Guidewire Software Inc

NYSE:GWRE

Earnings Call Transcript 2022-Q4

[Operator]

Greetings. And welcome to the Guidewire Fourth Quarter and Fiscal 2022 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 that this conference is being recorded. I will now turn the conference over to your host, Alex Hughes. You may begin.

[Alex Hughes, Vice President, Investor Relations]

Thank you, operator. Good afternoon and welcome the Guidewire Software's earnings conference call for the fourth quarter and fiscal year 2022, which ended on July 31st. I am Alex Hughes, Vice President, Investor Relations, and with me today is Mike Rosenbaum, Chief Executive Officer; and Jeff Cooper, Chief Financial Officer. A complete disclosure of our results can be found in our press release issued today, as well as in our related Form 8-K furnished to the SEC, both of which are available on the Investor Relations section of our website. Today's call is being recorded and a replay will be available following the conclusion of this call. Statements made on this call include forward-looking ones regarding our financial results, products, customer demand, operations, the impact local, national and geopolitical events on our business and other matters. These statements are subject to risks, uncertainties and assumptions are based on management's current expectations as of today and should not be relied upon as representing our views as of any subsequent date. Please refer to the press release and the risk factors and documents we file with the SEC, in our most recent annual report on Form 10-K to be filed with the SEC for information on risks, uncertainties and assumptions that may cause actual results to differ materially from those set forth in such statements. We will also refer to certain non-GAAP financial measures to provide additional information to investors. All commentary on margins profitability and expenses are on a non-GAAP basis unless stated otherwise. 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. With that, I'll now turn the call over to Mike.

[Mike Rosenbaum, Chief Executive Officer]

