GWRE 2023Q2

Greetings. Welcome to Guidewire's Second Quarter Fiscal 2023 Financial Results Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. At this time, I'll turn the conference over to Alex Hughes, Vice President, Investor Relations. Alex, you may now begin.

Thanks, Rob. I'm Alex Hughes, Vice President of Investor Relations, and 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 this 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 or 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; a reconciliation of additional data is also posted as a 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. I'm pleased to share the results of what has been another great quarter for Guidewire. We continue to steadily execute and improve in all key areas of our business, and second quarter results were a good demonstration of this. Strong sales execution, great cloud adoption, and improved cost discipline delivered better than expected results. We exceeded our targets for ARR, subscription and support gross margin, operating margin products, and our performance this quarter provides a strong foundation to build upon for the remainder of this fiscal year. As we continue to lead an industry transition to modern cloud-based core systems, we enable our P&C insurance customers to better engage with their customers, innovate with new products, channels, and agile approaches to risk management, and grow more efficiently than is possible with legacy core systems. We continue to make steady progress in the key pillars of our strategy—cloud adoption, cloud deployment, cloud efficiency—while also growing our ecosystem of partners by amplifying everything we do on sales. On the call today, I'll discuss our quarterly progress in each of these areas. Starting with adoption: Q2 sales activity was strong with eight cloud deals including two new customer wins, three migrations, and three insurance suite expansions at existing customers. In the Americas, we had two new customer wins, including one for InsuranceSuite with a $2 billion DWP insurer, and another for ClaimsCenter with a $1.4 billion DWP insurer. We also closed two cloud migration deals: one for ClaimsCenter with a Global Tier 1 insurer and another for InsuranceSuite with a long-time Guidewire regional customer. Additionally, we continue to work with one of the largest insurers in the world to steadily expand on Guidewire Cloud with a new greenfield initiative. In EMEA, we had three cloud wins, making this a strong quarter for us in this region. Two of these deals were with one of the largest insurers who will be migrating an on-prem implementation of InsuranceSuite to the Guidewire Cloud platform while also introducing InsuranceSuite to a new line of business. Moreover, a major UK-based insurer will adopt BillingCenter on the Guidewire Cloud platform after using it last year. All of these transactions reinforce confidence in our platform and cloud capabilities, illustrating the unique benefits that our partners can provide with cloud-based modern core systems. Turning to cloud deployment, we continue to build momentum with nine more go-lives on Guidewire in the quarter. The breadth and pace of deployment in Q2 were exciting and have kept us all very busy. The go-live activity this quarter was international with three departments in the United States, three in EMEA, and three in Canada, reflecting both Tier 1 and Tier 2 deployments. In the quarter, we saw a Tier 1 insurer and a Top 20 P&C insurer in the United States deploying ClaimsCenter on Guidewire Cloud illustrating the ability of GWCP to scale with the largest insurers. At the same time, a startup insurer was able to deploy PolicyCenter and BillingCenter on the Guidewire Cloud platform in just a few months, demonstrating that GWCP can be deployed quickly. I was also pleased to see insurers successfully modernize and transform their core systems to GWCP. This included AMA Insurance Company, one of Canada's largest motor insurers, deploying InsuranceSuite on GWCP to deliver greater efficiency and better experience for its customers and its agent network. We also saw a major UK insurer with over a 300-year history deploy ClaimsCenter on the Guidewire Cloud platform for its transformation journey. Altogether, 31 customers have gone live on Guidewire Cloud, which encompasses migration, modernization, and greenfield deployment. I believe this speaks to the capability, agility, and stability of our cloud platform. We will obviously continue to increase this total in the quarter; as we do, we will enhance our operating capabilities and efficiencies with each new deployment and lead. We still have much to learn—every time we complete a go-live, we identify ways to improve both our operational efficiency and, more critically, the experience for our customers. We remain committed to relentlessly driving further improvement in our cloud operations' reliability, performance, and security. While we are thrilled to now have doubled our production customers and proud of the work we have done to achieve this, we recognize that inevitably, this number will be in the hundreds or even thousands. The work we are doing now to improve the efficiency of our operations is critical to our long-term success and is a key component of our intention to be a source of durable long-term profitable growth. One of the assumptions we made coming into this year was that we could hold our cloud operation headcount flat while continuing to scale cloud adoption. This was based on a significant investment we have made and continue to make in our cloud platform. In the past six months, we have nearly doubled the number of production customers on Guidewire Cloud and have effectively controlled the infrastructure and headcount expenses required to support that growth. The significantly improved subscription gross margins we saw this quarter were driven by these decisions and the determined execution of our team. We will continue to learn and improve as we grow and to leverage the experience and feedback we gain from each go-live, confidently positioning Guidewire Cloud for every relevant insurer worldwide. Regarding the Guidewire Partner ecosystem, we continue to build momentum with both our SI partners and our agency partners. The number of Guidewire consultancy and system integrators grew to approximately 21,000 at the end of Q2, a 27% increase year-over-year. The number of cloud-certified consultants increased year-over-year, reaching 6,300 at the end of Q2. This provides our customers with a valuable bench of cloud-trained professionals to draw on as they start their path toward modernization or cloud upgrades. The importance of this community is underscored by the fact that SIs have participated in over 70% of our cloud projects to date, with 15% of those being SI-led. Before I turn it over to Jeff, let me comment on our headquarters. Around four years ago, we moved into a beautiful new building in San Mateo, California, with approximately 180,000 square feet of space. Shortly after this move, the COVID pandemic changed the world. Post-COVID, our teams have become more distributed, and our hiring strategy has become more global. This move allows us to realize significant savings while rightsizing and aligning our office footprint with the needs of a more distributed, flexible, and global workforce. Jeff will comment in more detail about the financial impact of this move, but essentially, we expect to save $10 million to $12 million a year starting next fiscal year. I want to congratulate our real estate team on executing this transaction in a challenging environment for such activities, and I look forward to discussing this move further through Guidewire policies in the coming weeks. With that, I'll turn it over to Jeff.

