Description

Not many people on VIC like high growth, limited earnings, or tech stocks, but maybe some will like a good company on sale a ~25% discount.  Hope folks find this one timely and interesting:

Duck Creek Technologies (NASDAQ:DCT) is a core system provider to the Property & Casualty (P&C) insurance industry.  DCT provides a comprehensive, modular suite of insurance policy administration, billing and claims management tools for large and small property and casualty insurance carriers. The Company’s primary product suite targets institutions that seek to upgrade traditional onsite server platforms to hybrid or 100% cloud-based solutions for their core policy / billing system of record.  Duck Creek is one of two full suite SaaS options specifically designed to handle the operating nuances of the P&C industry, the other being Guidewire (NYSE:GWRE). 

Duck Creek presents a situation to take advantage of temporary dislocation of a best-in-class, high growth SaaS company if you are committed to being a long-term holder.  On Friday, October 15, DCT reported a beat in revenues, EBITDA and earnings, and issued 2022 EBITDA guidance 15% higher than Street consensus. 2022 revenue guidance was issued slightly below (~2%) Street consensus, in the words of the CFO "to err on the conservative side," sending the stock into a tailspin.  Stock traded down ~25% to ~$35 per share.

Thesis:

- Attractive, underserved and growing market with long-term tailwinds: The P&C insurance industry spends ~$75bn / year on information technology solutions, with 18-20% specifically dedicated to upgrading or replacing core systems. As a result, addressable market for P&C core system changes was ~$13bn in 2020, and third party consultant studies estimate that it is only 25% penetrated.  As a result, it is expected to grow 20%+ per year in the medium term and 10%+ per year in the long term, largely driven by SaaS subscription growth, which is expected by DCT's Management to grow in excess of 40% per year through 2025.  Anectdotally, the P&C industry is in the early innings of its digital transformation and will take many years before the smallest niche carriers have fully converted their technology. 

- Differentiton vs. Guidewire its key competitor:  Key reasons cited by customers for the selection of Duck Creek over Guidewire include ease of use, pricing, ability to maintain existing user interfaces while the system runs in the background, and strong customer service.  Guidewire is a "clunkier" system requiring downtime for implementation, difficulty of upgrades and extended onboarding (anectodally, it took over 5 years to onboard one small, rural P&C insurer onto Guidewire).  DCT is also cited by customers as better for scaling alongside their business, customization, and ease of use amongst its applications for non-technical business users. As a result, DCT's contract win rate in SaaS is 60%+, and is growing significantly faster (~15% in 2021 and ~30% in 2020 vs 3% and 5% for GWRE). Guidewire is larger by revenue (~$785mm) vs. $260mm for DCT.

- Sticky customers with high renewal rates and switching costs: Retention rates are nearly 100% on a gross revenue basis, and 115-120% on a net dollar basis for the DCT products. Insurance software solutions providers are deeply embedded in the primary business functions of P&C carriers and can also layer on top of existing legacy systems that the carrier does not wish to replace. Furthermore, excessively high implementation costs further discourage carriers from discontinuing service or alternating providers.  For instance, large carriers may pay more than $20mm+ for a one-time implementation of the product, and reverse engineering the DCT onboarding to replace with a new system would cost about the same amount in addition to the new system setup costs.

 - Organic and inorganic growth opportunities: Management expects to drive growth through up-selling and cross-selling products to existing customers, driving growth in Europe and other underpenetrated markets and continuing to execute on accretive tuck-in M&A opportunities. DCT can continue to penetrate existing installed base/wallet share - DCT typically sells ~2.5 modules per new customer and after the customer has been with DCT for two years, has been able to increase that number to 5 modules.   The Company expects to continue to penetrate customers on SaaS and hybrid cloud solutions, and it has discontinued offer its solely on-premise solution to incentivize customers and upsell these solutions.  On the M&A front, DCT has acquired 4 companies since 2016, in total of $30mm of revenue at <5x LTM revenue, which focused on improving/expanding the Company's product set.

- Continued pivot away from lower-margin services: ~35-40% of DCT's business mix is currently implementation services, which Management views as lower value-add and lower margin vs. being an "expert" solution provider with SaaS and partnering with expert implementation firms instead to ensure quality end-to-end product.  As recently as 2019, 45% of DCT's business was implementation services, so significant progress has been made on this effort.  The long term goal stated by Management is ~30%.  Margins expect to uplift at this level with less contribution from implementation, and more contribution from SaaS, whose margins continue to expand with scale.

