Good day, ladies and gentlemen and welcome to the Guidewire’s Third Quarter Fiscal 2019 Financial Results Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Curtis Smith, Chief Financial Officer. Please go ahead..

Good afternoon and welcome to Guidewire Software’s earnings conference call for the third quarter of fiscal year 2019, which ended on April 30, 2019. I’m Curtis Smith, 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 of any subsequent date. We disclaim any obligations 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 the call over to Marcus for his prepared remarks and then I will provide details on our results before providing our outlook for full year fiscal 2019. Marcus and I will then take your questions..

Thank you, Curtis. Our third quarter financial results exceeded our revenue and profitability guidance ranges with total revenue of 162.9 million and non-GAAP earnings of $0.18 per share.

We had a very active bookings quarter, contributing to a strong year-to-date sales performance that is under represented in our reported financial for several reasons.

Most significant among these is the faster shift to cloud that we are both driving and responding to, reflected in third quarter subscription sales that were 60% of the quarter’s bookings, which was at the upper end of our anticipated full year range.

While this is positive, both for the lifetime value of our customer relationships and for our industry platform strategy, it dampens near term results, since the revenue from subscriptions is recognized over multiple quarters, unlike term licenses whose revenue was recognized upfront.

Notably, we signed two new InsuranceSuite cloud deals in the quarter. The first is with Amica Mutual, the oldest mutual auto insurer in the US, and one ranked at the very top of customer satisfaction measures by Consumer Reports, JD Power and others.

Amica, a tier 2 insurer and a Guidewire customer since 2005 will look to us to upgrade, migrate and manage their existing InsuranceSuite core data and digital implementations to Guidewire cloud, encompassing their entire DWP.

Amica also selected our digital products, integrating to Salesforce’s financial services cloud, representing one of two additional wins for our strategic partnership with Salesforce for the quarter, the other being [indiscernible] in Scandinavia. The second InsuranceSuite cloud win was with Macif, one of the largest domestic insurers in France.

While technically on migration of an existing customer, this deal had many characteristics of a new customer win for Guidewire cloud. Less than a year ago, we added Macif as a new customer with a starting footprint of less than 100 million in DWP under contract.

This new deal expands that relationships to full InsuranceSuite core as well as data and digital and increases in scope DWP to 4 billion.

This project will be an anchoring reference for cloud demand and delivery in continental Europe and is further significant in being led by one of our F5 partners, advancing a key objective to increase our implementation capacity as we expect the pace of new cloud deals to accelerate.

With three new deals for InsuranceSuite via Guidewire cloud completed in the first three quarters of the year, and a growing pipeline of deals of both new and existing customers of all sizes globally, we are increasing the number of such transactions we expect to complete this year from 5 to 8 deals to 7 to 8 deals.

Another quarter of market experience also continues to reinforce our pricing expectations for this new division of labor with our customers, once they are fully ramped. Consequently, we now expect that new subscription sales as a percentage of bookings for the year to finish at the higher end of our previously communicated 40% to 60% range.

However, despite our year-to-date bookings performance and our positive outlook on cloud demand, we are adjusting our expectations for the year.

First and foremost, the increased demand for subscription sales of ratable revenue recognition pushes into future quarters revenue that would have been recognized upfront in term arrangement, an effect that is greatly magnified for sales in the fourth quarter.

While overall bookings seasonality is expected to follow historical patterns, new subscription sales are significantly more backend weighted than overall bookings this year, as evidenced by the four to five InsuranceSuite cloud deals that we expect in Q4.

We believe that this rather extreme seasonality is one time in nature, since our definitive go to market push for InsuranceSuite cloud only commenced at our connections events in October 2018. A second factor impacting revenue, ARR and free cash flow this year is higher revenue attrition than our historical norm.

In addition to science attrition mentioned last quarter, a small portion of our InsuranceSuite customers renewed or are expected to renew at lower license amounts in fiscal year 2019.

While InsuranceSuite customer non renewals continue to be negligible, we now expect our revenue retention, excluding any customer expansion, to be a few percentage points lower in fiscal 2019 than what we have experienced in the past.

