Guidewire Software Inc (GWRE) 2018 Q1 法說會逐字稿

Good day, and welcome to the Guidewire First Quarter Fiscal Year 2018 Conference Call.

Today's conference is being recorded.

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

Please go ahead, sir.

Good afternoon, and welcome to Guidewire Software's earnings conference call for the first quarter of fiscal year 2018, which ended on October 31, 2017.

My name is Richard Hart.

I'm 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 this 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 and actual results may differ materially.

Please refer to the Risk Factors in our most recent Form 10-K and 10-Q 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 a supplement on our IR website.

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

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

With that, let me turn over the call over to Marcus for his prepared remarks, then I will provide details on our first quarter results and our outlook for Q2 and the rest of fiscal '18.

Thank you, Richard.

As anticipated by our announcement earlier in the month, first quarter revenue of $108.2 million was above our guidance range, moderately exceeding expectations on all revenue lines.

That upside carried through to the bottom line and narrowed our non-GAAP net loss to $4.8 million.

Q1 was a significant quarter for Guidewire.

We completed the next unified release of Guidewire InsurancePlatform, which introduced numerous enhancements to our complete product set.

We unveiled several new cloud-based products and announced a strategic partnership with Salesforce.

We also won a second mandate for InsuranceSuite cloud to be deployed and wholly managed by Guidewire in the cloud, and we made significant progress at developing our InsuranceNow business with both new sales and customer [go-lives].

Just after the end of the quarter, we closed our largest acquisition to date mainly for the next-generation risk analytics [company], Cyence.

And we recently held our Connections user conference, which grew by 25% in attendance and refreshed our perspective of our markets' priorities.

This is a time of rapid change for both Guidewire and our end market.

And in this call, I'd like to elaborate on the most important of these trends to offer context in the moving parts of our business that impact our guidance for the fiscal year.

The dynamic most visible in our results in our current sales efforts is the pace at which the P&C insurance industry appears to be moving toward cloud-based solutions.

In addition to interest for our cloud-only offerings such as InsuranceNow, Underwriting Management and Predictive Analytics, we see a growing proportion of our prospects considering both cloud and on-premises option for InsuranceSuite.

This leads us to increase the estimate we shared last quarter of 20% to 30% of new sales coming in subscription form this year to a range of 30% to 40%.

Our first quarter reflects this transition with the substantial majority of sales from cloud-based solutions.

Indeed, our second InsuranceSuite cloud transaction also illustrates how current customers may participate in this transition.

This customer, whose name we cannot share at this stage in their project, had already licensed ClaimCenter but revised their approach prior to implementation and opted for a Guidewire cloud-based arrangement instead.

As a result, we were able to consummate the transaction and provision the software more rapidly than we would otherwise expect for a cloud transaction, contributing modestly to our outperformance in Q1.

The appetite for cloud-based delivery and the accompanying willingness to further standardize implementations are quite positive in the long term.

They will drive more rapid upgrade cycles, reduce customer TCO, improve our understanding of how customers use our products and speed the development and adoption of new Guidewire offerings.

Moreover, we continue to expect that InsuranceSuite cloud arrangements will increase the economic value of the Guidewire, of the customer relationship, by 2x or more versus our current on-premises model, albeit at a somewhat lower gross margin.

There are 2 adverse impacts on our reportable results however.

First, an increasing proportion of our license revenue come in (inaudible) form will negatively impact our license revenue growth this year.

Second, the prospective customers evaluating cloud-based and on-premises delivery option may increase the complexity and duration of sales processes in the near term, which could offer us less time to recognize new ratable revenue streams in the current year.

These considerations, combined with an anticipated decline in perpetual licenses, have led us to reduce our license and other revenue outlook for the year.

At the same time, and for related reasons, we expect services revenue to accelerate in the near term.

As we've noted previously, InsuranceNow implementations are led by Guidewire, augmented by subcontractors.

And we are in the early stages of developing an SI ecosystem for that product.

Similarly, our goal for InsuranceSuite cloud is to have our SI partners responsible for significant portions of implementations in the future.

But for these critical early projects, we believe much heavier Guidewire involvement is necessary to minimize risk.

Heavier Guidewire involvement is also motivated by the robust demand we are seeing in Continental Europe, which has become meaningfully more active for us over the previous 4 quarters.

Our experience is that European insurers expect Guidewire to bring experts with local language skills and that they often prefer to have key software vendors lead their implementations to the degree that we may agree to act in a prime capacity in select strategic cases.

Because of this increasing European demand and the overall transition of our markets' preferences, we believe it is important to avoid gating new sales wins with capacity constraints and delivery.

Consequently, in the near term, we will experience an outsized growth in services revenue as we continue to hire aggressively to ensure that we can service the new core system mandates we win.

These adjustments in our resourcing strategy are part of a larger evolution for the company that we highlighted at our recent user conference, Connections, a shift toward shouldering more complexity and risk on behalf of our customers and the global P&C industry overall.

We believe that insurers are seeking this transfer to a proven partner in order to redirect focus on transformation initiatives.

Catalyzed in part by the surge in insurtech investment over the last several years, P&C insurers are responding to new competitive (inaudible) for digital transformation of the distribution in service and the leverage of new data sources and machine learning [to align] operational insights, to automate underwriting and claims decisions and to grow by creating new insurance products to address emerging risks such as cyber.

In addition to cloud-based delivery of the core, we are also well positioned to serve these data and digital initiatives after the investments we have made.

