Guidewire Software Inc (GWRE) 2014 Q3 法說會逐字稿

Good day, and welcome to the Guidewire third-quarter fiscal 2014 financial results conference call.

Today's conference is being recorded.

At this time, I would like to turn the conference over to Karen Blasing, Chief Financial Officer.

Please go ahead, ma'am.

Thank you.

Good afternoon, and welcome to Guidewire Software's earnings conference call for the third quarter of fiscal 2014, which ended on April 30.

This is Karen Blasing, Chief Financial Officer of Guidewire, and with me on the call is Marcus Ryu, Guidewire's Chief Executive 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.

To access the press release and the financial details, please see the Investor Relations section of our website at www.Guidewire.com.

As a reminder, today's call is being recorded, and a replay will be available following the conclusion of the call.

During today's call, we will make statements related to our business that may be considered forward-looking under federal securities laws.

These statements reflect our views only as of today, and should not be reflected upon as representing our views as of any subsequent date.

We disclaim any obligation to update any forward-looking statements or outlook.

These statements are subject to a variety of risks and uncertainties that could cause actual results to differ materially from expectations.

These risks are summarized in the press release that we issued today.

For a further discussion of the material risks and other important factors that could affect our actual results, please refer to our annual report on Form 10-K for the period ended July 31, 2013, and our quarterly report on Form 10-Q for the period ended January 31, 2014, both of which are on file with the SEC.

Also, during the course of today's call, we will refer to certain non-GAAP financial measures.

A reconciliation schedule showing GAAP versus non-GAAP results has been provided in our press release issued after the close of market today.

Additionally, we are providing detailed reconciliation data, as well as recurring revenue calculations in a supplement posted on our IR website at IR.

Guidewire.com.

Finally, at times in our prepared comments or responses to your questions, we may offer incremental metrics to provide greater insight into the dynamics of our business, or our quarterly results.

Please be advised that this additional detail may be one-time in nature, and we may or may not provide an update in the future.

With that, let me turn the call over to Marcus for his prepared remarks and then I will provide details regarding our third-quarter financial results and our outlook for the rest of fiscal 2014.

Thanks, Karen.

We're pleased that our third-quarter results exceeded expectations for both revenue and profitability.

Total revenue of $82 million grew 20% from a year ago, reflecting continued demand for our modern, flexible, core system software, serving the global P&C insurance industry.

Our recurring revenue from term license and maintenance fees on a rolling four-quarter basis grew to $165.3 million, an increase of 26% compared to a year ago.

We also outperformed relative to our profitability expectations, expanding both gross and operating margin.

Based on these results, and our view towards the fourth quarter, we are slightly increasing the midpoint of our full-year revenue guidance, as Karen will detail later.

Our mission is to build software products that transform the global P&C industry, while ensuring every customer succeeds in the journey.

Strategic constancy has served us well over the last 13 years since our founding, and we remain singularly focused on the opportunity to serve a huge global industry, modernizing its obsolescing core technology.

We believe that we are still less than 10% penetrated in this opportunity, and we are positioning ourselves to lead the industry through this transformation for many years to come.

Over the last two or three years, we have invested heavily in three areas: Sales and marketing, professional services and technology.

I'd like to take a deeper look at each of these, including some examples of third-quarter success, and describe how our progress will guide our investment strategy with an eye towards fiscal 2015.

Regarding sales and marketing, we have often underscored that our products address highly complex problems, that our sales cycles are very long and demanding, and that consequently, it takes time to ramp selling teams into effectiveness.

Notwithstanding those challenges, we have made considerable investments since going public to broaden our geographic reach, especially in Europe, to target more Tier 1 customer engagements, and to develop our sales pipeline through inside sales teams.

In the third quarter, we had continued success on all these counts.

For example, during the quarter, we signed our first customer in Switzerland, one of the most profitable but conservative markets in the industry.

Basler Insurance is a $2 billion domestic insurer, who selected PolicyCenter and BillingCenter, and its multilingual deployment will support users in German, French, and Italian.

Another international win was with QBE Insurance Group of Australia, the largest insurer in the country, and a global Tier 1, with $18 billion in written premiums, who licensed PolicyCenter and BillingCenter to become a full suite customer.

QBE also selected our data management tools to further leverage their Guidewire investment.

