Guidewire Software Inc (GWRE) 2017 Q2 法說會逐字稿

Good day, and welcome to Guidewire's second-quarter FY17 financial results call.

Today's conference is being recorded.

At this time, I would like to turn the conference over to Mr. Richard Hart, Chief Financial Officer.

Please go ahead, sir.

Good afternoon, and welcome to Guidewire Software's earnings conference call for the second quarter of the FY17, which ended on January 31, 2017.

My name is Richard Hart.

I am the 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, both of which are available on the Investor Relations section of our website at IR.

Guidewire.com.

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

During the call we will make forward-looking statements pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, regarding trends, strategies, and anticipated performance of the business, including developments in connection with our recent acquisition activity.

These forward-looking statements are based on Management's current views and expectations as of today, and should not be relied upon as representing our views as of any subsequent date.

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

Actual results may differ materially.

Please refer to the risk factors in our most recent Form 10-K and 10-Qs filed with the SEC.

We will also refer to certain non-GAAP financial measures to provide additional information to investors.

A reconciliation of non-GAAP to GAAP measures is provided in our press release.

Reconciliations and additional data are also posted in the supplement on our website.

During the call we may offer incremental metrics to provide greater insight into the dynamics of our business.

These details may be one-time in nature, and we may or may not provide updates in the future.

With that, let me turn the call over to Marcus for his prepared remarks, and then I will provide details on second-quarter financial results and our outlook for the third quarter and the FY17.

Thanks, Richard.

We had a successful second quarter, based in our key measures.

We delivered financial results that were above the high-end of our guidance ranges, and we made substantial progress on our new products and strategic initiatives.

Total revenue in the second quarter was $115.6 million, and non-GAAP operating income was $28.4 million.

Total license revenue was $64.1 million.

Recurring-term license and maintenance revenue for the previous 12 months totaled $285 million, an increase of 20% from a year ago.

As always, we strove both to earn new customer wins and expand existing customer relationships.

In the second quarter we saw a strong cross-section of deals around the world.

Among them in North America, we expanded our relationship with California Casualty, a ClaimCenter customer who now licensed PolicyCenter, BillingCenter, Data Management, and Digital Portals for their enterprise.

We initiated a new relationship with the second largest AAA club, Auto Club Group, in Michigan, whose $2.2 billion insurance operation serves 8.5 million members in 11 states in the Midwest, and who licensed PolicyCenter, BillingCenter, Data Management, and Digital Portals.

Also, a US Tier 2 insurer selected ClaimCenter and our Data Management products for there entire book of personal and commercial lines, and NYSIR licensed all of InsuranceSuite to support their insuring half the school districts in New York with auto, property, liability and other insurance.

In Europe, we earned a mandate from $600 million insurance operations of Saga Services, a UK company serving 2.7 million members, aged 50 and older, to replace their legacy platforms with PolicyCenter, BillingCenter, and DataHub.

And alongside IBM, we also won our first customer in Austria, UNIQA, a multi-national insurer with EUR1.9 billion in premium.

UNIQA will be implementing PolicyCenter, ClaimCenter, DataHub, and Digital Portals for their Austrian business, as well as for multiple countries in Central and Eastern Europe.

Overall, we are witnessing noticeably stronger motivation in larger continental European insurers to invest in core system replacements and digital transformation, which we take as a validation of our investments in European sales and implementation personnel, as well as in country-specific product content.

Also validated, have been our investments in digital and data products.

We are seeing more core-system decisions motivated by, or accelerated by, the competitive necessity of virtually every insurer to create or enhance digital engagement with policyholders and agents.

During the quarter we added seven new Digital Portal customers, including Direct Line Group in the UK, the Co-operators in Canada, Self Insurance Corporation in Australia, and Seguros SURA Argentina, in addition to all the customers mentioned earlier.

Customers also continued to adopt our Data Management product, with six new customers.

The success of products we've brought to market more recently, supports our belief that there are other opportunities to deliver value to customers, including with new products we have acquired this year and are investing to integrate into InsuranceSuite and InsuranceNow.

For example, we are now in the process of embedding the scoring algorithms of Predictive Analytics directly into the user interface of both ClaimCenter and PolicyCenter.

We believe this will transform the appeal of Predictive Analytics, from a tool for insurance data scientists, into business solutions for adjustors and underwriters, who can now make machine-learning informed decisions, at key points in the claims and policy processes.

Analogously, we're integrating the product we acquired in the first-quarter, Underwriting Management, into PolicyCenter, creating a unified offering which we believe will drive greater adoption of both products.

It's also worth noting that this quarter we completed our first post-acquisition sale of Underwriting Management to the US subsidiary of Mitsui Sumitomo.

We also increased our addressable market through the acquisition of ISCS.

Guidewire and ISCS have much in common, including an exclusive focus on P&C primary insurers, our cultures, and headquarters based in the Bay Area.

This has eased the challenge of integrating the two organizations, a task we have undertaken with urgency since the close of the acquisition on February 16.

While we still have much work to do, we are excited by this combination and believe it represents a very worthwhile investment.

We have rebranded ISCS's offering as InsuranceNow, an all-in-one, cloud-based core platform for P&C insurers.