Thank you, Alex. Good afternoon, everyone. And thanks very much for joining us today. I'm happy to report a great finish to our fiscal year as we continue to steadily execute on our plan to lead the P&C industry to a modern Cloud Platform. Our progress in the fourth quarter is underscored by 16 cloud deals for our core software, bringing the total for the fiscal year to 40 and a constant currency ARR growth rate of 17% which was higher than our expectations going into this fiscal year. I'm very happy with the continued progress we are making on our cloud platform and the customer programs it supports. Overall, I'm very pleased with the results in the quarter and the fiscal year, but do want to call out that overall sales activity fell short of our expectations. Although, we drove healthy deal volume in the quarter, we closed transactions with smaller upfront commitments, which we expect to grow as customers expand. We also closed fewer large cloud migrations than we expected heading into the fiscal year. All our existing on-prem customers are evaluating their plans with respect to cloud. But we have not yet created an acceleration of these migrations. These two factors had an impact on fully ramped ARR which grew at 14% on a constant currency basis, and will have an impact on some of our forward looking metrics, which Jeff will cover in a bit. While there are certainly days when we would like this industry transition to move faster, I am proud of the product innovation we have delivered, thrilled with how well we are competing for new deals and confident that our current trajectory leads to our long-term goal of modernizing this critical, although risk averse industry we serve. Before I jump into the Q4 details, I want to take a step back and reflect on how far we've come. We started our cloud transformation in earnest two and a half years ago with the launch of Assets, Our first cloud platform release. Our goal was to establish a more efficient and Agile Platform that would form the foundation for all future Guidewire releases. We architected Guidewire Cloud Platform to support a more seamless release cadence so customers can update each release and take advantage of new innovation without an expensive and lengthy upgrade. We believe this approach to updating the product and platform is essential to supporting the industry's effort to modernize core platforms, engage with customers more effectively, innovate with new products and grow efficiently. In October, we will announce playing our sixth release in less than three years, [Inaudible] continues to enhance the operational maturity and scale required to support the world’s largest insurers, it includes advancements to further simplify and speed, development of integrations to and from Guidewire. It also dramatically expands on the packaged product solution and country specific content available under the Guidewire Go program, including content that accelerates time to market in Japan, Australia and the London market. Finally, this upcoming release marks the introduction of Guidewire’s Jutro digital platform to enable rapid delivery of rich digital experiences that work seamlessly with our core applications. The next objective was to drive adoption of our cloud platform. This adoption would provide us the practical experience we needed to ensure we would continue to lead the P&C core market worldwide. We have been enormously successful on this front, we now have over 120 customers committed to cloud including 79 for Guidewire Cloud Platform, of which 19 are now operating in production on GWCP. Cloud is now consistently above 90% of our sales activity and subscription revenue has now surpassed licensed revenue, which is an important milestone for the business and our transformation. The progress we have made to date gives me confidence that we're on the right path and that we will successfully transition our enterprise to the cloud. We of course, have a lot of work to do. But everyone at Guidewire is excited for the challenge and opportunity ahead. With that let me turn to some of the highlights and takeaways from the fourth quarter. It was great to see continued progress, driving deal volume through the quarter, while also further penetrating Tier 1 and Tier 2 insurers, of the 16 cloud wins in Q4 nearly half are with Tier 1 and Tier 2 insurers. Similarly, for the full year, we had 40 cloud wins and over half of these were with Tier 1 and Tier 2 insurers. Some notable wins in the quarter included a cloud expansion with one of the largest insurers in the world who is extending InsuranceSuite cloud to more lines of business. We also saw Kemper Corporation, one of the largest specialized insurers in the United States elect to migrate InsuranceSuite to the cloud. A Top 10 International insurer adopted policy center in the cloud for the United States and InsuranceSuite in the cloud for the London market. This is a new customer win and represents a significant potential expansion opportunity for us. InsuranceSuite cloud was also selected for two exciting Greenfield projects, serving large car manufacturers that plan to embed auto insurance at the point of sale. The first of these was for OnStar insurance, which is affiliated with General Motors. The second deal is with a large partner and European car manufacturer to enable the upsell of insurance contracts throughout Europe. These deals are starting relatively small from an ARR perspective, but have meaningful upside as these initiatives grow. And finally, I was thrilled to see our team plant Guidewire Cloud flags in Japan and Brazil. They saw automobile and fire insurance has become our first cloud customer in Japan by selecting ClaimCenter Cloud to replace an in-house built legacy system. We now have the opportunity to demonstrate the success of cloud in this important insurance market and drive continued expansion and modernization in Japan. Turning to cloud deployment activity, we had seven more go-lives on Guidewire Cloud in the fourth quarter. A Tier 2 US based specialty insurer serving niche Property Casualty and Surety markets deployed ClaimCenter on the Guidewire Cloud Platform. This project was delivered on time and at budget and has enabled them to update their implementation to be more aligned with our out of the box configuration. They've also enhanced their end user and employee experiences and freed up valuable IT resources to support a new focus on innovation and business value. A large Tier 1 went live with ClaimCenter on Guidewire Cloud Platform. And this was a successful Greenfield implementation and is a great proof point for us, as it demonstrates a Tier 1 carrier’s ability to leverage out of the box features and functionality to support innovative business initiatives quickly. Finally, Church Mutual Insurance Company, a 125 year old insurer operating in all 50 states went live with ClaimCenter on Guidewire Cloud Platform. This project was delivered on time and at budget and has enabled more out of the box configuration, reducing technical debt and leaner workflows by eliminating manual processes. This has enhanced end user and employee experience and allows their IT organization to focus on innovation and driving business value going forward. P&C core modernizations are often incredibly complex. Though we are generally thrilled with the progress we have made on our cloud programs. We do have a few of our early cloud projects that are more complicated and taking longer than we originally anticipated. And this does show up in our services margins. As I have said previously, we are committed to the success of every customer and intend to invest what is needed to ensure their success. While we are seeing higher expenses in some of these programs, I'm confident that we will see better efficiency and predictability going forward. There is of course a benefit in all this complexity, and in that it establishes tremendously valuable and durable relationships. The financial measure of this durability is reflected in an overall growth ARR attrition rate below 2% and core insurance suite growth attrition of approximately 1% excluding the impact of Russian customer attrition. This is a testament to the mission critical nature of the solutions we provide. Turning to our ecosystem, SIs partners continue to play a critical part in many of the cloud projects underway. With nearly 60 Guidewire Cloud projects in Q4 including SIs. It was great to see continued expansion in this community through the fourth quarter, we finished with nearly 19,000 Guidewire Consultants from the largest Sis in the world, an increase of 38% year-over-year, and the number of Cloud Certified Consultants increased 122% year-over-year to over 5,100. We also added 13 new solution partners to the Guidewire Marketplace and now have over 160 solution partners on our platform. We are fortunate to serve a big resilient industry that is steadily going through a significant digital transformation. With a singular focus on this industry for the last 20 years, we occupy a market leading position marked not just by the usage and resilience of our core solution, but also by the cloud leadership we have now established, I believe we are poised to establish a once in a generation cloud based technology platform that will serve as a source of innovation for customers while delivering durable and profitable growth for our stakeholders. I'm excited to share more about our platform in October when we host our Analyst Day on October 6 at our headquarters and then at Guidewire Connections which will take place this year from October 23 to the 26th. I'll now turn the call over to Jeff.