And this year, we are accelerating in product expansion.

We are now sharpening the use of our organically developed digital products, which have enjoyed rapid adoption on their own, into a focused offering to support the drive of insurers for digitally distributed small commercial insurance, which we call DSBs.

We are also integrating our digital portfolio with Salesforce's Financial Services Cloud to provide a unified digital front office for captive agents and customer service reps.

We are integrating our predictive analytics capabilities into InsuranceSuite to support decisions at key points in the insurance life cycle, enabling [things we call] a smart core, and we are evolving our BI solution into a new cloud-based offering called Live Analytics, which provides near real-time data visualization and operational insights.

We are confident that the significant investments we have made to introduce these new products, aligned as they are, with the increasingly [future] focused priorities of our customers, will become engines for future growth, even though they are contributing only modestly to revenue today.

Our investments continue to gain us industry recognition.

We were doubly pleased that this year Gartner rated InsuranceSuite as a category leader and placed InsuranceNow in the challenger quadrant of their Magic Quadrant for P&C core platforms, the inaugural year for this category.

Finally, we fully welcomed our colleagues from Cyence on November 1. Cyence's Internet scale data listening platform and its machine learning powered risk analytics will enable insurers to grow by underwriting new categories of risks for which actuarial data is not available or is incomplete.

Longer term, we see a unique opportunity to integrate Cyence's external data with the internal data gathered in real time by Live Analytics and to provide insurers the full life cycle from product design to transactional management of these new insurance products.

We were fortunate to retain the employees of Cyence and Arvind Parthasarathi, its Founder and CEO.

And he will continue to serve as the Head of Cyence risk analytics.

Arvind's Connections keynote is available on our Investor Relations website, ir.guidewire.com, and it explains Cyence's unique value proposition.

In addition to Arvind joining my core team, I want to comment on previously announced organizational changes.

I thank Scott Roza for his service to Guidewire since 2013 as he leaves for another opportunity at the end of the calendar year.

I was pleased to be able to (inaudible) 2 12-year Guidewire veterans: Steve Sherry, who is already responsible for worldwide sales and now reports to me; and Eileen Maier, who assumes Scott's title of Chief Business Officer and heads our product line business strategy, presales, product marketing and value consulting teams.

Recognizing the importance of the cloud to our growth ambition, we also named 14-year Guidewire veteran, Alex Naddaff, as Chief Cloud Officer, adding to his current title of Chief Customer Officer.

It is my great privilege to work with such a capable and long-tenured leadership team at Guidewire, and I believe that we're well equipped to extend our collective success.

With that, I'll turn it over to Richard to detail the financial results of our first quarter and update our view for the fiscal year.

Thank you, Marcus.

As Marcus indicated, we've exceeded our revenue and earnings guidance for the first quarter.

Total revenue in the first quarter was $108.2 million, an increase of 15% from a year ago.

Within revenue, license and other revenue decreased by 22% from a year ago to $30.1 million.

As we previously noted, any sequential quarterly comparison has taken into account the $6.1 million which was recognized in the fourth quarter due to the early receipt of customer payments.

I also note that the first quarter fiscal 2017 featured a significant perpetual license amount, while this quarter was marked by a substantial majority of sales coming in as subscriptions.

Adjusting for these factors, license and other revenue would have grown year-over-year.

Maintenance revenue was $18.9 million in the first quarter, a 15% increase from a year ago.

As a reminder, maintenance services are included as part of subscriptions.

And as a result, increases in subscription sales as a percentage of total sales will reduce maintenance revenue growth in the future.

Our rolling 4-quarter recurring revenue comprising of recurring license and maintenance revenue totaled $324 million in the first quarter of fiscal 2018, up 19% from a year ago even as its sequential growth was negatively impacted by the shifts in deal mix, which characterized the first quarter of 2018.

The shift in mix from licenses that are recognized upfront on an annual basis to subscriptions that are recognized ratably will reduce the growth rate calculated by this metric while the shift is underway.

Services revenue was $59.1 million, a 52% increase from a year ago and was above our guidance, primarily due to the higher-than-expected services revenue from InsuranceNow implementations.

Turning to profitability.

We will discuss these metrics on a non-GAAP basis, and we have provided the comparable GAAP metrics and a reconciliation of GAAP to non-GAAP measures in our earnings press release issued today, with the primary difference being stock-based compensation expenses.

Non-GAAP gross profit in the first quarter was $55 million compared to $58.3 million a year ago.

This represented a non-GAAP gross margin in the quarter of 50.9% compared to 62% a year ago due to the higher mix of lower-margin services revenues and the decrease in license and other margin due to our investments in our cloud operations.

Total non-GAAP operating expenses were $63.3 million in the first quarter, an increase of 11% compared to a year ago.

This resulted in a non-GAAP operating loss of $8.3 million, which was better than our guidance range primarily due to higher-than-anticipated revenue, and the non-GAAP net loss of $4.8 million or $0.06 per basic and diluted share compared to our non-GAAP net income of $1.1 million a year ago.

Turning to our balance sheet.

We ended the quarter with $653 million in cash, cash equivalents and investments, down from $687.8 million at the end of the fourth quarter.

Operating cash outflow in the first quarter was $31.2 million, primarily due to the seasonal use of cash for bonus payments in the first quarter.

Cash balances do not reflect the impact of our Cyence acquisition, which closed on November 1 after the end of our first quarter.

Total consideration net of cash for Cyence was $265 million, consisting of net cash of approximately $130 million as well as 1.6 million of newly issued shares of Guidewire common stock and options.

