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Morningstar | Guidewire holds its Fiscal 2018 Analyst Day; Raising FVE to $114. See Updated Analyst Note from 23 Sep 2018

On Sept. 21, wide-moat Guidewire held its fiscal 2019 analyst day, and as a result of added clarity on the firm’s long-term growth targets, we are raising our fair value estimate to $114 from $107. As a reminder, Guidewire reported a mixed fiscal year 2018 end a couple of weeks back, as metrics generally met our expectations, but the firm saw large cloud deals pushed out into the current fiscal year. However, the analyst day--where Guidewire’s CFO laid out a five-year financial plan with margin expansion metrics that exceeded our long-term assumptions--coupled with insights around the firm’s land-and-expand strategy and cloud migrations give us confidence in our fair value increase.

Our long-term thesis for Guidewire is oriented around the firm’s penetration of the $2 trillion property & casualty insurance industry. There are about 1,500 insurers globally, which can be subdivided into Tiers, with Tier 1 insurers writing more than $5 billion in direct written premiums, or DWPs, annually. During the analyst day, we received our annual update on penetration. Guidewire has 30 of the total 70 Tier 1 customers (up from 11 in 2013), 99 Tier 2 of about 200 total (up from 42 in 2013), and 251 Tiers 3, 4, and 5 customers of the remaining 1,200 (up from 130 in fiscal 2013). These incremental wins today can pay many multiples in the out years of our forecast period, particularly as wins continue to come from the less-penetrated European market. Expanding within Guidewire’s current customer base accounted for 61% of Guidewire’s fiscal 2018 sales.

Altogether, current penetration accounts for just under $0.5 trillion in DWPs, or 25% of the market. Our long-standing thesis is that Guidewire’s current wallet share penetration is much lower as certain insurers may only utilize Guidewire’s InsuranceSuite in one of their respective segments or current customers may not be purchasing Guidewire’s growing slate of ancillary services.

The second component of our bullishness surrounds the firm’s shift to cloud products. Guidewire took a near-term gross margin hit in fiscal 2018 that has continued into fiscal 2019, as the firm is in the early innings of cloud transitions for its customer base. Last year, MetLife was seen as Guidewire’s test subject, one of the first customers to migrate to Guidewire’s InsuranceSuite Cloud, serving as a major referenceable customer. In order to ensure a smooth transition for MetLife and other early adopters, Guidewire took on the implementation processes, leading to elevated services revenue, which is lower gross margin. As more customers adopt Guidewire’s cloud offerings over subsequent years, we model an acceleration in licensing revenue, which is higher gross margin, leading to expanding gross margins over the next 10 years. Our thesis on long-term gross margins was later substantiated by the CFO’s five-year growth and margin targets.

In terms of cloud, Guidewire brought in Nationwide’s EVP and CIO to discuss his firm’s transition from on-premises versions of Guidewire’s ClaimsCenter, BillingCenter, and PolicyCenter, to InsuranceSuite Cloud, which it expects to allow it to eliminate costly infrastructure upgrades that can lead to both downtime and operational risk. Guidewire has been on the record that they can extract two to three times the value for cloud-deployed versions of their software versus on-premises versions, but that’s mostly because customers avoid paying the infrastructure costs and services that were incurred to maintain the on-premises infrastructure. Furthermore, firms like Nationwide avoid having to implement product upgrades themselves going forward. As it relates to Guidewire, as the firm’s cloud offerings begin to gain scale, we model gross and operating margin expansion going forward.

Guidewire’s CFO outlined a five-year target. Guidewire expects that by fiscal 2023, subscription revenue will encompass 50% of Guidewire’s aggregate license revenue. Furthermore, Guidewire expects that the lower gross margin services revenue will fall below 30% of total revenue, giving us confidence in our long-term gross margin targets. The firm expects four to eight cloud deals in fiscal 2019. In terms of revenue, we model similarly to the firm’s near-term targets but modestly ahead of Guidewire’s 2023 revenue targets, particularly as we model acquisitions over the next few years. We were pleased with Guidewire’s 2023 non-GAAP operating income and free cash flow margin forecasts, both of which were modestly ahead of our expectations for fiscal 2023, which was indicative of faster operating leverage than we were previously anticipating, contributing to our fair value increase.

Overall, with shares once again trading at a modest discount to our $114 fair value estimate, we continue to like wide-moat Guidewire and recommend this as a name for investors looking to gain exposure to mid-cap enterprise software.