[Jeff Cooper, Chief Financial Officer]

Thanks Mike. Fourth quarter ARR ended at $683 million, up 17% year-over-year on a constant currency basis and ahead of our expectations. As a reminder, we measure ARR on a constant currency basis throughout the year, and then update ARR for yearend FX rates, making this update negatively impacted ARR by $19 million, resulting in ARR of $664 million. Reflecting on this outperformance especially as compared to our expectations coming into the year, we saw three trends drive this result. First, continued robust demand for our cloud products as reflected by the 40 cloud deals executed this year. Second, healthy sales performance for deals that converted into incremental ARR right away, as opposed to large ramped deals that we saw in prior years. And third, our gross ARR attrition was better than our expectations. Total cloud ARR which includes ARR for all of our cloud products and for customers that have contracted to move to the cloud grew 50% year-over-year and comprise 53% of total ARR. Fully ramped ARR, which is defined as the fully ramped annual price outlined in the customer contract grew 14% year-over-year on a constant currency basis. This growth rate was slower than overall ARR as we saw less ramp activity in fiscal 2022. As Mike noted, we saw less large cloud migration activity accompanied with large contractual commitments for future year fees at contract signing. Additionally, much of the large Tier 1 migration activity is still out there to be sold. We did see healthy new customer wins and new programs at existing customers and in many cases we expect these deals to grow significantly, but this growth is not committed. Total revenue for the year was $813 million, ahead of our expectations due to stronger performance across all components of revenue. Cloud strength continues to be visible in subscription revenue, which was $259 million, up 54% year-over-year. Subscription revenue also benefited from much better deal linearity in fiscal 2022 when compared with the prior year, where over 50% of our bookings activity took place in Q4. Subscription and support revenue was $344 million, up 36% year-over-year. License revenue was $259 million, down 15% when compared to last year. License revenue declines were the result of upfront revenue recognition of multi-year term licenses sold in prior years that had no corresponding revenue in fiscal 2022. And term license customers migrating to the cloud. Services revenue was $210 million, up 12%. Services revenue has benefited from ongoing increases in the number of cloud implementation programs. Turning to profitability for the fiscal year which we will discuss on a non-GAAP basis. Gross profit was $398 million. Overall gross margin was 49% compared to 56% a year ago. Subscription and support gross margin was 44%, a modest uptick over last year driven by margin improvement on our subscription line. Services gross margin was negative 2% compared to positive 5% a year ago. To meet the high demand for cloud and to drive early success, we have made investments alongside our early cloud customers, and we have invested in more subcontractors impacting services gross margins. Additionally, some of these projects have extended longer than originally anticipated. As Mike noted, our commitment to customer success has been a hallmark of Guidewire’s success. And we intend to maintain that commitment as the industry shifts to the cloud. Operating income was negative $45 million better than our guidance range due to higher than expected total revenue, partially offset by lower services margin. Operating cash flow ended the year at negative $38 million, lower expectations due to the timing of collections and higher subcontractor costs. We experienced stronger than normal collections in the first 10 business days of August, just after our fiscal yearend, where we collected almost $80 million. At the end of the quarter, we ended the quarter with $1.2 billion in cash, cash equivalents and investments. Now let me turn to our outlook. For fiscal 2023, we expect ARR of $745 million to $760 million representing 13% constant currency growth at the midpoint. Total revenue for the year is expected to be between $885 million and $895 million. We expect that subscription revenue will be approximately $340 million representing 31% growth. Subscription revenue is moderating off the 54% growth resulting from two factors that make fiscal ’23 a difficult compare with fiscal ‘22. First, we experienced less large ramp deal activity in Q4 fiscal ‘22 when compared with fiscal ‘21. Ramp deals are where customers commit to escalating annual subscription fees in the contract. Large multiyear ramps have a big impact on near term subscription revenue that you recognize. Sorry, large multiyear ramps have a big impact on near term subscription revenue given that you recognize the total contract value ratably over the committed term. A number of the deals executed in Q4 have significant growth potential, but this growth was not committed in the ramp schedule in the contract. Second, we experienced better linearity of sales in fiscal ’22 when compared with fiscal ‘21. In fiscal ’21, we experienced over 50% of our bookings in Q4, which resulted in little revenue in fiscal ’21 and a big step up from those deals in fiscal ‘22. Then in fiscal ‘22, we saw much better linearity which positively impacted fiscal ‘22 subscription revenue, but resulted in a step up in fiscal ’23 that is less than what we experienced last year. The full revenue were declined by about $7 million year-over-year as a result of the continued migration of our installed based cloud. The full revenue attaches to term license customers. For cloud customers, support activities are included in the subscription fee. License revenue is expected to continue to decline due to steady progress on cloud migrations. However, licensed