Guidewire Software, Inc. (GWRE) Q2 2020 Earnings Report, Transcript and Summary

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. [Operator Instructions] 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, V P-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 insurance now 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 [ph] 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 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 dive into the outlook, I want to highlight a couple of themes we are seeing that are impacting our numbers. First, our cloud deal activity is progressing well. We expect continued strong growth in InsuranceSuite Cloud deal activity this year. Our ability to execute in the cloud is the most important factor driving our long-term success and we are pleased with our progress to date. At the same time, the market is shifting away from self-managed core systems faster than we expected. Customers and prospects primarily in North America, previously considering self-managed systems are in many cases reconsidering that path and extending their thought process to consider Guidewire Cloud. As we think about the future, we believe we can best service our customers in the cloud modality. And as a result, we welcome the shift. However in the short term, the resulting slowdown in new term license sales activity has an impact on our outlook. ARR growth on a constant currency basis is now expected to be between 11% and 12% in fiscal year 2020 compared to our previous range of 14% to 16%. This revised growth outlook reflects about a $16 million adjustment prior to the midpoint of our prior outlook and is due to lower-term license new sales expectations. We expect subscription new sales, as a percent of total new sales to be between 70% and 80%, up from our previously stated range of 55% to 75%. As a result, we are increasing our subscription revenue outlook to between $114 million and $118 million this year, representing 78% growth at the midpoint. We are modifying our 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 lower outlook -- this lowered outlook is due to our updated expectations with respect to term license bookings activity and its associated upfront revenue coupled with maintenance. We do anticipate some benefit from term license contracts that deviate from our standard two-year initial term followed by annual renewals. Currently this impact is expected to be less than $10 million in the back half of the year, but this amount could be materially higher if we see large customers sign longer-term licenses. Our updated services revenue outlook is between $202 million and $208 million. This view is informed by continued success in working with SI partners on cloud implementations and lower new self-managed deal activity. Additionally, we did see a couple of large customers decide to in-house work that was previously being performed by our services personnel. Customers becoming more self-sufficient is generally positive for Guidewire, but these changes were not contemplated in our prior outlook. We expect total revenue of between $702 million and $714 million for the year compared to our previous range of $759 million to $771 million. With respect to gross margin, we still expect our overall non-GAAP gross margin to be between 58% and 59%. We expect license and subscription margin to be between 78% and 79% even within higher overall subscription mix. And we expect services margin to be between 6% and 7%. We are now expecting operating income to be between $61 million and $73 million representing a non-GAAP operating margin at the midpoint of 9%. We expect free cash flow to be between $75 million and $85 million excluding approximately $11 million of cash outlays associated with our new headquarters. Turning to the third quarter, we expect license and subscription revenue to be in the range of $78 million to $82 million. Subscription revenue in Q3 is expected 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 anticipate total revenue to be in the range of $153 million to $157 million. Currently, we expect ARR growth in Q3 to be between 10% and 11%. In Q4, ARR benefits from ramp activity from cloud deals sold in Q4 of last year which is embedded in our annual outlook of 11% to 12%. For the third quarter, we anticipate a non-GAAP operating loss of between $11 million and $7 million. In summary, while we were pleased with the activity we saw in the quarter, we are clearly seeing signs of a faster-than-expected shift away from on-premise solutions. P&C insurers' willingness to adopt core systems in the cloud is a positive long-term trend for Guidewire. However, the near-term business model and income statement impact is expected to be more pronounced than our prior expectations. We will do our best to help investors understand these puts and takes as we work through this financial model transition. Operator, you can now open the call for questions.

Thank you. At this time, we will be conducting a question-and-answer session. [Operator Instructions] 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, well 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?