While we anticipate that the market for InsuranceNow will naturally align with the needs of Tier 4 and Tier 5 US insurers, ISCS's traditional market segments, we see opportunities to internationalize InsuranceNow, as well as offer it as an alternative to smaller or completely new divisions of large insurers, whose needs generally align with InsuranceSuite for their primary books of business.

Going forward, we believe that these two core offerings, InsuranceSuite and InsuranceNow, will broaden the foundation for our core-data and digital platform, and will span the preferences of insurers of all types and sizes, advancing our mission to provide a standard platform for the entire P&C industry.

Finally, it is worth noting that we anticipate that the digital Greenfield project will go live in April or May.

The delivery of InsuranceSuite in the cloud on a subscription basis with a large insurer, where Guidewire takes full responsibility for the solution and production, is a significant step toward redefining how we deliver our software.

We believe that we are at the outset of a transition in market preference, that will take some years to unfold.

And we intend to increase our investments in cloud-based products over the next several years, accordingly.

Is important to underscore though, however delivered, InsuranceSuite will continue to be the heart of our offerings.

We take very seriously the obligation to maintain a compelling roadmap of continuous innovation for all our current and new InsuranceSuite customers.

Indeed, a large majority of our research and development investments continue to be focused on enhancing our core transactional applications.

The efforts of our development team were recognized last month, when we won three awards from the industry research firm Celent, in their recent survey of P&C claim systems, in the areas of breadth of functionality, customer base, and depth of service.

This is a uniquely exciting time to be serving the global P&C industry, as both incumbents and would be disruptors are investing in technology to transform how insurance products are defined, priced, distributed, serviced, and fulfilled.

We are investing to advance our position as the technology company best situated to help shape this transformation.

I now turn the call over to Richard, to review our second-quarter results in more detail, and to provide our financial outlook for the third quarter and the year.

Thank you, Marcus.

As Marcus indicated, we exceeded our guidance for the second quarter, in both revenue and earnings.

Total revenue in the quarter was $115.6 million, up 13% from a year ago.

Within revenue, license and other revenue of $64.1 million, represented an increase of 20% from a year ago.

License and other revenue was more than $4 million above the high-end of our guidance range, primarily due to the closing of transactions that we had anticipated and planned to close in the third quarter.

You'll note that we are now referring to license and other revenues.

We have adopted this convention in anticipation of the subscription revenue from sales of our cloud-delivered solutions.

As of today, those amounts are too modest to note and report on separately.

Maintenance revenue of $16.6 million, was within our guidance range and increased 16% from a year ago.

Services revenue was $35 million, an increase of 1% from a year ago, and was slightly above our guidance range.

Turning to profitability, we will discuss these metrics on a non-GAAP basis, and we have provided the comparable GAAP metrics and the reconciliation of GAAP to non-GAAP measures in our earnings press release, issued today, with the primary difference being stock-based compensation expense and costs related to the amortization of intangible assets.

Non-GAAP gross profit in the second quarter was $81.3 million, an increase of 12% from a year ago, and representing a non-GAAP gross margin of 70.3%, a decrease from 71.2% in the year-ago quarter.

This decrease was primarily due to the lower services margins we anticipated would result from the deferral of services revenue associated with our digital Greenfield project.

Total non-GAAP operating expenses were $52.9 million in the second quarter, an increase of 10% compared to a year ago.

Non-GAAP operating income was $28.4 million, or over $10 million above the high-end of our guidance range, due to the combination of $4 million in license revenue upside, and lower-than-expected expenses, in part due to delayed project starts, slower than anticipated hiring, and lower than anticipated costs related to the acquisition of ISCS.

With non-GAAP operating income above expectations, non-GAAP net income of $20.6 million or $0.28 per diluted share was also above the top end of our guidance range.

Turning to our balance sheet, we ended the second quarter with $728.9 million in cash, cash equivalents, and investments, up from $686.2 million at the end of the first quarter, primarily due to operating cash inflow of $42.6 million in the quarter.

Year-to-date operating cash flow was $29.6 million, reflecting normal cash flow seasonality.

Note that cash balances at the end of the second quarter do not include the impact of approximately $160 million used to acquire ISCS, an acquisition that was completed early in the third quarter.

Total deferred revenue was $89.3 million at the end of the second quarter.

While deferred revenue has grown over historical norms as a result of the digital Greenfield project, we expect to begin recognizing such deferred amounts by the fourth quarter.

Deferred revenue in the second quarter associated with the digital Greenfield project was approximately $5 million of services deferred revenue.

As a reminder, our deferred revenue balance can vary significantly from quarter to quarter, and should not be relied upon as a meaningful indicator of business activity, since we typically bill term-license contracts annually, and recognize the full annual payment upon the due date, however, in the future, deferred revenue will be impacted by sales of InsuranceNow software and related services.

Such revenues will be deferred until project completion and then recognized ratably thereafter.

I would like to refresh and update the impact we expect from the acquisition of ISCS, which we announced on December 19, 2016, and we closed on February 16, 2017.

As you may recall, ISCS primarily licensed its all-in-one software suite on a perpetual basis, to maximize near-term cash receipts so that it can fund its growth.

However, it deferred such ratable revenues until project completion.

We noted upon announcement of the transaction that deferred amounts were approximately $35.6 million as of September 30, 2016.

According to ISCS's audited balance sheet as of December 31, 2016, that deferred balance had grown to $43.8 million, approximately two-thirds of which was deferred license revenue.