Here in the states, W.R. Berkley Group is a Tier 1 insurer, operating a family of companies in different niches.

Berkley Risk Administrators Company, or BRAC, is the fourth Berkley affiliate to become a Guidewire customer in the past two years, selecting ClaimCenter for their $400 million strategic risk management business.

Looking ahead, we believe we can continue our successful sales track record with moderated growth in sales headcount, while continuing to invest in better supporting underpenetrated regions like Europe and Latin America as well as driving adoption of our newer product offerings.

While we plan to moderate sales headcount growth, we are focusing on driving sales productivity gains, as newer salespeople mature in their Guidewire experience, and we expect continued strong results from the team.

Regarding services, a consistent FY14 theme from us has been investment in a healthy ecosystem of system integrator partnerships, to handle an increasing portion of customer implementation activity.

By design, Guidewire is still involved at some level in all implementations, as an elite differentiator, and more heavily so for new products, and in new geographies, but our SI program is critical to our business model focus on generating recurring license and maintenance revenue.

In concert with our partners, we maintained our 100% success implementation track record with our customers in the third quarter, with several significant customer launches and upgrades to the latest version of InsuranceSuite.

These included major go-lives at American National Property & Casualty, Aviva Canada, GuideOne, Mitsui Direct in Japan, Workplace Safety and Insurance Board in Toronto, and Zurich UK.

We had PolicyCenter launches in the third quarter that included PZU in Poland, and CNA, a top 10 commercial lines insurer here in the US.

CNA was our first PolicyCenter customer in 2004, with an initial go-live in 2006, and they've relied on Guidewire to support their evolution for over a decade, spanning small commercial to now specialty lines of business.

I turn last to our third investment area, technology, which continues to be distinctively recognized by both insurers and other industry observers.

Guidewire has been named a leader in Gartner's first Magic Quadrant for insurance claims management modules, in their report published in May.

Earlier this fiscal year, we successfully delivered version 8 of InsuranceSuite, as well as new Guidewire Live apps, a selection of portal products, extending InsuranceSuite to policyholders, and our first version of Guidewire Data Management.

We are encouraged by strong indications that customers who have adopted our core system platform see Guidewire as the logical or even assumptive choice for strategic solutions that leverage that platform.

For example, in addition to QBE licensing our data management solutions in the third quarter, Travelers Canada and Wawanesa Mutual, both licensed Guidewire Live apps to build on the benefits they are seeing with their deployments of Guidewire's core systems software.

Product-wise, we believe there are considerable opportunities still in front of us to solidify our leadership position for the core suite, and to build a leadership position in the areas of mobile and portal extensions, data management and analytics, all of which represent expansions of our addressable market and enhancements of our value proposition to the industry we know best.

Consequently, while year-to-date R&D headcount grew only modestly as we tested the water with new offerings, we are planning to increase our technology investments over the coming quarters, with the goal of increasing our R&D team by over 20% in the next several quarters.

We are already underway with heightened R&D investments to extend our leadership position in core systems, and to accelerate our development of new products that will expand our TAM.

At the same time, we will continue to look for partnerships and acquisitions that could accelerate our development efforts.

As we consider our momentum and look out to fiscal 2015, we reaffirm our goal of 20% growth in term license revenue, consistent teens growth in maintenance, while expecting that our services revenue growth will moderate.

We will share our thoughts in more detail after our fourth-quarter results are announced in September, but we can share now that we do expect to gain modest financial leverage in gross margins in fiscal 2015, driven by a higher license and maintenance revenue mix.

I'll turn the call now over to Karen to discuss our financial results for the quarter, and to provide more detail on our outlook.

Karen?

Thank you, Marcus.

We are pleased to report solid results for the third quarter that exceeded our revenue and earnings expectations.

Total revenue was $82 million for the third quarter of fiscal 2014, a 20% increase from a year ago.

Within revenue, license revenue was $31.9 million, a 39% increase from the third quarter of fiscal 2013.

Term license revenue increased 58% year-over-year to $28.2 million, while perpetual license revenue remained quite small at $3.7 million, compared with $5 million in the third quarter of fiscal 2013.

As a reminder, in the second quarter of fiscal 2013, we saw $4.5 million in early payments of our software invoices from our current customers, which were expected in the third quarter of fiscal 2013.

And in the second quarter of 2014, we saw $1 million in early payments, which were expected in the third quarter.