So look I think anytime a company goes through a transformation like this, there's a point where it becomes clear that it's real. And I think specifically, that point right now is happening at Guidewire, right? We're headed to the cloud. That's the future. That's the future of the industry. And I think that's really clear to everyone. Employees, customers, partners, investors, I want everybody to understand that that shift is happening. It's happening faster than I think we thought it would. Our financial model assumed a pretty smooth and elegant transition from on-prem sales to cloud sales. And the assumptions we made in the model allowed us to make a plan and set projections about our future. What we're seeing in as we look at the second half of the fiscal year is that those assumptions are -- around that smooth transition are not lining up to what we see like I said in the second half of the year. Specifically we're seeing almost exactly the cloud demand we expected and planned for but we are not seeing the on-prem demand -- we're seeing the on-prem demand slow down faster than we expected. And like I've said in the call and like I think you just said I think this is a good thing. It's a positive sign. It's a validation of the strategy. And I think the obvious question is -- and I think I appreciate what you're saying in your question is, can we accelerate the demand for cloud and the cloud products such that it makes up for the slowdown in the demand for the on-prem licensing model. And I want to assure you that that is exactly what we're all focused on doing here right now. We're working to make a better and better cloud product such that it creates enough customer success and engenders enough customer confidence that they're ready to make the decision to move to cloud. And that's what ultimately will accelerate cloud demand and allow us to continue to grow and grow ARR at the rates that we believe that the market fundamentally supports. I'm firmly believe, we're on the right path and following the right strategy and very pleased with the progress. We've won the trust of one of the most revered insurance companies in the world in USAA. We deployed USAA on the latest and greatest cloud infrastructure designed to scale up to every single one of our customers. We actually recently combined the cloud operations team with our product development organization creating a unified function in the company around designing engineering and delivering a cloud service. And right now we're gearing up for the latest release of InsuranceSuite, which is really -- in May, which is really the first real cloud release of the product. And so I think, fundamentally you add up all of those things and that's what will enable us to accelerate the demand and bookings of the cloud such that it will make up for the slowdown in the on-prem license sales and that's what we'll get the ARR growth back to what we had projected initially. And just would reiterate again I'm confident we're on the right path and that the fundamentals of the business opportunity really haven't changed. There is a very, very big fundamental opportunity that remains in modernizing the P&C industry core systems and we are in the absolutely correct place to take advantage of that fundamental business opportunity.

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 exactly right. We haven't seen any change in competitive dynamic in the market. That hasn't changed quarter-to-quarter. It's simply us looking at the second half and we're seeing -- like I said, we're just seeing this whole market shift to the cloud in a way that was in the model to begin with. So, I don't -- there's really nothing else that you should read into that situation. They're taking more time to evaluate which I think is pretty logical. Like I said in the prepared remarks, we're seeing this mostly in North America, but we expect that this trend will follow in EMEA and also Asia -- in Europe and Asia, excuse me. And I think like I said, it's a very natural thing. If you take for -- if you take it as proven as I think that this indicates that the future is cloud-based core systems, it would be very logical for these insurers -- these insurance carriers to reconsider those decisions around on-prem implementations and think about moving to the cloud once it's more proven. And it's our ability to accelerate that market just goes back to all the things that we're driving here to further enhance the capabilities of the product and build out the proof points and the customer references which I think will ultimately like I said, accelerate us back to where the ARR growth gets back to where we were projecting.

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 absolutely thinking about it the right way. As we think about the shift to a higher subscription new sales as a percent of total that has -- that explains about half of the impact that is represented in our outlook. The other half is really the impact of the slowdown in term license bookings. That is a little bit ahead of what our expectations were for the year. So, we are seeing that activity roll through a bit as well. And then also some of the subscription activity we're seeing is a little bit more back-end weighted. And so the ratable revenue recognition is contributing less revenue in the year. So, though that explains the other half of the impact. And that's how we're thinking about it.

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 [ph]. 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?

Yes. Thanks for the question. I think every single Guidewire sale has a corresponding implementation projects. Sometimes they're big. Sometimes they're small. Certainly core system modernization is a shift from a legacy system to a Guidewire product is going to involve a significant and very strategic implementation project. Additionally, when we sell Guidewire Cloud it brings -- it requires an upgrade very often to InsuranceSuite 10, which again is a corresponding project. And so that's why the consultants and the trained consultants and the expertise associated with InsuranceSuite 10 and the standards that we're instantiating with those implementations are so important for our continued growth and success. There is a one-to-one between that project and the sale. And so the customer, the sales dynamic -- the customers are thinking about both things at the same time. And we're incented to make sure that we have a certified and capable bench of consultants in our partner ecosystem to ensure that when those projects are ready they can be staffed and they can be executed efficiently. I also think that there is -- there's a little bit of a nuance but I think it's really, really important. One of the things that we're changing with respect to Guidewire Cloud is the release frequency. There will not be an InsuranceSuite 11. Instead we will do releases of the product every six months going forward. And the basis for us doing that is around ensuring that the implementation of the product when we move it to our cloud is capable of taking those smaller but more frequent releases. That's going to drive the type of innovation delivery so to speak that really is important to the customers who are making this decision to move to our cloud. And so I think when you -- that's a long answer. But what I really want you to take away from that is how important these consultants are to our future and our future -- the future ability for us to continue to sell and accelerate the cloud sales.

