Guidewire Software Inc

NYSE:GWRE

Earnings Call Transcript 2018-Q4

[Operator]

Good day, and welcome to the Guidewire Fourth Quarter and Fiscal Year 2018 Financial Results Conference Call. Today’s conference is being recorded.

At this time, I’d like to turn the conference over to Curtis Smith, Chief Financial Officer. Please go ahead, sir.

[Curtis Smith, Chief Financial Officer]

Thank you. Good afternoon, and welcome to Guidewire Software’s earnings conference call for the fourth quarter of fiscal year 2018, which ended on July 31, 2018. My name is Curtis Smith. I’m the Chief Financial Officer of Guidewire. And with me on the call is Marcus Ryu, Guidewire’s Chief Executive Officer.

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. 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 any – 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-Qs filed with the SEC.

We will also 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. 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 insight 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 over the call over to Marcus for his prepared remarks, and then I will provide details on our results before providing our outlook for Q1 and fiscal 2019. Marcus and I will then take your questions.

[Marcus Ryu, Chief Executive Officer]

Thank you, Curtis. At the start of fiscal 2018, our goals were to continue winning a leading share of transformational mandate from insurers, particularly in Europe and to advance our industry platform strategy in which we unify core data and digital capabilities in a standardized core cloud platform for the global P&C industry. Our fourth quarter completed the year in which we succeeded on both counts.

I will begin with a summary of our Q4 and fiscal 2018 results. Revenue was $248.6 million for the quarter and $661.1 million for the year, while non-GAAP net income was $0.81 and $1.14 per share for the quarter and year, respectively. These results both above the high-end of our guidance ranges were driven by a record number of transactions and new licenses in our Q4.

During the quarter, we added 15 new customers across the Americas, Europe and Asia Pacific, including four selecting full InsuranceSuite and one selecting InsuranceNow. On top of these, 45 customers expanded their relationship with Guidewire, with new licenses for additional products during the quarter, including four that license additional core applications to complete their adoption of InsuranceSuite.

Especially consequential among our customers are those with over $5 billion in annual premiums, a segment that we following industry convention call Tier 1 insurers. During the year, three new and six existing Tier 1 customers selected 25 Guidewire products, bringing the total to 28 at the end of 2018.

Overall, we ended fiscal 2018 with 380 total customers, up from 328 last year. Direct written premium penetration of our customers licensing at least one of our core applications grew from $423 billion to $454 billion, measuring from the end of fiscal 2017 to the end of fiscal 2018. Despite these gains, the global market for modern P&C technology system is still quite underpenetrated, with a large majority of the $2 trillion in global premiums still managed on legacy core system.

This is especially true of Tier 1, where we now have relationships with about half of the insurers comprising the segment. But where the calculation of what we call wallet share shows us barely penetrated into the opportunity for customers to license our full platform for all their business lines.

We look forward to providing more market sizing and penetration data at our Analyst Day in two weeks to help quantify the opportunity we see in the years ahead, to build upon our market leadership position with additional offerings and deeper adoption by those hundreds of insurers with whom we have successful relationships.

As an example of this from Q4, we further broadened our relationship with multinational insurers like Aviva Italia selecting InsuranceSuite and Guidewire Digital and AXA Assistance France selecting ClaimCenter. Tier 1 multinational, MAPFRE España, being the largest domestic insurer selected ClaimCenter and Guidewire Digital, as did Royal & Sun Alliance, a Tier 1 insurer in the UK, and Basler Versicherungen in Germany selected all of InsuranceSuite, as well as data and digital products. These wins were part of a year of significant progress in the largest and most underpenetrated of our geographic markets, namely Europe.

We had our strongest year-to-date for new sales in Europe with 22 customers licensing 64 products during the fiscal year, 10 of whom were new customers, including the five, I just mentioned. We believe this traction reflect the demand environment coming to mirror the U.S. in its appetite for core application, data and digital products and cloud deployment, as well as our strengthening brand on the continent.

As one indicator of the latter, in the fourth quarter, Celent named Guidewire a winner of two of their top award for Policy Administration Systems in EMEA, with Policy Center earning the sole top position among 38 vendors in the breadth of functionality and depth of service categories. Additionally, our Cyence Risk Analytics team was voted Risk Modeler of the Year in Europe at the recent Reactions London Market Re/insurance Awards.

Returning to our home market in North America, here we closed a diverse set of wins during the fourth quarter, including Tennessee Farmers Insurance, a Tier 2 insurer who selected the breadth of InsuranceSuite and Guidewire data and digital products. Fred Loya Insurance, a Tier 3 insurer based in Texas selected ClaimCenter and business intelligence and Workmen’s Auto Insurance, a division of Mercury General, a longstanding and broadly adopted Tier 2 customer, with our fourth InsuranceNow selection for the year.

While insurance now has proven value in serving its target market of smaller U.S. insurers writing smaller – writing standard lines, total new customer sales fell short of our aspirations for the fiscal year, and we are confident that we will do better in fiscal 2019 and beyond.

Our non-core products continue to post the strong attach rates that we have enjoyed for the last few years validating our thesis, the digital engagement and predictive analytics are catalyzing technology investment in the P&C industry.

During the fourth quarter, 29 new and existing customers chose Guidewire Digital and we ended the year with 127 customers having licensed at least, one of our digital products. Cyence, the data listening and machine learning company, whose acquisition we closed earlier in the year, closed an important deal with the U.S. subsidiary of one of the leaders in cyber insurance, Beasley.

Also, Zurich Insurance Group, our largest multinational customer will use Cyence to strengthen their cyber risk capabilities. Cyence finished the year ahead of expectations with five wins post acquisition. And our predictive analytics product was selected by Society Insurance finishing a strong year, including the two largest deals for that product to date, reflecting a long awaited boost from integrating our analytics more natively into InsuranceSuite.

In light of this traction, we are expanding our investments in new data sources and analytic techniques by forming a new division called Guidewire Analytics and Data Services, or ADS, that combines our Cyence predictive analytics and Guidewire live teams. This division is already being led by a new executive on the executive team, Paul Mang, who brings a wealth of experience as the former global CEO of Analytics at Aon, one of the leading global insurance brokerage firms.

