Description

Guidewire Software

Thesis

·         The market doesn’t understand the business quality and long-term earnings power of Guidewire.

·         Guidewire is the dominant provider of mission critical policy, claims, and billings software for property & casualty (“P&C”) insurers. The software has high utility for customers, but represents a small component of costs as a full suite costs roughly 50 bps of premium revenue.

·         Competition is winner-take-most as track record of successful implementations is critical to distribution and winning new customers, which results in greater utility relative to price than competitors due to scale economies in research & development.

·         Guidewire’s on-premise software has historically been highly customized by insurers and revenue growth has recently slowed as insurers are waiting to see if on-premise software will successfully transition to cloud. We think Guidewire will be successful as despite roughly 1/3 of the software’s functionality being customized by insurers, roughly 3/4ths of this customization is common amongst insurers and can be significantly reduced through increasing configurability. Limiting customization will allow Guidewire to get closer to a single code base and achieve the automation and scalability seen in other SaaS businesses.

·         Large portion of the P&C insurance market continues to rely on legacy technology systems (COBOL-based software running on mainframe hardware) that are costly and inefficient to maintain, difficult to upgrade, and lacking in functional flexibility.

·         We think that by 2030 the majority of Tier 1-3 insurers will replace their legacy technology systems with 3^rd party software and Guidewire will have approximately $2 trillion of direct written premium (“DWP”) on their platform, revenues of $6 billion, and 50% operating margins, which results in $25 EPS and a 20% IRR over 10 years.

Business

·         The Guidewire software platform primarily consists of three applications PolicyCenter, BillingCenter, and ClaimCenter that can subscribed to separately or together.

o   PolicyCenter is an underwriting and policy administration application that serves as a comprehensive system-of-record supporting the entire policy lifecycle, including product definition, underwriting, quoting, binding, issuance, endorsements, audits, cancellations, and renewals.

o   BillingCenter automates the billing lifecycle, enables the design of a wide variety of billing and payment plans, manages agent commissions, and integrates with external payment systems.

o   ClaimCenter is a complete end-to-end claims management solutions that manages the claims lifecycle from first notice of loss through settlement, litigation, and recovery.

·         Guidewire generally prices their products based on the amount of DWP that will be managed on the platform. Cloud-delivered offerings are sold on a subscription basis and self-managed installations are sold through term licenses. Subscriptions are generally sold with an initial term of between three and five years and term licenses are generally sold with an initial term of two years; subscriptions and term licenses have optional annual renewals commencing after the initial term.

Industry Structure

·         The P&C insurance industry historically had large internal IT teams that developed massive COBOL based homegrown systems to help automate the processes of policy administration, billings, and claims management. Insurance companies primarily developed their own internal software as well as used mainframe-based systems from vendors such as Computer Sciences Corporation (CSC) and Policy Management Systems Corporation (PMSC). Over decades these legacy systems resulted in a patchwork of inflexible and customized systems that most insurers still rely on today.

·         Value proposition of 3^rd party policy, claims, billing software:

o   Legacy systems were built decades ago and need to be replaced as they have reached the end of their useful life. Legacy systems are also increasingly fragile, expensive, and difficult to maintain as the IT workers who built and maintained them are retiring and COBOL is a dying programming language.

o   P&C insurers that remain on legacy systems will find it increasingly difficult to compete against insurers running on modern, flexible 3^rd party software. For example, making product/pricing changes can take 6 months on legacy systems vs a couple weeks on 3^rd party software. Customers are also increasingly demanding digital, mobile, and self-checkout experiences that cannot be supported by legacy systems. Legacy systems also don’t allow for BI, data mining, machine learning, etc.

o   Insurers are not technology companies and internally developed software is expensive, commoditized and doesn’t offer any form of differentiation or competitive edge. Adopting a 3^rd party software platform allows insurers to focus on their core competencies.

