Guidewire Software, Inc. Q2 FY2020 Earnings Call

Greetings. Welcome to Guidewire’s Second Quarter 2020 Financial Results Conference Call. At this time all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the conference over to your host Curtis Smith. You may begin.

Good afternoon and welcome to Guidewire Software’s Earnings Conference Call for the second quarter of fiscal year 2020 which ended on January 31, 2020. My name is Curtis Smith. I am the Chief Financial Officer of Guidewire. And with me on the call is Mike Rosenbaum, Guidewire’s Chief Executive Officer and Jeff Cooper, VP of Finance. A complete disclosure of our results can be found in our press release issued today as well as in our related 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 the market shift to cloud offerings, our product roadmap and future product availability. 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-Q filed with the SEC. We also will 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 with the primary differences being stock-based compensation expenses, amortization of intangibles, the amortization of debt discount and issuance costs from our convertible notes and the related tax effects on these adjustments. 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 insights 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 Mike for his prepared remarks and then Jeff and I will provide details on our results before providing our outlook for Q3 and fiscal 2020. We will then take your questions.

Thank you, Curtis and thanks to those of you joining us for our second quarter earnings call. We had a solid second quarter, measured not just by our financial performance but also a few very notable and strategic milestones, which I'll touch on in a moment. We continue to see cloud momentum build with subscription revenue growth of 94% and total revenue and profitability above guidance ranges. As I've previously mentioned, I think that ARR is the key metric for our company, as we transition to a cloud-based subscription model and we ended the quarter at $474 million, up 13% from a year ago and putting us very close to an important emotional milestone of $0.5 billion in recurring revenue. As I mentioned a second ago, there were a couple of very strategic milestones achieved in the quarter. First, we were honored to be selected by USAA for their Policy Transformation Project covering all 22 billion of their DWP. This win follows on the heels of the USAA ClaimCenter deal we highlighted in our Q4 earnings call. This selection and the associated implementation and transformation project it represents will set a standard for the Guidewire Cloud and I believe chart a path for large Tier 1 insurers moving to and then running cloud-based core systems. Second, we got back on the board with an InsuranceNow win at Warrior Invictus Holding Company, a Tier 4 insurer and parent company to First Chicago Insurance Company and United Security Health and Casualty. I'm extremely pleased with this win as it's a critical milestone in the turnaround that we are driving in our InsuranceNow business. We have discussed in previous calls the investments we have made in the product and the organizational changes we made to more clearly focus on this segment of the market, and this selection is a direct result of those efforts. In addition, just after the close of Q2, we significantly expanded our ARR and existing InsuranceNow customer, Tuscarora Wayne Insurance Company by agreeing to migrate their on-premises instance to our cloud-based offering. These wins provide tangible evidence that our focus and investment in InsuranceNow are being well received by the market, and we are looking forward to more InsuranceNow momentum in the future. The deal at USAA and the InsuranceNow win represent examples of Guidewire's traditional business of core system modernization moving to the cloud. But we are also seeing an increase in the industry's interest in smaller Guidewire cloud-based initiatives designed to help carriers grow through innovation and rapidly bringing new insurance products to market. We are working with multiple Tier 1 carriers on these types of cloud-based projects and are seeing the demand for them increase. In Q2, a large existing Tier 1 self-managed customer selected PolicyCenter, BillingCenter, and Digital in the Cloud for use by the innovation group tasked with developing novel insurance products and bringing them to market quickly. It is exciting to see our customers begin to leverage InsuranceSuite delivered via Guidewire Cloud to accelerate innovation and agility in this way. In addition to these cloud deals, we are happy to welcome two new customers located outside the United States. In Tokyo, E.Design Insurance, a subsidiary of long-time customer Tokyo Marine and Nichido Fire Insurance selected the entirety of InsuranceSuite as well as Digital. And in South Africa, Susreia SoC, the only insurer to provide short-term coverage for risks such as civil commotion, strikes, riots, and terrorism in South Africa selected ClaimCenter and Digital. Outside of our core products, we added Clear Spring Property and Casualty, a subsidiary of Delaware Life Insurance as a new Guidewire customer. Clear Spring selected science for small business workers' compensation and is an example of the continued momentum related to our science-based data listening and analytics modeling engine being optimized for use cases beyond cyber. Turning to expansions. Including USAA and the other Tier 1 insurer I previously mentioned, 25 existing customers chose 63 additional products. Among these, three customers selected their InsuranceSuite core systems with the selection of additional products. AXA Hong Kong selected PolicyCenter, BillingCenter, and Digital; while the National Farmers Union Mutual Insurance selected