Risks:    

- Valuation: The valuation is a nosebleed.  After the 23% slide post earnings, that is still ~18x current revenue of $260mm.  If you don't like paying for barely any EBITDA/earnings ($17mm/ -$0.13 / share) at insanely high prices, this one probably isnt for you.  The good news is that, not surprisingly, this is in line with the wild west of SaaS valuation.  For publicly-traded, double-digit growth SaaS companies, the average forward growth estimate is 26% and the mean revenue multiple is 18x (both in line with DCT's current growth profile and valuation). GWRE trades at ~14x revenue for an inferior platform.  Using the Rule of 40 that is typically employed to make sense of the non-sensical in this realm (equalizing high spending, low margin SaaS companies with lower growth, higher margin cash generators), DCT is 70%+, which is a strong score and indicates support for the revenue mutiple.

- Ownership: ~52% of the current ownership is made up of investors who are not natural owners of large public equity positions.  Apax Partners (~24%) was the primary sponsor of the 2016 carve out of DCT from Accenture (~16%).  While both shareholders, along with Kayne Anderson (~12%), are committed as key medium term holders, they will likely continue to opportunistically monetize their positions over time, as they are both sitting on sizable gains.  A small incentive for Accenture to continue holding as they are a key integration partner to DCT that generates earnings for Accenture, which may grow as DCT outsources more integration work.

- Contract win rate outside of SaaS: This issue appears to be largely behind DCT, but worth mentioning that across all products, DCT has a contract win rate of ~35%.  As the carve out from Accenture took place following 2016 (private first, and then was taken public in 2020), at first there were restrictions on Duck Creek's ability to use a variety of outsourced firms for implementation rather than just Accenture.  Accenture was typically a higher priced integrator, and when bidding on RFPs, put DCT at a competitive disadvantage in some cases.  The restriction has been lifted following the full completion of the carve out in 2017 and DCT's SaaS contract win rate of 60%+ in recent years is more reflective of the duopoloy / oligopoly economics present in this niche sector.

- European expansion: DCT has essentially been standing up a new business in Europe.  Since 2019, they have hired ~16 sales reps to drive new growth over time, and the corresponding marketing spend has impacted EBITDA since their hires.  Management has been successful with these buildouts in the past in both Austrialia and the APAC region, including recent wins of local insurers like Hollard, Lawcover and Coal Services.

Company Overview:

Duck Creek is a leading provider of P&C insurance software and services based out of Boston, Massachusetts, with 11 additional offices across North America, Europe and Australasia. The Company was founded in 2000 and employs over 1,200 people globally, of whom 85% are devoted to research and development and professional services activities. Duck Creek offers a modular technology solution to P&C insurers so that the Company’s products may be deployed as a suite or as individual components depending on customer need. The Company offers a core systems suite of products which includes policy, billing and claims as well as additional products covering distribution management, reinsurance management, rating, industry content, insights and digital engagement. In 2021, the Company generated ~$260mm in total revenue and $16.9mm in Adjusted EBITDA. The Company has grown SaaS revenues at a 29% CAGR since 2017 and is in the process of unwinding its licensing business segment as customers shift from on-premises to the cloud.

Professional Services – Professional Services is Duck Creek’s largest source of revenue and is primarily comprised of implementation services of its software products provided to customers. These services may be provided on a stand-alone basis or bundled with other performance obligations, including SaaS arrangements, software licenses and maintenance and support services.

SaaS Arrangements – Duck Creek OnDemand is the Company’s end-to-end SaaS solution. Customers purchase and deploy OnDemand either individually or as a suite. SaaS Arrangements are the Company’s fastest growing source of revenue (29% CAGR). Duck Creek’s average contract period for its SaaS platform is 3 - 5 years. The majority of new bookings come from the sale of SaaS subscriptions of OnDemand. 

Maintenance & Support – Maintenance and support contracts associated with the Company’s software licenses entitle customers to receive technical support and software updates. These contracts are priced as a percentage of the associated software license.

License  – Some customers use versions of Duck Creek solutions that were purchased via perpetual and term license agreements. License agreements comprise a declining portion of overall revenue as the Company seeks to transition these customers to the current SaaS solutions.

