GWRE 2023Q3

Greetings, and welcome to Guidewire's Third Quarter Fiscal 2023 Financial Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Alex Hughes, Vice President of Investor Relations. Thank you, Mr. Hughes, you may now begin.

Thanks, Comal. I'm Alex Hughes, Vice President of Investor Relations. With me today is Mike Rosenbaum, Chief Executive Officer; and Jeff Cooper, Chief Financial Officer. A complete disclosure of our results can be found in our press release issued today as well as in our related Form 8-K furnished to the SEC, both of which are available on the Investor Relations section of our website. Today's call is being recorded, and a replay will be available following the conclusion of the call. Statements made on this call include forward-looking ones regarding our financial results, products, customer demand, operations, the impact of local, national and geopolitical events on our business and other matters. These statements are subject to risks, uncertainties, and assumptions and are based on management's current expectations as of today and should not be relied upon as representing our views of any subsequent date. Please refer to the press release and risk factors and documents we file with the SEC, including our most recent annual report on Form 10-K and our quarterly reports on Form 10-Q filed and to be filed with the SEC. For information on the risks, uncertainties and assumptions that may cause actual results to differ materially from those set forth in such statements. We also will refer to certain non-GAAP financial measures to provide additional information to investors. All commentary on margins, profitability, and expenses are on a non-GAAP basis unless stated otherwise. A reconciliation of non-GAAP to GAAP measures is provided in our press release, and a reconciliation of additional data is also posted in the supplemental on our IR website. With that, I'll turn the call over to Mike.