Due to the purchase accounting impact on acquired deferred revenue, substantially all of the amount will not be recognized in future periods by Guidewire.

In addition, while we intend to shift InsuranceNow towards a ratable subscription model, we anticipate having to defer revenue on new InsuranceNow sales until projects for the new sales or completed, which we expect that average to take about 12 to 15 months.

Following go live, associated revenues will be recognized ratably.

As a result of our need to defer revenues on new sales, as I've described, and the impact of purchase accounting on acquired deferred revenue, we expect to recognize no license revenue from ISCS for the remainder of this fiscal year.

In this fiscal year, revenue contribution will be limited to ISCS's implementation services revenue and revenue from existing cloud-hosted customers that are, or will be, live before the end of the fiscal year.

Currently, we anticipate that these services and hosting revenues, which will all be presented as service revenues, will total $14 million to $16 million, $1 million less than we had anticipated on announcement, as certain go-live dates have shifted incrementally.

Our updated guidance for the year reflects the effective cost of revenue and operating expenses for ISCS, now that the acquisition is completed.

We will be welcoming approximately 190 full-time employees from ISCS.

As a reminder ISCS had been operating at a loss in calendar 2016, as they had invested to scale their business through an essential increase in the size of their services organization.

In total, when combined with deferred recognition factors that I have described, ISCS is expected to dilute our operating income by approximately $11 million to $13 million in FY17, or 2.2% to 2.6% of revenue.

We anticipate that the acquisition of ISCS will also reduce the cash generated from operations by approximately $5 million to $10 million in FY17.

The difference between the transaction's effect on operating probability and cash flow is derived from the requirement that we defer revenues, as I've already noted.

Let me turn now to a detailed outlook for the full year our pre-ISCS business, in order to be more clearly communicate changes to our full-year outlook.

Let me speak to the full year so that you can more easily compare -- and let me then discuss changes in our full-year outlook first, and then we will discuss the third quarter.

We are increasing the mid-point of our license-revenue guidance for the full year to reflect our modestly increased visibility for activity in remainder of the year.

As we communicated on our first-quarter call, we expect FY17 to be characterized by historical patterns of sales seasonality, in which the fourth quarter represents a significant portion of new sales.

In fact, we anticipate that activity in Q4 will be even more pronounced this year than in the past.

As a result, we must be mindful in our guidance of the uncertainties attendant in any of our transactions because of the variability of structure, and therefore revenue recognition; the size of [in scope] direct-written premium that can influence the size of an initial license; and the timing of large complex transactions, which are sometimes difficult to predict.

In this year, the combination of deal volume in the fourth quarter, and the size and timing of certain large transactions that are still being negotiated, increases the difficulty of guiding for the year.

Nevertheless, we feel sufficiently confident to raise the lower-end of our license and services revenue guidance, in each case by $2 million.

With regard to maintenance, we are keeping the range unchanged, and we do not anticipate material maintenance revenue from ISCS for the remainder of the year.

We are increasing our guidance for operating income, again, not taking into account the losses associated with ISCS, by $4 million at the mid-point, as a result of savings in the first half, which will carry through for the remainder of the fiscal year.

We are raising our outlook on a pre-ISCS basis for free cash flow by $5 million, to $75 million to $90 million for the fiscal year.

When we combine our outlook with the effects of the ISCS transaction, we offer the following updated guidance.

We anticipate total revenue to be in the range of $491 million to $499 million, representing an increase of 16% to 18% over FY16.

Within revenue, we anticipate that license revenue will be in the range of $256 million to $262 million, an increase of 16% to 19% from FY16.

We expect maintenance revenue to be in the range of $66 million to $68 million, representing an increase of 10% to 13%.

And we expect services revenue to be in the range of $166 million to $172 million.

We expect non-GAAP operating income to be in the range of $70 million to $78 million, resulting in full-year non-GAAP operating margin of approximately 15% at the mid-point.

We also anticipate non-GAAP net income in the range of $50.1 million to $55.6 million, or $0.67 to $0.74 per diluted share, based on approximately 75.1 million diluted shares.

We anticipate a non-GAAP tax rate of approximately 31%, and an effective tax rate of approximately 26% for the full year.

Looking at cash flows, we are revising expectations to reflect the impact of costs associated with our ISCS transaction.

We now expect free cash flow between $70 million to $85 million, and operating cash flow of $78 million to $93 million, with anticipated capital expenditures of approximately $8 million.

Turning now to the third quarter, our outlook for the third quarter reflects the acceleration into Q2 of certain transactions.

It also reflects a conservative assessment of deal timing for several transactions that we now expect in Q4, that had originally been scheduled for Q3.

Some of these transactions, including the larger ones we've noted, may well end up being completed in accordance with our initial assessments on timing.

Nevertheless, while we don't anticipate this variability to impact our full-year results, our third-quarter outlook reflects greater than normal seasonality.

With that background, in the third quarter we anticipate total revenue to be in the range of $102 million to $106 million.

Within revenue, license revenue will be in the range of $43 million to $45 million, with a de minimis amount of perpetual license revenue for the quarter.

We anticipate maintenance revenue of $16 million to $17 million, and services revenue of $42 million to $45 million.

For the third quarter, we anticipate a non-GAAP operating loss of between $2 million and $6 million, and non-GAAP net loss of between $3.7 million and $1.2 million, or a loss of $0.02 to $0.05 per diluted share, based on approximately 74.3 million basic shares.