Paul and the ADS team’s mission will be to build world-class analytic solutions that can leverage data from our core platform, but stand on their own right as well and enable insurers to bring new products to market, price them more accurately, and to drive better outcomes across distribution, service and claims. This is another strategic theme that we look forward to elaborating upon at our Analyst Day.

Turning now to the cloud. Demand continues to grow across all segments of our market for Guidewire to take full postproduction responsibility for solutions delivered on public infrastructure. Consequently, throughout fiscal 2018, we intensified both our go-to-market activity and our internal preparations for what we expect to be a long-term trend. All products comprising Guidewire insurance platform either can or must be deployed via Guidewire Cloud.

And to date, we have 157 customers that have licensed one or more of our products this way, up from 103 customers last year. Most important and challenging among these are those insurers who have opted to implement all of InsuranceSuite Cloud. We added one to this number during the fourth quarter fewer than we anticipated, as the greater value of the scope and complexity of these deals caused two of them to move into fiscal 2019.

Hence while our FY 2018 result of 36% of new sales being sold as subscriptions was up from only 6% last year and was within our communicated range of 30% to 40%. It was lower than our expectations to be at the high-end of this range. As we gain credentials from the progress of our three early cloud customers, all of whom are now in live production, we expect to improve our timing and forecasting.

We will also become more practiced in implementation and production services, with experience being the best feature. As we have described in prior calls, our first InsuranceSuite Cloud project was a particularly demanding one to start our InsuranceSuite Cloud journey, as its scope included a completely new operational core, a new digital brand and market strategy and new machine learning based approaches to customer segmentation and pricing.

With its initial go-live a year ago and next major go-live expected in our second quarter, the customer is enthusiastic with progress and committed to the full cloud journey with us, where project effort has been greater than expected, a fact that is visible in our Q4 service margin that Curtis will discuss.

We are working to internalize these learnings and transfer them to our SI partners in order to surface up to twice as many InsuranceSuite Cloud deals in fiscal 2019, with the steepest part of this adoption ramp potentially in 2020 and beyond. Much of the investment required to ascend this ramp was undertaken in fiscal 2018, including significant hiring expanding R&D, sales and cloud operations, particularly in the latter part of the year.

Consequently, we expect our headcount growth to slow in fiscal 2019, as we leverage last year’s investment. Key to translating this into improving margins over time will be achieving scale in our InsuranceSuite Cloud and InsuranceNow installed base, which in turn requires continued excellence in sales and fulfillment of the promises that we make to customers.

As key indices of the latter, we also posted a strong quarter and year for implementation, with six customers going live with 13 products in the quarter, contributing to a total 38 customer go-live on 85 products for the year, along with negligible customer churn.

In summary, our fourth quarter and fiscal year advanced our mission of enabling insurers to adapt and succeed in a time of accelerating change. Our value proposition is a platform that unifies the core data and digital functions that an insurer needs to compete today.

And our strategy, simply put, is to drive our product set and our customer base to greater standardization and lower TCO in the cloud. We have the team, track record and capital to execute on this strategy, grow both new customer relationships and our existing ones and become the platform of choice for the $2 trillion global P&C industry.

I now turn the call over to Curtis to elaborate on our results and financial outlook for Q1 and FY 2019.

[Curtis Smith, Chief Financial Officer]

Thank you, Marcus. We had a busy Q4 with, as Marcus mentioned, a record number of transactions and a lot to get to on this call, so let’s get right to it. We’ve seen our revenue guidance ranges for all components of revenue. Total revenue was $661.1 million for fiscal year 2018 and $248.6 million for Q4, representing a 29% and 37% year-over-year increase, respectively.

Fiscal 2018 license and other revenues finished at $315.8 million, representing a 16% increase year-over-year and did not benefit from any material early payments. If you normalize for impacts of early payments in fiscal 2018, our year-over-year growth rate would have been 20%.

Additionally, perpetual revenue in the fourth quarter and full-year was $3.2 million and $11.8 million, respectively, compared with $6.8 million and $13.1 million last year. Perpetual revenue came in higher than the top-end of our previously discussed range of $8 million to $10 million, due to longstanding – the longstanding customer adding DWP to an existing perpetual license.

License and other revenue was $151.1 million in Q4, representing an increase of 38% from a year ago. As discussed last quarter, Q4 benefits from the very sizable recurring payment from one of our Tier 1 customers, which was recognized in Q3 last year, but recognized in Q4 in this and subsequent years.

Maintenance revenue for the year and quarter was $77.3 million and $20.5 million, respectively, representing a 13% and 10% year-over-year increase. As discussed previously, we expect maintenance revenue growth to continue to slow as we sell more subscription contracts, which include ongoing maintenance activities as part of the subscription fees and are reported under our licensing and other revenue line.

Our rolling four quarter recurring revenue consisting of term license, subscription and maintenance revenue totaled $381.3 million in the fourth quarter, up 17% from a year ago. As mentioned previously, our ongoing transition to subscription revenue and the adoption of ASC 606 in fiscal year 2019 make this metric less relevant to our business. As a result, we will be replacing this metric at our Analyst Day with other more characteristic of the subscription model.

Services revenue for the year and the quarter was $268 million and $77 million, respectively, representing a 54% and 46% increase from a year ago. Services growth for the year has been driven by increased sales activity, including cloud and European projects and two non-recurring elements. The impact of ISCS full-year services revenue compared to partial year benefit in fiscal 2017 and recognition in fiscal 2018 of deferred services revenue for work completed in fiscal 2017 at a large InsuranceSuite Cloud customer.

In addition, Q4 services revenue growth benefited from implementation work done for a large German insurer announced in Q2, where we needed to delay services revenue recognition and the majority of associated cost until Q4. All this work was delivered in fiscal 2018, but we were unable to recognize revenue until Q4 due to some particulars of this customer’s contract.

Turning to profitability. We will discuss these metrics on a non-GAAP basis and we have provided the comparable GAAP metrics and a reconciliation of GAAP to non-GAAP measures in our earnings press release issued today. With the primary differences being stock-based compensation expenses, amortization of intangibles, the amortization of debt discount and issuance costs from our convertible note and the related tax effects of these adjustments.