Thanks, Mike. We are thrilled with our second quarter cloud momentum, improved operational efficiency, and cost discipline, all of which resulted in an excellent outcome in Q2 and a strong foundation to build upon as we execute our fiscal '23 and longer-term financial targets. Second quarter ARR ended at $707 million, ahead of our expectations. This represents 17% year-over-year growth on a constant currency basis. The first half of fiscal '23 benefited from minimal ARR attrition and healthy growth in ARR coming from deals sold in prior years with escalating fees, which we refer to as ramp deals. Total revenue was $232.6 million, above the high end of our outlook. Cloud strength continues to be visible within subscription revenue, which grew 37% year-over-year to $86 million. Subscription and support revenue was $105.8 million, up 25% year-over-year. License revenue was $73 million, up 5% year-over-year. Services revenue was $53.7 million, up 6% year-over-year. Turning to profitability for the second quarter, which we will discuss on a non-GAAP basis, gross profit was $131.9 million, with overall gross margin at 57%. The subscription and support gross margin also stood at 57%, compared to 49% a year ago. This was significantly ahead of our expectations. Strong subscription revenue growth combined with our focus on cloud infrastructure efficiency is having a positive impact. We are also recognizing benefits associated with our new agreement with our cloud provider, including some one-time savings that positively impacted Q2. However, we are expecting some higher costs in the back half of the year related to cloud customer upgrades to the latest release and healthy go-live activity. Collectively, we were pleased with our margins in the quarter and how subscription and support margins are tracking for the year. The services gross margin for Q2 was just below breakeven compared to positive 8% a year ago. We continue to make steady progress working through complex early cloud programs and other programs that have leveraged subcontractors at higher-than-normal levels, and we still expect services to return to positive margins in the second half of the fiscal year. Operating income was $15.1 million, which was significantly higher than our expectations due to better-than-expected subscription and support gross profit and lower-than-expected operating costs. Overall stock-based compensation was $36.2 million. Indiscernible expenses were down year-over-year in Q2 and up 2% year-over-year in the first half of '23. We expect unit growth in BC in the back half of this year, which is consistent with our slowdown in hiring as we scale our business without adding additional headcount. We ended the quarter with $870 million in cash, cash equivalents, and investments. In Q1, we announced a $400 million share repurchase program. As part of that program, we executed a $200 million accelerated share repurchase program, which was finalized in February 2023, involving the aggregate share delivery of 3.2 million shares at an average price of $61.93 per share. The initial tranche of 2.6 million shares was delivered in Q1, with approximately 600,000 shares delivered in February, which falls into our Q3. With respect to the outlook for fiscal year 2023, we are maintaining our ARR outlook of $745 million to $760 million. We are pleased with our progress in the first half and feel confident in our pipeline for the back half of the year, though it seems prudent to maintain our outlook at this point in the fiscal year. As I previously noted, the first half benefited from strong ARR based on ramp deals and low ARR attrition. The second half presents more challenging year-over-year comparisons in these two areas, which is already factored into our guidance. We are excited by the pace of new modernization this year, whereas in the earlier part of the cloud transition, much of the bookings activity focused