Thank you, Alex. Good afternoon and thanks for joining us today. We had a strong third quarter highlighted by sustained demand for InsuranceSuite Cloud and ARR and profitability both exceeding guidance. We were pleased with overall software revenue led by 34% subscription revenue growth. However, services revenue was below expectations, primarily due to the timing of revenue from a few complex engagements, which we will address later in the call. We were thrilled to see continued improvement in subscription and support gross margins, which more than offset the services shortfall. Our cloud gross margin trajectory drove operating income outperformance and gives us confidence to raise our full year outlook for operating income. A few highlights of the quarter related to our main corporate objectives: we closed eight cloud deals, and sales momentum remains solid ahead of our seasonally strong fourth quarter. Cloud deployments were also strong with eight go-lives in the quarter across both commercial and personal lines. We continue to drive improved cloud efficiency with subscription and support gross margins finishing five points above expectations. Before I go into more detail, let me just make a couple of comments about the P&C insurance industry. The service industry and core system use case requires a platform that reliably and securely addresses and ensures complex business requirements while also providing greater agility and innovation. Sales cycles and deployment projects are lengthy, complex, and sometimes arduous, but when we win a customer and successfully deploy a customer in production, we establish a durable relationship with significant lifetime value. I believe our hard work demonstrated execution with the Guidewire Cloud platform and the growth of our ecosystem have clearly established us as the cloud leader in our market and have positioned us well to serve the top insurance carriers in the world. From this position, we will continue to expand the breadth and depth of our solutions and ecosystem to help insurers drive innovation and improve decision-making at scale. The second point I would like to make is about the macroeconomic environment and its impact on our P&C customers. The industry is generally resilient to economic cycles, but it is not immune. The inflation-driven increase in claims expense has impacted the profitability of many insurance companies and is causing scrutiny on near-term investments and budgets. Given this backdrop, we are pleased to see our momentum on strategic deals and projects continue to progress, and we remain confident in our sales outlook. Our industry is adept at managing market cycles, and its cycle has the undercurrent of an ever-increasing need for innovation and agility in the market, which strengthens our strategic positioning with customers. The value of being on our platform is increasingly clear as carriers navigate the current cycle. So while I'd say we are navigating through this environment well, it is appropriate to acknowledge that expense pressures are present. With that said, let me turn to discussing our Q3 results in a little more detail before handing it over to Jeff to cover the financials. As I said earlier, it was a strong quarter with eight cloud deals, seven of which were for InsuranceSuite. In addition to insurers seeking to modernize legacy mainframe systems, we are starting to see increased interest in replacing previously modernized on-prem systems, which is a very positive market development for us and a great validation of the investments we've made in the Guidewire Cloud Platform. Deal volume in Q3 was well balanced with three new logos, three migrations, and two expansions. First, let me walk through our new customer wins. Texas Farm Bureau, a Tier 2 insurer headquartered in Waco, Texas, selected our InsuranceSuite Cloud to modernize their existing portfolio of legacy and on-prem core systems. We look forward to helping them achieve improved system performance and operational excellence, staying current on functional and technical capabilities via Guidewire Cloud updates while taking advantage of Guidewire's extensive marketplace offerings and improving agent and customer experiences. We were also fortunate to welcome a rapidly up-and-coming Tier 3 carrier to the Guidewire community. This commercial insurer selected Guidewire as their long-term partner and will use InsuranceSuite Cloud to retire legacy systems and transform core operations across policy, billing, claims, digital, and data. Predictive analytics was a key differentiator in this hard-fought competitive deal, and it represents a key mid-market win for us, as this progressive carrier has substantial growth aspirations. The insurance company of Prince Edward Island, a growing Canadian property and casualty carrier, selected the Guidewire Cloud platform to expand their product line and streamline operations so that they can efficiently and effectively support growth in commercial markets across Canada. Turning to cloud migrations, we saw Country Mutual, a Tier 2 carrier focused on personal and commercial lines across 19 states, elect to upgrade their on-prem ClaimCenter system to the cloud. They also expanded their Guidewire footprint by selecting PolicyCenter Cloud for its commercial and agricultural lines of business. A Tier 2 provider of reinsurance and insurance will migrate to PolicyCenter on the Guidewire Cloud platform and expand to additional lines. The advanced product designer capability within PolicyCenter Cloud was a key differentiator to increase agility and support their growth strategy. The Home Building Compensation Fund, a provider of safety net insurance for homeowners in Australia who are faced with incomplete or defective building work, will migrate to InsuranceSuite Cloud. Finally, looking at expansions, CNA, a top 12 commercial carrier based in Chicago, expanded their investment in ClaimsCenter Cloud to support additional commercial lines, and a Tier 4 insurer expanded their InsuranceNow investment to include additional lines. This brings the total number of wins for the Guidewire Cloud platform to 20 for the year. Over 70% of this total was with Tier 1 and 2 insurers, which I think validates the approach we have taken to ensure we can support the most demanding customers in the world as well as provide a system suited to the success of the Tier 3 through 5 customers that make up a significant proportion of our customer base. The improving maturity of our platform is also reflected in the increased cadence of cloud production go-lives. In Q3, we added another eight cloud deployments, bringing the total number of customers live on Guidewire Cloud platforms to nearly 40, with healthy activity in both personal and commercial lines. In personal lines, some of the deployments included Auto Club of Southern California, the largest member of the AAA federation with 16 million members and a Guidewire customer since 2004, which went live with InsuranceSuite on the Guidewire Cloud platform. In addition, a large insurer with over 2 million customers across the Nordics that processes 90,000 claims per year and 4,300 new policies per day went live with PolicyCenter, ClaimCenter, and BillingCenter on GWCP. With respect to commercial lines, some of the deployments included a commercial trucking and specialty insurer based in South Carolina that deployed PolicyCenter on GWCP to drive scale, operational efficiencies, and innovation for agents and customers. A provider of commercial lines to multiple industries across 20 states went live with ClaimCenter on the Guidewire Cloud Platform to further reduce claims processing times and automate claims adjustments and costs. Moreover, an insurer of over 1.5 million Texas workers deployed PolicyCenter, ClaimCenter, and BillingCenter on GWCP to further improve operational excellence and customer satisfaction. All of these deployments represent incredible work by our customers' project teams, our Guidewire service teams, and our ecosystem partners. As I mentioned earlier, this is a community that is increasingly leading cloud deployments, and I'm pleased to see it continue to expand. SIs now have over 22,000 Guidewire consultants as of the end of April, up 27% year-over-year. Moreover, the number of cloud certified consultants increased 67% year-over-year to approximately 7,300. These are important stats because a healthy partner ecosystem helps drive customer success but also because it is critical to providing ever-increasing predictability and cost efficiency to our customers and prospects. We are committed to enabling SIs to serve increasingly as the prime integrator on cloud projects. This will inevitably lead to Guidewire services revenue growth slowing relative to the growth of the total services ecosystem and allows us to focus on a more scaled services model that drives expert services in coordination with the SIs and retains the scale required for the delivery of new products and strategically important projects. This approach will provide us with a more durable and profitable service model. The services revenue shortfall we saw in the quarter speaks to the importance of this. Earlier in our cloud journey, we took on complex fixed-fee arrangements where we leveraged SIs as subcontractors, both to deliver the work and to fuel the SI cloud ecosystem. For the past year and going forward, we are limiting subcontracting and fixed-fee arrangements, and we are seeing DSIs step into the prime role on most cloud projects. As this portfolio of early projects is completed, the services margin burden associated with these early cloud customers will lessen. Turning to our solution partner ecosystem, we also continued to grow the number of partners on the Guidewire marketplace. This collection of integrated applications amplifies total platform innovation for our customers and serves as a powerful differentiator for us. We now have 180 solution partners in our marketplace, and we have added six new solution partners in areas such as providing more granular and accurate property data for better risk scoring and enabling greater workflow automation and speed. We are building a powerful cloud platform where greater innovation will layer on over time and where customers can accept this innovation more easily and with less integration friction. An example of a recent strategic partnership showing good momentum on our platform is one with One Inc., where we are seeing strong interest from insurers to incorporate its technology to enable a more frictionless payment experience for their customers. I would also like to briefly discuss generative AI and large language models and their exciting potential for Guidewire and the insurance industry. First, and I think the most important consideration as it relates to Guidewire is that insurers begin to look at their systems and processes to evaluate if they are equipped to take advantage of this technology shift. They will realize that modernization is a key first step. We believe that insurers who have already modernized their core systems will be dramatically better positioned to take advantage of the potential this technology provides. Those who are still relying on legacy systems will be held back and will reconsider that approach, and I believe this could support efforts to justify modernization initiatives. Second, generative AI has the potential to make developers more productive, which in turn will drive more efficient implementation projects and improved product innovation. I think it's likely that in the course of 12 to 18 months, most developers internally and in our services organization and in our SI ecosystem will be able to leverage large language models to support software development and project execution. Third, like a lot of software companies and many of the companies in our solution partner ecosystem, we are working on incorporating large language model-driven product enhancements into our cloud product suite that will enhance the value of the products we offer to our customers. Broad-based productivity gains should be a logical outcome of embracing generative AI, and we expect that our cloud-based product suite will be an enabler of this. Overall, generative AI has tremendous potential to have a positive impact on our mission, and we look forward to taking a leadership position in how the industry adopts generative AI in the months and years to come. Finally, let me spend a minute on leadership in the organization. I was very happy to announce the addition of Michael Howe to the Guidewire team as Chief Product Officer. Michael is a long-time veteran in the insurance technology industry, having led product at Applied Systems for over a decade. He will lead product strategy and product marketing here at Guidewire. We are now in a position to build on the tremendous progress made by Diego de Vale and the engineering team in establishing our cloud platform and InsuranceSuite product releases. Michael will help us increase and optimize our focus on product innovation and the alignment of our data and analytics solutions with our core, while Diego continues to lead platform growth, performance, and scale, which is all foundational to everything else we do. With that, I'll turn it over to Jeff to discuss the financials.