PolicyCenter, Digital and Data; and State Accident Insurance Corporation selected ClaimCenter. We also continue to see existing customers add Digital and Data products with Admiralty CAA Club Group of Canada and Western Reserve Group adding data management in the second quarter and Republic Indemnity, RSA Canada Group, Western National Mutual Group, and Zurich Insurance adding digital. Additionally, Global Indemnity Services and Safety Insurance added both data and digital capabilities in the second quarter. Of course, our track record of successful go-lives continues to be the real measure of our ultimate success. During the second quarter, we had seven customers go live for the first time on 20 different products. On top of that, five customers completed major version upgrades, including two customers who upgraded to InsuranceSuite 10 and one customer who upgraded to the latest version of InsuranceNow. This market momentum would not be possible without a robust partner community. We made a number of investments to better enable our partners to be ready to work with customers in a manner consistent with our cloud standards. Notably, within our partner community, approximately 290 consultants from 18 partner companies have now earned the advanced certifications required for Guidewire Cloud implementations, almost tripling the number of certified consultants since the end of last fiscal year. Guidewire remains a top priority for large global systems integrators and consulting companies, and they continue to invest in our training programs to better serve the global P&C industry. Seven months since my role here, I can confidently say that Q2 was a solid quarter. But make no mistake, we are in the midst of a very significant transformation, not just for our company, but also the industry. The market imperatives motivating core system modernization are as strong as ever. Too much of the P&C industry still runs on legacy systems that are a big constraint for insurers looking to connect with customers in modern ways. The transformation to cloud and the shift away from on-prem, self-managed implementations is clear, and the product direction and strategy we have chosen is absolutely correct. We are confident that we will continue to build on our market-leading position as the partner of choice for core modernization projects as we invest in and continue to deliver on cloud product offerings. This shift to the cloud means a shift away from on-prem self-managed deals, and this dynamic has real implications in the short term to our financial model and financial projections. As insurers recognize that cloud-based core systems are the right long-term strategy, their demand for on-prem self-managed system slows. We are seeing this switch very clearly in North America and expect that it will follow in Europe and Asia as well. Curtis and Jeff will discuss the financial implications of this change, but I want to stress that in the medium to long term, I think that this is a very positive signal. The shift to cloud validates our product and company strategy. And as our ability to market, sell and deliver our cloud service strengthens, we believe it will accelerate cloud sales enough to outpace the slowdown in our on-premise license sales. We remain as confident as ever in our position to serve the $2.4 trillion P&C industry as its core platform of choice. We are still in the early stages of the industry's transition to cloud. And to see validation and clear demand in the market is a very positive sign. We officially launched InsuranceSuite Cloud less than two years ago and currently have 15 customers, five of which are already in production. The success of these InsuranceSuite Cloud customers as well as InsuranceNow customers serve as important proof points and references that will boost the confidence of future cloud customers and prospects. So while that transition requires us to reset our projections for how it will play out financially in the short term, it only strengthens our belief in the underlying business strategy and medium- to long-term implications for our company. Finally, I want to proactively address COVID-19 and its potential impacts to Guidewire and the actions we're taking here to be prepared. We're monitoring the fast-moving events very closely and have a regular team meeting to update our response. We have some formal restrictions on travel in place in line with government and CDC recommendations. We are also supporting and accommodating employees who do not feel comfortable traveling for work-related activities. Additionally, we have seen evidence our customers and prospects are enacting their own preventative policies and believe that more will follow. Our employees regularly use a variety of tools to work and engage remotely, and we are ramping up our approach to supporting and, in some cases, encouraging remote work. While widespread restrictions on travel and in-person meetings could affect service delivery and sales activity, we do not currently anticipate a material financial impact this year. Before handing the call over to Curtis and Jeff, I want to thank Curtis for his service to Guidewire as our Chief Financial Officer. As you know, Curtis took on a tremendous amount of responsibility, leading our organization through the adoption of ASC 606 accounting standard and the early days of Guidewire's Cloud transition. On behalf of everyone at Guidewire, I wish him all the best after his transition later this month. I'm also pleased to announce that Jeff Cooper, our current VP of Finance, will be assuming the role of interim CFO after filing of the 10-Q. Many of you have already interacted with Jeff and no doubt can appreciate why we feel we are in good hands with Jeff at the helm of the finance team as our CFO search continues. Now, I'll turn the call over to Curtis and Jeff.

