Software is a great business. Once you pass the “break-even” point, each additional sale drops straight to the bottom line.
Many investors realize this and bid software stock prices up to crazy heights. Today, though, we’ll put on our contrarian hat and highlight a rare overlooked gem in this sector.
The Two Keys to Software Success
I’ve learned firsthand that the best customer you can ask for in software is a business customer.
SAP, Oracle and Microsoft built empires selling software to businesses. They “automated” work that used to be done by human beings and were richly rewarded for it.
The key is following a “lame” act. Microsoft Excel was huge because there were no personal spreadsheet applications at the time. QuickBooks won the accounting software market because Excel wasn’t equipped to handle small-business finance.
When selling to large businesses, the ideal scenario is replacing “dinosaur” mainframe computers. Which is exactly what Guidewire Software (NYSE:GWRE) does.
Mainframe Computing’s Last Stand
Insurance companies are the ultimate technology Luddites. Most are still running their businesses on “old school” mainframe computers!
That’s where Guidewire comes in. The company develops “modern” software for the insurance industry. It’s a core system that automates everything insurance companies do… helping them into the 21st century at last.
Competition… or Lack Thereof
You don’t need to be the best to win at software. You just need to be better than your competitors.
Guidewire’s biggest competitor is – get this – Accenture. Yes, a consulting company is the only thing standing between Guidewire and its next deal. Needless to say, it’s been smooth sailing on the sales front.
And the insurance industry has a follow-the-leader mentality. The IT manager of yesteryear never got in trouble for buying IBM. Today’s insurance executives protect their own skins by purchasing Guidewire Software.
Steady Recurring Revenue
Guidewire signs its customers to multiyear recurring revenue contracts. As an investor, this really warms my heart!
The company has an excellent handle on the amount of money it’s going to make years down the road. It’s essentially an annuity stream funded by its customers.
Management defines this as “four-quarter recurring revenue” – which most recently totaled $130.9 million.
Don’t be fooled by the high price-to-earnings ratio shown on financial websites. Guidewire recently turned profitable – all license sales drop to the bottom line from here.
The recurring revenue is money that Guidewire could collect with no effort. It would require a small engineering team merely hanging out to answer the phone and solve a bug report now and then.
Guidewire Has Growth at a Reasonable Price
Guidewire sports a market cap of $2.51 billion, is sitting on a cash pile of $153 million and carries no debt.
Recurring revenue has been growing 25-35% since Guidewire went public in early 2012. As I said earlier, I love this business metric, and it’s doubling every two or three years.
There are 1,000 additional insurance companies that need Guidewire’s software. And its existing customers have purchased only a fraction of the full product set. CEO Marcus Ryu believes he can multiply revenue four times by just selling Guidewire’s existing product set to its current customers.
Let’s assume Guidewire can grow 25% per year for the next six years. That’s a double every three years.
Which means, in 2019, we’ll have a company that sports annual recurring revenue over $500 million. And they’ll have many new and existing customers to sell insurance software as well.
A Rare Overlooked High-Growth Software Company
There aren’t many “ignored” companies in this space. Guidewire owns its niche and will be powering the operations of insurance companies for decades to come.
Some armchair observers have looked at GWRE’s big run-up since IPO, as well as its “high” P/E ratio, and apparently concluded that it’s a good short candidate! I think this is crazy. And I’m thankful for this knee-jerk reaction and lack of homework. It’s rare to see great companies such as Guidewire sporting a contrarian setup like this!
Skeptics set it up for a short squeeze.
It appears that Wall Street doesn’t yet fully understand (read: appreciate) Guidewire’s business model. Just tee up its earnings conference call and you’ll hear analysts concerned only about next quarter.
I’m also anxiously waiting for “The Street” to misinterpret an earnings report and take the stock to the woodshed. Guidewire management focuses solely on creating long-term value. This can be an issue for the stock jocks who live life by the quarter!
My recommendation is to put Guidewire (NYSE:GWRE) on your watch list and buy at or below $42 per share.
Please be patient and wait for this price. As discussed, GRE’s earnings reports have a history of being misinterpreted. We will likely see our buy price sooner, rather than later.