Thanks, Mike. I want to highlight a few topics as I walk through the financial results for the quarter. First, as Mike noted, sales momentum continues to be strong. Notably, we are seeing more new customer wins and new modernization programs. We are also seeing some insurers looking to replace core systems put in place over the last decade or two as they evaluate their cloud strategies and ensure they have a partner that is investing to grow and innovate with them. This is an exciting development for us. At the same time, we are seeing steeper ramps than last year, which means the initial ARR impact of new sales activity is lower in the first year, but fully ramped ARR is preserved. This combined with the macro backdrop are the primary reasons healthy sales activity is not translating into a higher ARR outlook for the year. Second, continued sales momentum combined with better-than-planned execution on cost controls and efficiency initiatives are driving cloud margins ahead of our FY '23 expectations. Our subscription and support gross margin trajectory gives us increased confidence in the long-term earnings power of our operating model. Third, in the services portion of our business, we are working through several very complex core system modernization programs. A handful of these are fixed bid arrangements where changes in the project plan can impact the timing of services revenue. A couple of programs had an adverse impact on services revenue in the quarter vis-à-vis our forecast by approximately $4 million. Finally, turning to cash flow, we are seeing slower collections than we expected in our model. Accounts receivable grew by $43 million over Q3 last year and over 60% of that incremental ARR is coming from payments outstanding for over 30 days. In the quarter, we also shifted our operating bank account from Silicon Valley Bank to Bank of America, which did cause a brief disruption to our collections cadence, but this is now resolved. Given slower collections, combined with the fact that we have approximately $150 million in collections due in the last five days of our fiscal year, we've adjusted our cash flow expectations for the year. This adjustment to the timing of collections has no impact on the long-term cash generation assumptions we have discussed with you all at our Analyst Day. Now turning to the results for the quarter. Third quarter ARR ended at $722 million, ahead of our expectations. This represents 17% year-over-year growth on a constant currency basis. Total revenue was $207.5 million. This finished below our outlook due to services revenue results. All product components of revenue were either better than or in line with our expectations. Cloud strength continues to be visible within subscription revenue, which grew 34% year-over-year to $89.1 million. Subscription and support revenue totaled $107.5 million, up 24% year-over-year. License revenue was $50.5 million, down 6% year-over-year. Services revenue was $49.4 million, down 13% year-over-year. As I mentioned previously, we had two Guidewire lead programs where project replanning resulted in an adjustment to the timelines and, as a result, an adjustment to the revenue recognition timing. This was an approximately $4 million impact compared to our outlook last quarter. Additionally, there has been increased scrutiny on services statements of work that has caused some streamlining of scope or pushing more services work to lower-cost partners, which resulted in lower-than-expected billings in the quarter and accounted for approximately $2 million to $3 million. Turning to profitability for the quarter, which we will discuss on a non-GAAP basis. Gross profit was $107.7 million. Overall gross margin was 52%. Subscription and support gross margin was 55% compared to 47% a year ago. We are thrilled with the progress we're making on subscription and support gross margin, which continues to track ahead of our expectations. Services gross margin finished at negative 2% compared with positive 4% a year ago. We had been expecting a positive margin in Q3, but revenue headwinds impacted margins in the quarter. We continue to be confident in our services strategy to return to profitability in the fourth quarter and beyond. Operating loss was $12.2 million, better than our expectations due to strong subscription and support gross profit and lower-than-expected operating costs. These factors more than offset the impact of services margin shortfall in the quarter. Overall stock-based compensation was $35 million. Stock-based compensation expense was up 6% year-over-year in Q3 and up 3% year-over-year through the first three quarters of 2023. We ended the quarter with $807 million in cash, cash equivalents, and investments. As of the end of Q3, the accelerated share repurchase program was settled in full with the delivery of an additional 648,000 shares of common stock, which resulted in total repurchases under the ASR of 3.2 million shares at an average purchase price of $61.93 per share. Also in Q3, we repurchased an additional 207,000 shares at an average price of $77.19 per share. Turning to our outlook for the full fiscal year 2023. We are adjusting our ARR outlook to $745 million to $755 million. As I previously mentioned, we are seeing healthy sales activity and expect this to continue in Q4, but we are seeing steeper ramps this year. This results in less ARR in the first year of new sales arrangements. However, we are still preserving attractive fully ramped ARR terms in these arrangements. So while ARR growth this year is expected to be approximately 13% at the midpoint, I expect fully ramped ARR to grow at 14% to 15%. We will also provide more detail on fully ramped ARR at year-end as this is a metric we discuss on an annual basis. As a reminder, our ARR outlook assumes foreign currency exchange rates as of the end of the last fiscal year, and then we update exchange rates at year-end. Last year, the year-end exchange rate adjustments to ARR were negative $19 million. If exchange rates stay the same as current rates, then we would expect a negative $5 million adjustment at year-end largely driven by the dollar strengthening against the Canadian dollar. With respect to revenue, we are increasing our expectations for subscription, subscription and support, and license revenue. We are adjusting subscription revenue to approximately $349 million, a positive adjustment of $1 million. We are adjusting subscription and support revenue to approximately $426 million, a positive adjustment of $1 million, and we are adjusting license revenue to approximately $261 million, a positive adjustment of approximately $5 million to $6 million. We are lowering our services revenue expectations by $10 million to $12 million. As a result, our outlook for total revenue is $890 million to $900 million, a $4 million adjustment at the midpoint. Turning to margins and profitability, which we will discuss on a non-GAAP basis, we expect subscription and support gross margins to be between 54% and 55% for the year, an increase of 3 percentage points compared to our outlook last quarter and 8 to 9 percentage points from the Q4 call. We expect services gross margins to be around breakeven for the year. This implies a Q4 improvement that assumes the successful completion of ongoing fixed bid arrangements. As a result, we now expect overall gross margins of approximately 54% for the year. With respect to operating income, we expect between a $4 million operating loss and a $6 million operating profit for the fiscal year. We expect stock-based compensation to be approximately $140 million, representing 2% growth year-over-year. Given this, combined with the impact of our accelerated share repurchase program and our active repurchase program, we expect fully diluted shares to decline by approximately 1 million shares this fiscal year. As mentioned above, we are adjusting our cash flow from operations expectations to between $10 million and $40 million. Finally, as we look ahead to fiscal year 2024, we feel it is prudent to wait until after our fourth quarter before discussing ARR growth expectations. With respect to profitability, we are committed to demonstrating non-GAAP operating margins of 6% or higher and GAAP operating margins of negative 10% or better. We will continue to monitor both GAAP and non-GAAP operating income metrics. But we expect to ultimately measure our success in hitting targets that capture the real cost of Guidewire and our shareholders associated with stock-based compensation. With that, let's open the call for questions.