Thank you, Mike. Total revenue in the second quarter was $173.5 million and was above the high end of our guidance range. License and subscription revenue was $105 million, an increase of 21% from a year ago, driven primarily by 94% growth in subscription revenue to $28.6 million. This increase in subscription revenue is attributable to strong InsuranceSuite Cloud sales. As we stated in our previous call, although we continue to expect the vast majority of term license activity to conform to the two-year initial terms followed by annual renewals, we are also open to considering longer terms when it makes sense for us and our customers. In the second quarter, we experienced a small revenue uplift of less than $3 million from deals with renewals extending beyond one year. From a new sales mix perspective, 63% of new software sales in the second quarter were subscriptions compared to 53% a year ago. On a year-to-date basis, 59% of new software sales were subscriptions. Maintenance revenue was $21.1 million, relatively flat compared to a year ago and was also above the high end of our guidance range. As stated in our previous call, we expect maintenance revenue to be muted by the growth in subscription revenue, which includes maintenance activities as part of the subscription fees. This includes the impact of cloud migration deals when a customer converts from a term license to a subscription service. ARR, as Mike noted, was $474 million on a constant currency basis at the end of the second quarter, an increase of approximately 13% from a year ago. Services revenue for the second quarter was $47.4 million, which is slightly below our guidance, impacted by additional investments we made in the quarter for a large customer to ensure project success. Turning to profitability, as I mentioned in my opening remarks, we will discuss these metrics on a non-GAAP basis. Gross profit was $102.4 million in the second quarter compared to $101.1 million a year ago. The relatively similar result was due to greater license and subscription revenue and a lower professional services mix, offset by greater investments in expanding our cloud capabilities and the impact of professional services investment. As a result, gross margin for the quarter was 59% compared to 60% a year ago. Services gross margin for the quarter was 1%, down from 10% a year ago, again mainly driven by an investment to ensure the success of an ongoing customer project. Total operating expenses were $86.9 million in the second quarter, an increase of 15% from a year ago, driven by net increases in headcount and the timing of connections which was held in Q2 this year but held in Q1 the previous year. As a result, operating income was $15.4 million, exceeding the high end of our guidance range largely from revenue upside and favorability in expenses due to the timing of hiring and projects. Net income was $17.6 million or $0.21 per diluted share. Turning to our balance sheet. We ended the quarter with $1.3 billion in cash, cash equivalents and investments flat compared to the end of the first quarter. Operating cash flow for the quarter was $19.5 million compared to $14.3 million a year ago. Free cash flow for the quarter was $16.7 million excluding the positive impact from a net $0.3 million for tenant improvement allowance associated with the new headquarters compared to $12.1 million a year ago, which excludes approximately $6.6 million in buildout expenses. I will now turn the call over to Jeff to discuss our outlook.

Thank you, Curtis. Before we discuss the outlook, I want to emphasize a few themes that are influencing our results. First, our cloud deal activity is on track. We anticipate continued strong growth in InsuranceSuite Cloud deal activity this year. Our ability to execute in the cloud is crucial for our long-term success, and we are satisfied with our progress thus far. At the same time, the market is moving away from self-managed core systems more quickly than we anticipated. Customers and prospects, particularly in North America, who were previously considering self-managed systems are now often reevaluating and looking at Guidewire Cloud. Moving forward, we believe we can best serve our customers through cloud solutions, and we welcome this transition. However, in the short term, this shift has led to a slowdown in new term license sales, affecting our outlook. We now expect ARR growth on a constant currency basis to be between 11% and 12% for fiscal year 2020, down from our earlier range of 14% to 16%. This revised outlook reflects approximately a $16 million adjustment from the midpoint of our previous forecast and is based on lower expectations for new term license sales. We anticipate that subscription new sales as a percentage of total new sales will be between 70% and 80%, an increase from our earlier range of 55% to 75%. Consequently, we are raising our subscription revenue outlook to between $114 million and $118 million this year, indicating 78% growth at the midpoint. We have also updated our total license and subscription revenue outlook to between $413 million and $425 million, and our maintenance revenue outlook to between $83 million and $84 million for the year. This reduced outlook is due to our revised expectations concerning term license bookings and the associated upfront revenue along with maintenance. We do expect some benefits from term license contracts that are not following our typical two-year initial term with annual renewals. Currently, this impact is anticipated to be less than $10 million in the second half of the year, but it could be much higher if we see large customers signing longer-term licenses. Our updated services revenue outlook is between $202 million and $208 million, influenced by our continued success with SI partners on cloud implementations and lower activity in new self-managed deals. Additionally, we have observed a few large customers opt to in-house work that was previously handled by our services team. Customers becoming more self-reliant is generally good for Guidewire, but these developments were not anticipated in our previous outlook. We expect total revenue to be between $702 million and $714 million this year, compared to our earlier range of $759 million to $771 million. Regarding gross margin, we continue to expect our overall non-GAAP gross margin to be between 58% and 59%. We project license and subscription margin to be between 78% and 79%, even with a higher overall subscription mix, and services margin to be between 6% and 7%. We are now forecasting operating income to be between $61 million and $73 million, representing a non-GAAP operating margin of 9% at the midpoint. We expect free cash flow to be between $75 million and $85 million, excluding about $11 million in cash outlays related to our new headquarters. For the third quarter, we expect license and subscription revenue to be between $78 million and $82 million. Subscription revenue for Q3 is anticipated to be between $28 million and $29 million. We expect Q3 maintenance revenue of $20 million to $20.5 million and Q3 services revenue of $53 million to $57 million. We estimate total revenue for the quarter to be between $153 million and $157 million. Currently, we project ARR growth for Q3 to be between 10% and 11%. In Q4, ARR will benefit from ramp-up activity from cloud deals sold in Q4 of last year, which is included in our annual outlook of 11% to 12%. For the third quarter, we expect a non-GAAP operating loss between $11 million and $7 million. In summary, while we are pleased with the activity in the quarter, we are clearly witnessing a quicker-than-expected transition away from on-premise solutions. The willingness of property and casualty insurers to adopt core systems in the cloud is a positive long-term trend for Guidewire. However, the short-term impact on our business model and income statement is expected to be more significant than previously anticipated. We will strive to help investors understand these dynamics as we navigate this financial model transition.