There were no significant early payments in the third quarter of 2014.

Including these early payments in the respective third-quarter results, license revenue growth would have been 20% year-over-year.

Maintenance revenue, which is recognized ratably through the year was $10.4 million for the third quarter, up 15% from a year ago, reflecting overall license growth trends.

Services revenue was $39.7 million, up 10% from a year ago, as we continue our strategy to increasingly leverage our SI partners for customer implementations.

Geographically, the US represented 59% of revenue in the third quarter, with 41% of revenue coming from outside the US.

Turning to expenses, we will discuss our profitability measures on both a GAAP and non-GAAP basis, and we have provided a reconciliation of these measures in our earnings release issued today, which is also posted on our website with the primary difference being stock-based compensation expenses.

Non-GAAP gross profit in the third quarter of $49.3 million represented a gross margin of 60%, a significant increase from 52% a year ago.

This improvement from the third quarter of fiscal 2013 was primarily due to the combination of increased service margins and decreased service revenue as a percentage of total revenue, reflecting the longer-term trend leverage we see in our model, as SI partners take on more implementation responsibilities.

Non-GAAP license gross margin was 98.6%, compared to 99.4% a year ago, due to an increase in third party royalties, and the cost of Guidewire Live.

Non-GAAP maintenance gross margins of 81.5%, up from 80.6% a year ago.

Non-GAAP gross margin for services was 23.5%, which increased from 15.5% in the prior year.

We have managed our services headcount growth in line with our support of our SI partners, resulting in a higher utilization of our services team.

Our services margins in the prior year were significantly dampened by our investment in new employees, who required ramp-up time to be billable.

Turning to operating expenses.

Total non-GAAP operating expenses were $38.5 million in the third quarter, an increase of 21% compared to a year ago, primarily from investments in R&D and sales and marketing.

Despite these continued investments in our growth, operating expenses in total were lower than assumed in our guidance, due primarily to the timing of new hires, and tighter management of some discretionary expenses.

Profitability was ahead of expectations in the quarter.

We saw higher than anticipated revenue, and lower than anticipated expenses, resulting in a non-GAAP operating income of $10.9 million, and non-GAAP net income of $7.6 million, or $0.11 per diluted share, both of which were above our guided ranges.

Turning now to our balance sheet.

We ended the third quarter with $600.1 million in cash, cash equivalents and investments, up from $588.4 million at the end of the second quarter.

Our increase in cash was driven primarily from operating cash flow of $20.3 million in the third quarter.

Total deferred revenue at the end of the third quarter was $58.3 million, an increase from $51.5 million at the end of the second quarter.

As a reminder, we do not believe that deferred revenue is a meaningful indicator of business activity during the quarter, since we typically bill term license contracts annually, and recognize the full annual payment upon the due date or other contract terms.

Further, our multi-year contracts combined with annual payment terms means that a significant amount of our contractually committed fees are not visible on our balance sheet.

We believe that the combination of this contracted business and our best-in-class renewal rates continues to provide us with a high level of visibility into future recurring revenue today.

Now I'd like to turn to our outlook for the fourth quarter and full year fiscal 2014.

Based on the third-quarter performance and our anticipated new sales, we remain confident in our fourth-quarter outlook.

As stated on our last call, we continue to expect growth in services revenue to moderate this year, as our system integrator partners continue to gain traction, and our customers increase their engagements with our partners.

We expect our term license and maintenance revenue growth rates to outpace our services growth.

This trend will gradually shift a larger percentage of our revenue to license and maintenance.

With that backdrop, we expect fourth quarter revenue to be in the range of $109.5 million to $113.5 million, representing year-over-year growth of 15% at the midpoint.

We expect license revenue to be in the range of $62.5 million to $64.5 million, maintenance revenue of approximately $11 million, and services revenue in the range of $36 million to $38 million.

For the fourth quarter, we anticipate non-GAAP operating income of between $30 million and $33 million, and non-GAAP net income of between $19.7 million and $21.7 million, or $0.27 to $0.30 per share, based on a fully-diluted share count of 73.1 million shares.

Our non-GAAP operating income and net income expectations for the fourth quarter exclude approximately $14.5 million in stock-based compensation expense, and $0.4 million in amortization of intangible assets.