Every year, it is necessary to adjust the economics of a few customer relationships at renewal time due to M&A consolidation, or because customers are behind internal rollout schedules or have changed strategy.

However, this year because we intentionally remediated almost all customer contracts to renew annually in anticipation of ASC 606, we saw a concentration of these issues affect us in a single year.

We expect to have most of this effect behind us by the end of fiscal year 2019, the first full year post the remediation program, and expect to converge back to our historical revenue retention rates.

Third, and finally, we expect to see a services impact as we have invested significantly in the success of our early cloud customers, as well as enabling our SI partners to support cloud implementation.

While greater than anticipated cloud demand has motivated this intense focus, the strategic transfer of capacity will reduce our own services revenue at the same time that it improves our ability to scale, consistent with our longer term objective to reduce services and increase recurring streams as a portion of our overall revenue mix.

The MACIF win that I mentioned earlier, is an encouraging example of our progress toward this goal. As we think ahead to next year, we expect cloud momentum to continue with strong contribution from migrations of in production, self managed customers to Guidewire cloud.

We are fully committed to serving self managed customers indefinitely, and we expect that this evolution will take years to fully unfold.

At the same time, we welcome the faster shift to the cloud because it enables lower TCO through standardization and more rapid upgrades and it encourages customer contribution of data for syndication, in addition to materially increasing the lifetime value to us of each customer relationship.

However, InsuranceSuite cloud demand, exceeding what was previously estimated in our multi-year model, has two consequences. First, again a dampening of near term revenue growth due to ratable revenue recognition and second, additional expense pressure as we invest in cloud operations capacity to meet demand.

Curtis will quantify our early view of these dimensions. Returning to our market progress in the quarter, both with new sales and customer go live, we continued to attract new customers.

National Mutual Insurance Federation of Agricultural Cooperative, a mutual insurer serving the agricultural industry in Japan, with 4.7 billion in DWP selected claim center.

In addition, two smaller insurers in Canada selected a broad range of products from the Guidewire platform, including all three core insurance products Guidewire digital and data and rating management and reinsurance. We also continued our momentum in data and digital.

11 customers chose to add digital products and seven customer selected data products in the quarter. A total of 21 customers existing selected 35 additional Guidewire insurance platform products, including a new science customer.

As anticipated, we saw science attrition normalize after calendar fourth quarter, and we continue to recruit data customers who are seeing positive results in applying science to mature insurance business lines beyond cyber.

During the third quarter, we also had a total of 16 customer go lives on 40 products, including Grinnell’s go live of InsuranceSuite via Guidewire cloud. To date, a total of four customers have gone live with at least one InsuranceSuite cloud implementation.

In summary, we made e continued progress on multiple fronts in the third quarter, including adoption of InsuranceSuite and InsuranceSuite cloud, Guidewire digital products integrated to Salesforce, and our other digital and data products.

Despite the factors, including the underlying strength of our business, we expect a faster shift to subscription to generate a strong tailwind to our long term revenue and profitability.

We are optimistic about the demand we are seeing for Guidewire cloud and we look forward to serving the $2 trillion global TMC industry and its digital transformation initiatives over the long term. I will now turn the call over to Curtis to cover our results and financial outlook for the remainder of fiscal year 2019..

Thank you, Marcus. Please note that the year-over-year comparisons that will be discussed are based on our amended 10-Ka for the fiscal year ended July 31, 2018, which was filed on June 3. Total revenue for the third quarter was 162.9 million, an increase of 15% from a year ago and above the high end of our guidance range.

License and subscription revenue was 76.2 million. A portion of our better-than-expected performance was due to the ClaimCenter term license deal with a large Japanese customer that Marcus mentioned, which we previously expected to close in Q4. Year-over-year license and subscription revenue growth was 45%.

As we noted in our Q1 earnings call, year-over-year license and subscription revenue comparisons are impacted by the adoption of ASC 606, which affects the timing of revenue recognition of our term license contracts. Subscription revenue was 14.7 million, compared to 8.6 million a year ago, representing a year-over-year growth rate of 71%.