Thank you. At this time, we will be conducting a question-and-answer session. Our first question is from Sterling Auty from JPMorgan. Please proceed with your question.

Yes, thanks. Hi, guys. So I think everyone appreciates the faster shift to the cloud and agrees with you that that's the right move. But help us understand in terms of your ARR calculation, why the impact there? Because I think conceptually, investors might think, wait a minute, if you sign a cloud deal that's a recurring revenue. Why isn't that just supplanting what you would have signed in a term deal? Is it a timing difference? Or what else is going on there to cause that lower ARR growth this year?

Anytime a company undergoes a transformation, there comes a moment when it becomes evident that the change is genuine. Right now, that moment is occurring at Guidewire as we shift to the cloud, which is the future of our industry. This is clear to everyone involved, including employees, customers, partners, and investors. It’s important for everyone to recognize that this transition is happening, and it’s occurring more quickly than we anticipated. Our financial model presupposed a gradual and smooth shift from on-premises sales to cloud sales, allowing us to create plans and projections for the future. However, looking at the second half of the fiscal year, we see that our expectations for a smooth transition don’t align with reality. We are experiencing the cloud demand we anticipated, but the on-premises demand is declining more rapidly than expected. Nonetheless, I view this as a positive development; it validates our strategy. An important question arises regarding whether we can accelerate cloud demand enough to compensate for the slowdown in on-premises licensing. I want to assure you that this is our main focus right now. We are dedicated to enhancing our cloud product to ensure customer success and build the confidence necessary for them to transition to the cloud. This will ultimately boost demand for our cloud offerings and facilitate continued growth in Annual Recurring Revenue (ARR) at rates we believe the market can support. I am confident we are on the right track, following the correct strategy, and pleased with our progress. We have earned the trust of USAA, one of the most esteemed insurance companies, and have implemented their operations on top-tier cloud infrastructure capable of scaling for all our clients. Recently, we merged the cloud operations team with our product development team, creating a cohesive unit focused on designing, engineering, and delivering cloud services. We are also preparing for the upcoming release of InsuranceSuite in May, marking its first genuine cloud version. All these factors contribute to our potential to speed up cloud demand and bookings, making up for the decline in on-premises license sales and returning our ARR growth to the levels we initially projected. I want to emphasize my confidence that we are on the right track and that the core business opportunity remains strong. The opportunity to modernize the core systems of the property and casualty industry is significant, and we are in an excellent position to capitalize on it.

And then maybe just as a follow up just to clarify. So, it's not that those term deals self-managed on-premise opportunities are dead, just they're taking longer because they want to consider the move to the cloud. It's not like they've chosen the competition?

That's correct. We haven't observed any changes in the competitive landscape of the market. This has remained consistent from quarter to quarter. We are simply looking toward the second half and noticing a significant shift toward the cloud, which was anticipated in our model. There isn’t any further implication in that situation. Companies are simply taking more time to assess their options, which makes sense. As mentioned earlier, this trend is primarily seen in North America, but we anticipate it will also be reflected in Europe and Asia. It seems quite natural. If you consider it proven that the future lies in cloud-based core systems, it is logical for insurance carriers to reassess their decisions regarding on-premise implementations and contemplate moving to the cloud once it becomes more established. Our ability to expedite this market transition will rely on our ongoing efforts to enhance product capabilities and provide clear evidence and customer testimonials, which I believe will ultimately lead us to return to our projected ARR growth.

Got it. Thank you.

Thank you. Our next question is from Bhavan Suri from William Blair. Please proceed with your question.