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

Yes, thank you.

Our next question is from Ken Wong from Guggenheim Securities. Please proceed with your question. Your line is open. It appears there may have been a default line. This must be the real line from Ken Wong from Guggenheim. Please proceed with your question.

Yes. Okay. Sorry about that. So just wanted to focus on the slowdown in term I guess what gives you confidence that there wasn't maybe -- gives us confidence that there wasn't any change in maybe the underlying retention rates here? I think we got used to the fact that term was historically viewed as sort of this heartbeat motion where kind of every year you can somewhat depend on it. And to the extent that it was lower it's because Cloud is higher. And now with the slowdown or the pushout, just kind of wondering -- I just wanted to make sure that that was not -- nothing out of the ordinary there. And any connections in terms of services moving in-house to customers that might be pushing out 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. So, obviously, the -- what we're seeing with respect to term license activity has a pretty significant impact on the near-term outlook. We're still working through how we think that comes back into our demand profile in the cloud modality and what the impacts are on the long-term model. So, not in a position to update that right now Ken, but you should expect us to do that at Analyst Day as we do every year.

Got it. All right. Thanks a lot guys.

Thank you.

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 relative 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?

Yes. Thanks for the question. Like I said in the prepared remarks, we're very, very excited about that win. It's come up a couple of times in the previous quarters that I've had an opportunity to talk to everybody about. I really just see it as a -- just a phenomenally executed plan by the organization to -- we revamped the product, we revamped the approach to doing the services implementation. We refocused the sales and the marketing efforts around not just this product but you also want to think about that product in North America, specifically focused on that segment of the market. And I'm excited about the forecast and the pipeline that we see through the rest of the year. And as that pipeline materializes and close deals, we'll obviously update you on future calls. But this is a -- it is an important and strategic aspect of our company and product strategy like I've said before on previous calls. And so I just feel very, very pleased and proud of the execution of the organization getting that win. I think anecdotally or sort of I guess to give you a little color, my understanding of the selection process sort of had a lot to do with Guidewire, the company and the organization and the commitment that we've made to the industry and to that product line. That was really the characteristic that pushed it over the edge and got it to our favor. As you're probably aware this is a -- it was a competitive deal. It's a competitive space. And I was excited to see us sort of reinstantiate our ability to compete successfully in that segment of the market.

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's changed quarter-to-quarter. I would reiterate the comments I made -- I think back to the comments I made about answering the question about the importance of consultants. The feedback I'm getting is really just about making sure that we are putting together a plan that justifies the overall long-term value proposition to support the upgrade expense and the implementation project around getting the implementation to the standards necessary to support that cloud model going forward. As you're I'm sure aware, these are very significant transactions. They're very carefully studied. And we work very, very hard to ensure that we are putting together a product and a proposal that will justify that move. But that's basically -- things haven't changed but it's just more focused on what can we do to help minimize that transition, that upgrade expense, such that it helps move the balance of that equation more in favor of the insurance carrier. So nothing's changed but just that that dynamic is very real and it's what we're working through as we justify the sales of the cloud products going forward.

Great. And then just as a follow-up. I know Mike you -- one of the things you talked about at Analyst Day in terms of your focus this year was on subscription costs and scaling up on gross margins. So, just wanted to hear if we could just an update on how that's trending so far. Can you talk a bit about some of the specific initiatives you're working on to drive cloud gross margins up to 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 and 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 creates 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.

Yes, thanks a lot.