·         Barriers to entry for Tier 1-3 insurers:

o   Insurance software has an order of magnitude more code than other software verticals (roughly 7MM lines of code). It would take 5-10 years for a new entrant to accrete all the product and regulatory expertise, program logic, code, and configuration that is specific to all the variations of a large insurance company’s business lines in all the different regions in the world.

o   There are very high switching costs as the cost to implement the software is roughly 5-10x the annual subscription price. Also, the cost for an existing Guidewire on-premise customer to move to the cloud is roughly the cost of a typical upgrade (2x annual on premise subscription cost), which is significantly less than the implementation cost of switching to a new software vendor.

o   Software vendors need a strong track record of successful implementations given mission critical nature of software, high cost of failure, and inherently risk-averse customers. It is difficult to achieve a track record of successful implementations due to long sales cycles of 2-3 years, 1-2 years of software implementation, and several years before carrier in full production. Large insurers have also been burned before by other software companies where the software worked for small insurers, but not at their scale.

o   System integrators (SIs) like PWC, EY, Deloitte, Accenture, and Capgemini are critical to distribution and drive the vast majority of deals given the substantial software implementation costs. These SIs typically specialize in either Duck Creek or Guidewire systems, although some like Deloitte and Capgemini do both. SIs don’t have incentives to build new implementation practices around another software vendor given highly risk-averse insurance customers and the incremental costs for SIs to build out a new implementation practice.

o   Policy, claims, and billings software has very low levels of churn due to a long product life of approximately 20-30 years. Due to this long product life insurers want to partner with large software vendors and won’t take a chance on a small vendor that might not be around in 20 years or be able to sustain a competitive software product.

·         Competition:

o   Competition is winner-take-most as track record of successful implementations is critical to distribution and winning new customers, which results in greater utility/price than competitors due to economies of scale in R&D. For example, Guidewire and Duck Creek have much broader feature functionality and greater ability to customize and configure than other vendors.

o   Guidewire ClaimCenter is the gold standard in claims software with an estimated 80% market share for North American Tier 1-3 insurers and approximately 50% market share in Europe and Asia-Pac ex China/India Tier 1-3 insurers. Competitors like Duck Creek do not appear to have much interest in developing their claims products as the market is largely captive to Guidewire and it wouldn’t be worth the R&D dollars in terms of return on development cost.

o   Guidewire PolicyCenter in North America has roughly 40% market share among Tier 1-3 insurers and this share is skewed toward large insurers with personal lines and small commercial lines. Duck Creek has roughly 40% market share among Tier 1-3 carriers in North America as well and this share is skewed toward smaller insurers with specialty and commercial lines. This segmentation in North America is the result of Guidewire initially focusing on large personal lines and Duck Creek starting out as a rating engine for smaller insurers with commercial lines. In Europe and Asia-Pac ex China/India, we estimate PolicyCenter is winning at least 50% incremental market share among Tier 1-3 carriers. While the U.S. market is largely homogenous between states, countries in Europe and Asia-Pac require country specific functionalities due to different regulations. Guidewire has spent the last +5 years developing this localized functionality that comes in prepackaged solutions sitting on top of the core platform. Duck Creek has not developed these localized capabilities and has almost no presence outside North America. Internationally, Guidewire typically competes against smaller, local consulting companies that have developed their own software that specializes in a local market’s needs.

o   Guidewire BillingCenter has a roughly 80% attach rate to PolicyCenter. Integration between billing and policy software is difficult so typically these applications are sold together.

Cloud

·         Guidewire’s software has historically been sold on-premise and the functionality of the software was highly customized by insurers. Highly customized on-premise software creates challenges to both Guidewire and its customers:

o   Customers often customize too much, which results in very expensive implementations, upgrades, and system maintenance. These systems are expensive and difficult to manage as large insurers typically have +100 integrations with third parties (custom code integrations to CRM, California DMV, LexisNexis, Safelite, etc).

o   Guidewire would often be blamed for how expensive and difficult the software is to manage. Also, innovation and feedback from customers is slow as Guidewire would release a major upgrade every 2 years, but customers would typically only upgrade every 4 years.