The impact of this acquisition will appear in our second quarter and fiscal year financial results.

Total deferred revenue remained at $111.2 million at the end of the first quarter compared to the end of the fourth quarter.

As a reminder, our deferred revenue balance can vary widely from quarter-to-quarter and has not been 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 may continue to be variable but may increase as we sustain higher levels of our percentage of subscription-based sales which, as you know, we recognize ratably.

Now I'd like to turn to our updated outlook.

For clarity of presentation, I'll first detail our revised outlook for Guidewire standalone and then combine that outlook with our view of Cyence's contribution to our revenue and to operating income.

Today, we are modestly increasing our standalone total revenue outlook for the year from $611.5 million to $623.5 million up to $631 million to $641 million.

For reasons Marcus elaborated, we are anticipating a greater percentage of orders to be subscriptions, leading us to moderate our license revenue outlook and increase our services revenue estimates for the year.

This revision is atypical for us and underscores the uncertainty we face in estimating the pace of adoption of our cloud-based solutions.

Our revised fiscal year outlook for license and other revenue now incorporates a 10% increase in the percentage of subscription orders, rising -- raising prior expectations of 20% to 30% to 30% to 40% of software sales.

Term and perpetual licenses are expected to decline as a result, with perpetual licenses declining to approximately half of last year's $13.1 million and well below the 5% of total revenue, which perpetual licenses had represented in the last 3 fiscal years.

We are monitoring 2 other dynamics that have emerged as market sentiment has evolved.

First, as Marcus mentioned, we are experiencing an elongation of certain sales cycles where customers are considering both cloud-based and on-premise deployment solutions.

This is driving a more backend-weighted year and may extend a few purchasing decisions into our next fiscal year.

Second, sales of the newer offerings, which Marcus itemized, could lead to a deferral of revenue if those offerings are combined with existing products.

In these situations, we will defer revenues until product delivery requirements have been met.

As a result of these factors, we are revising our license and other revenue to $292 million to $302 million, representing a decline of approximately $7 million at the midpoint of the range.

Together with the anticipated contribution of $9 million to $11 million of Cyence subscription revenues, we've reaffirmed -- which we reaffirm, we anticipate license and other revenue of $302 million to $312 million, an increase of 11% to 15% from fiscal 2017 on a reported basis and 16% to 20% after excluding the effect of the $6.1 million in early payments in the fourth quarter of fiscal 2017.

Conversely, we now anticipate higher services revenue for the year for 2 primary reasons: first, the combination of aggressive hiring and an expansive use of subcontractors to remediate capacity constraints in our InsuranceNow implementations; second, our intention to lead InsuranceSuite cloud implementations in the near term to ensure the effective transition of newly implemented systems to Guidewire production services.

We believe that after several InsuranceSuite cloud implementations, we will be better positioned to leverage our SI partners as we currently do in our on-premises business.

The resulting increases in the number of InsuranceSuite cloud subscriptions will likely result in higher service revenue estimates for the fiscal year.

Consequently, we are increasing our outlook for services revenues from $235 million to $245 million to $250 million to $260 million, representing a $15 million increase at the midpoint of the range.

We are mindful that this services revenue increase is not [consummate] with past expressions of our target revenue model.

Nevertheless, we believe this hands-on approach is necessary to manage this transition effectively, and we intend to reduce services revenue growth as we leverage our SI partners as I described.

We expect maintenance revenue to remain in the range of $73 million to $75 million, representing an increase of 6% to 9% from a year ago.

I again note that customers that subscribe to our cloud services obtain maintenance support as part of their subscription and no separate amounts are recognized as maintenance revenue.

Therefore, for fiscal year 2018, we now anticipate total revenue, including Cyence, to be in the range of $631 million to $641 million, representing an increase of 23% to 25% over fiscal 2017.

Turning to expenses and profitability.

As we noted at our Analyst Day in September, fiscal 2018 will be one of increased, but necessary, investments as we lay the foundation for future growth.

We intend to return to our more historical pace of expense growth starting in fiscal 2019.

Our hiring this year is focused primarily on research, development and services with tactical additions to sales to help grow our broader array of products, including Cyence, and to capitalize on European demand.

This year, we felt a greater sense of urgency in meeting our hiring goals and increased our recruiting efforts.

And as a result, unlike in past years, we have met our hiring goals for the first quarter and expect to meet our targets again in the second quarter.

We also expect to experience an increase in G&A this year in order to scale our business to meet new revenue standards and accommodate the increasing breadth of products and variety of go-to-market models that we are deploying.

Our operational teams in finance, IT, HR and sales implemented a new ERP system and a new configured price quote system in the quarter.

Our upgraded planning software application will be delivered in December.

And the implementation of a new ASC 606-compliant revenue module will be completed in February.

We estimate that these investments, which will not regularly recur, will cost approximately $8 million to $9 million over the year, all of which will be expensed.

Even with these additional expenses and gross profit compression, we are maintaining our standalone non-GAAP operating income expectations.

When we announced Cyence, we indicated that costs and assumed operating loss associated with that acquisition would dilute operating margin by approximately 3 percentage points.

We are confirming that to you today as we expect total transaction costs of approximately $5 million and anticipate operating losses in the fiscal year of $12 million to $13 million.

