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Morningstar | Wide-Moat Guidewire Caps Off its Fiscal 2018; Raising FVE to $107 per Share. See Updated Analyst Note from 05 Sep 2018

Guidewire reported a mixed fourth quarter and end to its fiscal 2018. After rolling our model, we are raising our fair value estimate to $107 per share, from $105 previously, while maintaining our wide economic moat rating. Revenue for the quarter and next fiscal year were in line with our expectations, but Guidewire's margin guidance was on the lighter side. However, we firmly believe our long-term thesis around Guidewire remains intact. Guidewire's growing presence at the top of the market, the expanding number of customers using its nascent cloud platform, 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, with the firm being protected by adamantine switching costs. These factors give us confidence in our modest fair value increase, and with shares once again trading at a discount to our fair value estimate, we see this as an attractive entry point for this name.

Guidewire reported $661 million in revenue and the firm now has 380 total customers (up from 328 last year), aided by 15 new customer wins in the quarter. Color from the conference call indicated that the vast majority of these wins were in Europe, where the firm has been strategically focusing on penetrating the fickle European P&C insurance market. European customers have historically bought from regional software vendors and look to partner with vendors with referenceable customers in similar geographies. Thus, we believe Guidewire's traction in Europe today will lead to easier incremental wins ahead. Our valuation thesis remains very simple, while Tier 1 P&C insurer penetration remains robust, as the firm had 28 of the 70 Tier 1 Insurers, wallet share remains much lower. Tier 1 insurers write more than $5 billion in direct written premiums, representing the largest market opportunity, but oftentimes Guidewire sells only one or two products to these customers.

Coming into the quarter, we had previously identified two factors that had a likelihood of affecting our assumptions around both the results for the quarter and guidance for Guidewire’s fiscal 2019. Both ASC 606 restatements and the continued shift of current customers to Guidewire’s cloud platform were expected to possibly obfuscate the firm’s results in some regard. First, Guidewire shifted customers to term licenses that will renew annually after 2019 in anticipation of ASC 606, leading to no surprises for the transition. Second, Guidewire still expects muted GAAP operating margins due to cloud migrations, but as a positive, they expect 40% to 60% of new sales will be cloud sales. The firm had two notable cloud wins.

The one lagging piece of the business was that InsuranceNow, Guidewire’s cloud application for smaller insurers, saw less traction than expected, but we note this accounts for less than 10% of revenue. InsuranceNow last reported a single Tier 1 insurer and over 30 Tier 3 or lower insurers.

Investors should be aware that Guidewire has an analyst day on Sept. 20. We intend to closely track new information provided the penetration of Guidewire’s nascent data and analytics products.

In terms of our modeling of the business going forward, we forecast a 18% revenue CAGR for the firm over the next five years and a 13.5% 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 GAAP gross margins compressing from 63% in 2017 to the 56% range in 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 66% by 2028, with operating margins sitting well above 30%, as licensing revenue expands at a faster rate.

As we have previously iterated, we believe Guidewire’s unit economics are largely unparalleled. 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.