Our first question comes from Dylan Becker with William Blair. Please proceed with your question.

I appreciate the question and certainly get the product versus services side here. Maybe, Mike, for you, I think you noted some of those existing on-prem customers seeing accelerated migration activity. I wonder how much of that is a function of the updated garbage release here and the shift to, I think, three product releases annually versus two, maybe widening the functional gap kind of the on-prem capabilities versus the cloud. And from a go-live perspective now maybe having more of those customers that can validate that update versus upgrade type of framework you guys have talked about?

Thanks for the question, Dylan. I appreciate the insight. I'd say in addition to those topics, which I'll discuss briefly, I think the most important thing is our experience and track record running these programs at scale, going live over those special go-live weekends repeatedly now. It's something that we're getting better and better at. So, just building the overall confidence in the ecosystem, in the community of P&C customers, I think it is helping us. The shift to three releases a year is great, and it helps. I think the most important thing is what you should read into that is our increased confidence that we have in executing these updates seamlessly. We're still working through that with our cloud customer base and with the new customers. This is a different approach that this whole P&C ecosystem and the entirety of the way that this all operates throughout the world is changing, and we are changing it. I think customers, especially those that have been on the journey with us for a couple of years now, are seeing it, and our experience in it is very exciting about the potential that it offers. Personally, I know I commented a little bit on generative AI. I am very much looking forward to the idea that we have production cloud customers where we can put these changes into updates and then get them shipped out to customers seamlessly, and they can hopefully just literally turn them on. It's a very different operating model than Guidewire has been operating under and the industry has been operating under for the last 20 years. I think that is helping us drive the continued sales activity that we're seeing. So, thanks for the question.