Non-GAAP gross profit was $408.6 million and $168.6 million for the year and the quarter, respectively, which represents a 16% and 27% increase from a year ago.

Non-GAAP gross margin for the year was 62%, compared to 69% a year ago. The decrease in fiscal 2018 margin was due to the increase in services revenue as a percent of total revenue, the decrease in license and other margin due to the shift to subscription revenue and the incremental costs associated with supporting cloud customers, and an unanticipated $7 million one-time charge we took in Q4, which is related to services investments to ensure a successful outcome at a large cloud customer.

Non-GAAP gross margin for the quarter was 68%, compared to 73% a year ago. Notably, services gross margin for the quarter was 6%, due to the charge I just referenced. Total non-GAAP operating expenses were $290.8 million and $84.8 million in the fiscal year and fourth quarter respectively, an increase of 23% for both the year and the quarter.

This increase was primarily driven by continued investments in R&D, sales, costs from the Cyence acquisition and several large internal systems projects that we have discussed, including new ERP, Configure Price Quote and revenue management systems.

For the year, this resulted in non-GAAP operating income of $109.7 million and non-GAAP net income of $90.9 million, or $1.14 per diluted share. For the quarter, non-GAAP operating income was $83.7 million and non-GAAP net income was $66.3 million, or $0.81 per diluted share.

Turning to our balance sheet. We ended the year with $1.3 billion in cash, cash equivalents and investments, up from $1.2 billion at the end of the third quarter, primarily due to operating cash flow of $102.1 million and free cash flow of $98.4 million in the fourth quarter. In addition, operating cash flow in the year was $145.5 million and free cash flow was $128.4 million.

Now turning to guidance. I first want to address our expectations for the full-year, I will then speak to Q1. We are pleased that we successfully modified 100% of the greater than 300 multi-year term licenses we targeted. So that they now will renew annually in 2019 and beyond. This was a tremendous internal effort, and I’m very thankful to our team and for our customers’ willingness to work with us.

As we have mentioned in the past, this effort was intended to minimize revenue lost to retained earnings and ease comparison of fiscal year 2018 and ASC 606 fiscal year 2019 financials. However, as a consequence, our modified contracts received ratable revenue recognition treatment under ASC 605 in fiscal year 2019, rendering them incommensurable to fiscal year 2018 605 financials. Therefore, our forward-looking commentary will consider ASC 606 financials only.

For the full-year fiscal 2019, we anticipate total revenue to be in the range of $740.5 million to $752.5 million, an increase of 12% to 14% from fiscal 2108. We expect annual license and other revenue, including subscription revenues to be in the range of $365 million to $377 million, an increase of 16% to 19% from fiscal 2018.

Our fiscal 2019 license and other revenue outlook is informed by two factors. First, the adoption of ASC 606 will result in a transition adjustment to retained earnings or revenue that would have been recognized in future periods under 605. A large majority of this transition judgment is related to new two-year contracts signed in fiscal 2018, where the second year of the contract will be lost to retained earnings in 2019.

Offsetting this impact, the adoption of ASC 606 allows us to recognize the full committed term of our primarily two-year term licenses that start in fiscal 2019. While this new revenue recognition pattern will increase the volatility of term license revenue going forward, we expect that these two factors to largely neutralize each other in fiscal 2019.

Second, our ongoing transition to cloud-based subscription sales, which we expect to be approximately 40% to 60% of new sales. We also expect to add 48 new InsuranceSuite Cloud deals, which receive ratable revenue recognition treatment. We expect to report subscription revenue in fiscal 2019 and currently expect that we will end fiscal 2019 with $48 million to $54 million in subscription revenue, representing the year-over-year growth rate of over 75% at the midpoint.

We expect perpetual license revenue to be less than $10 million for the year, a decrease from $11.8 million in fiscal 2018. Our fiscal 2019 outlook for maintenance revenue is $79.5 million to $81.5 million. As discussed previously, we expect maintenance revenue growth to continue to slow as we sell more subscription contract, which include ongoing maintenance activities as part of the subscription fees.

Our outlook. Our services revenue is $290 million to $300 million, representing a 10% growth rate at the midpoint. While this is lower than expectations that informed our commentary last quarter, services revenue mix continues to be elevated compared to recent history.

This moderated outlook reflects: first, delays in the start of services work at two InsuranceSuite Cloud prospects, as mentioned by Marcus; and two, our increased efforts to enable our strong SI partner ecosystem to deliver cloud implementation services.

With respect to gross margin, we expect overall non-GAAP gross margin to decline by 1 to 3 points to 59% to 61% because of investments in cloud operations and the shift to ratable revenue recognition. We expect services non-GAAP gross margin to be between 17% and 18% this fiscal year.

Our outlook for non-GAAP operating income for fiscal 2019 is $104.5 million to $116.5 million, representing a non-GAAP operating margin of 15% at the midpoint, as we continue to execute on our investments that were initiated in fiscal 2018. Cloud operations and R&D continue to be key investment areas.

In addition, as Marcus mentioned, we’re making important investments in our analytics and data services capabilities. Both gross and operating margin are sensitized to the percentage of new sales sold as subscription and decreased as subscription sales increase.

Finally, as a result of adopting ASC 606, we will start capitalizing commission expenses in fiscal 2019, and expect to see a net benefit to operating margin of a little over 1 percentage point. We are assuming a five-year customer life for these calculations.

With respect to cash flow. We expect free cash flow to be between $115 million and $130 million before the one-time impacts associated with the build out of our new headquarters, which is expected to be approximately $35 million to $40 million and completed in fiscal 2019.

In addition, our outlook for non-GAAP net income is $94.8 million to $104.3 million, or $1.15 to $1.26 per diluted share based on approximately $82.7 million diluted shares and an assumed non-GAAP tax rate of 21% for fiscal 2019.

Now turning to Q1. We anticipate total revenue to be in the range of $159 million to $163 million. Within revenue, we expect license and other revenue to be in the range of $73 million to $77 million, representing 149% growth at the midpoint. Two unique factors are contributing to the outsized year-over-year increase.