revenue declines will not be as extreme as what we saw this past year as many of the multiyear deals signed in fiscal ‘20 and fiscal ‘21 will start to renew annually again. Additionally, we did not execute many multi year term license deals in fiscal ‘22. Finally, as per our typical approach, we have not modeled in any positive impact of new term deals or renewals of longer duration than our standard terms. Services revenue is expected to be approximately $220 million. Before turning to our outlook on margins, I want to let you all know that we are adjusting how we allocate certain expenses to better align with our business practices. Our updated approach is more aligned with many of our peers. Starting in Q1, we will expense headcount count related costs for IT, payroll and procurement in G&A, as opposed to our prior methodology of allocating these costs out to other expense lines. Historically, our IT personnel located in a specific country were allocated to the departments that had operations in that particular country. This made sense when IT was primarily co-located with the functions they supported, but it is no longer appropriate in a model where we are creating shared IT service functions. As our workforce has become more distributed, it was clear that we needed to adjust our approach. We expect this adjustment to have approximately two percentage points of upward impact to overall gross margins. And we will see a positive impact to all components of gross profit with the exception of licensed gross profit was never had much headcount associated with it and as a result, no real allocation impact. Additionally, G&A as a percent of revenue will increase by approximately five percentage points in fiscal 2023. We will provide a reconciliation between the two approaches in our first quarter 10-Q. With that in mind, we expect total gross margins for the year to be approximately 50%. Improving subscription margins are offset by overall revenue mix shift away from high margin license and support revenue. Subscription and support gross margins are expected to be approximately 46%. Finally, we expect services margins to be in the mid-single digits. This is expected to benefit approximately five percentage points from the previously mentioned allocation change to our income statement presentation. Additionally, we expect services margins to be higher in the second half of the year, as we continue to rely on higher than normal subcontractors in Q1 and some of Q2. With respect to operating income, we expect an operating loss of between $30 million and $20 million for the fiscal year. We expect growth and operating expenses to be muted in fiscal 2023. And our outlook assumes approximately $4.5 million in long-term incentive compensation that will transition from RSUs to cash LTI and approximately $2 million in restructuring costs that will hit in Q1. Cash flow from operations in fiscal 2023 is expected to be between $50 million and $80 million. Our CaPex expectations for the year are between $20 million and $25 million, including $14 million in capitalized software development costs. Before turning to our Q1 outlook, let me make a comment about our target model expectations. We will address this in more detail at our Analysts Day but wanted to comment quickly here. First, we don't expect any changes to our long-term model expectations. With respect the fiscal 2025 targets outlined in our last Analyst Day, I have a couple of comments. First, we still expect to achieve $1 billion in ARR by fiscal ‘25. Although FX impacts we are currently experiencing have put this target under a bit of pressure, under a bit more pressure than we were expecting at the start of last year. Second, we are moderating our near term expectations to align to the buying patterns that Mike discussed. Specifically smaller upfront commitments will cause near-term subscription revenue growth to be a bit slower than our expectations last year. This is because we ratably recognized total contract value over the committed period for subscription arrangements. So as commitments decline, then we pull forward less subscription revenue into earlier years of the arrangement. Our overall expense assumptions have shifted a bit. As such, our gross margins and operating margin expectations are now a couple of percentage points lower than our prior expectations, and subscription and support margins in fiscal ‘25 are now expected to be in the low 60% range versus prior expectations in the mid to upper 60% range. Finally, I want to reiterate that we are confident in our long-term margin targets and the future cash generation of our business. We have long durable customer relationships, we expect to drive scale benefits over time. And smaller upfront commitments do not negatively impact the longer term revenue potential as we expect these customers to grow as they are successful with their cloud programs. Our business is rapidly evolving. We always want to provide you with our best perspective in a timely fashion and will certainly give more detail at our Analyst Day. Finally, let me address our outlook for Q1, we expect ARR to finish between $667 million and $670 million. We expect total revenue of between $190 million and $195 million. We expect subscription revenue of approximately $78 million, and services revenue of approximately $55 million. Services margins are expected to continue to be under pressure in Q1 as we rely on higher than normal subcontractors. But this is not expected to persist throughout the year. Services margins in Q1 are expected to be negative 8% to 10%. We expect an operating loss of between $45 and $40 million in Q1. In summary, we are proud of what the team was able to accomplish in fiscal ‘22. We feel very confident in our market position to help the insurance industry thrive. Operator, you may now open the call for questions.

