Guidewire Aims to Be the Industry Standard

When it comes to software, the property and casualty insurance industry has been living in the past. Many insurers rely on clunky, decades-old proprietary legacy systems that lack sophistication and often lead to overpayment on claims and customer attrition. As insurers look to shore up operational efficiency and data integrity, IT spending on core software applications is set to grow to nearly $11 billion by 2020 from $8 billion in 2015, according to research firm Gartner.

Guidewire Software GWRE has emerged as the global leader in replacing these legacy systems with its full-feature core application suite, which manages claims and the entire policy life cycle.

Guidewire's applications are scalable to the largest insurance organizations in the world, and its suite is deployable either on premises or in the cloud. The company has doubled its customer total since 2012 to 260, with 162 customers live. Chief competitor Duck Creek had just 31 live customers at the end of 2014. Guidewire models its pricing based on the amount of premiums written and processed over its applications and has relationships with more than 25 of the roughly 55 global Tier 1 insurers, yielding a strong recurring revenue base.

Guidewire has invested heavily in making its core applications robust, but we believe the firm is differentiating its offering through a number of add-ons. Guidewire's DataHub standardizes data from legacy systems (which is often unstructured) to make data migration to its applications much smoother. Guidewire Live is a cloud-based network that allows users to access real-time, anonymized claims data from Guidewire customers while leveraging a growing suite of visualization and analytics tools. This type of complete offering is unparalleled in the industry.

We are encouraged by Guidewire's growing presence at the top of the market, and there remains a long runway for growth, evidenced by the firm's 20% penetration of premiums written by Tier 1 insurers. We expect the firm to continue to win the bulk of new projects while upselling to additional business lines in its current customer base.

Robust Products and Scale Contribute to Wide Moat
We believe Guidewire has a wide economic moat. Application software providers often carve out economic moats by developing robust products that become ingrained in a customer's processes, creating a sticky relationship. Providers with the strongest competitive advantages are able to scale these products to reach a significant portion of the addressable market. In our view, Guidewire has achieved each of these milestones, roughly quadrupling the customer totals of its nearest competitor while becoming a stalwart vendor among the world's largest P&C insurers, with solutions deployed in 23 countries. Guidewire's core insurance suite and add-on applications handle vital processes for property and casualty insurers, from policy underwriting to claims management and billing. In return, customers pay annual term licensing fees (whether deployed on premises or in the cloud), giving Guidewire strong visibility into its long-term revenue stream. The firm operates in all segments of the P&C insurance market, and it has proved to be a capable partner for the world's largest insurers. The company counts more than 25 Tier 1 insurers (firms with greater than $5 billion in annual premiums written) among its customer base, including a companywide relationship for InsuranceSuite with Nationwide, which generated roughly $17 billion in annual premiums in 2013, and a new relationship with State Farm, the world's largest P&C insurer. Guidewire has a product tied to roughly 50% of the premiums written by its Tier 1 customers. Globally, the firm has a product tied to nearly 20% of premiums written by Tier 1 firms, and total penetration in terms of direct written premiums tied to a product stands at roughly 15%. Overall, Guidewire has 260 customers, with 162 in live production at the end of fiscal 2016.

Guidewire's implementations take anywhere from 12 to 36 months based on the size of the organization as well as the number of modules being implemented. Frequently, customers will begin by licensing ClaimCenter within 12 months, while PolicyCenter and BillingCenter often come online 6-24 months later. Guidewire aims to install its full suite across all business lines. Though businesses have typically licensed one or two core applications to one business line before upgrading to the full suite and turning to other lines of business, larger firms are now evaluating the entire suite at once, which should shorten implementation times. These implementations require intensive training and integration, creating a significant switching cost for the customer once the products go live. The firm's research and development efforts have yielded a number of useful add-on applications and features that further ingrain Guidewire's ecosystem in an insurer's day-to-day operations, including data migration, ratings management, and agent performance measurement tools. Guidewire Live is a proprietary network of analytics and visualization applications and streaming data from participating customers that allow firms to make more mindful decisions about pricing and claim payouts, an offering that we believe is unique to the industry. These solutions 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. Investments in these solutions should peak in fiscal 2016 and 2017 at roughly 26% of total revenue before fading in fiscal 2018 and beyond, which should yield significant operating leverage.

A number of large systems integrators work with Guidewire (including Accenture, Capgemini, Ernst & Young, and PricewaterhouseCoopers, among others), which affords the company strong implementation references when attempting to land new customers and allows it to scale rapidly and efficiently. Guidewire counts 5,500 trained implementation consultants, a number that has grown quickly and consistently over the past several years. Although Guidewire offers cloud deployments for its core applications through its systems integrators, few customers have chosen to go this route to date. Still, we view Guidewire's flexible implementation strategy as a positive, particularly when approaching Tier 3 and 4 customers, which have greater agility for moving to a cloud implementation.

Guidewire has generated GAAP profitability for several years, and although it has undergone a period of heavy investment in recent years that has depressed operating margins, we expect its investment in new product development to yield incremental customer wins and upselling opportunities, and we expect returns on invested capital to easily outpace the firm's weighted average cost of capital over the next several years.

Competition Is Primary Risk
The chief risk facing Guidewire is competition at the top of the market. Visibility into Duck Creek's solutions is low, although Gartner estimates that business generated software and maintenance revenue of just $142 million in 2014 (compared with Guidewire's $230 million in fiscal 2015), and Guidewire's growth has substantially outpaced Duck Creek's over the past several years. Smaller players such as Majesco offer compelling solutions, but typically compete only at the lower end of the market and on a regional basis. Larger software firms like SAP (which has a small P&C software business) could enter this market more directly and place added competitive pressure on Guidewire.

Although software is among the fastest-growing segments of the insurance IT budget, IT spending is unlikely to experience material growth over the next several years. If the global economy enters a recession, insurers may choose to ride out legacy systems and applications longer, which would challenge Guidewire's ability to generate incremental customer wins.

Guidewire's business model is predicated on converting low-gross-margin services revenue into high-gross-margin software license and maintenance revenue, which would negatively affect profitability if the mix does not continue to shift toward the latter businesses.

Finally, Guidewire is responsible for managing sensitive financial data through each of its core applications, both from the insurer and insured's perspective, which could leave Guidewire at risk of a data breach.

Guidewire is in solid financial shape. As of July 2016, the firm had $628 million in cash and investments with no debt. The firm spent $14.7 million in cash and stock to acquire Millbrook in 2013 and $39 million on a pair of acquisitions in 2016, but it has been quiet on the acquisition front overall. The early returns on the Millbrook acquisition are promising in terms of building out Guidewire's data migration product, and management has said that it will look to make further strategic acquisitions to solidify its product offering. We expect margins to bottom out in fiscal 2017 as the firm invests in its core product suite and add-on applications, but the firm should maintain GAAP profitability during this time.