Including these non-cash expenses, we anticipate GAAP operating income of between $15.1 million and $18.1 million for the fourth fiscal quarter.

We anticipate GAAP net income between $8.5 million and $10.3 million or a profit of $0.12 to $0.14 per share, based on a fully diluted share count of 73.1 million shares.

We anticipate an effective non-GAAP tax rate of approximately 34%, and a GAAP tax rate of approximately 40.6% in the fourth quarter.

For the full year fiscal 2014, we anticipate total revenue to be in the range of $341.5 million to $345.5 million.

This represents an increase of $5 million at the midpoint from our prior guidance range of $334.5 million to $342.5 million, and a total revenue increase of 14% from fiscal 2013 at the midpoint.

Within revenue, we believe that license revenue will be in the range of $148.5 million to $150.5 million, an increase of 20% to 22% from fiscal 2013.

We believe perpetual license revenue will be roughly equivalent to, or slightly higher, in fiscal year 2014 than fiscal 2013.

We expect maintenance revenue to be in the range of $40.5 million to $41.5 million, an increase of 8% to 10% from fiscal 2013.

Keep in mind that we expect maintenance revenue growth to lag license revenue growth, and is recognized ratably over the support period.

We anticipate services revenue to be in the range of $152 million to $154 million, an increase of 9% to 10% from fiscal 2013.

Turning to profitability, we anticipate full-year, non-GAAP operating income in the range of $54.5 million to $57.8 million, an increase from our prior guidance range of $35.5 million to $39.5 million, reflecting upside in the third quarter, and representing a non-GAAP operating margin of 16% at the midpoint of our revenue, and operating income guidance.

As we anticipate non-GAAP net income in the range of $36.8 million to $39.1 million, or $0.51 to $0.55 per share, based on a fully-diluted share count of 71.6 million shares.

We anticipate an effective non-GAAP tax rate of approximately 34% for the full year.

On a GAAP basis, which includes approximately $62 million of stock-based compensation expense, and approximately $1.4 million in amortization of intangible assets, we anticipate a fiscal 2014 operating loss of between $9 million and $5.7 million, a net loss of $4.6 million to $2.5 million, or a loss per share of $0.07 to $0.04 per share, based on an estimated weighted average basic share count of 65.8 million shares.

We anticipate an effective GAAP tax rate of approximately 40.6% for the full year.

Looking beyond fiscal 2014, while we plan to share more detail in conjunction with our fourth-quarter results in September, we are anticipating that in fiscal 2015, we can continue to deliver term license revenue growth of approximately 20%, and deliver mid to high teens maintenance revenue growth.

We expect to achieve this strong term license revenue growth next year, even as we face more challenging period over period comparisons with a term license revenue base that is now significantly larger than it was two years ago.

In addition, international customers are increasingly key to our continued growth, so sales cycles in new territories are inherently longer, and less certain with respect to timing.

We are anticipating that most of our license revenue will come from term contracts, and that perpetual license revenue will decrease from fiscal 2014.

I would like to reiterate that with the success we are seeing in transitioning more of our implementation effort to our SI partners, we expect services revenue and hiring to be flat next fiscal year.

And we expect to start seeing a positive impact on overall gross margins as a result of the more favorable mix of license and maintenance, as a percentage of total revenue.

As Marcus mentioned, our heavier sales and marketing investments over the past two fiscal years are yielding good results.

Our focus is shifting to further productivity improvements, while continuing to build our sales presence in geographies like EMEA, and in sales support of new products.

Responding to customer appetite for new products from Guidewire, we will increase our investments in R&D.

We expect those increased investments to dictate a decline in FY operating margins, relative to FY14 levels, which have been above expectations, but we are confident this will allow us to offer more products and expand our TAM.

In summary, we are pleased with our third quarter results and are confident in the remainder of the fiscal year as reflected in our guidance and the momentum we are seeing in the marketplace across a combination of both new and existing customers.

Operator, can you now open the call for questions?

(Operator Instructions)

And we'll go first to Brent Thill with UBS.

Marcus, you mentioned a number of pretty high profile wins outside the US.

I'm curious if you could just talk a little bit about the pace of those wins, and any changes you're seeing, I know Karen noted some of the sales cycles continue to be pretty long there, but anything notable from your perspective, as you look at the international sales funnel?