Hey guys, thanks for taking my question. I guess maybe one for Chris and Jeff first, really quickly on numbers given Sterling's commentary. You've sort of historically said that every 1% increase is sort of a $1.5 million negative impact to revenue. And so I come to about a $15 million negative impact, but you obviously got it down by 30. Just help me reconcile those two numbers a little bit please?

Yes, you're thinking about it correctly. The shift towards a higher percentage of subscription new sales accounts for about half of the impact reflected in our outlook. The other half stems from the slowdown in term license bookings, which is slightly more than we expected for the year. We're noticing that activity flowing through, and additionally, some of the subscription activity we are observing is skewed towards the back-end. As a result, the revenue recognized over time is contributing less this year, which explains the other half of the impact. That's our perspective on the situation.

Got it. Got it. Okay. And then Mike for you, more importantly, when you look at this you've talked about increasing partners, professional services organizations consultants. You touched on that. And that's great because it drives broader reach and these guys are really interested in insurance and these are big implementations everything else. With the cloud, it changes the implementation dynamic. Are these guys part of the problem in terms of slowing the conversation? Or are they part of the solution ultimately? How should we think about that? It's great that they expand the reach. But obviously, the cloud in terms of Salesforce in the beginning, Accenture was not a partner because they didn't want to spend or get a project for $5 million permanent Salesforce from what they could do, $5 million see both. How should we think about the dynamic but professional service organizations as a positive or negative, given what you're seeing with the guys thinking about moving the cloud and slowing down of the on-prem?

Thank you for the question. Every sale of Guidewire is tied to implementation projects, which can vary in size. Transitioning from a legacy system to a Guidewire product typically involves a significant implementation effort. Moreover, selling Guidewire Cloud usually necessitates an upgrade to InsuranceSuite 10, which again involves an accompanying project. This interconnection highlights the importance of having trained consultants and expertise related to InsuranceSuite 10 and the standards we establish during implementations, as it is crucial for our ongoing growth and success. There is a direct correlation between these projects and the sales, and customers are considering both aspects concurrently. We are motivated to ensure we have a certified and capable team of consultants within our partner ecosystem to effectively staff and execute these projects when they arise. Additionally, there's an important change regarding Guidewire Cloud: we will move to releasing product updates every six months instead of launching an InsuranceSuite 11. This change is designed to facilitate the implementation of our product on the cloud by accommodating smaller, more frequent releases, which enhances our ability to deliver innovation that is essential for customers deciding to migrate to our cloud. In summary, the role of these consultants is vital for our future success and our ability to accelerate cloud sales.

Appreciate it. Thanks for the color. That was really helpful. Thank you, guys.

Our next question is from Ken Wong from Guggenheim Securities. Please proceed with your question.

Yes, I apologize for that. I wanted to address the slowdown in term and understand what gives you confidence that there hasn't been a change in the underlying retention rates. Historically, we have seen term as a consistent pattern where we could rely on it annually. If it has decreased, it is due to the increase in Cloud. With the recent slowdown or delays, I just wanted to confirm that there isn't anything unusual happening. Are there connections regarding services moving in-house for customers that could be delaying some of these term deals?

Yes. Hey Ken, it's Jeff. So, our customer churn continues to be negligible. And we do note that we did see a little bit of heightened churn last year in Q2 related to science. We did not see a repeat of that pattern. So, ARR attrition in the quarter or any lost ARR that we experienced in the quarter was very much in line with our expectations. And as we think about the year, it's still very much in line with our expectations. So, no impact there. And on the services side that's really customers who we've been live with for a long period of time but continuing to supplement their in-house IT staff with some of our services personnel. And so it caught us a little bit off-guard, but it was something that is a healthy thing for our customers to take on more of that work. So, it has nothing to do with any ARR attrition.

Got it. And then maybe a follow-up. I know this is probably something you guys haven't fully had a chance to flush out yet but any way to kind of steer us in terms of how we should be thinking about that fiscal 2023 trajectory now?

Yes. The current activity regarding term licenses has a significant impact on our short-term outlook. We are still assessing how this will reflect in our demand profile within the cloud sector and its implications for our long-term model. At this moment, I cannot provide an update, but you can expect us to address this during Analyst Day as we do annually.

Got it. All right. Thanks a lot guys.

And our next question comes from the line of Rishi Jaluria from D.A. Davidson. Please proceed with your question.

Hi guys. This is Anna on for Rishi today. Thank you for taking the questions today. So, kind of following up on a previous comment you made. You talked about some of your larger customers in-housing more work those previously done by your services personnel. What kind of assumptions do you have built into the remainder of the year on this? And do you expect this trend to accelerate or remain relatively stable?

This is a relatively isolated event. There were a couple of customers that made that decision. Again, we think it's a healthy phenomenon. We have done a little bit of a deeper inspection with our services team to understand that there are others that would fit this profile and we have embedded that into our outlook.

