Guidewire Software, Inc. — Fiscal 2019 Third-Quarter Form 10-Q
Business context and reporting period
Guidewire provides software, cloud subscriptions, data and analytics, digital engagement, and implementation services primarily to property and casualty insurers. The filing covers the three and nine months ended April 30, 2019, with comparative 2018 results presented as revised. The financial statements are unaudited.
Key financial metrics
| Metric | Three months ended April 30, 2019 | Three months ended April 30, 2018 | Nine months ended April 30, 2019 | Nine months ended April 30, 2018 |
|---|---|---|---|---|
| Total revenue | $162.9 million | $142.1 million | $511.7 million | $412.6 million |
| License and subscription revenue | $76.2 million | $52.4 million | $257.6 million | $165.3 million |
| Maintenance revenue | $21.3 million | $18.7 million | $63.6 million | $56.8 million |
| Services revenue | $65.3 million | $71.0 million | $190.4 million | $190.5 million |
| Gross profit | $82.6 million | $66.5 million | $270.1 million | $206.3 million |
| Gross margin | 50% | 47% | 54% | 50% |
| Loss from operations | $(15.8) million | $(28.9) million | $(19.6) million | $(63.7) million |
| Net loss | $(8.6) million | $(31.2) million | $(2.3) million | $(85.5) million |
| Net loss per diluted share | $(0.11) | $(0.40) | $(0.03) | $(1.09) |
For the nine-month period, net cash provided by operating activities was $13.2 million, compared with $36.6 million in the prior-year period. Capital expenditures were $31.0 million, producing negative free cash flow of $17.8 million versus positive free cash flow of $30.1 million in the prior-year period.
At April 30, 2019, cash and cash equivalents were $368.9 million, short-term investments were $636.3 million, and long-term investments were $243.0 million. Total cash, cash equivalents and investments were $1.248 billion, and working capital was $1.020 billion. The company had $400.0 million principal amount of 1.25% convertible senior notes due 2025, carried at a net amount of $314.2 million. The fair value of the notes was $458.1 million.
Material changes versus the prior comparable period
- Revenue increased 15% in the quarter and 24% for the nine-month period, driven primarily by term-license revenue recognized under ASC 606, increased product adoption, subscription growth and a ten-year term-license transaction.
- Term-license revenue increased 58% in the quarter and 54% year to date. Subscription revenue increased 71% in the quarter and 130% year to date, although subscriptions are recognized ratably over their contract terms.
- Services revenue declined 8% in the quarter and was essentially flat year to date. Services gross margin fell to 7% in the quarter and 2% year to date, reflecting investments in cloud implementations, higher personnel and subcontractor costs, and an unfavorable fixed-fee contract.
- Overall gross margin improved to 50% in the quarter and 54% year to date, primarily because of the higher mix of license and subscription revenue.
- Research and development expense rose 10% year to date and sales and marketing expense rose 13%, while general and administrative expense declined 7%. The company expects continued absolute-dollar investment in research and development, sales and marketing, cloud operations and corporate infrastructure.
- Interest income increased materially because of the larger investment portfolio following the 2018 equity and convertible-note offerings. Interest expense also increased because the convertible notes were outstanding for a full comparable period and include non-cash discount amortization.
Guidance, outlook, commentary, risks and unusual items
- The filing does not provide a clear numerical revenue or earnings guidance range.
- Management expects subscription sales to increase as a percentage of new sales. Because subscription revenue is recognized ratably, a shift from term licenses to subscriptions may reduce near-term reported revenue growth and increase deferred revenue.
- Revenue and earnings may remain volatile because of ASC 606, seasonal customer purchasing patterns, large individual transactions, contract duration, implementation timing and the mix between term licenses, subscriptions and services.
- The company adopted ASC 606 on August 1, 2018 using the modified retrospective method. Adoption increased opening retained earnings by $44.3 million and materially accelerated recognition of certain term-license revenue. For the nine months ended April 30, 2019, reported revenue was $511.7 million; the filing indicates revenue would have been $389.4 million under ASC 605.
- The company filed Form 10-K/A on June 3, 2019 to restate fiscal 2017 and 2018 annual financial statements, primarily due to a vendor-specific objective evidence revenue-recognition error and other corrections. The company identified a material weakness in internal control over financial reporting related to the existence and accuracy of revenue transactions. Disclosure controls were therefore deemed ineffective as of April 30, January 31 and October 31, 2018.
- Management is implementing redesigned controls for contract amendments and revenue recognition but stated that the material weakness had not yet been remediated as of the filing.
- The company expects operating cash flows to be positive annually but subject to significant quarterly fluctuations. Management believes existing liquidity is sufficient to fund operations for at least the next 12 months.
- The company entered into a new headquarters lease with total committed payments of $126.4 million over an expected 10.5-year term and provided a $1.8 million letter of credit for the security deposit.
- No material legal proceedings or material indemnification claims were reported. The company had $6.0 million of unrecognized tax benefits that would affect the effective tax rate if recognized. Potential future BEAT tax regulations could materially affect the tax provision when enacted.
- Principal risks include cloud migration and implementation costs, services-margin pressure, cybersecurity and privacy exposure, lengthy sales cycles, customer concentration, competition, foreign-exchange volatility, dependence on renewals, and the possibility of further reporting or control issues.
Important facts for investors to verify
- Reconcile reported results with ASC 605 or other comparable measures before evaluating growth, margins and trends.
- Monitor remediation of the material weakness and any additional restatements, regulatory inquiries, shareholder claims or delays in financial reporting.
- Assess the mix and growth of term-license versus subscription revenue, including bookings, deferred revenue, unbilled receivables and remaining performance obligations of $270.0 million.
- Evaluate services gross-margin recovery and the continuing cost of cloud operations, implementations and third-party consultants.
- Review operating cash conversion and the effect of unbilled receivables, deferred revenue, capital expenditures and the new headquarters lease on free cash flow.
- Consider the $400.0 million convertible-note obligation, potential cash settlement or equity dilution, and the company’s ability to fund repurchases or conversions.
- Verify the sustainability of the reported tax benefits, the $6.0 million unrecognized tax benefits balance and possible effects of future tax-law guidance.