First, due to ASC 606, a number of our term contracts that we previously recognized on a quarterly basis due to quarterly invoicing terms, will now be recognized upon the annual renewal. This effect moved revenue from later periods in fiscal 2019 into Q1, and as a result does not impact annual revenue expectations.

Two, in Q4, we signed a multi-year term license deal with a large European insurer that was delivered in Q1. In this instance, we expect to recognize approximately $8 million more in Q1 than we would have recognized had this been a standard contract. This deviation from our standard two-year initial term license contract was driven by unusual customer requirements. We intend to avoid similar arrangements in the future.

We expect Q1 maintenance revenue of $19 million to $20 million and Q1 services revenue of $65 million to $68 million. For the first quarter, we anticipate a non-GAAP operating income of between $14.5 million and $18.5 million and non-GAAP net income of between $14.5 million and $17.6 million, or $0.18 per share to $0.22 per share, based on approximately $82.1 million diluted shares.

In summary, it was a strong quarter and we were very pleased with our execution. While we know the transition to 606 in cloud creates complexities in understanding our financials, the underlying trends remain positive and we’re excited about the path forward.

We’re committed to helping investors see through these accounting complexities and we look forward to providing more detail at our Analyst Day scheduled for September 20 in New York.

Thank you. Operator, can you now open the call for questions.

[Operator]

Certainly. [Operator Instructions] And our first question will come from Sterling Auty with JPMorgan.

[Jackson Ader, JPMorgan]

Hi, guys. This is Jackson Ader on for Sterling tonight. Thanks for taking the questions. First one, Marcus, if we could just start with you. Any additional color that we could bet on why those two InsuranceSuite in the cloud customers pushed out of the fourth quarter of 2018 and into 2019?

[Marcus Ryu, Chief Executive Officer]

Sure. Well, every deal that we ever do and this has been true throughout our history has its idiosyncrasies and its evaluative quirks, that’s been true whether or not we’re talking about the cloud. These two deals, in particular, we had pretty high hopes of getting them done by the end of the year, but it was a broader surface area of evaluation.

I think we alluded to that being generally true of this new category of deal for us in our last earnings call, and we kind of just ran out of time on the clock getting them done. That’s not normally something that you will hear us talk about in the context of our other deals. But it did happen in two rather consequential ones, which is why we thought it was most forthright to call that out here.

In both cases, there’s no competitive issue. We’ve been decisively selected. It’s just a matter of final contract execution and approvals, et cetera. It – and it had a kind of outsized impact on one of the metrics that we had talked about, namely the percentage of bookings in the year that were coming in subscription form, because these are of course large transactions, which is another reason we wanted to mention it. But there’s really no change in our outlook or the complexion of where we see the demand or what we’re doing strategically.

[Jackson Ader, JPMorgan]

Okay, great. And then a quick follow-up. You had also mentioned that InsuranceNow was a little bit of disappointment. Any color there?

[Curtis Smith, Chief Financial Officer]

None in particular. I think, we had hoped for a few more transactions to happen within the year. It really wasn’t a question of underlying demand. I think, we’ve learned over the last year or so that is the different sales motion than what we’ve been accustomed to with InsuranceSuite with all these years. It’s a more standardized product. There is less emphasis on flexibility and kind of showing and telling how flexible the application is. It’s more about a straight line to getting live as quickly as possible on a standard solution.

There’s also – these are also cloud-based products, right? We’ll be taking full post-production responsibility for everything that happens once the customer implements with InsuranceNow and it’s been a great set of lessons for the competencies and customer expectations that we have to meet with InsuranceSuite Cloud, which of course is a much larger economic significance to us.

And so there were a few humbling lessons through the year that I think brought us a few below the target that we had set. But we remain really confident about the underlying demand for that product set as well and its importance in the whole platform since there a set of customers for whom it’s really the right solution as opposed to full InsuranceSuite Cloud.

[Jackson Ader, JPMorgan]

All right. Thank you.

[Operator]

Our next question will come from Jesse Hulsing with Goldman Sachs.

[Jesse Hulsing, Goldman Sachs]

Yes. Thank you. Marcus, I guess, taking a bigger picture view. How are cloud discussions for InsuranceSuite going in general? And are you seeing the same level of interest that you saw, I guess, in the middle of last year? And how are pricing discussions going? Are you still seeing that 2x to 3x [hold up][ph] as you get more data points?

[Marcus Ryu, Chief Executive Officer]

Sure. The most important thing to emphasize is that the demand picture, if anything, is stronger now than where we would have assessed it, call it, 9 to 12 months ago. The wind is blowing only in one direction. Our customers and prospects want the same thing that pretty much all enterprises seem to want these days.

They want IT simplification. They want to divert their scarce attention and bandwidth on to differentiating their brand in the new digital economy. They want to focus on differentiation through new predictive analytic techniques and the like, and they want to spend less time, less management focus on keeping the lights on with core operations.

That trend isn’t going away. It’s just getting stronger and it applies in a very significant way to our market, because what our – what all insurers want now is to rethink the division of labor that they have with their trusted IT partners. And we think we have a huge role to play there.

So that there’s no change in the demand picture at all, if anything. It’s – it continues to strengthen and we have more discussions with basically every segment of the market that we serve, including internationally. But both we and our markets are kind of feeling our way through what does evaluation look like? What are the questions to ask? What are the credentials they need to see? What do they want to have documented? What should a contract look like? What kind of protections do they need? What’s reasonable to ask for? What’s the standard?

All these kinds of questions are a little bit less mature for both us and our market, our customers. And they take a little more dialogue to figure out than other areas. And that I think is accounted for just a bit more sales complexity, more training on our side, more involvement of the executive team here and sales cycles and the like.

All that by the way is very standard for us. That’s what it was like when we went from just being a single product company to being a full suite company to talking about products outside the core. It’s always involved in bringing a new offering to market and really getting practice in the sales motion.

[Jesse Hulsing, Goldman Sachs]

Gotcha. And Curtis, I guess, when you look at guidance this year, how much of that did you factor in? And 2018 was the learning year undoubtedly, but I’m wondering how much of, I guess, that continued complexity and contract negotiations, this was factored into? How you thought about setting the guidance for 2019?