Including this impact, we anticipate non-GAAP net income in fiscal 2018 to range from approximately $90 million to $100 million or $0.82 to $0.90 per diluted shares (Sic-see press release "non-gaap operating income in fiscal 2018 to range from approximately $90 million to $100 million and non-gaap net income to range from $0.82 to $0.90 per diluted share") based on approximately 77.5 million diluted shares.

We are raising our free cash flow guidance for the year from $94 million to $106 million to $105 million to $115 million.

This revised range includes an anticipated use of cash by our newly acquired Cyence business unit, which we currently estimate to be $15 million to $20 million for the year and which was not included in our previous forecast.

For the second quarter of fiscal 2018, we anticipate total revenue to be in the range of $152 million to $156 million.

Within revenue, we expect license revenue to be in the range of $76 million to $78 million, with growth challenged by faster-than-anticipated shift to subscription licenses even in the second quarter.

We anticipate maintenance revenue of $18 million to $19 million and services revenue of $57.5 million to $59.5 million.

For the second quarter, we anticipate a non-GAAP operating income of between $18 million to $22 million and a non-GAAP net income of between $13.2 million to $15.8 million or $0.17 to $0.21 per share based on approximately 77.2 million diluted shares.

In summary, we're excited by the dynamic changes in our industry, by the opportunities that those changes are catalyzing and by our expanded lineup of software and services, which we hope to drive -- will continue to drive our industry forward.

Operator, we can now open the call for questions.

(Operator Instructions) And we'll take our first question from Justin Furby with William Blair & Company.

This is actually Vinay on for Justin Furby.

The first one, either for Marcus or Richard, with another quarter under the belt, I just wanted to kind of confirm, are you still seeing that 2x uplift from moving to the cloud?

And then I just want to confirm, is that a comparison of, in the old world, term plus maintenance versus subscription today?

Yes, thanks, Vinay, for the question.

It's still very early days, but we have the same reasons for confidence, I think, that we've had throughout that there will be significantly greater economic value for Guidewire in these arrangements and that customers will be enthusiastic, I think, to pay that additional amount to us because not only is our cost transferred but there is an absolute reduction in risk and complexity for them.

So something like 2x or even a bit higher than that is what we use in our internal modeling, and it's also the basis for the commercial discussions that we're having with a variety of different insurers right now.

But it is still early days.

And today, we just talked about only our second arrangement under this new form for InsuranceSuite, so we'll continue to update you as we have more experience on that count.

And to confirm, it does include both the license and maintenance numbers of our on-premises sales.

Got you.

Services are not in that, correct, just to be sure?

No, not at all.

Not at all.

Got it.

And then, Marcus, just following up, you mentioned Europe.

Could you just talk a little bit about the pipeline that you're seeing in Europe?

And then maybe add some color on the mix of cloud versus traditional license deals in that region and then perhaps how Accenture is sort of helping in that at all.

Sure.

I think the most striking thing about what's happening in Europe is that we have sales activity in a number of geographies that had been pretty dormant for us despite years of trying that have now gotten to be quite active.

These are the major countries in Continental Europe like Spain and France and Germany.

And that's -- we can't take the credit for that, of course.

I think there are dynamics in each of those markets, including the rise of a couple local insurtech industry in each of these countries on its own that has helped catalyze some of the demand.

So it's been very encouraging to be able to pursue a whole new set of opportunities, including with some of the major insurers in those geos as well as in the Nordics and parts of Central Europe as well.

Accenture has, as you know, has been allied with us outside of North America.

And I would describe the relationship as helpful but not transformative so far in those efforts.

It's always good to have more systems integrator options and partners in helping insurers make these major capital investments.

I think you also had one other dimension to your question...

Cloud versus...

Cloud, yes.

A bit to our surprise, I would say that, that deliberation has pretty much the same character all around the world.

And I would include even Asia Pac in that statement that insurers really everywhere are looking for the same things, namely a transfer of risk and complexity and acceleration of the kind of transformation initiatives in data and digital that we've been talking about.

We'll take our next question from Monika Garg with KeyBanc.

So Cyence was supposed to add about $10 million, and all of that revenue would have gone into license line.

So now that you're reducing license by almost $10 million, so is that -- all of that reduction is to the move to subscriptions?

So yes.

So what we've said, Monika, is that we've reduced license and other by about $7 million in the midpoint.

And a significant part of that is the mix and the type of deal that we're seeing in our pipeline and also the fact that we're seeing them push a little bit later in the fiscal year as these sales cycles take a little bit longer to conclude.

And if you recall, when we first started talking about the effects of this transition on our P&L, we suggested that every additional 10% of subscription revenue percentage would decline license growth by about 1 point, 1.5 points, and the same kind of impact for every quarter of delay we see for the average yield hitting the fiscal year that is subscription because we simply have less time to take on those ratable revenues.

The other very significant element, to be fair, is the reduction of perpetual licenses by about a half.

I mean, one of the things that a lot of these conversations are doing are actually pushing out some of the perpetual demand that we sometimes have to fight against in our sales process.

And so we think that those perpetual numbers are going to be half, and that also has an impact on our planning and our year.

Got it.

So if I include Cyence and the negative impact of moving to subscription, you're increasing your total revenue by some $15-ish million.

So is all of that as people are coming for more cloud implementations and that's why your service revenue is going up?

So yes.

So service revenue is going up for 2 reasons.

One is that, right, we're anticipating that we need more InsuranceSuite service representation on our engagements simply because if they come in as an InsuranceSuite cloud engagement, it will actually be a significant increase in the per engagement service revenue that we would generate, right, almost in order of magnitude.