·         Our work suggests that a typical Guidewire customer’s on-premise software is 1/3 customized, 1/3 configurable, and 1/3 out of box. In order for Guidewire to achieve automation and scalability like other SaaS businesses they need to get closer to a single code base amongst customers. Fortunately, our work suggests that roughly 3/4 of customization is common amongst insurers.

·         Guidewire’s recent release of Version 10 makes transition to cloud easy for customers because there are now customization limits at 20% and they added significant configurability. For example, one insurer we spoke with before their version 10 upgrade was 36% customized, 48% configurable, and rest out of box; after their Version 10 upgrade they are now 3% customized, 80% configurable, and rest out of box. We think over the next 5 years Guidewire can continue to decrease customization through increased configurability.

·         Transitioning Guidewire’s on-premise software to the cloud will create significant value to Guidewire and its customers:

o   Customers will receive 2 smaller upgrades per year, which will result in faster innovation and therefore more utility for customers. Customers will also no longer have to pay SIs for expensive upgrades due to limited customization and upgrades will be managed by Guidewire. Customers can also transfer the risk of managing these systems and focus on their core competencies.

o   Guidewire can manage these systems much more efficiently than their customers due to automation and scale economies. Guidewire is also able to increase pricing by 2.5X as % of DWP as they will now be managing insurer’s infrastructure and integrations.

Valuation

·         TAM and Revenue Analysis:

o   Per SwissRe, 2019 DWP in the Americas, EMEA, and Asia-Pac ex China/India was $1,082B, $750B, and $316B, respectively. We exclude China and India as Guidewire is unlikely to enter those countries due to piracy concerns and/or the low cost of software development.  These markets are forecast to grow at a 4% CAGR over the next 10 years and Tier 1-3 insurers as a % of total DWP is forecast to continue to be approximately 83%. This results in 2030 DWP for Tier 1-3 insurers in the Americas, EMEA, and Asia-Pac ex China/India of approximately $1,400B, $950B, and $400B, respectively.

o   In the Americas we forecast 3^rd party software penetration will be 75% of Tier 1-3 DWP by 2030. ClaimCenter is forecast to have 80% market share of DWP and cloud pricing of 0.22%. Policy/billings is estimated to have 40% market share and cloud pricing of 0.35%.

o   In EMEA we forecast 3^rd party software penetration will be 65% of Tier 1-3 DWP by 2030. ClaimCenter is forecast to have 50% market share of DWP and cloud pricing of 0.22%. Policy/billings is forecast to have 50% market share and cloud pricing of 0.35%.

o   In Asia-Pac ex China/India we forecast 3^rd party software penetration will be 65% of Tier 1-3 DWP by 2030. ClaimCenter is forecast to have 50% market share of DWP and cloud pricing of 0.22%. Policy/billings is forecast to have 50% market share and cloud pricing of 0.35%.

o   This results in Guidewire’s 2030 total DWP of $2,200B, ARR of $6B, and revenue as % of DWP of approximately 0.27%. This compares to Guidewire’s 2020 DWP of $518B, ARR of $514MM, and revenue as % of DWP of approximately 0.10%.

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·         Margin Analysis:

o   We forecast Guidewire to have approximately 50% EBIT margins by 2030 as mature, monopolistic software businesses should reach 50% margins and the long-term EBIT margin for Guidewire managing their customers infrastructure should approximate managed service providers average gross margins of 50%.

o   This long-term EBIT margin is also consistent with incremental gross margins outlined at Guidewire’s investor day and the scalability of their general & administrative, sales & marketing, and research & development expenses.

o   Assuming FCF/Share of $25 in 2030 and a 20x multiple, value per share would be $500, which doesnt include cash generated between now and 2030. IRR from $110/share price paid today would be approximately 20%.

Risks

·         Guidewire may fail to successfully manage their transition to a business model focused on delivering cloud-based offerings or fail to meet stipulated service levels with their subscriptions services. Guidewire has no history managing insurer infrastructure and the cost may be greater than expected or they may not be able to achieve the scalability expected.

·         Customers may adopt 3^rd party software at a slower rate than our forecast by continuing to rely on legacy systems.

Catalyst

Customers increasingly transitioning to cloud