Technology is aiding P&C insurance companies in addressing these demands, which is helping unlock new insights into core operations, most notably claims processing, billing, and policy underwriting and management.
No company has been more instrumental in this evolution than Guidewire Software
. Its InsuranceSuite uses modern software to address the core needs of P&C insurance companies. The company has added new capabilities via in-house development and clever acquisitions, pushing aggressively into data analytics and digital portals, which allow insurance companies to better serve policyholders and employees alike.
While the business is predominantly leveraged toward an on-premises environment today, Guidewire is well prepared for cloud migrations should insurers’ software preferences shift, evidenced by its recent implementation of a greenfield cloud-based solution for MetLife and a growing pipeline of cloud deals. These factors reinforce our view that Guidewire’s wide-moat fortress is virtually impenetrable, reflected in the company’s nearly 100% retention record. Despite the share price’s 65% run in 2017 thus far, we still see a decent margin of safety for investment.
Stranglehold on P&C Software Market
Guidewire was founded in 2001 as the brainchild of several consulting and software engineering veterans from consulting firm McKinsey and software companies Ariba and Kana Software. In response to the shortcomings of insurance industry IT, Guidewire’s mission has been to offload the operational workload of insurance companies to a modern software platform that can overcome these shortcomings and drive better business outcomes.
Guidewire has been at the forefront of technological innovation in the P&C insurance industry, as its InsuranceSuite addresses the core needs of P&C insurance companies: digitizing claims, billing, and policy management with modern software. We don’t see any signs of Guidewire’s progress slowing, given the company’s growing pipeline of cloud deals and a host of greenfield opportunities with Tier 1 and 2 P&C insurers, which make up the bulk of the market.
As we look at its competitive advantage today, we think Guidewire has a stranglehold on the P&C insurance software market. In our view, smaller vendors don’t have its broad, scalable offerings, and Guidewire’s penetration of the Tier 1 and 2 customer cohorts dissuades larger software vendors from entering the fray.
We believe Guidewire has a wide economic moat based on deep switching costs in its customer base and intangible assets based on its deep knowledge of the insurance industry and its ability to deploy this knowledge in its software applications.
Guidewire’s applications address both the core and peripheral needs of its customers. We believe the company has the most holistic suite of scalable software solutions to handle claims, billings, and policy management, and it has bought or built useful add-on applications for underwriting, data management, analytics, and agent and policyholder engagement to increase its grasp on its customer base. Further, each state, country, and insurance line comes with its own set of regulatory and product-specific requirements that must be baked into the software. Guidewire’s solutions are in place in dozens of countries and available in multiple languages, clearing the way for the company to serve the needs of the world’s largest insurers better than any of its competitors.
Though Guidewire has historically been an on-premises vendor, we think it is best positioned to offer scalable cloud solutions to large insurers, given the investments it has made in building a robust offering on Amazon Web Services. The success of a recent digital greenfield project that involved deploying all of Guidewire’s offerings in the cloud for MetLife, a Tier 2 P&C insurer, will serve as a valuable reference customer, in our view, and will lower the barriers for Guidewire to win more deals with large insurers regardless of their preferred method of software delivery.
Insurance companies move very slowly when replacing core software systems. In many cases, Guidewire is replacing legacy systems that date back as far as 30 years, meaning that once these systems are in place, they are there for the long haul. We believe that Guidewire benefits from similarly high switching costs, as it would be a massive undertaking for its insurance customers to rip out its software and replace it with other vendors.
In addition, we believe insurance companies view Guidewire as a long-term strategic partner that will serve their core software application needs for the next several decades, bolstering our belief that the company also benefits from intangible assets associated with its intimate customer relationships, again supporting its wide economic moat. Any player looking to enter this market and serve large, multinational insurers or even domestic insurers will need the ability to capture the various underwriting and regulatory intricacies across various products and jurisdictions on a state-by-state and country-by-country basis. We believe Guidewire’s ability to clear these hurdles extends its intangible asset moat source, evidenced by the company’s deployments with over 300 customers in more than 35 countries and supporting various languages.