Competitive Environment:

Industry Overview:

The P&C insurance industry is large, fragmented and highly regulated. Carriers compete on product differentiation, pricing, customer service, marketing and advertising and channel strategies. Insurers continue to modernize the transactional systems that support the key functional areas of P&C insurance: product definition, underwriting and policy administration, claims management and billing.

P&C insurers have been increasingly investing in technology to meet some of the significant changes occurring in the industry, which include:

- Growth in demand for personalized products and services

- An increase in technology-driven changes in vehicular risk

- Demand for coverage for 21st century risks such as terrorism, cybersecurity and reputational risk

- Advances in the use of data to better market to and engage with customers, price policies and manage claims

Estimates of total addressable market vary by source and depend on a combination of gross written premiums and IT spend by insurers. From a gross premium perspective, the total addressable market appears to be very large. In 2017, global non-life premiums amounted to ~$2.4tn with the US accounting for ~$876bn or 37% of the total. Duck Creek and other software solutions providers charge clients per their annual direct written premiums on a graduated scale.

While premium volume remains high, growth has been modest over the past decade. In fact, real direct premiums grew at a 1.2% annual rate between 2008 and 2017 as economic growth in the decade following the Financial Crisis was subdued. Swiss Re, who measures written premiums on an annual lag, estimates that total global insurance premium growth will accelerate over the next several years as the macro environment remains relatively stable. In their base case, Swiss Re anticipates US, European and Chinese GDP growth to be < 2%, ~1% and ~6%, respectively. While total written premiums have grown very modestly, non-life premiums have been growing at a relatively faster clip. The table below shows that total insurance premiums grew 1.5% in 2018 and were primarily driven by non-life policies which increased by 3%. In 2019 and 2020, Swiss Re estimated that total and non-life insurance written premiums will grow at 2.9% and 3.0%, respectively.

The other component of total addressable market is total IT spend. Several major themes will likely guide P&C insurers’ IT spend in the coming decade.

- Legacy Modernization – A substantial portion of insurers continue to use legacy core systems. It is expected that carriers will increasingly shift to cloud-based third-party systems in order to increase operating efficiency, expand into new lines of business and enhance their digital and data offerings. Management estimates that approximately two-thirds of non-life carriers rely on legacy systems that are > 10 years old.

- Improved Digital Engagement – Insurers will find it increasingly necessary to provide a more intuitive and user-friendly digital experience to prevent customer attrition. Such improvements will require investments in software products designed to enable easy and frequent interactions between carriers and their customers.

- Cloud-based Solutions – Companies will continue to recognize the economic benefits and improved security and reliability of software solutions on public infrastructure.

- Competition to Innovate – Insurers will find it necessary to innovate their user and back office platforms in order to grow their businesses and improve service quality.

Duck Creek management estimates that P&C carriers will spend $74bn on Information Technology solutions per annum with 18-20% of that devoted to upgrading or replacing core systems software, making the estimated total addressable market for Duck Creek’s products ~$13bn. Barclays also estimates that US companies will devote ~18% of their annual IT spend to software services in 2020 and beyond.

Third Party Partnerships:

In the current market, insurance software solution providers typically develop both an internal sales and marketing effort as well as a broader ecosystem of third-party partners to distribute, train and implement their systems with clients. Internal sales teams primarily serve an account management function and engage customers to understand their business needs and represent their firms’ products through demonstrations. Internal marketing staffs support the internal sales teams with competitive analysis and work to strengthen brand awareness through industry conferences, press releases and relationship building with industry partners.

Companies typically associate with two different categories of third-party firms to distribute and deploy their products:

- Systems Integrators – Provide implementation and other related services to the insurance carriers. SIs are not compensated directly by the software solutions providers but rather by the insurance carriers for their services. Many of the large SIs have developed sizeable business practices advising on and deploying Duck Creek and Guidewire products. Duck Creek maintains longstanding partnerships with Accenture, Capgemini and Cognizant.

- Technology Partners – Maintain the technical infrastructure for cloud-based products and other digitized offerings. Technology partners drive fewer sales leads to the insurance software solutions providers than the SIs but are critical to system functionality. Duck Creek utilizes Microsoft Azure and Salesforce for its SaaS platform and complimentary products.