But the big influencer, especially in the beginning of the year, is really a reassessment of the InsuranceNow customer base, their needs and our ability to actually staff the services professionals that will help them get to their finish line on time and on budget.

Got it.

Just the last one for housekeeping, just to understand the model transition, as you move the customers to cloud, you can get 2x to 2.5x higher revenue.

That will all go to the license line, and the service revenue, the implementation cost or implementation revenue will go into service line.

Is that a right understanding?

That's right.

We'll take our next question from Nandan Amladi with Deutsche Bank.

So Marcus, with this groundswell of cloud projects coming your way, how ready do you feel to be able to execute it against your opportunity, particularly on the hiring and training front as you bring more services people on?

I think that's a thoughtful question, Nandan, it's something that we have a lot of discussion about as a management team.

I think we're enthusiastic for this change.

It's one that we have been discussing for years and anticipating.

Of course, it's always hard to calibrate exactly the pace at which these changes come, and we had to make some guesses.

It's also quite sensitive to any individual relationship, a single major cloud relationship with a big Tier 2 or a Tier 1 insurer has a really meaningful impact on the services requirements from Guidewire, so there's a lot to try to forecast and calibrate in making our resource plan.

And what you heard from us in the prepared remarks was a determination not to have new sales gated by not being able to service them and to really err on the side of extra capacity, if anything, to ensure that we can meet the demand for the cloud deployments as well as some of the additional demand that we talked about in Europe.

So I'd say that we are -- we're ready and enthusiastic, but part of this journey has also been learning new skills in cloud production services, in cloud-based security, many other things as well.

We've been able to develop those skills in tandem with a strategic customer, MetLife, that we talked about quite a bit on these calls, and that's been super helpful.

But we think we'll be tested again as we take on the next wave of customers, which we expect just to continue to grow into the future.

And a follow-up for Richard, if I might.

With all of these moving parts, any view on what the new sort of leading indicators might be in terms of metrics or some additional metrics that you might be able to provide us that help that visibility?

Well, I think a couple of things, right?

We introduced a couple of new metrics in our Analyst Day, and we'd like to let those season a little bit and settle in.

And I will say that one of the things that we are really focused right now on as opposed to figuring out what the new metrics will be that can best describe our business is really trying to understand how the business is shaping up.

The fact that after setting our guidance for the fiscal year, we've had to shift both license and services lines which, for us, is a very significant change should indicate how much the variability of these lines may continue to impact our forecasting for the next year.

I would keep an eye out on the services line.

I think there is a chance for that services line to grow a little bit more as the year moves on.

I think we feel very comfortable that we've reset the shape of the license line now at least for the next couple of quarters.

We'll go for our next question to Sterling Auty with JPMorgan.

So Richard, I hate to do this to you, but I had the same question around metric.

Is there a thought to maybe giving us ARR or the number of cloud or subscription customers just so we have something that we can tick off to see the growth or the health in the business side.

It's going to be a while.

This is, I think, a little bit more of a unique subscription transition than the 14 or 15 others that I've seen over the last 10, 12 years.

So obviously, I don't want to necessarily say anything that The Street or you will want me to update over time because, obviously, this would not be a considered metric, but let me just give you a framing for what is driving some of our considerations.

So we had begun the year thinking that there would be kind of 2 new InsuranceSuite cloud customers.

That's what we were thinking.

I think as we look at the year now, that number has crept up to 4 and may go a little bit higher still.

Now the one thing that is a little bit of a challenge for us is that a lot of these discussions are at very early stages.

And so we have to try to intuit from what our customers are telling us of their priorities which way they may lean, and it's almost as if you're probability weighting the pipeline between cloud and on-prem, and that is how we're kind of generating some of our new figures.

With the InsuranceNow customers, I think we pretty much started from a standing start, the company had done very well at selling 3 or 4 transactions that they've been working on for a while before we acquired them, and so the pipeline which was still pretty good really required rebuilding, and we've done a very good job at that.

And I think now as we kind of come into the second quarter, I think we feel much more comfortable that we can double the InsuranceNow business in terms of number of customers from what they were able to do in our first year stewarding this group with the help of the former founder, Andy Scurto, and his chief engineer, Doug Moore.

And those are the 2 kind of significant numbers that will kind of really pivot our P&L around the service and license line going forward.

That makes sense.

And then just is there any -- Marcus, as you look at the types of customers that you're having conversations around InsuranceSuite and the cloud in particular, is there any commonality to them in terms of the type of P&C carrier or which insurance lines are looking to move first or anything else that you can really trend line?

Well, there's certainly a commonality in the motivation which we talked about, mainly risk and complexity transfer and a greater confidence in the stability and the inevitability of using public infrastructure and having major core business applications deliver the services.

So that's getting to be more and more universal across the industry.

And so we are having conversations with both current and prospective customers across really all of our -- all of the applications in InsuranceSuite along those kinds of themes.

Now as for the ones that will actually move forward, I think it is more likely that smaller insurers, they generally have fewer inhibitions about making that transition, but we are having these conversations also with very large and even Tier 1 insurers as well.

I just think that they tend to have a longer list of reservations that they have to get over institutionally before they can make the big decision, but I think the motivations are really the same.

So we expect to see it across all segments, all peers of our market, so more rapidly at the lower end, the smaller end I should say, and that's, in fact, what you [see] with InsuranceNow which, of course, is only (inaudible)

We'll go now to Ken Wong with Citigroup.