Although the P&C insurance market is heavily fragmented at the low end, an outsize portion of addressable market opportunity resides among Tier 1 and 2 insurers. According to Swiss Re, there are roughly 70 Tier 1 P&C insurance companies in the world, and these write roughly 45% of the world’s total direct written premium. About 220 Tier 2 insurance companies write roughly 30% of the world’s total direct written premium, meaning that approximately 75% of the total addressable market opportunity resides with these 290 companies. Guidewire has relationships with 107 of them, which we believe gives it an unmatched ability to amass dominant market share. The company has licensed more than 20% of global premiums to at least one software product, but it has a bevy of cross-selling and upselling opportunities within this customer base alone, and we think it is poised to gobble up the bulk of net new customer wins at the top of the market.
Guidewire has displayed robust internal development talent, but it has not been shy about tapping into the open market in making several savvy acquisitions in recent years to fill out its product portfolio, expanding its addressable market opportunity in the process. We view Guidewire’s core solutions as the initial hooks that establish customer switching costs, while the company’s incremental data and digital portal products reinforce the ecosystem, ultimately leading to a customer retention rate that is nearly 100%, supporting our wide moat rating.
Thus far, the preference among large insurance customers has been to take delivery of Guidewire’s software on-premises. While smaller insurers have been receptive of cloud-based solutions, larger companies tended to err on the side of caution, choosing to take a moderate leap into modernization and forgoing cloud-based deployments.
However, with the release of InsuranceSuite 9 and subsequent development, Guidewire now has a fully cloud-ready solution that is certified on Amazon Web Services. Aiding this development push is MetLife, which embarked on a digital greenfield project that involved deploying the breadth of Guidewire’s portfolio as a cloud-based solution. This project went live in 2017 with overwhelming success, which we believe is a vital step in sealing the one potential gap that previously existed in Guidewire’s portfolio: a scalable, cloud-based solution. We view MetLife as a crucial reference customer should more large insurance companies go down the path of cloud-based deployments, which should only further Guidewire’s ability to penetrate the Tier 1 and 2 cohorts of the insurance market. Just 22 customers have deployed InsuranceSuite in the cloud today, but we expect this number to rise dramatically in the coming years. The company is investing ahead of this demand, increasing cloud-related head count by 40% this fiscal year.
Further, the 2016 acquisition of ISCS unlocks opportunities to move down market with ease. ISCS’ offerings, rebranded as InsuranceNow, provides Guidewire with a standardized, out-of-the-box cloud-based solution that it can use to penetrate Tier 3, 4, and 5 insurers. The acquisition has also enhanced Guidewire’s cloud expertise, which we believe will prove invaluable as it pursues more large-scale cloud deals.
Guidewire also is embracing customer preferences beyond its own solutions. At its 2017 analyst day, management detailed a new partnership with Salesforce.com, integrating Guidewire objects and data within Salesforce’s financial services cloud. We believe this sort of partnership will only solidify Guidewire’s status as a best-of-breed vendor, particularly if large insurers more aggressively pursue software solutions in the cloud.
Up-and-Down New Millennium for P&C Insurers
We believe the P&C insurance industry’s performance over the past several years has played a key role in accelerating digital transformation and adopting modern technology solutions to drive businesses forward. Since the dot-com bubble burst, the insurance industry has seen peaks and valleys. Industry consolidation, volatile interest rates, and the financial crisis have all had a significant impact on the industry over the past 17 years. In fact, P&C insurance has seen more bad than good in the new millennium, as insurers have faced challenging underwriting conditions and flagging investment incomes that have led to mediocre combined ratios, the standard measure of performance for insurance companies. Over this period, the industry has enjoyed relatively consistent annual net earned premium growth of just over 3.5%, but incurred losses (2.8%) and expenses (3.3%) have kept pace. Further, the financial crisis has led to a sustained period of historically low interest rates, and investment incomes have grown at a compound annual rate of less than 1% over the same period. As a result, losses and expenses have consistently outstripped premium growth in that time, creating a challenging environment for profitability over a sustained period.
In recent years, factors such as falling oil prices, which have encouraged more driving by way of lower gas prices, yielding a greater number of collisions and subsequent insurance claims, have exacerbated poor underwriting performance. Automobile activity can have an outsize impact on P&C insurers, as auto insurance makes up 35% of direct written premium in the United States, more than double the next-largest insurance line (homeowners and farmers). Natural disasters can also have an outsize impact. Hurricanes Katrina and Sandy helped contribute to massive spikes in catastrophe losses in 2005 and 2012, respectively, hampering underwriting performance. Thus far in 2017, major storms such as hurricanes Harvey, Irma, Jose, and Maria have resulted in catastrophic losses in the Southern U.S. and the Caribbean, with some estimates placing the damage in the realm of $200 billion, the most since the 2005 hurricane season.