Yes, makes total sense. And then I think you made a comment as well around kind of some of the carrier pressures around elevated claims. Would think, again, core modernization can help address this, and there's a lot of optionality on the data side. But wondering what kind of role maybe digital twins could play in the future evolution of insurance and real-time data connectivity to help carriers predict with a more holistic view, maybe risk analysis and then maybe even preventative risk mitigation.

Yes. That's a deep strategic question, and I think it is top of mind as carriers think about modernization and getting to a core platform that provides an agile ability to roll out new innovative products that take advantage of the connectivity and IoT-enabled characteristics that you're describing. I'm not sure I'd go so far as to say those things would have prevented the cycle that we're in right now. I think inflation jumped up and caught lots of industries by surprise and has this impact that just has to be worked through. It's just sort of a normal cycle. I guess, normal in the sense that if there is inflation, there will be a disconnect between feeling the impact of that inflation and claims versus being able to adjust premiums and readjust the policies that support the risks involved in the replacement costs. But certainly, there is a lot of excitement in the overall industry about modernization in general and the ability for it to reposition insurance companies around providing risk mitigation services and controlling risk rather than just paying for things that break. Preventing risk and reducing the expense of mishaps and perils is an exciting part of what we do. I think part of the core system equation is the data and analytics that make these models more possible. I love the question, and it's definitely part of the story and what we're selling to customers.

Thank you. Our next question is from Peter Heckmann with D.A. Davidson. Please proceed with your question.

With the ACO lives this quarter, can you talk about how many live modules you have? And what percentage of ARR is now either live or committed to migrate to the cloud?

Let me pivot to Jeff in a second. I just want to say that there are a couple of things that are included in the statistics we talk about the number of customers that are live. Within each customer, they're going to sometimes have one instance, but often they will have many instances. When you dig into the actual number of instances of, say, ClaimCenter or PolicyCenter for a particular line of business, there might be and often are multiple instances that are live in production. Each instance carries with it a certain amount of DWP. The biggest go-lives for us in terms of scale are when you have like a fully deployed ClaimCenter or PolicyCenter, BillingCenter implementation on-prem and we move that to our cloud. Immediately, you have all that DWP operating on the cloud instance in production. In terms of factory, Jeff can give you a sense of this. Cloud ARR is now larger than non-cloud ARR at Guidewire, which is related to the price point as much as it is to the momentum in the count. But certainly, the majority of ARR at the Company now is associated with cloud.

The way we measure cloud ARR is that once a customer commits to go into that path, we count them in our cloud ARR calculation. As of the end of last year, we were just over 50% of our ARR coming from cloud ARR, and our expectation stated at Analyst Day is that we'd be in the 58% to 62% range of total ARR coming from cloud this fiscal year. I think that's still in line with our overall expectations. But we'll update on that particular metric.

Yes. We obviously know this and track this very closely internally, like the percentage of that ARR that is live or still in a project to go live. But we don't talk about that publicly, though we pay very close attention to it. The culture at the Company is that 100% of that will successfully get to production. That's the commitment we make, and I think it is part of the brand promise that is Guidewire. Despite these projects being complicated and hard, we are standing shoulder to shoulder with these customers and partners and ensuring that 100% of this eventually goes live in production. Sometimes it takes longer than a year because the price is complicated, but it ultimately does, or at least the intention is and the commitment is culturally that we will get it all live.

That makes sense. And then to your point on underwriting losses nationwide for insurance carriers, something like $30 billion of underwriting losses in the last two years. But won't that lead to further price increases for premium that could potentially lead to a higher growth in DWP over the next couple of years?

Yes. That's the expectation. It should. The system went in balance is equal on both sides of that equation, and the overall system can operate profitably. Over time, based on the variety of ways we contract for our core systems, that DWP will flow into Guidewire through complicated growth bands and barriers and thresholds that need to be crossed to trigger those increases. But generally, yes. This is a bit of a headache, let's say, or maybe an issue for us in the short term, working through this and causing, like I said in the script, a little bit of scrutiny around short-term expenditures. But in the long run, the industry is equipped to deal with this. Guidewire as a system is providing innovation and agility, facilitating carriers being better able to absorb this. One of the reasons we think sales activity continues to be solid heading into the fourth quarter.

Thank you. Our next question is from Kevin Kumar with Goldman Sachs. Please proceed with your question.

I wanted to double click on the ramp deal activity. Jeff, can you help us frame the types of multiyear ramp deal structures you're closing? And maybe how that compares to prior years? And how much of a headwind is it in the initial year or years? And kind of how steep is that ramp compared to historical levels?