We anticipate an non-GAAP tax rate of approximately 39%, and an effective GAAP tax rate of 19% for the third quarter.

In summary, we had a strong second quarter that exceeded our guidance.

We are excited about our expanded capabilities from ISCS as we continue to execute towards our vision of enabling the P&C insurance industry to deliver advanced, engaging solutions for employees, agents, and policyholders.

Operators, you can now open the call for questions.

Thank you.

(Operator Instructions)

Sterling Auty, JPMorgan.

Hi.

This is [Nina Acosta], in for Sterling Auty.

Thanks for taking my questions.

I want to start by asking for an update on the Tier 1 pipeline.

Can you talk a little bit about the prospects for the second half?

Sorry, Nina.

I missed the adjective in front of pipeline.

Did you say the Q3 or Q2 pipeline?

I wasn't clear what you were asking.

I was just asking for an update for the second half on the pipeline and the prospects for Tier 1.

Okay, for the Tier 1 pipeline.

I see.

I would say that, that continues to strengthen, there are Tier 1 conversations that will be important for us this year, and next year.

That's pretty much always the case.

They are a very important part of the TAM, they're not the totality of our TAM.

And, some of variability that Richard was alluding to in his guidance remarks refers to a phenomenon that we've talked about on a multiple other calls, which is that, it is not only a matter of the specific timing and the certitude of closing a transaction with the larger Tier 1s, it is also a matter of deal structure and scope, for the initial transaction.

So these are some additional elements of variability that we always have to factor into our outlook and guidance.

And that is the case this year, especially since some of those transactions are likely to close in the fourth quarter.

Makes sense.

And then, just a follow-up.

For the Tier 4 and Tier 5 opportunities following the ISCS acquisition, how shall we think about that geographically?

Are you going to be focusing on any specific geographies?

Or do you expect to see any particular benefits?

Can you talk little bit about that?

Well, we're definitely focusing on the same geography that they've concentrated on, namely your Tier 4 and Tier 5 insurers in the US.

We have a longer-term ambition to internationalize their product, and then potentially take it to a different category of conversation, with very large insurers than they typically have been involved in.

But the bulk of sales activity that we anticipate for, I'm going to call it, the next 12 months, will definitely be to Tier 4 and Tier 5 insurers.

We think that we can bring the product to market pretty effectively, as it is today, with our substantially larger sales organization, as well as the other assets we have in terms of brand, and presence, and existing relationships, and so forth.

And we do have pretty strong ambitions for how many transactions we think we can get done over that next 12 months.

Now, the accounting associated with that is a bit more complicated, as you heard Richard describe.

Not only will the revenue be ratable in the long term, these are cloud-based subscriptions, but we have some things to demonstrate to our auditors with respect to DSOE, that will result in deferral of revenue for some time, even as we accumulate bookings.

Okay.

Thank you.

Kenneth Wong, Citi.

Hi, guys.

This is Rich Hilliker, sitting in for Ken.

Just a quick one on my end here.

I am wondering -- I know when you discuss guidance you talk about the down -- how ISCS brings it down.

Then you talked about some of the deals that are going to land in Q4.

But, I was wondering if there's any other moving pieces that you can help clarify, particularly around the lower margin and earnings guide?

Sure.

So, as we mentioned at the beginning of the year, the digital Greenfield project that we have undertaken, which requires us to defer all services revenue and direct services costs, had an impact of about 6% on services gross margin.

That impact is actually enhanced a little bit on the negative side, by lower services margins for Predictive Analytics and Underwriting Management, where we are maintaining a group of professionals in place as we try to build sales and improve utilization of those teams over time.

So that is one.

The other one is on -- what we said is that the impact of ISCS on the year is about 2.2% to 2.6%.

When you combine that with the impact of FirstBest, which we closed at the beginning of the year, which dilutes us about 1.5%, all told over the year, the impact on margins is about 5.5% to 6%.

Okay, great.

That's very helpful.

And then I guess, just a quick follow- here.

Can you give us little more color on any progress with the Greenfield project?

If there has been any changes in timing or magnitude?

Or if there is a chance it's coming sooner than expected?

Thank you so much.

Well, naturally, we're trying to drive the project forward -- or help drive the project forward, as quickly as possible.

But, I think we are going to be very satisfied to have it come in on time, which is definitely our current outlook on the program.

Whether it is exactly in April or May -- I think is still a little bit in question, but we feel -- and the customer feels highly confident, that we will achieve go live in (technical difficulties).

Great.

Thank you.

Justin Furby, William Blair and Company.

Hi.

Thanks, guys.

Congrats on a great quarter.

Marcus, I guess first, I was wondering if you could give an update, in terms of any changes you've noticed competitively, over the last quarter or two, particularly with Duck Creek in North America.

And then, I would love to draw into your comments around Europe and the bullishness there.

Do you think that is purely a market mentality shift?

Or also something maybe, competitively that is changing in your favor?

And any sort of update on Accenture and IBM, and how they are impacting things over there, would be very helpful.

So, a multi-part question, sorry.

No, I follow you, Justin.

So, on the first part of your question, about the overall competitive landscape, no material change from over the last quarter.