[Curtis Smith, Chief Financial Officer]

Yes. We certainly use 2018 and took the learnings out of 2018 when we were putting our guidance together for 2019. So that was definitely part of our analysis and our thinking when we put together our guidance for 2019.

I think, the other thing I’d note too is that, we noted that the – and provided this in our guidance that, that our services revenue due to two of these cloud [competitors] [ph] moving into 2019 would delay the ability for us to recognize service revenue. So that was also part of our thinking when we put together our guidance on the services side going forward here, too.

So it definitely factored into how we thought about that, thought about our guidance, thought about our forecast. I think, the other thing I would add to what Marcus noted there when I look at where we are now from where we were six months ago, there’s just a higher level of confidence and our ability to go-to-market than where we were six to nine months ago.

[Jesse Hulsing, Goldman Sachs]

And a quick clarification, Curtis. That $8 million that was pushed into the first quarter, would that have been recognized in the fourth quarter, or was it – I guess, is it going to be recognized in both?

[Curtis Smith, Chief Financial Officer]

No, it would not be recognized in the fourth quarter. It was a deal that we signed in the fourth quarter, but delivered a provision in Q1. So that revenue would be recognized in Q1. Under 606 though, because it was multi-year deal, we get this outside impact of it taking place in Q1 that wouldn’t happen in a 605 world.

[Jesse Hulsing, Goldman Sachs]

Gotcha. So it would have been normally recognized in the fourth quarter except for this contract that had an arrangement for the customer?

[Curtis Smith, Chief Financial Officer]

No. We signed the deal in Q4, but it wasn’t delivered or provisioned until Q1 of 2019. So it would not have been recognized in Q4, it was always intended to be recognized in Q1 of this year.

[Jesse Hulsing, Goldman Sachs]

Okay, perfect. Thank you.

[Operator]

Our next question will come from Monika Garg with KeyBanc.

[Monika Garg, KeyBanc Capital Markets Inc.]

Hi, thanks for taking my question. First, just clarification, Curtis. The service gross margin of 6.5%, I think, you talked about unanticipated charge of $7 million. Could you just provide more color around that?

[Curtis Smith, Chief Financial Officer]

Sure. So I think you’re referring to the unanticipated $7 million one-time charge that we took in Q4 that I referenced earlier, add a little more color around that. After a successful initial release and go-live with this customer, we entered into the follow-on release and realized that additional efforts would be required. And midway through the Q4 agreed with the customer that we would make additional investments in the form of our services to assure customer success.

These investments increased in future periods and hit an accounting threshold that required us to take the $7 million charge in Q4. Marcus noted customer’s enthusiastic with our progress and committed to the cloud journey. If we take that one-time charge out, we noted that the services gross margin in Q4 was 6%, it would’ve been 16% without that. And then for the whole year, our services margin came in at 6%, 16% and it would have been 19% without that one-time unanticipated charge.

[Monika Garg, KeyBanc Capital Markets Inc.]

Got it, thanks. Then on the last earnings call, I think, you talked about flattish operating margins year-over-year. You were guiding about 150 bps lower on op margins. And maybe could you walk to the moving parts of that? Thank you.

[Curtis Smith, Chief Financial Officer]

Sure. I think, when we gave our preliminary commentary in Q3 with respect to our fiscal 2019 forecast, we expected that our operating margin would be no better than where we have guided, which was to a 16% to 17% operating margin for the year. As we noted in my earlier remarks, a few things are impacting that, that operating margin.

Notably, as we said before, a lot of the investment that we made in 2018, particularly on the R&D side, it was back-end loaded, and would realize the sort of full impact of that or the annual – annualized impact of that in 2018. We also had some of those headcounts that we hired in 2018 and are now being hired in 2019. So that’s one variable.

Another one that we talked about is that, our absolute commitment to being cloud-ready and our investment that we’re making in cloud operations, that’s continuing in – into 2019, as we prepare to continue to ramp up our ability to service more and more cloud customers, so that’s a piece of it.

And I think the third variable that we talked about earlier is our investment in the data and analytic services business that we recently formed. We see there’s a big opportunity there and are adding headcount into that business that we believe makes a lot of sense given the opportunity in front of it.

[Monika Garg, KeyBanc Capital Markets Inc.]

Thank you so much.

[Operator]

Our next question comes from Alex Zukin from Piper Jaffray.

[Alex Zukin, Piper Jaffray]

Hi, guys, thanks for taking my question. So I guess, maybe the first one for Marcus. You talked on the call or on the prepared remarks about a lot of Tier 1 deals they closed internationally. And I’m curious domestically, how should we be thinking about the Tier 1 deal landscape? We didn’t hear any mentioned. And is that due to the greater complexity of the sale cycles of some of these Tier 1 deals, where the cloud deals that you referenced and, or is there some other dynamic? And then I have a quick follow-up.

[Marcus Ryu, Chief Executive Officer]

No, I would distinguish between the Tier 1 market or the sub market in our customer base and prospect base. And then the general phenomena of cloud, they’re related, but they’re distinct as well. We have cloud discussions with Tier 1 insurers.

But for the most part with respect to their big core operations, their large books of business, those are really on-premise sessions, and we expect that will continue probably for a good while to come even though we may end up with cloud-based core system relationships with them. It’ll be more on ancillary lines or – and potentially new growth initiatives and the like.

I don’t think there’s any particular pattern to be read into, which deal is closed other than we had more traction – significantly more traction in Europe than we’ve had in previous periods, which is very welcome. There was actually hope for one point to even get more closed within the year, but those opportunities remain for us to get done in the first-half of the year that we’re in now. But there’s no particular pattern domestic versus international to call out there or fundamental differences in buying behavior or our competitiveness even.

[Alex Zukin, Piper Jaffray]

Got it. And then as a follow-up maybe to Curtis or Marcus, the one-time charge that you referenced with this InsuranceSuite Cloud customer, I guess, what is that – if there’s any more color that we can get in terms of, is this a potential recurring issue on some of these other larger InsuranceSuite transactions?

And then from a – from an operational standpoint, how are you thinking of or what changes are you thinking of making to the insurance now either go-to-market motion, or any other motion that you think did get that back to kind of where you wanted to be?