Okay, great. Thanks. And then second question. It seems like you guys have been having a lot of increased success with your InsuranceNow product. That's nice to hear. Could you provide a little more color on the one win you highlighted maybe why they chose you? And then maybe more generally how do you think about the growth of that business going forward?

Thank you for the question. As I mentioned in our prepared remarks, we are very excited about that recent win. It's come up a few times in previous quarters, and I view it as exceptionally well executed by the organization. We revamped the product and our approach to service implementation. We also refocused our sales and marketing efforts on this product, particularly in North America and within that specific market segment. I'm optimistic about the forecast and pipeline we see for the rest of the year. As we close deals from that pipeline, we will keep you updated in future calls. This win is a crucial and strategic part of our company and product strategy, as I’ve mentioned before. I am genuinely proud of how our team executed to achieve this. To provide some context, my understanding is that the selection process was significantly influenced by Guidewire’s commitment to the industry and that product line, which ultimately worked in our favor. As you may know, this was a competitive deal in a challenging market, and I'm pleased to see us reestablishing our ability to compete successfully in that space.

Very helpful. Thanks.

And our next question is from Chris Merwin from Goldman Sachs. Please proceed with your question.

Thanks very much for taking my question. I just wanted to ask about ongoing conversations with customers that are contemplating a migration to the cloud. Are you getting any incremental pushback on pricing or deal structure just given all the upfront costs there with professional services and maintaining the term license and then paying for the cloud subscription as well? I know the ramp structure has been really effective so far but just curious how those conversations are evolving? Thanks.

Yes. I would say nothing has changed quarter-to-quarter. I would reiterate my previous comments about the importance of consultants. The feedback I'm receiving emphasizes the need to create a plan that justifies the overall long-term value proposition to support the upgrade expense and the implementation project necessary to meet the standards for the cloud model going forward. As you are likely aware, these are substantial transactions that undergo thorough examination. We work diligently to ensure that we are presenting a product and proposal that will justify that transition. Essentially, while nothing has changed, we are focusing on how to minimize the transition and upgrade expenses to make the equation more favorable for the insurance carrier. So, nothing has changed, but that dynamic is quite real, and it is what we are addressing as we justify the sales of cloud products moving ahead.

Great. As a follow-up, Mike, one of the topics you mentioned at Analyst Day regarding your focus this year was on subscription costs and improving gross margins. I would like to get an update on how that's progressing so far. Could you discuss some of the specific initiatives you're implementing to increase cloud gross margins towards that long-term target? Thanks.

Yes. I'll point I would say two things at a real high level that will give you an indication of the kind of things that we're doing, both of which I sort of mentioned already, but I'll explain them a little bit more deeply. One is we merged the organization's cloud operations and product development. And that may sound like a small thing, but I think spiritually, it's a very, very important thing that we sort of instantiated the viewpoint with every engineer at this organization that we're not just writing code that becomes software, we're writing code that becomes a service and that we're working hand-in-hand with the folks that are running the cloud operations such that we are delivering a scalable, reliable and efficient cloud service. That partnership which you can sort of describe as an organizational change, but that partnership becomes really, really important when you think about how are we driving just the further development of the cloud service, but also making it more and more efficient every release and every period as we move forward. That's a really, really important milestone for us. The other side of it is that I talked about how USAA is now deployed on the latest and greatest cloud infrastructure. I think the comments I made is that we really believe that that's the future of how we're going to deploy our customers going forward and it gives us a lot of leverage in terms of ensuring that we're creating the efficiencies that create the margin that you're after. So, without getting into any of the technical detail is probably not appropriate for this call. Those are two of the things that I think happened this quarter that I'm very, very positive on in terms of setting us down the right course for making improvements in that area.

Great. Thank you.

Our next question is from Mayank Tandon from Needham. Please proceed with your question.

Thank you. Good evening. First, just a modeling question maybe for Jeff. Could you just provide a little bit more color on the margin trajectory next quarter, is that going to be a function of gross margin slippage or is that going to be more weighted towards SG&A impact in terms of the margin compression in 3Q?

Yes. I think it's more a function of where the revenue hits and where the kind of term license revenue hits. As an example we had a fair amount of term license activity in Q4 of 2018. Those deals go offline for a year and then reemerge in Q4 of 2020. And so it's more a function of the revenue rather than any expenses that I would highlight.

Got it. And then just another point of clarification. In terms of the disruption to growth, is this really a function of the new sales activity? Or are you also seeing a push from your existing client base to transition to the cloud and that's also creating some vacuum in terms of the growth rate as you go into the next couple of quarters?