on customer cloud migrations. This momentum is exciting for two reasons: it indicates increasing confidence in the maturity of our cloud platform, and it demonstrates our ability to compete and win at a high level since most of these deals are competitive. We are raising our outlook for total revenue to between $894 million and $904 million, representing 11% growth at the midpoint. The primary change is we now expect subscription revenue to reach $348 million, an upward adjustment of $6 million, representing 34% year-over-year growth. This adjustment was driven by better deal linearity and some meaningful cloud contract extensions from existing customers. Turning to margins and profitability, which we will discuss on a non-GAAP basis, we expect subscription and support gross margins to be between 51% and 52% for the year, an increase of 2% to 3% compared to our outlook last quarter and 5% to 6% from the Q4 call. This adjustment reflects increasing confidence in our margin trajectory as we execute towards our mid- and longer-term margin targets. We continue to expect services margins in the mid-single digits for the year with significantly improved services margins anticipated in the second half. This improvement assumes the completion of ongoing arrangements with investments from Guidewire, the ramp of new services hires replacing subcontractors, and the redeployment of some Guidewire services resources from non-billable to billable roles. As a result, we now expect an overall gross margin of approximately 53% for the year. Concerning operating income, we expect an operating loss of between $17 million and $7 million for the fiscal year. We anticipate stock-based compensation to be approximately $139 million, which represents a 1% increase year-over-year. Given this and the impact of the accelerated share repurchase program, we expect a decline in our fully diluted shares outstanding this fiscal year. There is no change to our cash flow from operations expectations. In general, the positive margin progression gives us confidence in our ability to scale cash flow, but the timing of collections can cause cash flow to fluctuate in a given quarter or year, especially since a significant portion of our annual collections is typically due at the end of our fiscal year. Looking ahead to Q3, we expect ARR to finish between $715 million and $720 million, which represents 16% growth at the midpoint on a constant currency basis. We expect total revenue between $211 million and $216 million. We expect subscription revenue to be approximately $88.5 million, with subscription and support revenue around $107 million and services revenue of approximately $56 million. We anticipate subscription and support margins to be approximately 50% and services margins to be about 10%, with overall gross margins between 50% and 51%. We expect a non-GAAP operating loss of between $20 million and $16 million in Q3. Finally, as Mike mentioned, we have entered into an arrangement to complete an office swap with another company in San Mateo. Our new office space is just a couple of blocks from our current headquarters and has less than half the total square footage. This arrangement will involve a write-off of the leasehold improvements, the right-of-use asset, and the lease liability in the existing location, with the aggregate amount expected to range between an $8 million to $9 million loss, which will impact our Q3 GAAP financial results. However, given the one-time nature of this write-down, we will exclude this from our non-GAAP financials, and therefore, it has no impact on the outlook provided above. Additionally, we have approximately $1.5 million in advisor and moving fees in the back half of the fiscal year, which is included in our outlook for the year. Looking ahead to fiscal 2024 and beyond, we expect to save approximately $10 million to $12 million annually as a result of this move.