Perpetual license revenue in the quarter was 1.3 million. As Marcus mentioned, we had a strong bookings quarter and subscriptions represented 60% of new sales at the upper end of our anticipated range for the year. Maintenance revenue was 21.3 million, an increase of 14% from a year ago, and was also above the high end of our guidance range.

Services revenue for the second quarter was 65.3 million, a decline of 8% from a year ago due to hosting revenue reclassification and continued investment in our initial cloud implementations.

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 issue today with the primary differences being stock based compensation expenses, amortization of intangibles, the amortization of debt discount and issuance costs from our convertible notes and the related tax effects of these adjustments.

Gross profit was 94.1 million, representing a gross margin for the quarter of 58% compared to 55% a year ago. The increase in gross margin was driven by higher license and subscription mix. Total operating expenses were 81.6 million in the third quarter, up from 75.2 million year-over-year.

The growth in spend was driven by investments in sales and marketing and increases in corporate infrastructure costs. We took possession of our new headquarters towards the middle of the second quarter, and we move into that facility at the end of this month.

During all of Q3, we were recording rent expense associated with both the new building and the existing headquarters. Operating income was 12.6 million, which exceeded the high end of our guidance range largely due to license and subscription revenue upside, and operating expenses coming in more favorably then forecasted.

Operating margin for the quarter was 8%. Net income was 15.2 million or $0.18 per diluted share. Turning to our balance sheet, we ended the quarter with 1.2 billion in cash, cash equivalents and investments, flat compared to the end of the second quarter. Operating cash flow for the quarter was 26.2 million compared to 20.2 million a year ago.

Free cash flow was 15.3 when adjusting for buildout expenses associated with the new headquarters compared to 19 million a year ago. Now looking forward, first, let me share our outlook for full fiscal year 2019. I will then make some high level comments on fiscal year 2020.

We delivered better than expected third quarter results, which included a higher than expected proportion of new sales from subscriptions.

However, given the ratable versus upfront recognition of these subscription contracts and the extent of the subscription activity we anticipate in Q4, we are trimming the high end of our license and subscription guidance.

The impact from the shift to subscriptions is particularly noticeable in the fourth quarter, given that far less revenue is recognized in a year when compared to upfront term licenses.

As Marcus mentioned, our higher revenue attritions combined with previously disclosed science non-renewals experienced in Q2 led to lost revenue of approximately 20 million for the year.

While this is largely offset by strong new business activity, we now expect license and subscription revenue for the year to be between 379 and 387 million, lowering the midpoint by 2 million. This includes anticipated subscription revenue of between 62 million and 66 million, raising the midpoint by 1 million.

And we are now anticipating perpetual license revenue of less than 2 million, a decrease from 11.8 million last year. We are increasing our outlook for maintenance revenue to 84 million to 85 million, an increase of 1.5 million at the midpoint. Turning to services, we are experiencing three factors impacting our outlook.

We have made better than expected progress shifting responsibilities for Guidewire cloud implementations to our network of system integrator partners.

We have continued to make services investment with early cloud customers and some existing self managed customers have delayed InsuranceSuite 10 upgrade projects as they assess potential migration to our cloud offering.

As a result, we are moderating our services revenue outlook for the year to 244 million to 250 million, representing a $14 million decline at the midpoint. We expect services margins to be between 10% and 11% this fiscal year.

Summing this all up, for the year, we now anticipate total revenue to be in the range of 711 million to 719 million, lowering the overall midpoint by 13.5 million. With a lower revenue outlook offset by lower than expected spending, we are maintaining our non-GAAP operating income outlook for fiscal 2019 at 112 million to 118 million.

We’re increasing our outlet for non-GAAP net income to between 112.2 million and 117.2 million, representing a 1.4 million increase at the midpoint or $1.36 to $1.42 per diluted share based on approximately 82.5 million diluted shares.

With respect to ARR, while the faster shift to subscriptions will ultimately have a positive impact on long term ARR, the ramped nature of these contracts, as we discussed last quarter, are negatively impacting ARR in the near term.