[Marcus Ryu, Chief Executive Officer]

Sure. Two distinct questions. So first, with respect to that, the large InsuranceSuite Cloud project, we talked about that customer relationship extensively in the past. There were a lot of things that were first time for us, where we leaned in on taking risk and on doing some new things differently with staffing it with a very large Guidewire Contingent and embracing a transformational scope, that was really substantially larger than maybe we’ve ever undertaken before. And that was, of course, arm in arm with the customer themselves.

So it was – it’s been a big and demanding transformational project. There’s a lot of success to point to. We’ve gotten through to the most – the critical first milestone, which happened last year and then there’s another set of key milestones ahead of us. But the entire scope of the project as it can happen on these programs on any large scale transformation program, it was larger than estimated.

Here we as part of the arrangement, we shouldered more of the financial risk went along with the program and is typical for us. We thought that was appropriate given the bet that this customer was taking on Guidewire and this is part of our share of the burden that, that come up that Curtis described. But it’s a fundamentally very successful program it’s one of the customers committed to, and there’s a lot of the lessons from it’s been internalized.

To your point, Alex, it’s really vital that we don’t – that our programs today contained well estimable, complete on time. There’s nothing more strategic for Guidewire than that even more than in winning new customers. And so, we have probably the most intense focus and management scrutiny on this program on every dimension than we’ve ever had on a project before.

Now with respect to InsuranceNow, I’d say, there’s no – there were lots of individual lessons from this or that sales cycle that we’ve internalized. There are a few sales execution issues that can – that always happen or we have to always question that when you become a lower than a number than you’d like.

But when we look at it from a bottoms-up basis, the opportunities ahead of us and even first-half of the year kind of forecast that we’re considering, our confidence there is fundamentally sound, And we think we have an offering that’s really well-suited for the market segment that we’re serving and much better so than than full InsuranceSuite. And it’s just getting more practiced than that with a dedicated team that they can go-to-market effectively with the company behind them. So it’s an important component of our bookings plan for the year that we’re in now.

[Alex Zukin, Piper Jaffray]

Great. Thank you, guys.

[Operator]

Our next, excuse me, our next question will come from Tom Roderick from Stifel.

[Matt Van Vliet, Stifel, Nicolaus & Co., Inc.]

Yes, hi. It’s Matt Van Vliet on for Tom. Thanks for taking my questions. I guess, Marcus, just a little more on the success that you had in Europe. Do you think that’s really primarily demand-driven? And if so, is there anything in the market that’s sort of driving that, whether it’s something on the GDPR side, or just broader adoption of new technology, or do you feel like some of the management changes and go-to-market strategies that you put in place are the bigger driver there?

[Marcus Ryu, Chief Executive Officer]

If I had to make a qualitative guess, I would say, it’s 70-30 demand versus sales execution. The demand environment has shifted for reasons that I could not exactly pinpoint other than the same kind of trends that we always talk about here in the States changing end market behavior with the demand for digital transformation, in digital engagement, digital distribution. And I think, it perhaps could also relates to incrementally improving economic conditions and performance for the industry in Europe, that’s my own speculation.

But it’s hard to point to any single catalyst. They’re certainly not one of them like GDPR, Y2K kind of thing that has changed the appetite for investment. What we do know and I think we’ve been forecasting this or foreshadowing this in previous calls is that, there’s – there was substantially more activity – demand activity in Europe than they had been in previous years.

We’re now starting to harvest some of that, and we don’t see that trend changing in the near to medium-term, which is very good. We’ve also made a lot of investments in the territory we’ve embraced, for example, the need to build really country specific content that conforms to local regulations in the major European countries and France and Germany and Spain and other countries seem to be, and that was – that’s been extremely well received by the market. It shows that we’re really there to stay and are investing in those countries as opposed to trying to apply an American or just generic solution to their markets, and that’s made a big difference as well.

[Matt Van Vliet, Stifel, Nicolaus & Co., Inc.]

And then looking at the sort of newly branded analytics and data services group, is this just a change in sort of go-to-market in having more cohesive strategy around sort of all things not InsuranceSuite, or is this really a different changing strategic outlook of, maybe potentially offering another sort of portfolio of solutions that don’t necessarily need or require InsuranceSuite in the background to be running?

[Marcus Ryu, Chief Executive Officer]

Yes, it’s really a combination of the latter, the ability well be the mandate for the team to build world-class analytic solutions for the P&C industry full stop, not necessarily ones that, that leverage over or require Guidewire InsuranceSuite to be implemented at the customer. That’s a primary motivation. And then I guess, secondary to that, giving a team the necessary autonomy and strategic independence, so that they can recruit, form partnerships maybe recommend acquisitions and just generally go-to-market with an analytics-first kind of value proposition.

What we’ve learned over the last year with Cyence is that, the constituency within the industry that we’ve become very well known to and very practiced in talking to is kind of very IT focused. There’s certainly business principles that are important in the claims operation or the underwriting operation.

But as a heavy IT element, there is a constituency often very executives in the industry, that doesn’t think about IT a lot. That’s very focused on markets, on data and new customer segments and often comes from an actuarial or modeling background. And in that – to that kind of audience, it’s very helpful to go in with the kind of data and market-first kind of message as opposed to a systems and application kind of proposition. So that, that also enters into our – into the organizational plan.

[Matt Van Vliet, Stifel, Nicolaus & Co., Inc.]

Great. Thank you.

[Operator]

Next, we’ll take a question from Ken Wong from Guggenheim Securities.

[Ken Wong, Guggenheim Securities]

Hey, guys. Marcus, maybe for you first. Based on your recent conversations with customers, I guess, any change in your thinking that cloud is more of a new license opportunity versus moving over some of the kind of the on-premise space, or has that dialogue started to shift?

[Marcus Ryu, Chief Executive Officer]

I wouldn’t say, we have a finally calibrated sense of what portion of the InsuranceSuite Cloud customers will come from existing Guidewire relationships and existing implementations and which will be net new field opportunities. It’s hard to tell, we certainly have examples of both – or actually with really three flavors, because there are no net new customers that are not doing a greenfield project, but they want their first Guidewire implementation to be cloud-based even though it’s for existing premiums, existing book, existing business. So there are really three flavors.