[Operator]

[Operator Instructions] And our first question comes from the line of Ken Wong from Oppenheimer.

[Ken Wong, Oppenheimer]

Thank you, operator. Mike, I wanted to just kind of take your pulse on the commentary on the demand environment. When thinking about the smaller upfront deals, the flatter ramps, fewer migration, I guess what would you characterize as maybe macro specific versus maybe the insurance market? And then to the extent that Guidewire, any execution dynamics that Guidewire has to sort through? How should we think about kind of what the kind of the puts and takes are in terms of that demand shift?

[Mike Rosenbaum, Chief Executive Officer]

Hey, Ken, thanks a lot for the question. First thing is, we're real happy with the deal count, the ARR activity in a lot of ways, this was a super, super quarter for us and continues the sort of what I would describe almost as this sort of inevitable march towards instant establishing Guidewire Cloud in the industry. As I tried to call out we are seeing this sort of, I don't know buying behavior, or propensity to request, the sort of structures where they get started smaller. And I think in a lot of ways, this lines up to buying patterns in other cloud segments in enterprise software, which might be a healthy thing. And as long as we execute on the programs, those deals will grow. That ARR or that future ARR is there, it just has to be delivered over time as the programs evolve as the lines of business expand. And I think we have a very, very solid track record to be able to say that we expect that, that future ARR and that future revenue to come in. With respect to migrations, I think these are just really complicated big decisions that these companies are making. We continue to make a lot of progress, working with existing customers around what they'd like to see from us on our cloud platform. And when it makes sense for them to make that decision. I continue to say every quarter and I firmly believe it will end up being true that this is a matter of when not if, we're building a platform that's going to support each and every one of those existing customers. And so all that demand is out there for us to be able to execute on as we proceed. So I look at this as much, much more of an insurance dynamic than I think a macro dynamic, at least that's what I'm seeing. But we're just, so hopefully that color gives you a bit of perspective into how we saw the quarter and how we sort of expect demand to play out as we proceed into this fiscal.

[Ken Wong, Oppenheimer]

Got it. And then maybe a quick follow up for you, Jeff. I realize some of this probably gets addressed at Investor Day. But as we think kind of the margin trajectory, I mean, just based on outlook for next year, it does feel like we're at a, this year was the trough just wanted to make sure we kind of confirm that or and if there's kind of anything that you're anticipating that maybe could shift that possibility.

[Jeff Cooper, Chief Financial Officer]

Yes, no. We'll certainly go into more detail at Analyst Day. I think the one thing we are calling out for you all today is some of the deal size impact that's associated with these ramps, our model previously assumed that we would see similar patterns this year that we saw in prior years. And that does have the effect in pulling forward some subscription revenue, right, because as a deal ramps over a five year period, you then total contract value out that and recognize it ratably. And so that dynamic can have an impact on our model. So we're flagging that that's embedded in our guidance. So that's all -- those shifts are embedded in our guidance, so nothing else beyond that phenomenon that we're seeing, and we'll help people understand that a little better at Analyst Day as we go into some of the details.

[Operator]

Our next question comes from the line of Matt VanVliet with BTIG.

[Matt VanVliet, BTIG]

Yes, thanks for taking the questions, guys. Maybe looking at performance across different international areas of the business, you highlighted a couple key wins, both in Europe and Asia. And I think you've highlighted Brazil as well. So curious if you're starting to see those markets, or those regions sort of pick back up after some slower times previously, and then any commentary around the North American market, as well would be helpful.

[Mike Rosenbaum, Chief Executive Officer]

Thanks a lot for the question, Matt, I'm glad you pointed that out. We were obviously Guidewire has had a lot of success internationally. And so thinking about establishing a cloud platform and transitioning that success to this new cloud platform you want to be able to do that successfully, internationally. That was absolutely part of the strategy of the company. And so this quarter, especially this deal in Japan, gives me and I think the whole company, just a lot of confidence that we are headed in the absolute right direction, that the approach we took to the platform, and the capability and resiliency and security and the infrastructure location of these data centers, on and on and on, it's really complicated. But getting this first win in Japan, I think and Brazil allows us to sort of clearly establish the idea that this is going to be an international cloud platform success story. So we're very, very happy with those events. In terms of whether or not it points to a change in the pace of the business, I think things play out slowly, and we'll see how things go. Certainly helps, doesn't hurt, and certainly helps. And I think, as we've said many, many, many times this is the success of our sales have a lot to do with establishing success stories, and other customers following buying patterns and implementation patterns that we can successfully establish. So from that perspective we're very, very happy with it. Just in terms of you also about the climate situation in the US. This deal that we did with OnStar, we are really excited about it, it gives us an ability to align to what we think might be a different channel for buying auto insurance and excited to partner with that organization as they execute on their business strategy. And then more broadly, in the US, we just see the pattern sort of steadily continuing to execute. We're going to see about a fair split between net new and migration activity, we're gonna see, we expect to continue to see greater than 90% of bookings activity being cloud. And kind of just, and I hate to say business as usual, because it never is, but just expect that we'll continue to make progress and execute in the US as we have for the past couple of years. So hopefully, that helps.