As an example, the three InsuranceSuite cloud deals we executed year to date, and the one expansion signed in Q2 will contribute less than 10 million in ARR in fiscal year 2019, but over 30 million in ARR when fully ramped. Additionally, the revenue attrition previously discussed is impacting ARR this year.

As a result, we expect ARR growth to be a few percentage points below the bottom end of the range of 15% to 18% communicated at our last Analyst Day. We do not anticipate this year's ARR growth to be reflective of our long term ARR growth rate, which we expect to be higher.

Excluding the one-time costs associated with our new headquarters, we are lowering our free cash flow outlook for the year to 100 million to 115 million. This is impacted by lower year-over-year services billings as well as the factors impacting ARR.

We still expect to spend approximately 35 million to 40 million in support of our HQ build out, a portion of which may move into fiscal year 2020. Looking ahead to fiscal year 2020, we want to provide some commentary on factors that will impact financial results.

As Marcus noted, we are pleased with the faster than anticipated pace of Guidewire cloud adoption. This trend will have a meaningful positive impact on our long term financial performance. However, this faster shift to the cloud is putting near term operational pressures on the business, three of which I want to reiterate.

First, replacing term license new sales with subscription new sales will put downward pressure on reported revenue in the near term in exchange for a greater revenue contribution in future periods.

Second, significant cloud operations investments and the supporting organizational infrastructure to ensure we can service cloud demand and commitment to customer success will impact gross margin and operating margin until we achieve economies of scale and customer adoption of standardization.

Third, higher cloud demand has necessitated even stronger SI enablement this year and we now expect partners to drive more cloud implementations in fiscal year 2020, enabling lower Guidewire services participation and a faster shift in our revenue mix away from services and towards recurring revenue.

While we are still in the early days of formalizing our fiscal year 2020 plan and Q4 activity can have a large impact on our final expectations, due to the factors I just described, we currently expect license and subscription revenue growth to be approximately 20% and we expect services revenue to be roughly flat to this year.

Additionally, we expect operating margin to be approximately 14%. In closing, it was a strong third quarter highlighted by two InsuranceSuite cloud deals.

We believe the faster shift to subscriptions will impact the near term optics of our reported financials, benefit our customers and ultimately drive increased revenue predictability, strong profitability, and enhanced cash flow. Thank you.

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

[Operator Instructions] We'll take our first question from Tom Roderick with Stifel..

Matt VanVliet on for Tom. I guess, from a high level, Marcus, obviously great, great job here getting customers, both existing and new to shift to the cloud.

Curious in terms of, how much you think the investments around a lot of the data and digital products as well as partnerships, like the one you highlighted with Salesforce are really influencing customers to make this shift now versus their own sort of internal digital transformations driving that..

I appreciate the question, Matt. Well, digital transfer, if you had to pick a single theme is the most important catalyst for the IT investment overall in the industry that we serve.

So it's very, very prominent in the investments that we've made in digital over the last number of years, has been absolutely essential, on top of the other operational kind of core operational improvements that the platform has always been about.

And you can see that from the very robust tax rates that we've had for our digital products, for several years now. I think that's distinct, though not as competitive with the motivations for our customers to think about the cloud.

Today, the primary motivation for the cloud is about a transfer of risk and complexity from an internal IT organization to a trusted partner in Guidewire, and that's with respect to everything that they want the core system to do.

Some of that is digital or a large portion of that ambition is digital, but it also includes the development of new products, core operational efficiencies, better customer service, basically everything on the strategic agenda that requires IT involvement becomes transformed and potentially accelerated if the core functioning of that platform in production is now the responsibility of a reliable partner..

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Could you try reposing that, please?.

Yes.

So Curtis, following up on the early 2020 outlook, if we see a pretty significant uptick, even from where you're expecting now, in terms of subscription bookings mix, are there still additional, pretty incremental investments in that cloud infrastructure that you need to make? Or are we on more of a steady state now with the step function investments that you made this year?.

Yes. So when we put together the five year model, we assumed a more steady pace of IS cloud adoption, we didn't assume an inflection point. But the current trend continues. And we see accelerated IS cloud adoption, and then we could see more pressure on margins in the short term, due to the revenue recognition.