SaaS Subscription Business Model:

In addition to a large and relatively unpenetrated market, SaaS subscription revenue platforms have the potential to generate highly attractive margins as customers renew subscriptions. In general, a recurring revenue company loses money on new business. However, the prospects of recurring revenue and high renewal rates makes subscription-model businesses attractive as renewal margins are highly positive. These dynamics are often overshadowed when these companies are in a rapid growth phase as new business acquisitions overwhelm positive margin contributions from renewals. As growth eventually slows, strong margin leverage flows through to investors. Cloud-based SaaS subscription models have several positive underlying trends:

- Strong Top Line Growth – Across a coverage group of 32 publicly traded subscription-based models, revenue growth averaged 26% in 2021. Morgan Stanley estimates that SaaS revenues from these public companies will compound at 19% through 2022 driven by increasing demand for application software and a broad shift to cloud-based SaaS models over the next several years.

- High Renewal Rates – Renewal rates among vertically integrated public SaaS companies is slightly >90% as these systems are designed to integrate into daily functions and tend to be difficult to disconnect from the business. Duck Creek, as well as other insurance software solutions providers, are deeply embedded in the primary business functions of P&C carriers and can also layer on top of existing legacy systems that the carrier does not wish to replace. Furthermore, excessively high implementation costs further discourage carriers from discontinuing service or alternating providers.

Management team:

Michael Jackowski, CEO

Michael Jackowski serves as the CEO and is a member of the Board of Directors of Duck Creek Technologies. Prior to Duck Creek, Mr. Jackowski held several leadership roles at Allstate. He served as Senior Vice President for Agency Technology and Sales business units, where he was responsible for strategic management and operations. He also led the business through a technology transformation that improved interactions and communications between the carrier’s employees, agents and customers. While at Allstate, Michael modernized the insurer’s claims operations through the use of new technologies and governance procedures. This “Next Gen” claims initiative was credited with two industry recognitions including Computerworld magazine’s “Premier 100 IT Leaders” and the Pink Elephant’s “Information Technology Infrastructure Library Project of the Year” award.

Andy Dey, Chief Product and Technology Officer

Andy Dey serves as the Company’s Chief Product and Technology officer. He is responsible for leading Duck Creek’s product, engineering and SaaS operations teams. Mr. Dey has over 20 years experience in the Information Technology industry most recently serving as Chief Technology Officer at Vertafore, where he led the development of one of the industry’s leading agency management solutions. Prior to Vertafore, Mr. Dey served as Global Head & Chief Business Officer of EdgeVerve, a subsidiary of Infosys where he developed solutions around automation and modernizing core banking systems. Mr. Dey has also held leadership roles in the SaaS transformation of Concur’s travel and expense management solutions; for SAP HANA, SAP’s modern cloud-based In-Memory platform; and at SAP Labs, where he led customer-driven innovation and managed the company’s India R&D Center.

Vincent Chippari, CFO

Vincent Chippari serves as the CFO of Duck Creek Technologies. Prior to Duck Creek, Mr. Chippari served as Managing Director and CFO of Interactive Data Corp. (“IDC”), a provider of financial market data to major financial institutions worldwide. At IDC, Mr. Chippari was responsible for financial management, accounting, tax, treasury, facilities and the corporate development functions of the business. His most significant accomplishment while at IDC was leading the organization through the successful sale to Intercontinental Exchange for $5.2bn, following a dual-track IPO/sale process. Mr. Chippari has led financial teams at both private and public companies and has completed more than 30 M&A transactions. His previous positions include serving as CFO of FleetMatics Group and Name Media, two PE-backed pre-IPO technology businesses, Chief Strategy Officer of Thomson Healthcare and Executive Vice President and CFO of Information Holdings Inc.  "Vinny" is retiring in February 2022, but will remain in place through the search process until a replacement is named. 

Valuation/returns:

Company is valued on revenue currently (~18x) as EBITDA margins are roughly 7%.

The Company expects to approach a fully scaled 40% EBITDA margin by ~2025, but will likely continue to be valued on revenue given market convention.

The upside case buying at $35 is as follows:

- market grows at 20% which is in line or below consensus forecasts

- industry penetrates TAM by 10% (from 25% today which appears conservative)

- DCT maintains mkt share on pentrated TAM (slight increase to 7% from 6.7% today)

- EBITDA margins improve to 40% by 2026

- Revenue multiple contracts to 15x as growth slows 

The base and stress cases take haircuts to these assumptions and provide a range of outcomes that appear to be asymmetric here.

Catalyst

Continued performance by the Company incl. posting strong earnings, improving margins, winning new business and / or any relevant M&A.