We always highlight Duck Creek as our primary -- or, our first and foremost, most important competitor globally, and that's the case, even though, really, the main geography was [counted on] here in the US.

And that has not changed, and they continue to be a formidable competitor that we take very seriously across a wide range of transactions, both with large insurers and smaller ones.

Now with respect to Europe, the enthusiasm, you may have heard in my remarks, comes really on the demand side.

The larger countries in continental Europe have been a few years later to the sense of urgency about digital transformation, than you would find in the US and Commonwealth countries; but it is now definitely there.

You see some of the indices of that urgency come from a new wave of Insure-tech investments in the [Docks] region, and multiple new attacker brands that have been emerging in the countries that they did not exist before, like France, like Germany, et cetera, and in the Nordics.

So that is all very welcome.

And I think we are pleased with the fact that we continue to believe in Europe, even through a few lean years, and kept steady, or even increased our investments on both the sales and the delivery side.

And now we have a team that is really much more utilized than ever on both counts.

We still have -- the transactions very challenging over there, because our credentials aren't quite as strong as they are here in North America.

But -- and there are also local requirements, that we have to demonstrate our worthiness to fulfill.

But, on the whole, we think we are really well situated, and that the competitive landscape there is at least as favorable over the long-term as it is here.

Got it.

And then, just Marcus, if you can hit on Accenture as a partner, and maybe, I think you mentioned IBM as helping in the deal in Europe in Q2.

Can you talk about what you are seeing from them in Europe and helping you guys win deals over there?

They are both partners in very good standing with us in Europe.

As we talked about before, we have more complex relationship with Accenture here in North America, but in Europe, and in Latin America for that matter, we are straightforwardly partners.

They are in our enablement program.

We go to market together, and we are engaged on projects together right now, and have a few early wins and go-lives under our belt together.

So, I think that relationship is doing quite well.

Nothing happens, it's not transformative overnight, but it definitely has been a positive and is delivering as hoped.

With IBM it has been a bit more opportunistic.

The UNIQA relationship is actually quite a meaningful win for us.

In Central and Eastern Europe, UNIQA is one of the largest, if not the largest, player focused on the region, and they are undergoing a huge transformation program across life and general insurance, really led by IBM.

And, it was a really great example of partnership to be part of that program, where really IBM was taking the lead on both sales and delivery responsibilities.

Got it.

Thanks.

And then just quickly for Richard.

A lot of moving pieces for the model.

It seems like cash flow is increasingly the best metric, at least over the next couple of years.

I'm just wondering, if you look at to FY18, do you think operating cash flow should outpace revenue growth?

Or what is the right framework for that looking out for 2018?

Thanks.

Yes.

So, if operating cash flow diverges from revenue, it is because we enter into transactions that we can bill and collect cash on, but we cannot recognize revenue.

So, for example, if we sell a license of ISCS, or now what we call InsuranceNow, we will no doubt collect both services and license billings, and therefore that will improve cash flow, but we will not see that effect on the P&L until we can start recognizing those revenues.

And so, the more of that kind of dynamic sneaks into FY18, the more operating cash flow should outpace revenue.

Got it.

Very helpful.

Thank you.

Thank you.

Tom Roderick, Stifel Nicolaus.

Hi guys.

Good afternoon.

Thanks for taking my question.

Marcus, now that you have had a few more months under your belt to assess and examine what you've gotten with ISCS, and you guys, certainly rebranding this looks like a good place to be going.

Can you talk a little bit about how some of your other clients, maybe Tier 2, and even Tier 1, are starting to assess what a cloud-based solution might look like for them?

I understand this has historically been a solution more embraced at the lower end of the market.

But you are rolling more and more out now from a cloud-basis.

So, just curious how the upper end of the market might be thinking about that, and when you might start to see a little more demand, or how they are thinking about it.

Thanks.

I appreciate the question, Tom.

It is an interesting one.

Overall, as I said in my remarks, we are very enthusiastic about the transaction.

You know our nature is not to be usually exuberant publicly, until we have demonstrable achievements.

And that is still ahead of us, but we are at work right now and engaged in as many conversations as possible.

As we mentioned, and as you noted, that's primarily with Tier 4 and Tier 5 insurers, where there is a very natural fit, lots reference, a very clear match in the offering and the requirements.

But what we are seeing, is that even with the very largest insurers, have, what are often Greenfield intentions.

Indeed, the digital Greenfield project we have is sort of an example of this, where they want to move very quickly in a different geography, or different line of business, or with a different branding strategy, or a different pricing strategy, and they may be starting with premiums, but they sense a growth opportunity.

For some of those, the attributes of the InsuranceNow value proposition might be a great match.

We have had enough discussions early on, and actually during the evaluation process for the transaction, that were suggestive of this, and we think there may be other cases where that is so.

What we don't think we are going to see, at least not for the next year or two, are examples of large insurers who want the full InsuranceNow proposition for their core book of business, right off the bat.

There are scalability considerations, and -- but more important than scalability, is their need, often for lots of configuration flexibility, in the offering, and the essence of the InsuranceNow proposition is that it's standardize.

You don't configure it very extensively at all, and you have a complete solution that gets live as quickly as possible, and at lowest possible long-term TCO.

I think down the road it is an inevitability, and you will see us investing accordingly, that more and more of the market, including the very high end, the very largest insurers will want more and more of the functionality delivered as a standard cloud-based service.