I wish I could report an acceleration, but every one of these cycles are really arduous and they come sometimes in clusters, just with no specific pattern, when we finally take a long conversation and get it converted.

We're pretty pleased about what we're seeing internationally, in that there's a consistency of demand.

We have a lot of confidence in our platform being generalized enough to serve the needs of a very diverse and global industry, and we think we have the only platform that's proven that it can serve that totality of the market.

Any P&C insurer of any size writing business in any language, and that's a pretty unique market position to have, that we don't think any of our competitors do, that's been pretty compelling.

And over time that's allowed us I think to penetrate some very difficult places, including a lot of organizations like one of the names I mentioned, Basler Insurance in Switzerland, that is really unaccustomed to buying packaged applications because they never believed that one would be able to meet their needs.

So those kinds of confirmations are very encouraging to us, but the cycles remain very, very difficult, and I think that's just the nature of the business we have and will always have.

Okay.

And just a quick follow-up.

You mentioned on R&D you're going to open up your investments a little bit faster than you have, and given that it sounds like you have some proof points, in some of the new products.

Can you give us a little more granularity in terms of where you've been pleasantly surprised on the R&D side, that now gives you confidence to step back on the investment in that area?

So as a refresher, we really have three additional vectors of new product development beyond the core suite, which of course is still the bulk of our business and is essential to our strategic plan.

We have to win the core system battle, and the new product offerings really leverage the value proposition of that core system, once it's been implemented.

But those three vectors build on it, on top of it, and they are data management, which is an operational data store and conventional data warehousing technology, but very specific for P&C insurers, and integrated to our suite.

Mobile and portal technology, that extends our platform to external constituents, and then analytics, where the primary asset we have today is Guidewire Live, but we have other aspirations as well.

And in each of those areas over the last 18 months, we brought new offerings to market, and the goal as with any new software offering, is can you get those early customers excited.

Can you get them engaged, and prove that you have something interesting to them, get them to actually pay you, and prove value that then is the basis for the next wave of customers, and eventually hopefully not too long from then, really bringing it to the mass market.

We feel really good about all three of those efforts, all three of those dimensions.

We've gotten a lot of great customer engagement and excitement about them, and now we have more product to build to fulfill the opportunity in each of those areas, and it's very satisfying to get license from existing customers, in each of those, who now recognize we can do more beyond just that core suite.

Thank you.

Next we'll move to Nandan Amladi with Deutsche Bank.

Marcus, first question for you on the system integration partnerships.

Clearly they're moving in a direction that you had stated a couple years ago.

But services mix has always been a bit of a leading indicator for large projects that you might have signed.

As this mix shifts in the stated direction, how should investors look at -- what should they look at as other leading indicators for new business you might have brought in?

Services engagements are still an indicator in the sense that we have heavier services involvement on the newer frontiers of our business, so that would be newer products, and newer geographies.

Of course, that's all blended in with the total services book, and our total portfolio of customers, so I appreciate the question of what else can you look to have a sense of how license sales might be going, and what could be anticipated for the future.

I think other very useful indicators are progress in countries, because one of the biggest gating factors for a non-US customer to buy our software is to feel comfortable that we meet their specific needs in Germany, and in the UK, and France, et cetera, and the single best thing that we can do to win more customers in a geography is to win some customers in the geography, so that's a very useful indicator.

I think the same applies to newer products and next quarter we'll be giving a more detailed profile of the new wins that we've had over the year for our newer products.

Obviously the more traction we have there, the same logic applies and we go up the adoption curve.

I think just generally the kind of confidence and the nature of the guidance that we deliver in every one of these calls is the other quantitative measure.

I think in aggregate, they should give a pretty declarative picture of how we feel about the future.

Thank you.

Then perhaps a follow-up on the previous question.

Your increased investments in sales and marketing, how are you targeting them in terms of certain geographies, certain product areas?

Right.

So consistent with what the answer I just gave you to your prior question, we're directing the investment towards those other frontiers of our business that we see more work to be done, and one of those is geographic expansion, primarily in Europe, where we made a lot of progress.

We had some really great wins this year, but we need a little bit of heavier coverage than we have right now.

So if you were to look at the territories of our average European rep compared to our average North American rep you would see they're really spread out over many more relationships or aspiring relationships, so we need a bit more coverage.