We have examples among those. And one of the customers we’ve already have and we’ve brought live and certainly examples in each of those categories in our forecast and outlook. I think, a year from now, we’ll have more data and perspective on where the demand will come and in what proportion. But at this point, we’re enthusiastically pursuing all three categories.

[Ken Wong, Guggenheim Securities]

Okay, got it. And then a quick one for Curtis. In terms of the two cloud customers that slipped, any rough sense of what that revenue impact might have been? And then as far as the services element, you mentioned how, I guess, service is a little lighter than expected this year? I guess, why would the services element kind of push out to next year or beyond if the deals are still closing this year? And I guess, any rough sense of what that impact might be?

[Curtis Smith, Chief Financial Officer]

Sure. So on the first point, no. We’re not providing revenue forecast on those two potential opportunities that moved into fiscal 2019. On the second part of it, we did talk to how the timing of those potential opportunities would affect our services revenue in 2019, and it has to do with the start time of when we begin the implementations, right?

So if we begin them in Q4 of this year, we get a full-year of potential services revenue from that versus if we were to begin those services revenues in Q2 of this year then we would only get three quarters of that instead of four. And so that’s what we factored in when we talked about the delays in the start of services work at two InsuranceSuite Cloud prospects that moved out of Q4 of 2018 into our fiscal year 2019.

[Marcus Ryu, Chief Executive Officer]

Can I think you were also asking what were we expecting in terms of revenue contribution in 2018 from those two deals. And I think, as you know, with ratable recognition and closing in the fourth quarter of the year, the contribution even for a fairly large transactions was modest, right, because there wasn’t – there weren’t a huge factor with respect to the revenue guidance, but they were consequential with respect to this other metrics that we introduced in the year, which is percentage of bookings coming in subscription form. And there they were significantly more consequential.

[Ken Wong, Guggenheim Securities]

Got it, got it. Thanks for the clarification. Yes, that’s a perfect, guys.

[Operator]

Our next question will come from Justin Furby with William Blair & Company.

[Justin Furby, William Blair & Company]

Hey, guys, thanks for the question. A couple. Maybe first for Marcus. Marcus, I think, I joined late, so apologies if you covered this. But your overall license numbers look pretty good. And I think, it sounds like you missed the benefit of some $4 million or so from a deal that moved into Q1 and you get 2X the license impact. So I guess, you obviously, I think, have a couple of cloud deals that’s left. And but can you just speak just sort of more generally on how you felt about Q4 and where you saw outperformance? And just sort of how you feel about the business today versus sort of this time last year? And then I’ve got a quick follow-up?

[Marcus Ryu, Chief Executive Officer]

Yes. It was sufficiently if we were to circumspect and we would put it in our prepared remarks, let me underscore now that we have the best demand environment that we’ve ever had at the company and we’ve closed more deals in the last few months than we ever have in a comparable period in our history. And we have more product to sell that we are winning at a higher rate than we ever have in the market.

At the same time, we’re trying to do a couple of very difficult things most importantly, sell our offering with a very different division of labor proposition to customers than we ever have before. And investing hard to build those capabilities to the satisfaction of a very conservative – rationally conservative customer base and learning the sales motions that go along with that. That’s what’s happening right now.

But we’re doing so in a very positive demand environment and competitive environment for us. And I would underscore, again, that a huge portion of our TAM in the Europe that had felt presence, but still kind of inert for many years now feels dramatically more active and that’s also very encouraging to us. So it was a period in which we closed many more transactions that we ever have before, but absent two that we worked very hard on put a lot of energy into, but couldn’t resolute the ground before we run out of time in the quarter.

And there’s no excuse for that that’s just – that’s where the enterprise software company with large deals and they’re always important. But that’s what happened this last period despite that we were pleased with the results we were able to post and the other metrics as well.

[Justin Furby, William Blair & Company]

Thanks. That’s helpful. And then maybe just a follow-up. Can you give a little bit of color on sort of the discussions you’re having with your systems integrator partners around how you think they fit in this cloud process and evolution as you are going through? Do you feel like it’s really more about the implementation work and getting those customers live and then you guys will manage post-production support, or could they have a role in that as well?

And if the latter is the case, then what does that do to that 2x to 3x number becomes something smaller? How does – just curious how all that fits together? And then, Curtis, I know you can’t give the numbers, but in just rough sense, I mean, is the services reduction versus kind of what you communicated last quarter, is most of that coming from the SI? Is there a big chunk coming from both the outsourcing of services, as well as the two cloud? Do you see any kind of rough sense there would be helpful? Thanks.

[Marcus Ryu, Chief Executive Officer]

Yes. Thanks for the question, Justin, it’s insightful and also timely, because one of the things we’re doing literally this week is a very systematic and educational outreach to all of our core SI partners. The COO of the company has deployed and set of meetings to discuss just this topic to make sure that there’s absolute clarity of how essential they are to the journey we’re on and how we – how complimentary we believe our offering is to their capabilities and how essential they are to us being able to scale to our ambitions here.

Specifically, we need their help in order to implement these core system programs, whether they’re in the cloud or not. The cloud does not magically make them simpler. It changes the division of labor that happens once they go into production. And it – but it does not simplify the core tasks of making a decision about what the core operating environment looks like and all of the implementation and integration decisions that have to go along with that.

And so there’s a ton of work involved every time. We don’t have the services organization or – nor are interested in building the services organization it would take to meet that demand. So we rely very heavily and we will rely even more heavily on our SI partners going forward to make that happen.

We had a very high attach rate on a couple of these early – earlier programs, especially the first. And that’s, because we have to ensure program success and even despite that as you’ve heard us talk about that those programs have been challenging and taking more effort than initially estimated.

But we have every intention and are to have the same kind of complementary arm in arm proposition to customers that we always have, which is that we focus on the great software and they assist with the program management and implementation that it takes to get live.

And then after that, of course, now with the help of another key partner, namely Amazon, we need to support those customers in an ongoing production mode, but that’s something that we’re going to do with our operations team.