In fact, we talked about and also the earlier hiring of resources that we’ll need to make in order to meet that cloud demand.

Q4 is always a big quarter for us, and in fact, the following year and so we'll look forward to gathering more data in Q4 on the go to market side of things and operational data and we'll be in a better position to potentially attract the longer term impact of the model at Analysts Day..

We'll take our next question from Ken Wong with Guggenheim..

In terms of, we'll touch on cloud again.

You mentioned closing seven to eight deals in ‘19 and obviously that pacing to be accelerating, how should we think about that pipeline next year? What are the – do you have the rough capacity to be able to get that number higher than where it is now and any sense of what that looks like?.

It's a little premature Ken for us to pick a number, let alone communicate one for next year that we have a view. I think we are, don't feel, demand constrained with respect, which is an interesting and exciting position to be in.

But we have to make sure that we have the capacity to deliver, there is an attach of internal operational personnel that go with everyone, every cloud relationship. There's a higher, dramatically higher attach than what you would have in a term license arrangement where it's really just a license of software. And so we have to be mindful of that.

And that's all being baked into the budgets and operational plans for next year. I think that we expect to stay on a similar trajectory to what we have now.

And we have, as I mentioned in my prepared remarks, somewhat of a compression in the back half of this year of cloud demand because we were not really assertive and aggressive in our pursuit of the opportunities until our connections event, which is really -- just gave us a half year of kind of full throated sales that yielded the deals that we have and expect to close this year and of course, a pipeline that much of which will be converting next year..

And then maybe a follow up in terms of the higher revenue attrition commentary, you mentioned, obviously a little more accelerated because of the remediation of deals. But in terms of the magnitude relative to kind of typical attrition, would you say it's similar or kind of higher than typical..

So it was multiples of the usual revenue attrition and to be direct, we were caught off guard a bit by that, but the primary cause was the dramatically higher volume of renewals that we had to process in the year and just to quantify that for you, in fiscal ’17, we had 50 customer renewals.

In fiscal ’19, we will have done over 350, so a 7 fold increase in the number of renewals and that's overwhelmingly the reason that we had the problem.

That, of course, these are annual renewals, and so we think that we've borne the brunt of it this year, we also made some operational changes to be equipped to fully anticipate, but also manage the issue. And, all of that we think is, where the vast majority of that should have surfaced this year.

And so we think we're going to have a convergence back to the historical rate, next year and beyond..

We'll take our next question from Michael Turrin with Deutsche Bank..

Just, you mentioned impacts from subscription revenues. It sounded like that number came in at 60% of bookings, which is at the high end of the prior range, but I think it's been roughly 50% for the first half. So we're still in that 40% to 60% range.

So I'm just looking for more detail on what's changing here that's lowering the full year guide, given Q3 came in ahead.

And we have just one quarter left, is it -- is the attrition you're articulating something new that you're seeing more pronounced now, is it some of the ramp deal impacts you talked about last quarter? Or are you expecting Q4 could actually bring that 40% to 60% number up above 60% for the year?.

Yeah, so a few things on that. First, the increased demand for subscriptions, as you pointed out and we talked about, subscription sales with ratable revenue recognition pushes into future quarters revenue that we would have recognized upfront in the term arrangement. So as we see, our percent of new sales come in in the quarter at 60%.

And then we noted for the year, we expect it to be up at the top end of that range, you'll see more subscription than it has an impact on having less term license revenue and given 606, you don't have that two plus one accounting for the term license revenue or you do have that for the term license revenue, you obviously don't have for the subscription revenue.

The other thing we talked about that’s impacting that was the revenue of attrition that was concentrated in fiscal ‘19, as Marcus pointed out, due to the first year of annual renewals related to the remediation program we’ve discussed, and so that was having an impact on the latter half of the year that we forecast into the Q4 results.

Our expectation is that that will be largely contained in fiscal ‘19 and we'll see lower revenue attrition rates going forward..

And then just on the services piece, it sounds like you're transitioning more over to Sis than previously expected. We expected that to play out with scale. But given three cloud deals year-to-date, we're maybe somewhat earlier than expected on that transition.