It's a good question. It's interesting because last Q4 we saw a little bit less ramp activity and a bit more kind of smaller starts that would grow in a more organic fashion. So, a little bit surprised this year to see a bit higher ramp activity. We are also seeing our deal portfolio skew more than we expected towards new modernization programs and new customer wins versus migrations. Migration always had steep ramp elements attached to it because we count a booking as the incremental ARR that is being added to Guidewire, and sometimes they are already paying ARR and a term license fee, which means it takes a while to get up and running and live in the cloud. So, there is not a big uplift associated with ARR from migration. Seeing higher ramps this year is both a little bit of an interesting fact pattern, but a positive fact pattern. It means that customers and prospects are willing to make big multiyear commitments to Guidewire and this path with Guidewire. We used to see steeper ramps which means that the starting point to the endpoint growth is bigger in those committed ramps than what we saw the prior year. Last year was notably a little bit shallower in terms of overall ramp activities, and we saw smaller starts rather than big commitments. So, it's a mix. I was a bit surprised to see that, but in general, we are pleased to see especially new customer wins and even some competitive displacements, which is very exciting for us to see, and we're seeing healthy fully ramped ARR events. I do think some of the near-term cost-conscious pressures that are existing in the insurance installed base are having a little bit of an impact on their appetite to sign up for new spend over the first year or two. But we're capturing attractive fully ramped ARR.

That's helpful context. And then maybe just on the subscription and support gross margin. Obviously, a nice outperformance there, higher than the guide you gave. Is that just a function of continued cost discipline? Anything else you'd call out there? And then how are you feeling about cloud infrastructure investments and the ability to reach $1 billion in ARR with minimal incremental costs?

We are very pleased with the efficiency gains we're seeing in the platform. The engineering team has done a lot of work to help us manage our overall cloud infrastructure costs, and that is continuing to exceed our expectations, which is a big positive. Another area of cloud COGS at this point in the cloud journey is cloud updates and upgrade costs. We did see a little bit of those costs push out. When I think about the outperformance in the quarter, if you think about 5 percentage points, about 2.5 percentage points was related to just core efficiency gains versus our expectations, and the other was this work getting pushed out. We tend to model this work conservatively, so we're not surprised by a lot of work coming into a quarter that was unforecasted. But that was the primary driver of the outperformance in the quarter.

Thank you. Our next question is from Ken Wong with Oppenheimer. Please proceed with your question.

Maybe the first one for Mike. Just in terms of the scrutiny of IT budgets, I guess, how has that materialized for Guidewire versus just broad IT spend pullback? And if that has hit sales conversations, is that more on the edges of your products? Or is that actually impacting core systems? I would love to get a sense of how that may or may not materialize.

Okay. Thanks for the question. My sense is Guidewire is more immune to this than most. People think about Guidewire investment in Guidewire projects very strategically, a five-year duration, ten-year duration is a very legitimate conversation—one of which I had this quarter. That company is not thinking about as much the day-to-day or quarter-to-quarter cash flow when they are thinking about what they will do for the next ten years. So, in general, Guidewire is more immune to this than probably most IT spend. But it does exist, and I bring it up because the ability for us to manufacture deals, the ability for us to accelerate things in a climate where the general mindset is conservatism regarding budget, makes it a bit harder. The things that were already in flight and the plans that were already in place are continuing to progress, giving us confidence in the outlook we've provided for Q4. But it is a bit of a headwind, and it is coming up much more in the last few months than it has in the past. This is a cycle. There is an adjustment period that we believe the industry will process through, and I think things will get a bit back to normal, it will open up, and the budgets will loosen a bit, allowing us to create a bit more acceleration beyond what we've got right now. Thank you.

Yes, super helpful. I really appreciate all the thoughtful color there. And then, Jeff, just wanted to dig into the cash flow reduction. How much of that is maybe a byproduct of the lower top line, trimming the ARR a little bit on the services side versus what was just pushed out because of timing and collection, etc., which you guys hope can be recaptured in future quarters?

The majority of it was given the environment that we're seeing and some of the dynamics that Mike just talked about, putting a bit more conservatism into our collections assumptions versus what will be billed and invoiced in Q4. That is the big part of it. We have the overall services billing also had an impact, but if you think about that, it's probably a pretty small percentage of the adjustment to cash flow. Most of it is just the timing of collections and ensuring we build in more conservatism. We are seeing a bit more process and bureaucracy that insurers are putting in place before they make large vendor payments, and we are having to jump through those hoops. The shift in our operating bank account in the quarter didn't help as we had to go through a lot of revalidation to make sure that everything was in order. That created a bit more process. It's behind us now. Looking ahead, we felt it was prudent to build more conservatism into our collections forecast.

Thank you. Our next question is from Rishi Jaluria with RBC. Please proceed with your question.

Mike, I wanted to go back to the generative AI theme. I'm really glad to hear the way you're talking about it and some of the transformational effects for Guidewire. I want to think about the impact on the industry itself, right? Not only does it force some of the peak drivers to modernize and kind of catch up and migrate to the cloud. But what's the potential for P&C insurers to actually change the way they view the business and maybe even more importantly, the way that they interact with customers? And what sort of impact do you think that can have on the overall spending environment as it pertains to budget for Guidewire? And then I've got a quick follow-up.