And that is definitely the long-term future and we are investing accordingly.

Wonderful.

Marcus, one more follow-up for you, just thinking about the digital Greenfield.

If I heard you right, it sounds like the timing for delivery of that product is at least on time, if not even ahead of where you guys had originally thought about it.

I am curious about -- I know you can't talk too much about what it is just yet, or who you are doing it for, but as you get this to market with the one particular customer, what is the opportunity as you look down the road one year, two years whatever it is, to sort of re-market, rebrand what you are doing there for other customers?

And when can you make them aware of that development?

We are active in the market right now.

I think we've made enough progress, and had committed ourselves in a sufficiently irreversible way, that we are starting other conversations, and we are receptive to other conversations, about similar projects with other, generally Tier 1, Tier 2 size insurers.

And I think that there may be other activity to announce over the coming months.

Nothing very specific, that I could be more specific about now, but it is thematically, not a one-off scenario.

There are other insurers who are thinking along similar lines, and for whom this kind of approach makes a lot of sense.

Now, there is a lot -- as we have always emphasized, there is a lot that we have to do as a Company to be prepared to execute.

It's not just a matter of responding to the demand.

We have had to develop some really new competencies, most importantly, the competency of managing a large-scale production environment, of a transactional core, entirely on our watch, as our responsibility.

And that is not something we have done through our history, and it's at least not for the core system.

And so, it is a big deal for us to build that competency, and we still have a lot to prove ahead, but we are committed to it, and have hired accordingly, and have set goals accordingly with that ambition.

Perfect.

Great detail.

Thank you, very much.

Nice job.

Ian Strgar, UBS.

Hey, guys.

Good afternoon.

If I could just tagalong onto the prior question.

Marcus, could you address the unit economics of that delivery model, relative to your traditional model?

And just how delivering more transactions under that structure, like the digital Greenfield project, where you are managing the post-production go live, can impact your long-term operating margin target of 28% to 30% over time?

Let me speak a little bit qualitatively to that, and then Rich should have some additional thoughts.

It is actually, quite a complicated question, that really, because there are a couple moving parts on there, on both the revenue and expense and the margin side, that really require people looking at a model together, to get the full -- get all the responses.

And we haven't proven this yet.

I think we have a hypotheses, based on what other cloud and hybrid offerings look like, that still have to play out in the market and our experience.

But broadly speaking, broad strokes, in terms of revenue capture, we are pretty confident that the pattern of something like 2x the recurring subscription revenue, per unit of customer premium, is I think, a very reasonable target.

Maybe more overtime, but we are taking in terms of a kind of 2x level there.

Now, of course that's at somewhat lower gross margin, because we have all the costs of delivering the solution, but there is every reason to expect that if you do that right, you can do it significantly more efficiently, and build up scale along that.

And we have, of course, modeled that out in our pricing proposals, and the like, and in fact, ISCS, their experience over the last few years is particularly instructive, because they have gone essentially entirely to a cloud-based delivery model.

And they have the economic experience to go along with that.

We've relied on that in our own modeling efforts.

As we mature the solution, so it becomes more and more cloud native, and more and more -- I should say less and less of the solution actually is delivered -- or I should say, more and more of the solution is a delivered just as a purely cloud-native service, then those economics continue to improve.

And, so, there is also an evolution in what the model looks like over time.

But, I think right off the bat, there is a customer expectation, or a customer willingness, to pay materially more per unit of revenue -- unit of premium, than they do on a traditional on-premise model.

Richard has a few other thoughts too.

Yes.

So, I think there are a couple of things that we still need to do a lot of discovery around, right?

And our modeling right now, has a number of questions that we have to fine-tune and become a little bit more [fassled] with, in terms of all the infrastructure costs, that we now have to absorb.

Having said that, I think that the way that investors should understand this, is that this represents a two, maybe a little bit more, in terms of revenues per DWP.

And the margin, at scale, for each customer and at scale for the operation, that we believe should be able to get to somewhere between 55% to 60%.

Now, of course, it competes with revenue, that right now is carrying closer to a 70% margin, for our business that has accrued over time, and that annuity business will continue to carry that kind of margin.

And it is very hard to try to determine what the impact of that blend will be over the next two to three years.

But that impact will be minimal.

And that impact should actually lessen over time, as the investments we are making today get amortized over more customers, both InsuranceNow customers, and potentially some additional InsuranceSuite customers, that might decide to consume our software like the customer that is part of the digital Greenfield project that we've initiated.

Okay.

Got it.

And secondly, if we are looking at roughly 21% operating margin this year normalized, if we take out all the dilutive M&A, and other dilutive items you guys are seeing -- Richard, I know you are not guiding -- you have not given any guidance for 2018.

But I am just wondering if you can update us on how quick you expect operating margins to kind of snap back in FY18, as you guys execute and work through some of the items that are impacting margins this year?

It is very hard for me, from this vantage point, to be in any way specific, but let me give you the trends that I think will drive changes in the gross margin and the operating margin.

The ISCS transaction will continue to be dilutive next year, because, unfortunately, we are still in a position next year where we can't recognize any revenue, and we are still absorbing the cost.

And, in fact, counterintuitively, the more success we have with that platform, the more cost we have to bear, and therefore the dilution is actually incrementally more significant.