As a result of these market conditions, industry returns on equity have suffered for several years, causing insurance companies to explore new avenues for revamping business processes and increasing efficiency in attempt to improve profitability. Pricing increases have been adequate, but inflation and rates have proved poor. While catastrophic losses have considerable variability, 2017 is shaping up to be a drag on the industry, and five of the past six years have registered above the 18-year median annual catastrophic loss total.
These developments have resulted in material changes in our P&C insurance coverage. Since 2008, we have made 11 changes to existing moat ratings of insurance companies (not including coverage drops and additions of previously unrated companies). Of those moat rating changes, just two have been upgrades, while nine have been downgrades.
We believe the challenges facing the insurance industry and the diminishing durability of competitive advantages have led to companies examining new methods of driving the business forward. More frequently, this has meant greater adoption of modern technologies to overhaul operations and improve agent and policyholder engagement.
Insurers’ Complicated Relationship With Technology
Although application software has proliferated across every industry over the past several decades, many core systems for P&C insurers were deemed “good enough” for a considerable period. In fact, many core insurance systems rely on manual, paper-based processes, creating a substantial gap in data integrity, often leading to poor underwriting, policy, and claims management. When software systems were in place, the original engineering often dated back 20 years or more, relying on infrastructure that was cobbled together in-house, no longer in active development, or had long gone off support from the original vendor. Further, many large insurance companies are a byproduct of mergers and acquisitions, complicating the IT ecosystem with disparate legacy systems with differing architecture. These shortcomings often included outdated programming languages, little (if any) ability to interact with other critical applications, and a very small pool of specialized IT talent to manage these systems.
Still, insurance technology remained on the back burner for years. While insurance companies themselves were partly to blame for standing pat with dated technologies, the technology and venture investing communities were at fault as well. Despite the explosion of new technology company formation over the past two decades--including numerous high-profile financial technology, or fintech, companies--insurance technology, or insurtech, has only recently become a focal point of new investment.
Even with the recent influx of new business formation and investment in insurtech, most of these businesses are aiming at disrupting the underwriting, management, and servicing of insurance policies rather than helping existing players embark on digital transformation and heightening operational efficiency. The impact of technology on insurance, even given modest venture investment levels, is notable: A McKinsey study revealed that insurers investing the most in technological overhauls are achieving nearly double the amount of revenue growth while yielding greater profitability.
Collectively, we believe these dynamics have helped clear a path for Guidewire’s ascension as the premier vendor of operational software in P&C insurance, driven by the company’s continual investment in its best-of-breed portfolio of solutions.
Guidewire’s Tier 1 Success Keeps Competitors at Bay
We believe Guidewire’s broad portfolio that taps directly into the core operations of insurers of all sizes yields material switching costs for its customers. Further, given the varying demands of individual insurance lines and various regulatory impacts on a state and country level, we believe Guidewire’s in-depth knowledge of the insurance industry yields a material intangible asset for the company. All in, these factors form Guidewire’s wide moat. The end market is not bereft of competition, but we think Guidewire’s position is particularly robust, given its ability to establish relationships with some of the largest insurance companies in the world, effectively cornering a significant amount of a total addressable market that we believe discourages new entrants.
The global P&C insurance industry generates roughly $2 trillion on an annual basis, spanning personal and commercial insurance lines. On the surface, the sheer volume of dollars that pass through this industry would suggest a sizable market opportunity for software companies to serve the core operational needs of these insurers. While this is certainly the case, the extreme fragmentation of the P&C insurance market, particularly at the lower ends, creates a unique dynamic that affords Guidewire an enviable position.
Most notably, the bulk of the addressable market opportunity resides among Tier 1 and 2 insurers. Generally, Tier 1 insurance companies, such as Nationwide or State Farm (both Guidewire customers), are those that write greater than $5 billion in direct written premium annually; Tier 2 insurance companies are those that write $1 billion-$5 billion in direct written premium annually. Tier 1 and 2 insurance companies are responsible for writing roughly 75% of total direct written premium globally, making it imperative for any software company looking to gain scale to deeply penetrate this cohort. There are just 70 Tier 1 companies, yet they are responsible for $900 billion of direct written premium (or roughly 45% of the global total), yielding an average potential customer size of nearly $13 billion in direct written premium.