So I was hoping maybe you could share some of the lessons you're learning that might be making that handoff happens sooner than expected..

Sure. So part of that is our own intentional efforts, we know that we're strategically motivated to have our SI partners be capable. I think we were a little slow in getting that or that lagged some of our cloud messaging to the market, but we've caught that up aggressively over the last, let’s say, a quarter or few quarters.

And, our partners are really mobilizing now to embrace cloud as a catalyst for demand for their services. And that's been holding positive. Now, there's quite a bit of swing depending on what each cloud deal or each cloud customer opts to do.

And the -- one of the two wins that I mentioned, with MACIF in France, was a little bit surprising that they decided to go entirely with an SI led program. We were enthusiastic for that as well as our partner, of course. But that was not something that was originally expected in our modeling and resourcing for the year. But it's very positive.

And that's what we want to have happened with more deals. So -- but it has a kind of an outsized impact, because now, these are large transformation programs, it’s multi billion dollars in scope across many products. So, it has a lot of Guidewire services attached that was originally anticipated that's not going to a partner.

I think, as the law, as we have more deals and also more visibility, and more, I think kind of conviction about partners attaching to those deals, we’ll be able to model this more precisely.

But what do you see reflected in our go forward guidance is an expectation that we're going to have a higher attach of partner’s services rather than Guidewire services next year than what we might have thought let’s say 12 months ago..

We’ll take our next question from Chris Merwin with Goldman Sachs..

Just a couple questions for me, I guess, first on margins, I think, again, the initial outlook for next year, you talked about a little compression, again, kind of given the accelerated pace of the cloud transition, but when we think about the mix shift towards partners, taking on the implementation, presumably that should be a tailwind to margin.

So just curious how you're thinking about that countervailing effect next year and then I have a quick follow up..

Yeah.

So what we talked about the margin expectation for next year and it's early, and once we finish out Q4, we’ll be able to provide a more detailed update on it, but we indicated our initial view of it is to expect a operating margin of approximately 14% next year, and the reasons that we pointed to are the same themes that we see impacting our Q4 guide, and one is more subscription sales, which has a – then term sales, which has a lower margin associated with it.

Second, continued investment in the cloud operations, as we want to get in front of the demand that we're now seeing, for those implementations that we hope to get in place by the end of Q4 and have up and running in 2020. And then, as you noted too, so we do expect to see more attach from our partners going forward here.

I think some of the things we were encouraged by coming into Q4 as we look at the IS cloud opportunities is there are more and more partners currently attached to some of those opportunities we see coming out of Q4..

Okay, great. And just the second question was on some of the pricing, it sounds like you had a similar ramp deal pricing structure for the new deals you signed in the quarter, similar to I think the CD deal last quarter.

So, should we think about that structure being applied to most of the new cloud deal business you're signing in the coming quarters and years and if so, how do we think about that in the context of your long term targets for cloud revenue mix five years out? Or is that still sort of the right number and just a more accelerated ramp in the coming years, just curious how we think about that..

I think we do expect most deals to have some element of ramp, because it's natural for customers to want to -- or expect to scale their subscription payments to their actual production usage of the software and the service.

And that's -- that relationship is a little bit more explicit and pronounced in a cloud context than it is in a software license, pure software license context. So I think that phenomenon is likely one to repeat.

And that's reflected, of course, in our own modeling and the way that we think about converting bookings into revenue and how it plays out over future periods.

With respect to pricing, as I said in the prepared remarks, I think we continue to be encouraged that it's -- that we're in alignment with our -- with the expectations that we started out on this journey.

But we think very much in terms of the fully ramped number, that's the steady state number that, if we do our jobs correctly, will persist indefinitely with each customer, and optimizing for that being as robust as possible has been how we've organized sales incentive plans, and how we think about the customer relationship really over that over a long term.

Now, of course, we're not insensitive to the early years of the relationship. And so we don't want that to get too unbalanced. But it's really the total lifetime value of the customer, the total area under the curve, if you will, that we're optimizing for..

We'll take our next question from Justin Furby with William Blair..