And our first question comes from Dylan Becker with William Blair.

Nice job here in the quarter. Maybe starting with Jeff this time on the margin front. I understand there's maybe some one-time dynamics there as you called out, but I wanted to dig into the reallocation from customer-specific to kind of platform-specific investments. How big of a portion is that headcount and the margin delta? And how much does that capacity shift from that small select number of projects contribute in the quarter, but also give you kind of confidence in that long-term margin outlook you guys have called out?

Yes. Overall, we are seeing benefits from the investments we've made in the platform to operate and execute more efficiently, which will allow us over time to reallocate some headcount. We touched on this in Q1, where some employees in our R&D and product development teams were previously engaged in customer-specific tasks that affected our cost of goods sold for our subscription products. These headcounts have since transitioned back to the product organization, focusing on building products for all of our customers instead of just for specific clients. We observed this shift in Q1. There were no changes in Q2 affecting the numbers, although we did experience solid momentum in overall platform efficiency. Nonetheless, we had anticipated a bit more update work that is now scheduled for the latter half of the year, which accounts for the larger-than-expected results relative to our forecasts. Generally, this reflects our ongoing efforts to manage improvements in our cost structure to support our cloud business.

Got it. Got it. Super encouraging there. Maybe switching over to Mike. As you talk to customers, again, a lot of emphasis on kind of core back-office efficiency and how that improved from an underwriting standpoint. What's the general sentiment around utilizing integrated data to improve marketing and efficiency? I would assume the challenges are in attracting but maybe the more significant challenge is retaining those customers that get that preferred risk profile. How is that discussion evolving from a core adoption standpoint?

Great question. The components of the platform, primarily on the PolicyCenter, ClaimsCenter, and BillingCenter sides, are crucial. From a new business perspective, particularly in claims, the digital capabilities allow them the flexibility and agility to roll out new channels, new mechanisms to quote and price products, and enhance the effectiveness of connections with agents and agencies. These digital user experiences matter even more for companies going through distribution channels. We support companies that go direct as well but also those utilizing distribution channels. It is becoming increasingly significant over time. We are enabling our customers with flexibility and innovative solutions on the digital front using Guidewire, GWCP, which has resulted in some exciting improvements that our customers are very enthusiastic about. We fundamentally aim to equip this industry with a platform that enables innovation and iteration, so they can implement projects more efficiently, which translates to overall improvements in marketing and distribution channels for both direct and indirect customers. Hence, it's a crucial discussion.

Our next question is from the line of Kevin Kumar with Goldman Sachs.

Can you provide an update on the overall demand environment? Have there been any changes in carriers' appetite for larger upfront deals? Also, could you share comments on any geographic differences observed? It seems Europe performed well this quarter.

That's a great question. We're continuously monitoring the demand environment, especially considering the constant news cycle. Generally, we are experiencing a continuation of the trends we've reported over the past few quarters. The insurance industry is not immune but is not significantly impeded. Many carriers are actively working through the inflation impacts they are feeling. Overall, as I've mentioned, the time frame for enabling these carriers to consider modernizations and strategizing around their core systems spans several years—potentially a decade. Therefore, decision-making and the demand environment remain steady throughout periods of macro uncertainty. To clarify, we haven’t observed a significant shift away from line-by-line purchasing strategies. Our cloud approach better accommodates these considerations, and I feel aligned with the overall market demand. We've had good quarters in both Europe and the Americas, experiencing widespread activity globally.