Marcus, you mentioned earlier about elongation of sales cycles.

Is that just purely due to, as you just mentioned, kind of institutional reservation?

Is it the kind of the cloud -- the actual concerns around cloud?

Is it pricing?

Any thoughts there?

And then you also mentioned being able to accelerate the deployment of a deal in this quarter that went cloud going from traditional ClaimCenter.

I guess, should we expect that those 2 kind of offset each other, kind of longer sales cycles, shorter deployment cycles?

I appreciate the question.

So to the first part about what could drive the potential elongation, I think it's not so much reservations as it is the need to evaluate 2 different options and contrast them side by side to consider what would it mean to deploy this in our conventional data center or what it means to have Guidewire take on full responsibility.

So it's almost -- it's not quite twice the set of questions, but it's a considerable expansion of the set of questions and topics that a prospective customer would go through, and that could include an existing customer.

I don't think that, that will always be the case.

That's -- there's an element of novelty to it that as we routinize things more and have more examples to look for, more references, just like any new offering, those things should -- we would expect an acceleration and, hopefully, even a structural acceleration over time because a lot of the questions that you would have to ask about an on-premise implementation are actually simplified by the cloud, and that's really the longer-term hope.

Now on the second part of your question about a possible acceleration for existing or even long-standing InsuranceSuite customers, I think we're hopeful for that as well.

So these are companies that -- insurers that have been using one or more applications in InsuranceSuite for some time.

And now there's no real product evaluation to go for, it's just a matter of rethinking the service relationship that they have with Guidewire and the transfer of responsibility.

That's what happened in the second case, and we fully expect there to be more of these.

And these will, in general, be faster than when a prospective customer or a current customer is considering a completely new application implementation.

As for the mix of those 2 effects, that's very, very hard for us to guess.

I mean, of course, we have our whole pipeline kind of mapped out with the guess of when they will all happen, but there's no way I could right now for you digest it all and cash it out into which effect dominates.

I think what you'll hear from us overall and reflected in the guidance is the general kind of caution about the pace at which the transactions will close and then, given this whole ratable element, how much of the revenue will get to recognize within the current period.

Got it.

And then, Richard, in terms of -- you mentioned the services mix could -- I mean that services number could continue to trend higher.

In the past, you guys have gotten as high as kind of mid-40s and, on a quarterly basis, as high as into mid-50s as a percent of total revenue.

Where do you think that could potentially settle in?

I mean right now your guide is 40%.

Is that kind of mid-40s a good feeling?

Or any help there will be great.

Yes.

So Ken, I think the answer is not one that I can easily give right now.

Let me tell you why.

We are right now embarking on a course of action which says we will help the industry transition as fast as it needs to be.

So we need to absorb all the services demands for any cloud implementation, whether InsuranceSuite now (sic) [InsuranceNow] or InsuranceSuite cloud or, frankly, for any of our other products that kind of tag along with those 2 core systems.

And in the meantime, we are -- and that is our first priority.

Our first priority is simply to absorb that demand because we do not want to hold our companies back and our customers back from whatever transformation they want to progress with.

At the same time, we are instituting new processes and coming up with new skills to be able to hand that back off to the SIs as soon as we feel comfortable that the risk is assessed and minimized and trained -- and we have trained those SIs appropriately in being able to help us with these exercises.

And it's the speed of that transition that gives me a little bit pause of being too comfortable knowing how high the services number can go.

I do believe right now that services will outpace license growth for at least 2 years.

And so you may see services revenue actually rise above 50% if this transition accelerates or paces at the speed with which we are seeing right now and then you're going to see it come back down after 2019.

That is my current gut.

Obviously, this is not a model that we are embracing in any way, this is simply the exigencies of the moment that are driving our decisions.

And as soon as we can, you will see us replicate the model that was able to bring down the services revenue down to 30% to 35% of total revenue.

We'll take our next question from Tom Roderick with Stifel.

Matt Van Vliet on for Tom.

I guess, sort of building on that last question about the overall services mix, as that accelerates, does this help get to sort of the low point in margins and then a buildup moving forward that you sort of went through at the Analyst Day?

Or is the acceleration in...

Yes.

Okay, so the acceleration really sort of pulls forward some of that?

Yes.

So what will happen, if our crystal ball isn't too cloudy, is you will see services increase as part of the mix for another 12 to 18 months and then start declining, right, that's our current assumption.

Obviously, we want to improve services margins.

But I think right now, with all the hiring we're doing to make sure that we can engender this transition effectively, we're going to keep that margin at about 20% or try very hard to do so.

And that will obviously have a gross margin effect that will then drop down to the operating margin.

The other issue though is that right now our license margin is actually down to 91% because we've invested in all these cloud teams and infrastructure.

And now these teams have to start being able to absorb more InsuranceSuite cloud and InsuranceNow implementations.

And so what you'll see is you'll see hopefully that margin start to improve over time as that line starts to increase because the ratable revenue starts being recognized.

So that will also be the other improvement that you will see affecting the gross margin line sometime in 2000 -- end of 2019, starting 2020.

I have one other comment, which I think speaks to your question, Matt, as well as the previous one, which is that some of the -- essentially all of the newer products that we have outside of InsuranceNow have almost no services attached with them.

So Predictive Analytics, anything to do with Cyence, Live Analytics, none of these products have really any services attached.

And if -- while they're all relatively modest in their adoption so far, if they attach to our core system customers at the pace that we're aspiring to or even faster than that, that would have a positive effect with respect to the -- [in light] of the subscription to services mix.