I don't believe this is a change between the existing customer base and new customers. It's simply a natural result of a shift in the way core modernization is being implemented. This adjustment will take some time, and as confidence in our cloud product offering improves, we will return to the usual pace of leveraging both the migration of our customer base to the cloud and the modernization of legacy systems, which is fundamentally what Guidewire is built upon. There is a clear shift happening, prompting many to reconsider and think that perhaps they should transition directly to the cloud. This transition will also require some time for adjustment, but eventually, we will return to the normal demand environment that supports our core sales opportunities. Does that make sense?

Yes it does. Thank you.

And our next question is from Michael Turrin from Wells Fargo Securities. Please proceed with your question.

Hey, there. Thanks, good afternoon. I want to go back to what's changing here in terms of the annual guide. I think the growing subscription mix impact is clear. So maybe focusing a bit more on the term license piece again. Can we just talk more around what's new there versus where we stood kind of heading into the quarter? And in terms of this extended evaluation process, any sense for how far that could extend before we get to the period of normalization you just referenced there Mike?

Yes. I can let Jeff add to my response if I don't answer your question thoroughly. There are two main factors at play. First, the transition from term to subscription will impact our revenue, which we have prepared for. Second, as I have mentioned in previous quarters, you can get a clearer picture by looking at ARR. Additionally, if we're not seeing an equal balance of cloud sales compared to on-prem sales, we need to determine when cloud sales will increase enough to offset the drop in term sales. We’ve provided solid visibility through the end of the fiscal year. We're an annual company, and we conducted a thorough assessment of our pipeline for the second half after Q2, analyzing demand and business visibility in detail to gauge our expectations for this fiscal year. We have limited visibility into next fiscal year, and it's crucial to stay focused on this current year. Over the next two quarters, we will be able to provide a clearer outlook for the next year. My priority is to avoid distracting from the importance of finishing this year strong.

I want to add that at the beginning of this year, we anticipated that customers who were not ready to transition to the cloud would opt for on-premise solutions in InsuranceSuite 10, potentially setting themselves up for a future migration to the cloud. However, we are not observing this trend. Many of these customers or prospects are choosing to delay their decisions instead of proceeding with InsuranceSuite 10 on-premise at this time.

Okay. That's helpful color from both of you. Maybe just one more. Mike, given your prior experience and where Guidewire is today and its cloud transformation wondering if you can talk about initial observations with the five production customers and where we are from your standpoint in terms of the implementations on the cloud side becoming just increasingly more repeatable over time?

Thank you for the question. Our current customers and the go-lives we've experienced have provided us with valuable insights, allowing us to improve our processes with each implementation. We have acquired enough information to establish the right infrastructure, which gives me great confidence moving forward. We believe our architecture is well-suited for scalability and repeatability. Additionally, if you consider that InsuranceSuite 10 has had 10 releases, we are preparing for the first cloud-optimized release of InsuranceSuite 10 coming in May, marking a significant milestone for our organization. When comparing our cloud value proposition to Salesforce, we are focused on continuously delivering innovations to our cloud customers, similar to their longstanding practices. This shift will be a tremendous advantage for the property and casualty industry and will enhance our ability to secure cloud deals in the future. By leveraging the efforts of our numerous engineers who are developing an improved core system, we can quickly integrate these advancements into our cloud offerings. This model is far healthier than our current approach, where it can take years for products and features to transition from Guidewire to on-premise implementations. I am extremely excited about this transition, and I believe the May release will be a pivotal moment for both the company and our customer base.

Great. Thank you.

Next question is from Tyler Radke from Citi. Please proceed with your question.

Hey thanks for squeezing me in. Mike I just wanted to go back to a comment you made earlier in the prepared remarks around seeing interest with some of your customers pursue smaller cloud initiatives. And I'm wondering obviously we've seen the mix for bookings increase in terms of cloud maybe being a little bit better than expected. But I'm curious if you're seeing any type of composition change just within those cloud deals, maybe skewing to more project-based versus kind of larger InsuranceSuite cloud deals. Just any type of color in terms of maybe the mix of cloud and type of cloud deals you're seeing relative to expectations and whether that's kind of a factor here and kind of the moving pieces with the guide. Thank you.

Thank you for the question. I wouldn't necessarily label it a factor because I view it as a very positive signal. Many of our customers have innovation groups or test and learn projects focused on creating new insurance products to bring to market quickly. They are exploring new channels for delivering these products. The key to operating successfully in this environment is agility and the speed at which ideas can transition from concept to reality and be assessed for effectiveness. The quicker this can be achieved, the faster the business can grow. This is an encouraging sign that our cloud delivery model supports this demand, and we are thrilled to be part of it. Insurers are looking at these innovative projects as proof points to validate their transition to the cloud, whether they are running on Guidewire or legacy systems. Once they observe how the cloud model operates, how upgrades function, and how it enhances business agility, it becomes easier for them to justify a significant shift of their major books of business to Guidewire Cloud. So, while it is indeed a factor, it represents a very positive development and presents another opportunity for us to establish the proof points necessary to accelerate our business.