That's helpful. Regarding InsuranceNow, can you provide an update on that product? What are Guidewire's competitive advantages in addressing the lower end of the market?

InsuranceNow has been quite successful for us. We have many satisfied customers in that segment and are making progress gradually shifting that customer base over to GWCP. The deal volume and velocity aren’t exponentially high every quarter, but we do maintain a consistent pipeline and plan. Importantly, we boast a solid, positive InsuranceNow customer base. We are also observing increasing synergy between the InsuranceSuite and InsuranceNow product lines, which allows us to explore analytical and platform use cases, providing lifts from the combination of both assets within Guidewire. This strategic positioning is essential for us in the down-market segment. We acknowledge this market segment's importance and are pursuing possibilities to drive faster developments compared to InsuranceSuite.

Next question is from the line of Rishi Jaluria with RBC.

Mike, I want to start with you and perhaps glean insights into the news surrounding the headquarters swap. It’s commendable that you’re embracing the distributed work model. How is your own hiring and workforce philosophy evolving in this context, particularly concerning investment areas and deliberate headcount additions?

Certainly. Switching to a fully remote work model has made us realize we can achieve high productivity regardless of where our team is located. This insight has led us to adopt a more global hiring strategy. Historically, we had a significant presence in Dublin and Krakow, both essential for strategic product development. In recent years, we've also expanded headcount in India strategically for R&D resources. Our future will increasingly focus on becoming more distributed rather than being San Mateo centric, though San Mateo will remain integral to our identity. Acknowledging our international teams' outstanding work is crucial. Consequently, our headquarters move reflects that fact—we had excess space we weren't growing into. The team did an excellent job executing this transaction, and looking forward, we plan to hire great talents globally while fostering in-person collaboration opportunities for teamwork.

That's really helpful. Jeff, we discussed subscription to support gross margins. I'd like to ask about services gross margin now. I appreciate the insight that you expect it to recover profitability in the back half of the year. Can you break down the drivers necessary for that change? Additionally, philosophically, how should we gauge long-term gross margins within the services segment? How do you balance it as a cost center versus aiming for decent profitability, which is common among other vendors?

Certainly! Our services organization is a highly strategic asset for Guidewire. As we embarked on the initial cloud transition, we recognized considerable uncertainty among customers about moving to Guidewire Cloud. We leveraged our services organization dynamically to help these customers become comfortable with the shift. This involved fixed-bid arrangements aimed to alleviate customer anxiety regarding costs of transitioning. Some projects did involve discounted rates as we gained insight from our experiences, often finding operational efficiency lacking in our billing activities. You can observe this in our margins as we've invested alongside our customers in their transition to the cloud. Over the last couple of years, we’ve learned a lot and devised a multipronged strategy to restore profitability to our services division. We're no longer relying solely on this department to finalize contracts. The product has significantly advanced and stands robustly on its own. We're anticipating a return to positive margin performance as ongoing fixed-bid projects reach completion and we implement a strategy involving new hires versus subcontractors at a higher rate, which has historically impacted our expenses. Our focus is also on improving the efficiency of billable versus non-billable roles, and these three adjustments are critical for our expectations going forward.

Our next question is from the line of Ken Wong with Oppenheimer.

Mike, I noticed your customer commentary seems to highlight Tier 1 go-lives with Tier 1 and Tier 2 insurers. Is this merely timing, or are you experiencing greater conviction from your largest customers?

It's a great question. There are various factors at play; the duration of deals and projects certainly affects timing. However, I believe our confidence is growing, not just limited to Tier 1 customers. The overall market awareness appears to be increasing, and we should credit our achievements. Having 31 production customers represents a significant milestone. The successful implementation of projects has provided valuable experience that elevates our credibility with larger customers, assuring them of our capabilities.