Hey guys, couple of questions.

Just going back to the retention, I guess what -- I was hoping for a little more color Marcus, around, are these InsuranceSuite customers, where are you seeing pricing changes? Are they actually taking their books of business off altogether? Is it insurance now, like any more color there? And I guess what I also kind of trying to get a sense for is don't all those customers also renew again this year and next year and actually like are all 350 up every year.

And so I'm just trying to get a sense for why do you think it gets better from here and I've got a quick follow up?.

Sure. Let me answer the second part of your question first, Justin. Yes, that's right. That's – and now, these are annual renewals as opposed to every three years, five years or sometimes eight or 10 years.

And that's actually a pretty meaningful change operationally for us in managing the customer relationship, and it's why we've made additional investments, and team changes to ensure that we have a focused renewal team that's going to marry the customer success and thinking about that annual cadence.

And that's a new discipline that we've kind of put in place this year.

The – to answer the first part of your question about the color, a lot of it isn't -- it's primarily InsuranceSuite and these are not cases of customers, I think in any, I don't think we have a single example of customers actually turning off or discontinuing their use of the software, but it's about an adjustment to the economic terms of the relationship.

Now why would that be? One big driver is M&A, which is kind of the background constants that happens in P&C, just like every other industry, and occasionally and we had a couple of these happen in the year, you'll have one of our customers will acquire another customer and sometimes the acquirer, which is obviously usually the larger entity, might have historical or more favorable pricing terms, or they have an ability to consolidate that premium.

And that results in an adjustment, downward adjustment in the amount paid by the acquired entity. Now, normally, these kinds of adjustments only happen at renewal time.

And if renewal time is every five years and staggered out over multiple periods like that, it effects both that we can anticipate better, and then also is not going to concentrated, whereas we had all of that happen from pretty much all of it happened in the single year, every one of those conversations, not only M&A, sometimes, it could be a change in strategy or a decision to prioritize the rollout of some other products, some other enterprise projects, as opposed to whatever Guidewire project they're on.

And so there was nothing qualitatively that changed. It was just the share of quantity that went from 50 renewals happening in the year to 350 that led to higher revenue attrition and it’s something perhaps we could have modeled better. But it was also the first time in our history that we had such a dramatic change.

So going forward, these are the same customers that we’ll be renewing, but now they've kind of taken their bite of the apple where it applied and it only again applies in a small minority of cases. And I think we have much clearer visibility across the entirety of our customer base and the renewals ahead of us.

So that's the basis for our belief that despite it was kind of a one-time phenomenon..

Okay, that's helpful. And then if you look at the moving pieces with the ramp deals, the attrition a bit heightens. And it sounds like your perpetual assumptions are effectively 0 or 2 million this year, like where's gross bookings looking or shaking out you think for the full year, relative to what you thought.

And I guess, in terms of the clouds deals this year, just curious like have any closed here through June for Q4 to give you more confidence in that number, and any color around the mix of conversions versus net new in terms of your pipeline and what you expect and so typical for me a lot of questions in one, but commentary there would be helpful..

Sure. So, in general, we don't want to comment on sales activity in the quarter and progress. Obviously, we have a very consequential seven weeks or so here remaining in Q4, which is a norm for us. It's even more than norm.

I mean, even more the case for us this year, because the deals are larger, because they're the most consequential ones, the cloud deals. And as we know, those are multiples of a typical term deal in terms of bookings. So we have a lot ahead of us that we have to convert, still in the weeks to come.

But obviously, we've also made progress in the quarter to date. Your question was also about new versus existing. I think that mix is pretty much as it has been.

Historically, we see demand for all of our products as well as for cloud, both from new and existing customers, which is both encouraging, but also not terribly surprising, it's the same set of business motivations in both cases.

And we care equally about net new logos as well as expanding existing relationships which we continue to do, I think, very successfully this year, not just with cloud but also expansions of data and digital and the Salesforce relationship, et cetera..

Okay. And then just –.

Sorry, you also asked about aggregate bookings for the quarter and the year. Again, I can't be too quantitative about it. But you can hear from our commentary that we actually feel we had -- we've had a very good sales year and expect to complete very strong relative to our targets.

