Business Context and Reporting Period
Guidewire Software, Inc. provides software platforms for property and casualty insurance operations, including PolicyCenter, ClaimCenter and BillingCenter, plus maintenance and professional services. This unaudited Form 10-Q covers the three and six months ended January 31, 2013, the second quarter and first half of fiscal 2013. The company operates as one segment and sells primarily through a direct sales force, with typical new-customer sales cycles of 12 to 24 months and implementations lasting approximately 6 to 24 months or longer.
Financial Results and Key Metrics
| Metric | Three months ended Jan. 31, 2013 | Prior comparable period | Six months ended Jan. 31, 2013 | Prior comparable period |
|---|---|---|---|---|
| Total revenue | $72.2 million | $55.1 million | $135.5 million | $107.5 million |
| Gross profit | $40.8 million | $34.4 million | $76.5 million | $67.2 million |
| Gross margin | 56% | 62% | 57% | 63% |
| Income from operations | $5.1 million | $5.4 million | $5.0 million | $13.5 million |
| Net income | $5.5 million | $3.7 million | $5.9 million | $8.5 million |
| Diluted EPS | $0.09 | $0.06 | $0.10 | $0.15 |
| Adjusted EBITDA | $16.4 million | $12.3 million | $27.2 million | $24.5 million |
| Operating cash flow | Not separately provided | Not separately provided | $3.1 million | $(12.3) million |
- Quarterly revenue increased 31%; first-half revenue increased 26%. License revenue rose 20% in the quarter and 11% year to date, maintenance revenue rose 35% and 34%, and services revenue rose 43% and 39%, respectively.
- Quarterly gross margin declined primarily because services, which have materially lower margins, represented 45% of revenue versus 41% previously. Services gross margin declined to 9% from 14%; license margin was approximately 100% and maintenance margin was 81%.
- Operating expenses increased 23% in the quarter and 33% year to date, driven by employee growth, higher research and development and sales and marketing spending, and increased stock-based compensation.
- Cash, cash equivalents and investments totaled $203.2 million at January 31, 2013, including $101.5 million of cash and cash equivalents, $64.4 million of short-term investments and $37.4 million of long-term investments. Working capital was $155.8 million.
- The filing reports no debt arrangements or material non-cancelable purchase commitments. Total liabilities were $81.7 million, including $45.1 million of deferred revenue.
- Four-quarter recurring revenue increased to $127.0 million at January 31, 2013 from $96.3 million at January 31, 2012.
Material Changes Versus the Prior Comparable Period
- The revenue mix shifted toward recurring term licenses: term license revenue increased 49% in the quarter and 56% year to date, while perpetual license revenue declined 79% and 90%, respectively. Recurring term licenses represented 96% of quarterly license revenue and 97% of first-half license revenue.
- Services revenue grew faster than total revenue, increasing its share of first-half revenue to 48% from 44%, which pressured consolidated gross margins.
- Research and development expense increased 31% in the quarter and 33% year to date; sales and marketing increased 35% and 50%, respectively. Management expects operating expenses to continue increasing in absolute dollars.
- Net income increased in the quarter despite lower operating income, primarily because the company recorded income tax benefits of $0.3 million versus a $1.4 million tax provision in the prior period. For the first half, net income declined because the prior-year period included a substantially higher tax provision but also a higher operating income level.
- Operating cash flow improved by $15.4 million year to date, partly because the prior-year period included a $10.0 million litigation settlement payment and because stock-based compensation increased. Investing cash outflows increased to $104.2 million, primarily from purchases of available-for-sale securities.
- Deferred revenue declined 19% from July 31, 2012 to $45.1 million, reflecting revenue recognition from existing contracts and implementation projects. Management cautions that deferred revenue is an incomplete measure of business strength because it excludes amounts not yet invoiced.
- Stock-based compensation increased to $20.2 million in the first half from $9.6 million. Unrecognized stock-based compensation was $44.6 million at January 31, 2013, with an average expected recognition period of approximately 1.4 years for restricted stock units and 1.2 years for options.
Guidance, Outlook, Commentary, Risks and Unusual Items
- Management expects continued investment in product innovation, research and development, sales and marketing, international expansion and professional services capacity. Cost of revenue and all operating expense categories are expected to increase in absolute dollars.
- Management expects annual positive operating cash flow, although quarterly cash flow may fluctuate significantly because of seasonality, bonus payments, commissions, collections and deferred revenue timing. Existing cash, investments and expected operating cash flow are believed sufficient to fund operations for at least the next 12 months.
- Guidewire Live, a cloud-based network and analytics offering introduced in October 2012, is expected to generate modest revenue during fiscal 2013 while the company incurs development and marketing costs.
- Revenue recognition depends on contract terms, payment timing, delivery, implementation progress, acceptance criteria and vendor-specific objective evidence. These factors can create significant quarterly volatility.
- The company has a pending Accenture appeal involving patent validity. It previously paid $10.0 million under a settlement and may owe an additional $20.0 million if Accenture prevails, or may elect to pay $15.0 million before an initial appellate determination to discharge the obligation. The appeal ruling was pending as of the filing.
- Key risks include customer concentration, long sales and implementation cycles, a growing mix of lower-margin services, competition, economic weakness affecting insurance-industry technology spending, foreign currency exposure, intellectual-property claims, product defects, cybersecurity and data-security incidents, personnel retention, international operations and tax uncertainty.
- The company had two customers representing 20% of total accounts receivable at January 31, 2013, although no customer represented at least 10% of revenue. The ten largest customers represented 38% of quarterly revenue and 35% of first-half revenue.
- Management concluded that disclosure controls and procedures were effective as of January 31, 2013, and reported no material changes to internal control over financial reporting during the quarter.
Important Facts for Investors to Verify
- Whether the shift from perpetual to recurring term licenses produces sustainable recurring revenue growth and how contract payment timing affects reported revenue.
- Whether professional-services capacity can scale without further deterioration in services and consolidated gross margins.
- The timing and ultimate amount, if any, of the contingent Accenture settlement payment.
- The impact of $44.6 million of unrecognized stock-based compensation and continued equity issuance on future earnings and dilution.
- Whether deferred revenue trends, implementation completions and customer acceptance milestones support future reported revenue.
- Customer renewal, expansion and concentration trends, particularly among the ten largest customers.
- Whether the company maintains sufficient liquidity after capital expenditures, RSU tax withholding, potential litigation payments and possible acquisitions or international expansion.