I appreciate that insight. Jeff, regarding subscription gross margins, you mentioned a new arrangement with a cloud partner. Is that the primary driver for the uptick from Q1 to Q2? Can you elaborate on the quantification of that benefit?

We are seeing benefits from multiple sources. There has been a significant focus across our engineering team. We previously emphasized ensuring the product functions correctly to meet customer needs. Now, we’re thinking strategically about making it more efficient over time. We did indeed establish a long-term relationship with our cloud service provider, which comes with some pricing incentives that contributed to Q2's positive performance. Our business model spans an annual perspective, and while some work is required to transition customers to later releases, we saw fewer costs in Q2 than originally anticipated. These costs are now predicted to occur in Q3 and Q4. However, throughout the year, we've shifted our outlook from an anticipated 46% in subscription support margins to now guiding towards 51% to 52%. We're pleased with this upward trend.

Next question is from the line of Matt VanVliet with BTIG.

In terms of the competitive landscape and your pipeline of deals currently live or in the late stages of deployment, are you noticing existing customers choosing to proceed with Guidewire without seeking competitive bids?

For existing Guidewire customers using our deployed products, we focus on making it unlikely that it would make sense for them to replace their implementation with anything other than Guidewire. Our strategy aims to minimize switching costs. The switching cost isn't zero as mentioned, but we have a solid foundation. While we’ve observed some existing customers opening requests for proposals for new lines of business, it’s mainly because they are looking at additional opportunities for modernization, not for the systems they already have. Our existing customer base does indeed stay with Guidewire, and while competition exists for greenfield implementations, we've built strong relationships with our current clients.

Understood. A quick follow-up for Jeff regarding ARR. While holding steady on your outlook, I noted the more challenging year-over-year comparisons. Could you elaborate on the macro factors or others contributing to your conservative outlook?

Certainly. The fourth quarter tends to be our most significant, so we generally don’t adjust guidance earlier in the year. The initial ARR levels are a crucial indicator of performance—this year, we've recorded substantial ARR in the first half. However, we anticipate tougher comparisons relative to last year, as that was an unusually successful period for minimal ARR attrition, leading us to expect retention rates around 3%. While we are within range, the metrics from last year were particularly robust, so we may see a slowdown in net new ARR growth during the latter half of the year. This dynamic is already woven into our guidance.

Our final question is from the line of Tyler Radke with Citi.

Mike, regarding go-live activity, how does that align with your expectations? Are you anticipating an increase in go-lives in the second half of the year?

Great question. Go-live activity correlates with project specificities, their progress, and associated delays. There are some variability factors influencing timelines. Generally, it aligns with our initial expectations. As we look forward, we expect our operational rhythm around go-lives will be consistent and replicable. This quarter’s execution coincides with a necessary rigor that will likely define our ongoing efforts. As the customer base grows and as new business opportunities develop, we foresee the trajectory of go-live activity continuing to expand.

I’ll hold you to $50 million a quarter from here on out. A quick follow-up for Jeff—given the real estate consolidation and other cost-saving measures, should we view that as potential upside to your existing targets?

Yes. Subscription and support margins are tracking somewhat ahead of our FY '23 targets, which is positive. While it's beneficial, I don't want to characterize this as upside yet. It gives us increased confidence as we work toward our targets. The impact of the building and real estate consolidation wasn’t part of our plan, so that’s an upside relative to our prior budgeting sessions. In general, we’re undertaking multiple initiatives that lend us operational confidence, but significant execution remains requisite in reaching our longer-term targets.

At this time, we have reached the end of our question-and-answer session. I will now turn the floor back to Mike Rosenbaum for closing remarks.

Thank you very much, everyone, for participating today. We’re delighted with the ongoing cloud momentum across new and existing customers. We had Tier 1 and Tier 2 insurers going live this quarter, contributing to improved margins. This quarter firmly validates our strategy, enhancing our long-term prospects. I look forward to catching up with all of you further through the quarter. Have a wonderful afternoon. Thank you.

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