[Matt VanVliet, BTIG]

Yes, very helpful. And then, not to nitpick too much on sort of the deal sizes or, Jeff, to your point around maybe the upfront commitments not being as encompassing as some of your past ones. Should we think about that, as maybe just policy centers included today or just a single line of business for migrating to the cloud is included and assuming that you execute on that in the past, you've seen the expansion into other areas? Or is there some sort of greater limitation around what they're contracting today? And you really need to go out and sort of re-win the other areas?

[Jeff Cooper, Chief Financial Officer]

Yes, no, I don't think, I think there's a variety of things that are going on. We are certainly seeing people take maybe a line of business or take a module rather than going for especially in a migration context the full suite. So we are seeing a bit of that, the deal that Mike just referenced OnStar, which is a super interesting one, they have big plans. In prior years, we may have seen some of those plans negotiated upfront and kind of embedded into the contract. But this one, we're going to see how that one plays out. And we feel very confident that they will be successful and are excited to be attached to that success. I've often said that you can generally capture more area under the curve, if you are willing to invest in a success based pricing model. And I think that will play out for us over time. But the way the revenue gets recognized, it does have a meaningful impact in our model as customers were making slightly bigger commitments in prior years. So it's nothing that gives me pause about any commentary on the pace of as this industry starts to shift to the cloud. But the commitments we're seeing at the initial contract signings were a little bit lower than what we expected, and we've adjusted our models to account for that to build a bit more conservatism into them.

[Operator]

Our next question comes from the line of Parker Lane with Stifel.

[Parker Lane, Stifel]

Yes, hi, guys, thanks for taking the question. You've mentioned in the past, a lot of investments will add alongside the cloud customers that are sort of impacting margins here in the near term. When I think about subcontracting from the fixed fee services arrangements, when should we expect that to fall out of the model? I know, Jeff, you mentioned that it shouldn't be a full year phenomenon. But is it maybe a quarter more of an impact? Or is that a multi quarter situation that we'll see play out next year? Thanks.

[Jeff Cooper, Chief Financial Officer]

Yes, I think you're going to see it, certainly in Q1, you're going to continue to see it a bit in Q2. And as we look to the back half of the year we have very well defined concrete plans to address it. And so we do feel confident that as we exit the year, we'll be at a much more normalized services margin, we are no longer entertaining fixed fee arrangements, that was something that was important for us to tackle with some of these early cloud customers, but are moving away from that. And we feel much more confident with what we've learned over the last 24 to 18 months, in our estimation models, and have identified some of the issues and problem areas that arise in these programs. So we feel like we're just much better able to estimate total program costs and work with our customers [Inaudible].

[Parker Lane, Stifel]

Got it. And then in the context of hiring, I know you've talked about being very pleased with your employee attrition rate. On the new hiring front, is that something you're seeing become a little bit easier as you try to backfill some of these roles to support cloud customers? Or is the environment still as tough as it has been in recent years?

[Mike Rosenbaum, Chief Executive Officer]

The environment is tough. But I'd say as we look ahead to our headcount plans for next year, we are slowing down our hiring quite significantly. So there we don't expect to be adding nearly as much as what you've seen in prior years. And so that's, the environment for the technical talent that we're looking for remains difficult, but we're not end market as much as it used to be.

[Operator]

Our next question comes from the line of Rishi Jaluria with RBC Capital Markets.

[Unidentified Analyst]

Hey, thanks. This is Phil [Inaudible] on for Rishi. Appreciate you taking the questions. I wanted to start with one question on the idea of lower upfront commitments or softening demand? Is this the dynamic that you're seeing play out more one end of the market versus the other? Yes, any color there'll be interesting.

[Mike Rosenbaum, Chief Executive Officer]

That's a good question. Maybe you're making me think about what we're seeing. I think certainly the higher you go in the segments, the more lines of business and the more DWP at play. So kind of aligns to the potential for more of this sort of deal dynamic relative to all the way down to the Tier 5 sort of segment where the reality is their organizations aren't really big enough to support a sort of mix mode, and they really need to be all-in on a particular core solution strategy. And so yes, there is differentiation across tiers but I would that's probably not the main takeaway. I think the main takeaway aligns to what Jeff just said just the idea that cloud services do support this model. And our ability to deliver successfully on the programs aligns to our ability to as I think Jeff just said, extract more value under the curve over the long run, it's a bit more of a risk sharing approach that, honestly, I'm excited to take, it does have an impact on the way that we model the business. And it is slightly different than how we've operated previously, but it's not necessarily a bad thing in the long run for Guidewire, or for our customers and maybe, if you zoom out, like I said, it sort of aligns to how people think about cloud in general. So it might be pretty good. So basically, that's how I would think about it is, is the more complex the environment, the more complex IT operating environment is, the more potential there is for a structure like this to make sense.