[Curtis Smith, Chief Financial Officer]

And to your question on the services outlook going forward here. We know there were a couple of variables affecting the outlook. One of them being as Marcus just talked about our increased efforts to enable our strong SI partner ecosystem. And we’re encouraged by what we’re seeing early in the quarter and their ability to be able to take on some of those services this year and have modeled that into our forecast.

The second one, as we noted earlier, was the delays in the start of services work for two of these cloud customers that moved out of 2018 and into 2019. If we were to talk right now very early view and how we see that split roughly 50-50 right now, which we can update as we get more data through Q1.

[Justin Furby, William Blair & Company]

Super helpful. Thanks, guys.

[Operator]

Our next question will come from Tyler Radke with Citi.

[Tyler Radke, Citigroup]

Hi, thank you for taking my questions. And I apologize if my question has been asked already. I’m jumping around earnings calls today. I wanted to do ask, so it sounds like there’s a lot of moving pieces in the quarter in the guide with the accounting standard, as well as some of these slip cloud deals.

But I was wondering if Curtis, maybe if you could either directionally or just help us understand kind of what either revenue growth rate would be in FY 2019 under 605, just so we can kind of compare apples-to-apples understanding the moving pieces with ASC 606?

[Curtis Smith, Chief Financial Officer]

Yes. And Tyler, so what we talked about in our commentary and we referenced that in earlier calls, too, is given all the remediation efforts that we’ve done over the last two years to our business is that, it will render the 605 financials in 2019 non-comparable. And so we’ve guided people to not to look to our 605-based financials that we will be reporting in 2019 as a metric to use compared to a prior period, but that our 606 2019 financials have been set up to be more comparable with our 2018 numbers. And so 605 in 2019 won’t offer a comparable metric for prior periods.

[Tyler Radke, Citigroup]

Okay. So I guess may be asked it another way. If we were to look at the 606 numbers under both FY 2019 and FY 2018, what would we – what ballpark would just kind of revenue growth be for if we’re looking at either 606 to 606 or 605 to 605?

[Curtis Smith, Chief Financial Officer]

The guidance we gave and I’ll start with the most important one for us, which is the license and other, right? We noted in the guidance range that we provided, that would be between 16% and 19% growth rate over our license and other revenue in 2018. And so that’s how we’re thinking about that our 605 license and – I’m sorry, 606 license and other revenue in 2019, compared to our 605 license and other revenue in 2018. And that’s I think the best way to give – to look at it given all the remediation efforts that we did and that we discussed in the call.

[Tyler Radke, Citigroup]

Okay, and I appreciate that. And then just a follow-up for Marcus. On the data and digital, I guess, digitally, you sounded like you kind of created a specific business unit around. Can you just talk what you’re assuming in terms of contribution from data and digital into your forecast for FY 2019?

[Marcus Ryu, Chief Executive Officer]

I don’t think we have that broken out, but we certainly have a bookings planned by product and by customer segment. I don’t think we have a specific revenue contribution intended or trends. We don’t have a specific translation of that bookings into a revenue contribution that’s certainly not in a form that we’re prepared to share on the spot here.

We will give a lot of metrics about attach rates that go with each of the new product areas and the kind of pricing experience that we’ve had and the head of demand outlook and penetration that we have in our customer base, share of wallet, et cetera. So we want to be as transparent as possible about where these products are and how much more of them we have to sell into our own customer base and beyond. But we don’t have a specific number to share now about what fraction of our revenues in 2019 that they will contribute.

Another thing that we’ll share that, that we’ve just done our own computation on is a view on TAM or what I call the ADS division for analytics and data services. That we have thought of for most of our history as a kind of ancillary offering that, that enhances the proposition and contribute to the value proposition of the core.

We now have a more expensive notion of that as being a category in its own right, which relates to the core, but can be thought of a separate from it and is a substantially larger TAM, because now we’re thinking – we’re including a lot of other solutions investments that insurers make in that area that where we can bring really distinctive improvement to. So we’ll share a bit about that in two weeks at Analyst Day as well.

[Tyler Radke, Citigroup]

Great. Thank you.

[Operator]

Next we’ll take a question from William Fitzsimmons from Morningstar.

[William Fitzsimmons, Morningstar]

Hey, thanks for fitting me in. For Marcus, I know we’ve talked about InsuranceNow a little bit. And last I checked, you had maybe one Tier 1 customer and maybe 30 Tier 3 or below customers. Could you maybe talk about where that’s tracking and what percentage of revenue InsuranceNow makes up of the overall business? Thank you.

[Marcus Ryu, Chief Executive Officer]

Sure. Well, as for competition by customer segment, InsuranceNow is focused generally on smaller insurers. Currently, it’s only in the U.S. And probably for fiscal 2019, it will continue to be only U.S. We think we have plenty of market here in insurers that are generally $300 million or less in premiums, which is relatively small insurer, right, compared to the Tier 1, where that are $5 billion and significantly larger.

Of course, some of the largest insurers have multiple subsidiaries and divisions and so forth, some of which are appropriate customers for InsuranceNow. And you mentioned or alluded to one example of that and they will be – there are and will be others as well where that makes sense.

Though in general, there are a lot of – there’s a lot of benefit to platform consolidation. Insurers are already grappling with too many different core system environment in our legacy world and part of our proposition is that, you can unify them all on one platform in InsuranceSuite, and that’s usually the direction that will go.

In terms of contribution to the next year’s revenue, again, I don’t have that ready to share, I would say, In general, InsuranceNow has been some fraction of our total bookings were planned for InsuranceSuite. And we think that, that proportion will remain probably roughly consistent going next year. As you can sense from the prepared remarks, we were – we kind of underperformed in the contribution from InsuranceNow in the year. But that doesn’t change our result to make sure that we meet the target for the next year, which we think we can.

[Operator]

And ladies and gentlemen, that does conclude our question-and-answer session for today. I’d like to turn the conference back over to Marcus Ryu for any additional or closing remarks.

[Marcus Ryu, Chief Executive Officer]

No other commentary. Thank you all for participating in our call today. Goodbye.

[Operator]

That does conclude our conference for today. Thank you for your participation.