We emphasize direct written premium given the pricing mechanism Guidewire deploys. Generally, Guidewire prices its software based on total amount of direct written premium licensed to an individual application. Management has disclosed that this range is typically 15-30 basis points of revenue for every dollar of direct written premium, and the company has historically been able to extract greater commissions at lower volume, namely in Tiers 3-5.
We think two qualities unlock a greater portion of the core addressable market for Guidewire than competitors: Guidewire’s deep portfolio of add-on modules and applications and its proven scalability. First, we believe the company’s data and digital portals portfolio is unrivaled, and we believe this dynamic unlocks an incremental addressable market.
Second, Guidewire has by far the most experience replacing core legacy systems relative to its peers, yielding far more Tier 1 customers than the rest of the market. This is a huge factor in our wide moat rating. Given that so much of the market opportunity is concentrated in a small subset of companies, we think Guidewire’s significant number of existing relationships with Tier 1 vendors discourages larger software companies from entering the market and explains why few large companies are playing in this realm. While most of Guidewire’s prime competitors are private, we believe the market share of rival application vendors is fairly low.
We have long contended that Guidewire’s solution is the broadest and deepest toolset on the market, characterizing the North American market as a two-horse race between Guidewire and Duck Creek Technologies, while internationally Guidewire stands the best chance of winning significant share. If we focus on solutions scaled for the world’s largest insurers, Guidewire is a clear cut above. Components of InsuranceSuite were in production in 227 instances as of March. Gartner estimates Guidewire secured 33% of total customer wins in the prior year, more than 3 times the nearest competitor (which we suspect is Duck Creek). Comparatively, Duck Creek has just 90 in-production deployments of its core modules, and we believe a larger portion of its customer cohort falls in Tier 2 and below (though we believe it has a handful of Tier 1 customers).
Until last year, Duck Creek was a wholly owned subsidiary of Accenture, which we believe severely hamstrung the company from establishing incremental relationships with system integrators and other channel partners. Although we think Duck Creek stands to benefit in some ways by having Accenture spin out a majority of its ownership stake to Apax Partners, we believe Guidewire is the bigger beneficiary of this development. Guidewire already benefited from a strong partner ecosystem, including large relationships with companies such as Capgemini, EY, and PwC on the consulting side, while major cloud vendors including Amazon, Microsoft, IBM, and Oracle are partners. Following Accenture’s spinout of 60% of its stake in Duck Creek, the company announced it was forming a partnership with Guidewire to lead deployments in Europe and Latin America, regions where there is far less penetration from modern software vendors in P&C insurance.
The International Growth Lever
The international opportunity is a material, untapped one for Guidewire. Although the company has a broader set of competitors internationally, management has intimated that most international Tier 1 insurers have yet to adopt a modern software solution for core operations, which we believe is a significant opportunity for Guidewire. The company has been diligent about establishing itself in international markets, particularly given how different each competitive environment is (particularly in Europe).
Most of Guidewire’s revenue and Tier 1 customers come from the U.S. market. However, the company has accelerated its international inroads in recent years, and the opportunity is massive. The international opportunity is roughly 50% larger than the opportunity Guidewire has in the Americas, and penetration is much lower.
While breaking into foreign markets can be challenging for U.S.-based software vendors, Guidewire’s early work is beginning to bear fruit. The company has customers in more than 35 countries and supports a variety of languages. The combination of reference customers, language support, and baking regulatory standards into the software is a substantial hurdle for entrance into new markets, and Guidewire is the furthest down the path of accomplishing these feats. Despite a number of familiar faces internationally, such as Duck Creek (in Australia-New Zealand primarily), Pegasystems , Sapiens , and SAP , none of these companies have achieved Guidewire’s level of success or developed a broad set of solutions to meet the needs of insurers across multiple theaters. Guidewire is beginning to grab a hold on several foreign markets, particularly in Europe, where it is taking a tailored approach to reaching customers. For example, German insurers have a strong preference to buy from German companies, and Guidewire has diligently established a German arm equipped with a German salesforce to overcome these hurdles.
Market Penetration and the Changing Insurance Landscape
We believe Guidewire is in the early stages of its growth story, given the relatively slow cadence to which insurers have historically moved and the amount of opportunity that lies beyond the borders of the U.S. If we evaluate Guidewire from both a direct written premium and wallet share perspective, its growth runway is incredibly long. Collectively, while Guidewire has roughly 20% of global direct written premium licensed to at least one product, its total dollar penetration is much lower. However, this needs to be put into context from both an existing customer and net new customer perspective. Because insurers generally roll out Guidewire’s software gradually, we think Guidewire will capture the overwhelming majority of wallet opportunity among its existing customers. However, the remaining global opportunity inclusive of existing and net new customers remains even larger.