[Unidentified Analyst]

Got it. That makes that a ton of sense. I appreciate the color there. Then one on HazardHub, you had a, there's a blog post about a month or two ago, with the leader, they're kind of talking about aspirations of HazardHub’s ARR doubling by the end of fiscal ‘22, and aspirations for that to happen again, next year. I don't know if you want to comment on those targets, or the growth that you're seeing, but maybe, if maybe just talk about like sort of what's driving the momentum you're seeing there and kind of how you feel about the assets and the more data analytics space and insurance going forward?

[Mike Rosenbaum, Chief Executive Officer]

Yes, sure. Great question. Very happy you brought it up, couldn't be happier with the acquisition, it's a great group of people, it’s a great product, fit right into Guidewire, connected it right into our sales and distribution organization, and there's been a lot of demand for the product and that's up and down the sort of scale different size companies, different sides use cases and really lines up to the thesis behind the acquisition in the first place, which is that we can take this great data and analytics asset and with a real modern API approach, apply it to all sorts of different use cases, within an insurance company and an insurance business process. And that is going very well, I don't want to get into the specifics about the targets and doubling but we're doing really well, with that acquisition and feel great about the concept in general just that we can take a modern approach to data and analytics, operationalize it alongside of the policy and claims operational business processes that Guidewire runs but then, in addition, just plug that company into all the insurance companies right now in the United States but maybe someday into the whole world. So and then I think there was a touch of your question that relates to just why is this important to an insurance company, rating risk, has a lot to do with where that risk is, what is it, I think it's 120 degrees, we were just talking about in California, which is a pretty unique circumstance. And so the climate in the world is changing. And there's changes in weather patterns, and there's changes in risk profiles associated with these locations. And so this is a dynamic situation that insurance companies are dealing with when they think about rating a property, and assessing the risks associated with underwriting that property. And if we can make that easier for them. And we can make that more accurate for them. And we can apply modern analytics and data science to the sort of idea that each and every time they touch a risk, and they're getting that price, right, we can really help them and we can really help the market in general, and aligns really well to our mission. So we're very, very excited about HazardHub and its success so far here at Guidewire. So I appreciate the question.

[Operator]

Our next question comes from the line of Peter Heckmann with D.A. Davidson.

[Peter Heckmann, D.A. Davidson]

Good afternoon. Thanks for taking the question. One thing I wanted to clarify, I didn't hear you say I may have missed it. But in terms of your first quarter guidance, what are you embedding there in terms of your FX assumptions about 300 basis points of headwind?

[Jeff Cooper, Chief Financial Officer]

Yes, I mean, we've kind of adjusted our forecast for current FX rates. And so I don't I'm not sure about on the basis points perspective, but yes, we are factoring in current FX rates.

[Peter Heckmann, D.A. Davidson]

Okay, and so for the year, just basically looking at spot rates currently. And so if we get some improvement from that, and then we could potentially get some upside but on the ARR side, we're now we're just looking at like your first your ARR guidance that is now based on the constant currency, as of –

[Mike Rosenbaum, Chief Executive Officer]

Exactly, so yes, so we've reset ARR for the fiscal year moving ahead, and we will kind of hold that constant as we move through the year. That's right.

[Peter Heckmann, D.A. Davidson]

Okay. And then just a question on the M&A outlook, companies continues to have a significant war chest and it certainly seems like there's a lot of interesting smaller companies out there, and maybe some valuations have come in a bit, would you expect to be relatively more active on M&A over the next two or three years compared to the last two or three?

[Jeff Cooper, Chief Financial Officer]

Yes, I think it's a fair question. And certainly we watch closely, multiples valuations and unexpected transaction costs. And so that is all headed towards that pushes us towards the possibility that we'll be more active. I think that's appropriate. It’s, and I think the other side of that equation is we're feeling more and more comfortable with the strategic position that we have earned, I guess, with respect to the cloud platform and the confidence we have executing there. So I think it's fair to say that it's reasonable to think that we will be more interested in the small companies and M&A activity just given valuations are more in line and possible given where we are with the overall state of technology, multiples and valuations.

[Operator]

[Operator Instructions] Our next question comes from the line of Dylan Becker with William Blair.