What we have said in the past, is that we expect 2018 to also be around 2.5% diluted, and I think that that's a good number.

It might creep up a little bit, but not much.

At the same time, we think that the digital Greenfield project actually now comes back and snaps back a little bit, and improves gross margin for services, and not insignificantly.

And, the dilutive effects of First Best, we fully hope to be able to countermand in 2018.

Those are the drivers.

I can't speak right now as to what I am going to guide for operating margins next year, there is just too much between now and our budget planning, but I think but you should at least see, is about 2.5% of the current impact, should be vitiated over the course of the 12 to 15 months.

Thanks a lot, guys.

Thank you.

Jesse Hulsing, Goldman Sachs.

Thank you.

Marcus, you mentioned embedding Predictive Analytic capabilities into InsuranceSuite.

I am wondering, is that something that you think you are going to be able to charge your customers for?

And if so, relative to your data and digital products, how much of an uplift do you see both in the near-term and longer-term as you start delivering predictive capabilities?

Right.

So, you've grasped the central point here, which is that, our go-to market approach with Predictive Analytics is different.

I think we've benefited a lot from six to eight months of market activity.

Understanding how customers think about Predictive Analytics, how they think about our products, how they would like them to interact; and what has become clear to us, is that what they are seeking -- and will certainly be more rapid to adopt, is a business solution as opposed to a predictive analytics platform, as such.

It makes all the sense in the world for us therefore to, rather than selling a platform, a very sophisticated platform, selling it as a set of business solutions that are embedded directly in the process in question, where you are trying to make better machine-learning driven decisions.

And so, what we anticipate doing, is having a host of predictive-analytics-driven solutions, that can be turned on in both ClaimCenter and PolicyCenter, to start with.

Actually, we are starting with Claim, but PolicyCenter is very soon to follow.

Now, for 10 to 20 key categories of decisions that you are making in those processes, and then targeting, individually, for that solution.

And they range from things like fraud estimation, or segregation potential estimation, or total customer value estimation, each of which is its own independent business solution, each of which commands its own subscription price when you turn on the predictive analytics functionality.

It is premature to say how much we can capture overall.

We don't have, really, any pricing experience at this stage, but our hope is that a customer that really embraces the entirety of that, for either ClaimCenter or PolicyCenter, at least in terms of the value created, and a reasonable expectation for us, as a vendor, to capture some of value, would be something like, up to a third or a half of the price of the application itself -- the underlying application.

That is the ambition.

We don't have experience to back that up yet, but we think that the value created is supportive of that kind of pricing regime.

Got it.

That's helpful.

And Richard, we started to see some other companies in software provide some initial guidance on the impact of ASC 606.

I am wondering if you could give us your updated thoughts on how you are planning to adopt, and how that might impact your model?

Thank you.

So, what we have said, and what we continue to say is that because of our contracts extending for a significant term, and many of them extending past the transition point between the old and new model, we are in a position where, unless we remediate those contracts and enter into new contracts that actually terminate by our August 18 date, we are at risk of losing revenues to retained earnings.

That is, if I have a license that extends past that transition point, and I still have term-license revenues that I could recognize under the contract for years to come, under the new model, I would have had to have recognized those revenues at the outset, and therefore, there is nothing left for me to recognize post that transition.

So we have been doing, is we have a going back to our clients, and asking them to remediate their contracts with us to shorten their term, so that it is coterminous with our current revenue standard, and before the transition to the next revenue standard.

We had already started to shorten the term of our contracts.

So, it wasn't necessarily a shock to our customers.

And what we have been doing every quarter, is, monitoring where in that timeline we are in terms of our remediation efforts.

And we are ahead of schedule with regard to our goals in any particular quarter, with respect to how many contracts have been remediated, and how many contracts are still subject to remediation.

So, that is the operational side of things.

From a revenue side, what we expect will happen, is that post the transition when we are on a two-year, with one year automatic renewals you're not see a significant change for our heartbeat revenue, right?

You might see a slight increase in the seasonal nature of those revenues, simply because, following the transition, if I start with two year and then I go to one your automatic renewals, my first year I recognize two years worth of revenue, and the next year I don't recognize any and then following that, I will recognize on a heartbeat basis again.

And, if you actually look at what happens if you assume a seasonal pattern of bookings, that two-year initial booking will actually increase the seasonal impact of that bookings distribution.

Now, while we do get a benefit the first year after transition of that two-year booking model, there is no way we can avoid losing some of our revenue to retained earnings.

And when you look at the numbers, and when you look at all of our contracts, that's almost a wash.

So, one of the interesting things that I actually am looking forward to seeing, is what those two profit and loss statements will look like, side-by-side, which is what we will be reporting in the first fiscal year after the transition.

And those differences will likely be modest, but -- and it is hard to tell right now, how significant they will be.

But the model long-term -- when we look at the model long-term, we don't necessarily see a significant change in revenue growth rate if we are indeed successful at ameliorating the effects by remediating our contracts.

Does that make sense, Jesse?

Yes.

That is great detail.

Thank you.

Alex Zukin, Piper Jaffray.

Thanks guys.

Thanks for taking my question.

Marcus, first one's for you.

Are you seeing any change in your general customer's priority, where it is actually talking about doing the front-end digital transformation projects first, and putting the -- at the risk of putting the core-system transformation project, maybe on hold, or on the back burner, even though, at the end of the day the customer probably realize that you can't have one without the other?