And that's certainly a lever that we want to push on hard.

And by the way, to Marcus' point and to further it, those products also have a higher license margin associated with them because they don't necessarily share the infrastructural and production environment costs that InsuranceSuite cloud and InsuranceNow require and, therefore, those margins will actually improve.

As the mix towards the new product increases, our gross margin will improve over time as well.

Great.

And then looking at from a sales compensation and overall management perspective, what are you doing to push or not push more cloud revenue?

Are you -- is that still based on sort of total contract value?

Or are you really pulling into a recurring revenue basis, driving higher upside for individual salespeople?

Well, we've always had a recurring revenue basis for sales compensation.

We try to keep it very simple, which is essentially an ARR target for each of our quota-carrying reps.

And we wanted to apply that with a minimum of modification to cloud-based revenue as well.

Actually, because of the economics of these InsuranceSuite cloud relationships where there is a transfer of cost as well, we apply a bit of a haircut to that ARR that comes in cloud form.

But even taking that haircut into account, a rep has substantially more to gain in total quota attainment for consummating an InsuranceSuite cloud opportunity.

So there's plenty of enthusiasm on the sales team because it's -- there's a chance to go for larger or even substantially larger transactions for which they're rewarded.

We'll go next to Rishi Jaluria with JMP Securities.

Appreciate the detailed commentary.

Marcus, I hate to keep going back to the commentary around the elongating sales cycles, but just kind of want to get a sense, where are you seeing this?

I mean is this with new customers or with the expansions, with potential conversions?

Help me understand where are you seeing this the most often.

Well, let me try to characterize it this way: in every sales evaluation with a prospective customer or even an existing customer who's considering licensing a new product, there's a portion of the sales evaluation which is functional.

They want to know, does it meet all of our business requirements, can we achieve the business benefits that we want.

But then there's a substantial portion of the sales cycle which is planning the project and estimating the scale of the project and figuring out what resources will we need, what systems integrator partner might we need, how long will it be, what are the levers we have to bring this in to a certain envelope of expectations, et cetera.

And that's a distinct part of the sales cycle.

Now that part of the sales cycle is a bit complicated when a prospective customer has to think about 2 different approaches.

One where they're implementing on-premise, which is pretty much how all of their applications, their core applications certainly, are running today; or a new cloud model.

And what we're seeing is that some customers or prospective customers are essentially modeling out both of those scenarios and comparing them to make a decision.

And there's -- there are lots of quantitative and qualitative factors that go into making that choice.

And that takes a bit longer.

Now I don't -- again, I don't believe that will always be the case.

I -- we think that over time we would -- we will probably start to lead much more aggressively and confidently with the cloud option being the right one, and there will be more references to attest to that.

And the increasing preference that we see in the market for that simplification of risk transfer will motivate them to really opt maybe exclusively for evaluating the cloud option.

So that's our expectation.

And so I think that the -- this temporary period where -- of greater analysis requirement will be a temporary phenomenon maybe on the order of the year, something like that, that's our best guess right now.

I hope that clarifies it.

Yes, that's helpful.

And Marcus, I wanted to go back to a comment you made earlier.

Can you just help me understand why you expect Cyence to have little to no services attached, especially because it's in kind of a more emerging business than what your typical InsuranceSuite has?

Right.

So as a technical matter, there's essentially no implementation.

It's an entirely cloud-native offering.

You -- what you do as a Cyence customer is access their universe of companies that they have modeled the cyber risk for and they're keeping that data current.

And then you look at a set of -- a score or a dashboard tool to appraise the amount of cyber risk.

This is what an underwriter would look at.

And so their current customer today has effectively 0 integration and really 0 implementation.

Now that's -- there's an oversimplification because sometimes a customer may want to add additional data stream.

Of course, there's a business change, a process change dimension to this that has to be involved, and Cyence has a few folks who come from an industry background that help advise on that.

But when you contrast that to the kinds of services that are required for a full core legacy system replacement, there's no comparison, not in absolute terms, not in relative terms.

It's extremely light touch in terms of services presence compared to what's involved in the major legacy replacements that we do or have always done as a business.

Okay.

Got it, that's helpful.

And last one from me.

Richard, just want to look into the guidance.

For Q2, I mean, there's a really big sequential increase, higher than we normally see, going from Q1 to Q2, even controlling for the Q4 prepayment.

Can you help us understand the dynamic here, especially given that we're seeing increased subscription adoption and the associated headwind with that?

I don't think there's much that I can explain.

I mean, I think that we're seeing a quarter from up which will lead to a particular set of license revenue and subscription revenue dollars that come into the quarter.

We also have Cyence that increases our quarterly revenue by about $2 million.

And don't forget, right, in Q1, we had that $6.1 million that simply disappeared and came into Q4 of the previous year.

And that's one of the things that's showing and making that jump that much more visible.

We'll take our next question from Brad Sills with Bank of America Merrill Lynch.

Just one on Cyence.

I know it's early, and I know the deal just closed, but to the extent you can provide some color on early reception, particularly in the Tier 1 and Tier 2 market, what type of use cases are being considered for deployment of Cyence?

And what kind of traction are you seeing there just in terms of interest at this point?

Brad, in terms of interest, it has been significantly ahead of my own expectations.

And not only in the breadth of insurers that are interested, so these are the ones that -- these are insurers -- some insurers who explicitly target these emerging risks like trying to write a new cyber product but also very traditional mainline, standard line insurers that are concerned about the degree of embedded cyber risk that they have even in their traditional lines of insurance.