Great. That's helpful information. To follow up on that, last quarter you mentioned that some of your major customers are collaborating with partners to transition to AWS infrastructure, and they may not be fully adopting Guidewire and InsuranceSuite Cloud, instead just moving their on-prem solutions to AWS. Are these the kinds of customers we should consider as potentially testing the waters with smaller projects, or is that a different group? Could you help clarify these two dynamics and if they are related at all? Thank you.

Yes, I view that as a separate matter. I believe this represents a transitional phase in the market that will eventually diminish. When migrating an on-premises software package to the cloud, a logical approach is to transfer it to one of the cloud platforms. This can be done independently or with a partner, and I believe those businesses or strategies are acceptable. However, it differs significantly from aligning with the cloud version of Guidewire, which receives upgrades every six months and is enhanced with cloud-native services to improve the functionality of InsuranceSuite 10. I still expect to see some of those transitional approaches, and they may be suitable in certain situations. However, the majority of cloud use cases will likely move directly to Guidewire Cloud, where the real value will be delivered. While that positive transitional step still exists, I anticipate it will diminish over time, with more customers opting to go directly to Guidewire Cloud.

Thanks Mike. Appreciate it.

Our next question is from Brad Sills from Bank of America. Please proceed with your question.

Thank you for taking my question. Mike, you mentioned that the next version of InsuranceSuite Cloud will be more cloud-ready. I understand that this means it will be able to deliver more features more quickly. Could you provide more details on what being more cloud-ready means for this upcoming release? Thank you.

Certainly. The current focus of our engineering team is on optimizing the cloud implementation of InsuranceSuite 10. We are assuming that customers will be using our Guidewire Cloud platform through our cloud provider, allowing us to enhance the delivery of new innovations and product features for that scenario. However, we will not neglect our on-prem customers, as providing functionality for InsuranceSuite 10 on-prem is crucial for us. It's important to emphasize that our primary goal is to deliver new innovations for the InsuranceSuite 10 implementation on the Guidewire Cloud platform. We will also be introducing cloud-native capabilities and services that enhance InsuranceSuite 10 beyond that specific implementation. Additionally, we are rolling out various data and analytics services that will operate as cloud services. Moving forward, you can expect us to concentrate our engineering efforts on these enhancements with releases scheduled every six months, with the first one coming in May. Does that clarify things?

Yes. Absolutely. No. Thank you. And then one more question if I may please. Thanks Mike. You mentioned that during the quarter you saw more shift of services to in-house. This the beginning do you think of a longer-term trend? In other words, are customers more capable at this point and we're comfortable running more of the services support for the hosted versions in-house? Is that an ongoing thing? Thank you.

Yes, Brad, this is Jeff. Just to clarify, those are not hosted versions; they are on-premise versions chosen by some large customers. Our goal is to empower our customers to be self-sufficient, and while we do have some projects that require us to be on-site for an extended time, this remains a priority. We have incorporated this into our model, and we acknowledge that a few instances this year took us by surprise.

And we have Joe Vruwink from Robert W. Baird & Company. Please proceed with your question.

Mike, regarding the upcoming product release, it appears to focus significantly on front-end development tools, the digital offering, and the relationship with Salesforce. I'm curious if Guidewire could see a different mix between core systems and digital data in a few years, and whether that mix might contribute to accelerating cloud growth.

I would say that the way we are designing the system can drive cloud growth. Specifically, we believe that analytics and data will be integral to every implementation of an insurance core system, including claims, policy, or billing. This has now been established. Recently, we spent a couple of days gathering feedback from our top customers on where we should focus our product investment. The enhancements you've mentioned, particularly regarding digital capabilities and APIs that allow carriers to connect core policy and claims processes to portals, websites, mobile applications, and other channels, are quite expansive. The innovative ways these carriers are looking to broaden the reach of Guidewire-driven business processes is very exciting. There was strong support for our efforts to enhance these digital capabilities, making it easier for carriers to adopt and expand into these channels. This feedback was a significant validation for us. As we move forward with our six-month release cycles and continue to improve the core capabilities of InsuranceSuite 10, the digital and analytics-based features included will significantly drive our cloud offering.

Great. Thank you very much.

So I think we're at the top of the hour now. So I want to thanks everybody. Thank you all for participating on the call today and we'll see in the quarter. So thanks very much.

This concludes today's conference and you may disconnect your lines at this time. Thank you for your participation.