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 think that it's a shift between customer base versus net new. I just think that is a natural -- it's a natural outcome of a shift in the accepted approach to the implementation of core modernization. And that is going to take a period of time to adjust to and then -- and like I said, as the confidence and surety in that cloud product offering increases we get back to the normal rate around which we can take advantage of both the customer base migration to the cloud as well as that -- the core legacy system modernization opportunity that underlies the premise for Guidewire fundamentally. I really just think it is this -- there is a shift going on right now that has become very clear and that's causing everybody to just take a second look and say, okay maybe we should go straight to cloud.' And that's going to take a period of time for them to adjust to and then we will get back to that normal pace of the demand environment that underlies what the core sales opportunity that we attack. 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. Well maybe I'll let Jeff chime in if I'm not doing an appropriate job answering the first half of your question. I think that there's two things that are going on. One when you have a shift from term to subscription, there's going to be revenue impact to that which are -- which we have adjusted to support. At the same time if you think back to what I've been saying for the last couple of quarters you can normalize that by just looking at ARR, right? And so the other side of that is well, if we're not seeing the same -- that equal weight of cloud sales to on-prem sales and when are we going to see the cloud sales increase enough to compensate for the slowdown in term sales, I think we've given you the visibility we have which is very solid through the end of the fiscal year. We're a very annual company. And so to give you a little sense of where these numbers came from, we did a complete assessment of the pipeline that we can see in the second half after the close of Q2. We went through all of the demand, all of the business that we have visibility into and kind of looked at a deal-by-deal in great detail with the organization so that we can assess the demand and what we should expect for the rest of this fiscal year. We have a small amount of visibility into next fiscal year. But to be honest with you I think we really need to stay focused on this fiscal. And over the course of the next two quarters we'll be able to give everybody a better picture of what it looks like next year. But it's almost -- if you think about my job I want to be a little bit careful about distracting people away from the necessity to really focus on closing out this year in a strong way.

And then just one thing to add. One of the things that as we were evaluating the year at the beginning of this year, one of the trends we were expecting to see is that customers who weren't ready to go to the cloud would buy on-prem in InsuranceSuite 10 and maybe implement in a way that would allow them to migrate to the cloud in the future. And we're not seeing that step. Those customers -- a lot of those customers or potential customers are choosing to wait rather than going with InsuranceSuite 10 on-premise right now and then migrating in the future.

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?

Yes. Thanks for the question. So, obviously, the customers that we have and the go-lives that we've had given us a tremendous amount of experience in being able to do this a little bit better every single time we do it. It's also given us enough information and enough learning to be able to sort of set ourselves up with the right infrastructure approach that I talked about previously in a couple of questions and answers that I'm very, very confident and positive about going forward. We really feel like we have the right architecture right now to do this scalably and repeatedly going forward. The other part of this is that I'd say if you think InsuranceSuite 10 has had 10 releases, we're about to do the first sort of cloud optimized release of InsuranceSuite 10 coming up here in May and that is a really, really major milestone for our organization. If I can compare and contrast the mindset of -- and the value proposition associated with the concept of cloud from here back to Salesforce, it really is around this idea that we are continuing we are setting ourselves up to be able to continually deliver innovation back into our cloud customers' implementations in the way that Salesforce has been doing for a long time. I can see the difference between the value delivery that a model like that creates and I think it is going to be a phenomenal benefit to the P&C industry and it's really going to help us sell those cloud deals going forward. When we're able to take the efforts of the hundreds and hundreds of engineers that are working to build out a better core system and immediately deliver those into the cloud implementations of our customers, that is just such a more healthy model than what we have right now where we are literally years away from products and features being completed here at Guidewire and for them to find their way into the on-prem and self-managed implementations in our customer base. I'm incredibly excited about that. And I think that release in May is going to be a really, really important milestone for the company and for our whole 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.

Yes. Thanks for the question. I don't know whether I'd call the factor because I also think that this is a very positive signal, right? I think that what I'm seeing is in a lot of our customers they have what they call innovation groups or test and learn projects where they are trying to innovate. They're trying to think of new creative insurance products that they can bring to market quickly. They're thinking of new channels that they can deliver those insurance products through. And the name of the game when you're operating a business like that is agility and the speed around which you can take an idea from the sort of whiteboard to reality and assess that it's going to work. The speed around which you can do that is exactly how fast you can grow your business. So I see it as a very, very positive sign that the cloud delivery model facilitates our ability to meet that type of demand. And that's an exciting -- that is a really, really exciting thing for us to participate in. And I think in multiple cases, the insurers are looking at these projects as proof points around which that they will use to validate that the underlying project and the underlying moves to the cloud of the major books of business that they are running either already on Guidewire or on legacy systems that once they can see how the cloud operating model works and that the upgrades are functioning and that they're really able to deliver on that increased business agility, it makes it easier for them to justify and take the leap with us around that sort of more major -- that major book of business move to the Guidewire Cloud. So yes, I think it is a factor but it is a very positive sign and I think another opportunity for us to create those proof points we need to continue to accelerate the business.