Then, as we bring new products to bear, there are more conversations to be had, more constituents at our prospects that we have to persuade, and so that takes more focus.

In some cases, especially with something like data management, and we anticipate more and more with analytics, we want to bring some domain expertise, it's very specific to those areas to bear as well.

That's where our investments in sales and marketing you'll see directed.

Thank you.

Our next question comes from Walter Pritchard with Citi.

Two questions.

One, Marcus on your end, with SI doing more of the go-live or I guess more of the implementation work, I understand you're still involved in a lot of those deals, can you talk about whether the go-lives have happened, have they happened faster or slower than when you've had primary involvement in that, and how are you tracking that, getting comfortable with that?

Appreciate the question.

First, an important clarification is that we really demand to be involved in all of our projects, not just some of them.

In some cases at a very modest level, at least by headcount but it's very important.

And it's precisely to ensure that all of the promises and expectations of the customer are being fulfilled.

I would not report any difference in project duration or in success rate, or anything of the sort, between us and our SI partners and that's a very important part of the pledge that we make to customers, that we stand behind our estimates jointly with our partners, arm in arm, and that we'll make them successful together, and own it equally.

We're not passing off any responsibility or accountability, but we're just bringing more resource to bear, and in some case more cost efficiently than we could do on our own.

Got it.

And then Karen, just on seasonality here, we understand you've been giving us guidance here for this year for quite a while, so we understand you have quite a bit of confidence in that.

Could you just help us understand though, as we look forward at seasonality, your business does appear to be getting more seasonal, especially weighted towards the fourth quarter.

And I'm wondering like it was 30% of the year in terms of license revenue in 2012 and then 40% of the year in 2013, and this year, it's looking like it's going to be above that, in the low 40s.

What's driving that and should we expect that trend to continue in terms of back end loading to the years?

Thanks, Walter.

That's absolutely right.

Our sales team has signed more contracts in the back half of the year than in any other time.

So the customer base of those annual invoice payments, which triggers the license revenue for us, there's a preponderance of them in the fourth quarter for the existing customers, and you can see that in the pattern that you've described.

And then historically, new business has come in much heavier in that back half of the year with it as well, particularly in the fourth quarter, and so it continues to just be a higher mountain range in each of the four periods.

So a good portion of that, of the revenue that's recognized in that fourth quarter is already booked in existing contracts.

So we should expect that becomes even more the case in 2015?

If history repeats itself, yes, that will be the case.

Thank you very much.

Tom Roderick with Stifel has our next question.

Marcus, my first question's for you.

You talked a little bit about the adoption of sort of non or modules beyond the core suite.

I'm interested in learning a little bit more about product demand or customer demand out there for some of the Millbrook assets you picked up a while back, and how customers are embracing and adopting data integration and analytics that you've built up around that acquisition.

Millbrook was a contributing asset to our data management offering, and it was a great accelerant to our own efforts in that space.

I think, if you were to ask anyone on the team here, we were really enthusiastic about the way that's gone.

As a matter of integrating the organization into Guidewire, that wasn't that challenging.

It was quite a small acquisition, they were only -- it was less than 25 employees.

But it really was -- it was a definitive, an important step for the Company to expand its footprint, into a very well-established and kind of high-IT spend domain for an insurer, which is aggregating their data into an operational store, often across many systems, and using that as an integration point to a lot of downstream systems, which is just a universal problem.

It's not one that we invented or brought any particularly novel approach to, but we think we can bring a lot of efficiency for those customers that have implemented our suite.

So in terms of demand, there's actually more than we can meet right now, would be the most forthright way to describe it.

There are a lot of customers who -- pretty much any customer who's implemented the suite has a set of needs there, and we want to be very judicious as we've always been in our history not to take on more than we can successfully implement and fulfill every promise to, and that's one of the motivations for us to step up investment in data management, because we see such evidence of demand, and have such -- have reasonably well-validated pricing now, even though it's an early product.

Great.

Thanks.

Second question, you've talked a lot about the Tier 1 pipeline for a while.

You've been openly enthusiastic about what that pipeline holds, and named a number of sort of Tier 1 international wins this quarter, or expansions with Tier 1 customers.

But as you look back in that pipeline, particularly some of the proof of concepts that might be getting closer to going live and becoming something more formal, how do you think about what that pipeline looks like, and should we expect to see some acceleration in these big deals in 2015?