[Dylan Becker, William Blair]

Hey, guys, appreciate you taking the question. Mike, maybe I wanted to double click on a couple questions prior, I wanted to get your take on the idea of continuous underwriting, and maybe what the value and visibility this can deliver for the industry, and maybe as an enabler of that, how you think about the evolution of insurance business models, and that emphasis on data to serve as that further incentive on some of these core modernization projects.

[Mike Rosenbaum, Chief Executive Officer]

Phenomenal question, in general, I remember back to when I first joined Guidewire, and I was talking to one of the insurance executives responsible for Guidewire modernization, right. So we're not talking about cloud, we're just talking about mainframe to modern system. And what they explained to me very nicely and politely was that their entire operation operated on a 24 hour batch based cycle. So agents and brokers would talk to customers about quotes, and offer estimates to cut customers about the potentially underwriting their risk. But it wasn't, but you had to wait 24 hours for the mainframe batch system to kick in, in order to provide an actual quote back to that customer. And then if there was any change to that, quote, you had to wait another 24 hour cycle in order to get this to actually transact. And so what they're explaining to me is, establishing Guidewire’s, the core system was going to enable that process to execute continuously want to quote, here's a, quote, want to change something, here's a new quote, and that could enable [Inaudible] when you think about it that way, makes it super easy for you, understand what people are talking about when they say that we're going to execute a digital transformation in the insurance industry. It's just the seamless type of experience and interaction that we expect to have from every company that we interact with, and we were going to make that possible. So if you take that a step further, which is what I think that you're getting at, sort of behind the, your next question is like, well, okay, well If you're looking at a risk, and you're making a decision about underwriting that risk, how frequently are we checking to see that the underlying conditions associated with that risk are still valid? And what's the term of the agreement that we've established for that risk? Is it a month? Is it six months? Is it a year? How frequently are we resetting that price? With when you take it to the extreme, there's the potential to be looking at these risks continuously pricing these risks continuously. And we all see that to some extent maybe it's pretty early in its evolution. But we see this to some extent in the way that we drive cars, and the feedback that we're getting about how we're driving the car, and how the risks we're taking, while we're driving our car impact, the price, we're paying for the insurance that we get for driving that car, now but you can really extend this out to the whole, all these different lines of business, in the insurance industry. The other thing that I think is really interesting about your question is that it doesn't just, it isn't just the idea that it impacts this one risk and this one transaction, but these companies have to be looking at their entire portfolio. They have to be using and I'll kind of touch back to one of the earlier questions about HazardHub, they have to be looking at all the property risks that they have, and they have to be assessing have things changed with respect to the risks that they've already underwritten, and should that have an influence on the way that they want to price the next risk that comes into the door and or it comes into the funnel, the sales funnel, so to speak, I just think all this is pretty exciting, that we can establish a better platform, we can make the data and the analytics more easily available. We can create more agility in the way that these systems are deployed. And you can get to a place where insurance companies are just operating a lot more fluidly and a lot more efficiently. And I think that that's really what's underlying the sort of potential behind this sort of industry transformation. So hopefully, that lines up to what you were talking about. But it's an exciting way to think about what we can do for our customers and for the industry.

[Dylan Becker, William Blair]

Yes, no, I really appreciate the detail and super exciting overall opportunity set. They're super interesting. Maybe a more boring question for, Jeff, as we think about the services kind of component and mixing the business to maybe moving away from some of those fixed fee arrangements dilutes those to a certain extent. But how should we think about that outside of against some of the third party outsourcing to Sis but the services revenue line item is some of that leading indicator of some of the overall business momentum as well, right. So having to work towards that implementation, enable the provisioning and then the actual go live for some of these solutions in the cloud? How does that – how should we think about that as a potential leading indicator at the subscription momentum as well?

[Jeff Cooper, Chief Financial Officer]

Yes, I think I think you've got to be a little bit careful there. We did see healthy growth on our services revenue this year, we are actively pushing more and more work to our partners, and intend to create a very large opportunity for our partners as we effect this transition to the cloud. And it's the only way we can attack this problem scalable. So looking at our services line, and the growth of our services line, I don't think is necessarily an early indicator of overall cloud demand, as I expect our partners just to continue to take more and more of that work, which is a positive thing for the both of us.

[Operator]

We have reached the end of the question and answer session. I'll now turn the call back over to Mike Rosenbaum for closing remarks.

[Mike Rosenbaum, Chief Executive Officer]

Hey, thanks very much. I just want to thank everybody for participating on the call today. And we look forward to seeing hopefully all of you at our Analyst Day on October 6. So thanks very much, everybody.

[Operator]

And this concludes today's conference. And you may disconnect your line at this time. Thank you for your participation.