Great. That's helpful color. I guess just to follow up on that, I think last quarter you talked about how you're seeing some of your large customers, in some cases working with partners to just kind of move to AWS infrastructure and maybe not adopting Guidewire and InsuranceSuite Cloud just kind of lifting and shifting if you will the on-prem and AWS. Are you seeing those -- are those the type of customers we should think about that are kind of maybe testing the waters on these smaller projects? Or is that kind of a different cohort? Or maybe just help us kind of understand those two dynamics and if they're related at all. Thank you.

Yes. I see that as something separate, right? And I really see this as something that was a transition phase of the market that will go away over time. This was -- when you take an on-prem software package and you say 'move it to the cloud' a logical way to do that is that you can move it to one of these cloud platforms. You can do that yourself. You can also do that with a partner. And I think that those businesses let's call them or those strategies are okay. Okay? But it is not really the same thing as aligning yourself to the cloud version of Guidewire that's being upgraded every six months that's being enhanced with cloud native services to augment the functionality that we're able to deliver in InsuranceSuite 10. I still think we'll see some of that. I think it might be appropriate in certain circumstances. But the vast majority of cloud use cases are going to go directly to Guidewire Cloud and I think that's where you're going to see the real value delivered. So, that was a positive transitional step that still exists to some extent. But I think going forward, you'll see less and less of it and there'll be more customers choosing to just go directly to the Guidewire Cloud.

Thanks Mike. Appreciate it.

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

Great. Thanks guys for taking my question. You mentioned Mike that the next version of InsuranceSuite Cloud will be more cloud-ready. I think what you're getting at is that with it'll be capable of delivering more features more rapidly. Is that really the benefit? Or what -- I guess if you could elaborate a little bit more on what that means for this next release being more cloud-ready please. Thank you.

Yes. Sure. No problem. I think -- I guess the way to think about it is that the situation our engineering organization is now optimizing around is a cloud implementation of InsuranceSuite 10 and that the assumptions that we can make that is -- that that customer is running on our Guidewire Cloud platform on top of our cloud -- our platform provider and we can optimize the delivery of new innovation new product features around that use case. Now, that's not to say that we won't provide functionality that can be made available to InsuranceSuite 10 on-prem customers. That's a very important part of our model and our ability to maintain the maintenance and support for our customer base that is running on-prem is very important to us. But just make no mistake, the focus of the organization is around delivering new innovation to that InsuranceSuite 10 implementation running on top of the Guidewire Cloud platform. I mentioned a second ago, we will be adding cloud native capabilities services that augment InsuranceSuite 10 that are not part of that specific implementation but our native cloud services that customers can use. There's a variety of data and analytics services that we are adding to the cloud implementations that just natively run as cloud services. And so more and more I think that you will see us optimizing the engineering work that we are doing around these every six month releases the first of which is coming in May. Does that make sense?

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. Hey, Brad this is Jeff. And just to be clear that -- those aren't hosted versions. Those would be on-premise versions and those are some large customers that made that decision. The goal is to always make our customers self-sufficient. And we do have some projects where we have to be on-site for an extended period of time. So this is always the goal. So we have this built into our model. We understand there were just a couple that caught us a little offguard this year.

Got it. Thank you.

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

Mike just going back to the upcoming product release. It seems to have a pretty heavy emphasis on like front-end development tools, the digital offering, the relationship with Salesforce. I'm wondering could Guidewire -- is the mix between the core systems digital data could that mix maybe look different a few years out and that mix is helping to accelerate cloud growth?

Well I'd say, the way I would answer that question is I think that the way we're designing the system can accelerate cloud growth. And specifically, we are assuming that analytics and data are just going to be part of every single implementation of an insurance core system, whether it's claims, policy or billing. I think that fact is now proven. And I think the way -- we actually just got done with a couple of days with our top customers giving us feedback about where we should be focused in terms of our product investment. The things that you pointed to in terms of enhanced digital capabilities, specifically APIs that enable carriers to expose core policy and claims-based processes out to portals and websites and mobile applications and other affinity channels, it's really never-ending. The new innovative places that these carriers are looking to extend sort of the reach of Guidewire-driven business processes. That's really, really exciting. And I think there was a lot of support for the work we're doing around enhancing those digital capabilities, making them easier for the carriers to adopt and like I said, push into these other channels. That was a really exciting validation that we've got from that meeting. So I think, as we continue to evolve in these six-month release cycles and we continue to enhance the core capabilities of InsuranceSuite 10, the digital capabilities, the analytics-based capabilities that they will get as part of that offering are going to be real accelerators for the cloud offering.

Great. Thank you very much.

Yes. Thank you. 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.