That could happen.

But one nuance that we've always taken pains to underscore is that even if a Tier 1 Company chooses to license Guidewire, they may do it with only a fraction of their business.

In fact, that's the more likely move, that it will be some fraction of their business that they will commit to us to begin with.

That may be, as a matter of just implementation bandwidth, what they feel they can take on, or capital investment bandwidth, or it may be because they want to really validate that this is a platform worthy of serving their enterprise and that's a decision that a very large conservative organization likes to take in steps, as opposed to in one big leap, no matter how well validated our technology is from references and a lengthy evaluation cycle.

So I think we feel great about the number of those Tier 1 dialogues we're in, and I think we have more proof points than ever to validate that we're the right platform for them.

But just as a matter of buying preference, we still expect the majority, not necessarily the totality, but the majority of them will still choose to buy one application for one portion of their business, or a suite for a small portion of their business, and as it impacts our bookings and our revenue, that may be comparable to a bigger, more enterprise decision by a smaller, say, Tier 2 company.

And that's an important nuance to understand.

Great.

Karen, one last quick one from you.

I just want to make sure I understand the thinking on the gross margin discussion for next year.

You talk about that, you expect it to go up modestly.

Is that strictly a revenue mix shift issue?

In other words, as term license outpaces services, that will drive the entirety of the gross margin increase, or is there room for greater efficiencies, even within each of the lines?

It's mostly in mix shift.

As you notice, the gross margin -- that the services margin that we achieved this third quarter was pretty good, in excess of 20%.

So there's not a lot more to kind of squeeze out of those gross margins in services.

The big benefit to total gross margin will come from a higher mix of license and maintenance.

Great.

Perfect.

Thank you, guys.

Nice job.

Our next question comes from Sterling Auty with JPMorgan.

Two questions, guys.

First one, just want to make sure I understand.

If you look at the services revenue in the quarter, how would you say that it came in relative to your expectations, it came in a little bit better than we would have thought, and just wondering if there was anything in particular that drove that strength in services revenue?

It did come a little better than we thought.

And we start out every quarter with an estimate of how much project work is going to be completed, particularly with some of the larger engagements that we have.

And sometimes, the pace of work actually outpaces what our expectation was.

And so thus, we ended up with higher service revenue in the third quarter.

There was a little bit of a utilization uptick, I would say, relative to expectation and then it's also the case that sometimes our services are billable in a sales engagement, and sometimes they're not, depending on the dynamics of the sales cycle, and how much -- there's a lot of factors that can go into whether it's billable or not, and that's another element that's a little bit less predictable than the conventional services utilization, but it counts towards services revenue too.

Those are other factors.

What Marcus is alluding to there is most of our services revenues is related to time and materials billing.

There's a small proportion of things that sometimes are more billed based on milestones rather than the strict number of hours or billable days in that, and that can have some influence over the amount of billings, and therefore revenue in any one of the periods, but it's -- there's small fluctuations really between the quarters for that.

Right.

Okay.

On a separate question, maintenance revenue, I still think there's some confusion out there from people, in terms of how much of that maintenance revenue comes from perpetual license, what, if any, comes from term or the subscription contract, and how should we think about that trend going forward?

So both perpetual licenses and term license carry maintenance -- or post contract support maintenance contracts with them as well.

But as the -- both of them are roughly 20% of the license value.

But as the perpetual revenue has continued to come down over time, the amount of nominal maintenance revenue, most of the components of the maintenance revenue today is from term licenses, with very little left over from the old residual perpetual licenses of years gone by.

So the pace of maintenance revenue has definitely slowed, and part of it is the transition from perpetual to term as well.

One clarification, Sterling.

It's not that the maintenance revenue from existing perpetual relationships has gone away, it's just that it has declined as a percentage of total maintenance that we get, because most of the maintenance now comes from term licenses as opposed to perpetual.

That's correct.

It's 20%, just like it is for perpetual, there's no other difference, so we should see this hit a baseline and then grow in correlation to term license?

Absolutely.

All right.

Perfect.

Thank you, guys.

That does conclude today's question-and-answer session.

Mr. Marcus Ryu, I'd like to turn the call back to you for any additional or closing remarks.

No other remarks.

Thank you all for participating on our call, and good-bye.

Once again, that does conclude today's conference.

We appreciate your participation.