Thanks for the question. I spoke recently at a Guidewire event and talked about how you can think of these things on a spectrum from near term to long term. You can get a bit wrapped up in how dramatically impactful it can be to systems like insurance in the long run, but I think you're making a mistake if you do that and miss out on the potential for us to generally improve process efficiency and operational efficiency and all the little things that we do every day. I think there's potential or maybe a lot of potential to better operationalize these models and use them with human beings in the loop. This isn’t to replace human beings but to augment them and make them more productive in managing sales processes, managing customer service, managing claims, and ensuring that all those processes are more efficient. There are hundreds of little details that can be managed more effectively through systems like Guidewire. There is a very important story to be told, and granted this stuff needs to be built, fleshed out, rolled out, and proven, but it's exciting to see something with this much potential and very accessible. One thing I really like about these generative AI and large language model solutions is they don't necessitate a replacement of a system like Guidewire. You can augment what you're already using Guidewire for. If you're running a legacy mainframe system, it will be much more difficult to augment that system and that workflow with generative AI, which I think might drive these transformations. Guidewire will provide a cloud API, allowing you to grab information and get timely answers that assist those on the phone with agents or customers, enhancing process efficiency. I think a lot of people in the industry are excited about it and we are excited about how we can productize it in the coming months.

Got it. That's really helpful. I appreciate all the thoughts there. I wanted to go back to some of the dynamics around ramped ARR. I know you touched on this a little bit of a surprise, seeing that versus the smaller lands with potential upside we saw last year. But what's driving that change in behavior? And as we see some of those shallower lands or whatever you want to call it, the smaller lands from last year, as those come up for renewal, should that be a driver in ARR and potential ARR acceleration?

As I mentioned, I think it's an exciting pattern that insurers in this environment are tackling large strategic programs and making big commitments in investments with Guidewire. We're seeing that in the total contract values that support these ramped agreements. In terms of the shift over last year, it was a bit interesting. Last year, we saw a bit slower starts with a dipping-their-toe-in-the-water dynamic, and there was a thought that maybe that would persist and could have a pretty big impact on how we think about our model if that was the way the industry chose to adopt and buy. I think it's a positive fact pattern that we are seeing some of these bigger commitments this fiscal year. The way we measure bookings is the average ARR delivered over a five-year period. We have certain metrics that we look at internally, such as the ratio between the Year 1 ARR to that average ARR over a five-year period. That ratio—our model is quite sensitive to that ratio. If you see that ratio go down a little bit, it means that there’s attractive fully ramped ARR, but the Year 1 dynamics are a little lower than we had modeled. It’s one of these multiple levers that we have to manage through, and we try to provide insights into that. For a period of time, I thought fully ramped ARR may fade into the background of relevant metrics, but as we execute through this year, we're seeing that metric outpace ARR growth once again, which gives us confidence about the long term but also creates some dynamics we need to manage through.

Thank you. Our next question is from Matt VanVliet with BTIG. Please proceed with your question.

I guess just one more on the higher mix of fully ramped ARR or fully ramped deals. How should we think about that over the next couple of years from both a backlog perspective on the implementation side and then related to that, the overall staffing needs for the services group, especially as you push more to SIs in general?

I don't want to make this out to be a bigger deal than it is. We saw ramped activity look more akin to what we saw two years ago. Coming out of last year, we adjusted our models a little bit to make those ramps shallower. So, I don't want to overplay this, but it is a dynamic we wanted to call out in the business. How it relates to the services engagement is pretty detached. What we're seeing in the services part of our business is part of our longer-term strategy to shift more and more of this work to our partner community. We went through a cycle of certifying and enabling the partners to lead these programs. We’re starting to see more and more of that today, which will allow us to build a more scaled and durable services organization in support of the broader ecosystem that will take the lead in managing these programs.

I don't expect the manpower in our services organization to go down; I just think as the overall economy of Guidewire implementations grows more of that growth will flow to the SI partners and it will flow to Guidewire. I think there's a very important role that our team plays with respect to the expert services we provide, especially around new product introductions and strategic projects, and just some percentage of the prospect base. The potential customers will want Guidewire to take a role in the implementation. It's important for us to maintain that manpower. So, I wouldn't be thinking that this is going to contract, just it will grow more slowly than the overall ecosystem as we shift to a more durable, more leveraged model.

Yes, makes sense. And then I guess, a few of the answers, you talked about a number of customers wanting to lean more into data and the analytics behind that. It sounds like more projects are maybe going live with those implemented originally. But I'm curious how that overall demand cycle is impacting the upsell, cross-sell motion versus now just being included from the start because of the value perceived by the customers?

It's a great question. I think we're doing a much better job designing the product to work together, to be integrated from the beginning, pitched, sold, packaged, marketed, and the sales process described as one unified solution that can solve, of course, system modernization problems but also deliver business benefits through predictive analytics. It's exciting to see, as often the economic justification for modernization is attached to efficiency gains that can be either significantly or partially produced with predictive analytics. There’s been a lot of excitement for predictive analytics, but also for the operational machinery to deploy the prediction to a user experience that causes end users to change their behaviors. The industry in general is pretty good at making analytics and predictions but not as good at activating those predictions and bringing about business change. A part of what we're producing here and what customers are excited about is that we will be able to take these algorithms and turn them into practical, useful predictions that end users can use to either make better decisions about underwriting risks or processing claims. That's exciting, and it's growing in importance.