The P&C insurance has remained relatively stable from a direct written premium perspective over the past several years, tracking roughly in line with global GDP, which we believe is a reasonable assumption moving forward when thinking about Guidewire’s business. But under the hood, there are potentially large shifts for P&C insurers.
Most notably, the future of auto insurance is a point of contention among insurers, particularly as technology disrupts the way people drive and how driving behavior is tracked. The introduction of telematics on the lower end of the technology spectrum has allowed insurers to maintain lower pricing to retain good drivers, while more aggressive pricing can be deployed for drivers with poorer records who are more likely to churn anyway. Over the medium term, telematics could dramatically improve underwriting performance, but longer term, the threat of autonomous vehicles casts a shadow over this line of business, which accounts for roughly 35% of domestic insurance premiums. While we do not believe the threat of autonomous vehicles is immediate, it is a risk factor to both insurers and Guidewire’s business. Autonomous vehicles are unlikely to render auto insurance obsolete, but they would drive a major industry shift, such as moving the onus from personal insurance for drivers to commercial insurance for original-equipment manufacturers or technology companies developing the software, components, and algorithms that ultimately control vehicles, which could severely reduce premiums. In the near term, however, auto insurance premiums continue to grow at a healthy clip, aided in recent years by low oil and gas prices that have encouraged more driving and subsequently yielded more accidents. We do not bake in any direct assumptions about the decay of the auto insurance market into our model for Guidewire, but it is a downside risk factor we monitor.
Conversely, we see a pair of major growth levers that could have a positive impact on Guidewire’s total addressable market. First, many of Guidewire’s existing customers write insurance beyond the P&C space, including life and health insurance. While Guidewire has no immediate plans to move into these markets, we have heard from several customers at investor events in recent years that a Guidewire-branded product for these lines would have plenty of demand. Management has insisted that its focus remains on the largely underpenetrated P&C space, but we consider this a more likely upside driver over the next several years than the potential downside of auto insurance decay. Collectively, Gartner estimates the insurance industry will spend in excess of $15 billion on vertical-specific software within the next five years, a meaningful portion of which lies beyond P&C insurance.
Second, cyber insurance is already presenting Guidewire with a tangible market opportunity. According to a study by EY, more than 60 carriers in the U.S. are underwriting billions in cybersecurity insurance premiums. EY estimates the annual U.S. cyber insurance premium total is nearly $3.5 billion and could more than double in a few years. Guidewire is already angling to capture this growth in its products, including advanced product definitions to underwrite these policies. Further, Guidewire’s recent acquisition of Cyence will help push this use case; Cyence uses data science to help insurers better understand the source and potential damage of modern risks, and Guidewire will deploy this technology to aid in underwriting, pricing, and potential loss estimation for risk management.
We’re Bullish on Guidewire
We believe Guidewire is poised to capture significant market share in the largely underpenetrated P&C insurance software space. Several key assumptions drive our $95 fair value estimate, including an ongoing mix shift in the top line away from lower-margin professional services revenue (which the company’s broad partner ecosystem will aid) toward higher-margin license and maintenance revenue. We model a consolidated top-line compound annual growth rate of 15% over the next 10 years (compared with a 25% CAGR over the previous eight years), with license and maintenance revenue easily outstripping services revenue growth. License and maintenance revenue account for roughly 80% of revenue by the end of our explicit forecast period, yielding $1.6 billion in total annual software revenue by the end of our forecast period. This level implies roughly 30% penetration of our total addressable market estimate. Given the amount of pricing power we believe Guidewire can exert, we believe operating margins have upside to the high 30s by the end of our explicit forecast period.
We think a company like Guidewire, given its wide moat and position as a big fish in a small pond, is worthy of a premium valuation, but we think our base-case valuation is reasonable in the context of free cash flow generation. We use a three-stage discounted cash flow model to derive all our fair value estimates in software, but we believe free cash flow multiples unlock the true value of software companies that are going through periods of elevated growth, particularly when ratable revenue recognition models temporarily exacerbate the margin profile of a business to the downside. Using free cash flow as context, the broader software market has traded at far more reasonable multiples in recent years despite pockets of extreme growth. This is particularly true when considering historical cyclical peaks in the dot-com bubble and prior to the global financial crisis.