, analytics, and digital offerings are expected to provide ample upsell opportunities, notably DataHub and Guidewire Live.

Guidewire’s growing presence at the top of the market, the expanding number of customers using its nascent cloud platform, international expansion (particularly in Europe), and upsell opportunities give us confidence that the firm still has a runway for growth. Guidewire’s offerings in the P&C niche are largely unparalleled.

In terms of financials, we forecast a 21% revenue CAGR for the firm over the next five years and a 16% CAGR over the next 10 years. In terms of cloud, in the near term we expect an expansion in lower-gross-margin services revenue, as Guidewire takes on the implementation workload of migrating current customers to its nascent cloud offerings. Thus, we model gross margins compressing from 63% in 2017 to the 56% range in 2018 and 2019. In the longer term, our modeling is predicated on an acceleration in licensing revenue as subsequent customers adopt Guidewire’s cloud-based solutions (InsuranceSuite for Tier 1 customers and InsuranceNow for Tiers 3, 4, and 5) and Guidewire begins to rely on system integration partners to take care of the migrations. Guidewire, while still in price discovery, expects to extract greater value from cloud customers than from on-premises customers. Thus, we see the gross margin compression as temporary, anticipating expansion to 65% by 2027, with operating margins sitting above 30%, as licensing revenue expands at a faster rate.

By our estimates, Guidewire’s lifetime value/customer acquisition ratio, or LTV/CAC, is 5.15, if we take the median of the past eight quarters. We view this as best-in-class, the highest we’ve seen among software vendors in our coverage, even above the elite pantheon of Workday and ServiceNow. We believe the LTV/CAC metric is an important indicator of a software vendor’s efficiency in attracting new customers and retaining existing ones. For every $1.49 spent to acquire a customer, Guidewire extracts a $7.65 lifetime value for the customer. Similarly, as we look at Guidewire’s fluctuating GAAP profitability and transition to cloud products, we use the LTV/CAC ratio to assess whether the firm lacks pricing power and operating expenses are out of control, or whether the firm is making wise investments in order to secure more customers and future revenue. We think the latter clearly applies to Guidewire and its operations today. For Guidewire, we believe the firm’s expanding slew of products (InsuranceSuite Cloud, InsuranceNow, DataHub, and so on) have provided ample cross-sell and upsell opportunities. These exemplary unit economics give us confidence in the stability of Guidewire’s business and economic moat.