Thank you. Our next question is from Joe Vruwink with Robert W. Baird. Please proceed with your question.

A little bit on the last topic since you brought up analytics. But just on that new logo win with the Tier 3 carrier, the mid-market does seem a bit more competitive of late. What are you finding to be the differentiator for Guidewire when you're winning in that segment or Tier 3 through 5 outside of Tier 1 through 2? Is something like analytics catching on? Or would you maybe point to some broader themes there?

Great question. First, it's important to deliver a complete solution that is consistent across claims, policy, and billing. Larger carriers may have more horsepower to tolerate different systems for different use cases, but these smaller companies often have more limited IT organizations. A consistent platform with one approach to integration, data, analytics, configuration, and one vendor is important. The one vendor being responsible for the predictive analytics and that part of the equation is also valuable to these customers. Another factor is the track record of success that we have in terms of onboarding customers. I think we have several customers in production and several years of experience running this, plus the vision for these three releases a year makes customers see that momentum. That helps us. Also, I wanted to mention something that hasn't come up yet: we are seeing conversations about competitive displacements that I have not seen in my four years at Guidewire. We used to mentally think of these systems as being mainframe-based, but now companies are discussing the possibility of replacing those systems. That’s exciting and is partly a reflection of the time that has passed along with the momentum and innovation we've been establishing through our execution.

I'll just quickly follow up on that last point. I think in the past, you said something like 20% to 25% global DWP. You manage that, and half of that remains on a mainframe system. You're talking about like that half being unbounded at this point. I mean, it's all up for grabs?

Yes. If you play that concept out, you could say all of that is now up for grabs. It depends on which vendor you're talking about, and when the implementation was done, along with unique circumstances related to that implementation. It might be an exaggeration to say it is completely all up for grabs, but part of that segment of the market is up for grabs. It’s a very exciting thing to see, and I think it's unlocked based on not just time, but also on the momentum and innovation we've established and proven through our execution.

Thank you. Our next question is from Michael Turrin with Wells Fargo. Please proceed with your question.

Just one for me. Going back to just some of the other comments. So the 3Q ARR came in ahead of the prior guide. The fiscal Q4 compared to the full year is more of a tightening of the range. I appreciate you not wanting to turn this into a call around ramp deals. But is the second-half impact you're characterizing last quarter there, the difference between what was previously expected? And is that more what's driving the decision to wait for Q4 before framing the preliminary growth outlook as you historically have? Or is some of that also just macro fiscal Q4 being important and that's what's driving the decision process there? Any further context is helpful.

You're thinking about it right. That's exactly our thought process. I also think in prior years when we assessed the analyst models and looked at what was out there, if there was something we felt was critical to get in front of, we tried to do that. But given where we are and how critical Q4 is for establishing the right framework for the next fiscal year, we felt it was prudent to wait until that is completed.

Thank you. Our next question is from Parker Lane with Stifel. Please proceed with your question.

I'll just ask one in the interest of time. Mike, I was wondering if you could talk about the share migrations that carrier expansion as part of the project and the general appetite you see for customers embarking on the cloud journey to either hit the ground running and ensure they have a successful cloud migration or widen the scope of what they're trying to achieve?

Super question. This dynamic is something we have also noticed. Very often, it is the modernization projects that trigger the conversation about also upgrading to the cloud. Sometimes, it's the other way around where we're discussing a cloud upgrade or a version upgrade and that prompts the conversation about new lines of business or other components of the core system modernization. Deals like this require triggers—they need compelling events and business-related objectives to drive the projects and deal for us. In this case, a lot of times, we have an initiative to tackle X, Y, Z in the business, we need a modern system to do that. We have Guidewire for claims already. So, we're happy—let's talk about policy. Then we see the conversation evolving. That’s the way these conversations progress and result in migration and upgrades. Compelling events are created and driven by these business objectives. It's also a part of the value of the product we offer, where you can tackle everything in a consistent way. A unique aspect of Guidewire is that all of these products have been built organically, not through acquisitions, which contributes to our overall success and is why we are seeing such strong engagement.

Thank you. There are no further questions at this time. I would like to turn the floor back over to CEO Mike Rosenbaum for closing comments.

Thanks very much. I just want to thank everybody for participating in the call today. We're obviously thrilled with the continued cloud momentum across new and existing customers, Tier 1 and Tier 2 insurers, while also driving margin improvement. I was particularly happy to see the continued improvement in margins. There's been a huge effort here at the company to make that happen, and this was a great validation of that hard work. We're excited about the future and look forward to having a great Q4. We'll talk to everybody again at the end of our fourth quarter at our next call. So thanks very much.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.