I wouldn't put it quite that way Alex, but yes.

I think what we do see is, an emphasis, or a sense of urgency, around digital transformation, around activating the digital channel, or upgrading digital service, self-service, and omni-channel kind of capabilities.

And these are definitely much higher in the priority stack than they would have been a few years ago.

I think that we get very, very strong traction with our central thesis, which is that you cannot do that on the back of an ancient core-transactional system, because if the products are hard-coded, and the process is hard-coded, you cannot instantiate a highly flexible and contemporary digital customer experience, no matter how much work you do on the user interface and with mobile devices.

And I think that fundamental argument isn't a hard one to make, and indeed, most of the market already accepts that.

But in terms of the motivations for the program -- in terms of the business case, or the strategic drivers, they are very much digitally oriented and digitally focused.

And, I'd say, up till now, that has been a very positive catalyst for us because we have customers now that are leading us with a set of ambitions that they have in the future, as opposed to us having to evangelize the reason that they need to think deeply about the transformation of their environment.

Got it.

And then, with respect to the Tier 1 pipeline, is the uncertainty more calibrated towards the initial size of those transactions, or the timing of their closing?

I guess it reminds me of the last time that you guys had a spike in Tier 1 deals, all I think, in the fourth quarter where you were surprised by the volume of the deals, as well as the initial size of them.

Trying to get more color, is that the scenario that you are trying to prepare for?

That is right, broadly speaking.

One of the rocks in our backpack, that we have to carry, is that not only is the demand concentrated, especially at the upper end of the market, but that our growth ambitions require us to close a certain number of these major transactions.

That is inherently difficult, but that, in predicting the exact scope, structure, size of those transactions is a hard thing to do.

And it is not just a matter of prediction, it's a matter of negotiation, and we don't want to -- we never want to mortgage the long-term value of these customer relationships, in order to maximize a short-term financial outcome, or reportable outcome for ourselves.

That's an attention -- that is our job to manage.

I would say that we feel better than ever about our overall competitive position in these kind of discussions, given our scale, stature, size of the customer community, ability to deliver at these large complex programs.

I think we've are getting more and more differentiated by the quarter, but that does not make that negotiating task any easier, and especially as things, just as the state would have it, have kind of concentrated more around the fourth quarter of this year.

There is heightened risk and uncertainty there, with respect to the reported outcome.

Got it, and then if I could sneak in one more for Richard.

Richard, kind of piggybacking on the earlier questions around free cash flow and the headwind on operating margins, the move to the cloud deployment model.

I guess the question is, should we start putting a greater focus, particularly, maybe next year, on the free cash flow margin profile, as a better proxy for the longer-term profitability.

Because it does sound like you might have a perpetual, call it two to three-year headwind, if the cloud business takes off to a greater extent than what you are predicting.

So, I think that's a very good question, and it aligns with a number of questions we are considering internally, which I think will find their expression in our analyst day, when we are considering how to maybe revise the metrics that we judge our business on, as some of these new models take hold in our business.

Having said that, it is very difficult for me right now, to have any kind of view as to how fast that transition occurs, how significant it is with large companies versus small, and what the cash implications really are.

Having said all that, I do think that if you are looking at a model in which revenues need to be deferred more often, in more transactions, free cash flow and operating cash flow, and cash flow from operations become maybe a more important, or more meaningful metric to understand the health of the business.

And so, we will be taking more time and extentiating maybe some additional processes internally, so that we can actually give some formal guidance to cash flow next year, as opposed to just simply giving a perspective on what cash from operations should be.

Perfect.

Thank you guys.

Rishi Jaluria, JMP Securities.

Hey, guys.

Thanks for taking my questions.

Just two quick ones.

Richard, if I back out the services revenue guidance, there is a steeper ramp than normal from Q3 to Q4.

I want to make sure, is that upside beyond outside normal seasonality, primarily digital Greenfield revenue, with a little bit of contribution of hosting ISCS?

Or are there other factors baked into that guidance?

No, that is really it.

Those are by far the two biggest drivers.

One is, that we should now start recognizing some of the revenue that is being deferred to date, and it has been depressing services revenue over the course of the year.

And second of all, we do have this additional $14 million to $16 million of both hosted and implementation service revenue, which finds itself on the services line, and that is going to be causing the growth of that line.

Okay.

Got it and a follow-up.

Just thinking, now that ISCS is closed, and you have repackaged it and there is going to be a move towards Tier 4 and 5 customers, what is the best way for us, as investors, to be able to benchmark your success in getting into those new logos where you weren't before?

Well, we're always disclosed, to a very specific number about all the relationships that we form.

I think we should be in a position to announce most, if not all of them, as they happen.

And we will certainly, every year at analyst day, as we have in the past, update our market share penetration and pricing metrics, based on our experience.

The accounting is a complexity, at least for the next year or two, but I think on all of the other standard business metrics of win rate, price per unit premium, market penetration, share of wallet, et cetera, I think we can be very disclosed and specific.

Okay.

That is helpful.

Thank you, guys.

Thanks, Rishi.

And, with no further questions in the queue I would like to turn the conference back over to Mr. Marcus Ryu, for any additional or closing remarks.

No other comments.

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

Ladies and gentlemen that concludes today's conference call.

We thank you for your participation.