And there's tremendous interest across-the-board, across all these categories of customers at all sizes.

So that has been very encouraging.

Now of course, we have to convert that early enthusiasm into actual commercial relationship deals.

And we've just recruited a new sales leader, a veteran, who will have -- who will be fully dedicated to leading the -- a sales team that focuses on Cyence.

Prior to the acquisition, Cyence had really no sales organization at all.

It was entirely kind of founder and executive level sales, and we're hoping to institute -- implement a much broader outreach to the market.

As for use cases, I talked about those insurers that are focused on new risks and those who are worried about embedded risks.

We are also very interested in the possibility of using their data listening approach to standard lines and the more standard insurance use cases.

The conventional way the data is gathered in the insurance industry is from the insured.

You ask the insured for lots of information.

And then on the basis of that, you underwrite the risk.

It's supplemented with some other data but primarily from the insured.

Cyence's approach to data listening proposes a kind of inversion of that where you build a profile of the insured even before they have applied for an insurance policy and come to that insured very informed about the character of their business and their risk.

And that could have significant implications for both a much more satisfying digital distribution experience as well as making better underwriting judgment.

That's a much more provocative possibility, but it's one that could have a very big impact if we get it adopted more broadly.

Great.

And then one on InsuranceNow.

Any commentary on how that performed amongst kind of new market entrants, with insurtech companies coming in increasingly and how that offering is resonating with that end market.

Yes.

We're pleased with InsuranceNow.

I think we've -- after a little period of complication, I think we've stabilized the customer relationship well, and we've been able to convert a number of deals in their pipeline and have been building the go-forward pipeline pretty much according to plan.

So I think we're -- we would enthusiastically ratify the decision we made to add that second core to our product portfolio.

With respect to insurtech, there's a huge wave of investment in insurtech.

Almost none of it has gone to funding new core system providers that we would consider competitors.

And then an enormous amount has gone towards funding competitors to our customers, new insurance companies that have some kind of new angle or value proposition.

But as for software players that are trying to sell to the insurance industry and in core system, potentially none.

Some of our competitors have been recapitalized.

But in terms of completely new entrants coming in out of the blue, we really haven't seen any of that in the last few years despite the huge wave of insurtech investment.

So I think there's a lot of interest in competing with insurers as opposed to serving insurers, and we're very much on the serving insurers side of the equation.

We'll go next to Alex Zukin with Piper Jaffray.

This is Taylor Reiners on for Alex.

I was wondering if you can maybe dig in a bit on what you're seeing with respect to attach rates on your data and digital products.

And then is that all being impacted by the uptick in cloud that you've been seeing?

I think attach rates in data and digital continue to be very strong.

I don't have the exact numbers for you, Taylor, but they are at least as strong as they have been historically.

And we're confident that will continue or even increase as they just become thought of as all different aspects of the same platform that -- you heard that theme from me at our Analyst Day and maybe at our user conference, too, if you heard those presentations, and I think that will continue.

So we're very confident that there'll be strong attach rates for basically everything we're doing in data and digital, and that's really the heart of our strategy.

Cloud does not really intersect with that in any particularly novel way, i.e., whether or not you have deployed InsuranceSuite in the cloud or in the traditional on-premise mode, you will still want to access these other ancillary products, which themselves are generally all cloud-based.

And from a business user's perspective, it's all the same application, it's all the same environment.

So that's -- it's sort of an orthogonal dimension to the question, but it's worth mentioning here that essentially all the new products that we expect to build or acquire in the future will be cloud-based.

It's really a question of getting that huge core application adopted and implemented that gates the adoption of most of these products, but we want to make it as easy as possible than to adopt the data and digital products once you've made that big core decision.

Q1 is always our lightest quarter and, therefore, the data is not so revealing as I look at the full year.

And at the end of the last full year, our attach rates for data and digital had been 50% or better.

So they had continued to strengthen over the last couple of years.

We'll take our next question from Kevin Kumar with Goldman Sachs.

Regarding InsuranceSuite and InsuranceNow, is having high-end and low-end cloud offerings accelerating growth in the number of opportunities in the pipeline even if some of those opportunities elongated in some cases?

Yes, that's very much the strategy here.

We want to cover the waterfront.

So any primary insurer pretty much anywhere in the world that writes nonlife insurance, we want to have, of course, some offering for them, and we want to give them -- if they're a very small insurer, they will probably insist themselves on having it be delivered in the cloud, and that's what InsuranceNow is for.

And if they're a medium or a large insurer, we want to be sure they have the option either to deploy on-premise or in the cloud.

We want to -- we try to meet the customer on their own terms.

And I think now with the array of choices we have, we're -- we really are covering the waterfront.

One interesting fact to note is that I would say at least half of the InsuranceNow prospects that are in the pipeline, we would not even have gone after with only InsuranceSuite because they'd be too small for us to have an effective solution for those customers.

Yes.

It's also worth adding, of course, that we cannot -- we are not selling InsuranceNow internationally yet.

Though despite it -- we have a couple of early conversations in English-speaking geographies.

But another dimension of market expansion for us is to ensure that we can sell it around the world the same way that we do with InsuranceSuite today.

That concludes today's question-and-answer session.

At this time, I'll turn the conference back to Marcus Ryu for any concluding remarks.

No additional remarks, thank you for joining our earnings call.

This does conclude today's conference.

Thank you for your participation.

You may now disconnect.