It's just that the accounting complexity, not so much complexity, just the accounting treatment of ratable deals that are closing in the latter half or in the closing days of the year combined with a bit of the negative surprise on revenue attrition that has led to what we talked about in the prepared remarks..

We'll take our next question from Sterling Auty with JP Morgan..

Yeah, thanks. Just want to follow up on the crowd line of questioning, you gave some of the preliminary commentary as we think about the 7 to 8 deal target for this year that carries into next year. I think you had given us just some idea of what the mix of cloud subscription would be for this year.

Any preliminary thoughts around where that should go for next year?.

I don't think we're ready to quantify that yet, Sterling. But I would say if it goes, if there's a change, that’s going to be further in the direction of subscription. And it would just be premature to put a pin in a number right now. But we expected it'll continue in that direction, it will not be a night and day switch.

We still have meaningful discussions with prospects that for any number of reasons, believe that the traditional self managed approach is better for them. And we also continue to have upsells to the vast majority of our customer base that are self managed that will want the next application self managed.

But I think the wind is blowing in one direction. And, we'll look forward to quantifying that after we get Q4 behind us..

And then the one follow-up question is, I want to make sure because there's a lot of buzz that feel like they're in the air in terms of what's impacting the business.

You talked about the InsuranceSuite attrition, but I thought in the prepared remarks, you talked about stance and a $20 million hit, is that the right number and can you again walk us through what specifically is happening in that business to cause that type of impact?.

Well, in Q2, you may recall, we had some actual customer attrition.

The revenue attrition we referred to in this call was not customer attrition, that was not, but we actually had some science, customer attrition post acquisition that were customers discontinue they used to the software, by the way, we believe that many of them or almost all of them are recoverable, and that the motivation for the change was not anything to do with the product or their service.

It was because of their changing outlook about the underlying business, the new cyber lines of insurance that they wanted to roll out. But we did have a negative surprise on that with respect to science.

That was a big chunk of the aggregate $20 million number that Curtis referenced with the rest of it being primarily InsuranceSuite revenue attrition that we've just been discussing..

We'll take our next question from Rishi Jaluria with D.A. Davidson..

This is actually Hanna on for Rishi. Thank you for taking my questions.

First, I was wondering if you could just talk about, if there's anything that surprised you or anything significant you learned this quarter around go to market with InsuranceSuite cloud, you're not limited before?.

Well, there is a huge manifold of learnings in every customer relationship. I mean, it's important to understand that the switch from self managed to cloud is a very fundamental transition for Guidewire, it has us taking on a much broader array of responsibilities. It also makes us a much -- even more strategic partner to our customers.

But there are all kinds of new competencies that we've had to recruit for and develop within the company, related to data and infrastructure management, relationship with AWS, core cloud operations, customer success, many other things that we've been investing like crazy in over the last two years, but, really intensely in this year.

So I can't point to any specific surprise, but we are being very attentive to what this first wave of cloud customers are telling us and making sure that -- and in each of their cases, they are making a very fundamental mission critical strategic board level decision, to work with Guidewire in this way.

And we're making very solemn promises about ensuring their success high water every time. And so getting it right every time is essential.

And we're continually hardening our capabilities to do that, not just for the customers we have, which are now in multiple different countries and in all different sizes, but to be prepared for the vast majority, if not the totality of our customer base working with us in this way, over the coming years..

And then could you just comment on what contributed to the operating cash flow coming in a little bit lighter than consensus expected?.

Yeah, sure. So the things that we noticed and we noted, our first, the services billings are down year-over-year, is almost 20 million due to the revenue being down year-over-year. So that was a part of it. We also noted that the attrition impacted our free cash flow as well.

So we quantified it for the year of approximately 20 million that we're not invoicing and collecting against this year.

And then the third piece that contributed to it, were the steeper ramps for our migration deals from existing customers to IS cloud customers, and that initial ramp being steeper means lower invoiced amount and lower cash associated with it..

We’ll go next to Tyler Radke with Citi..

Hey, thank you and I appreciate all the color as usual. You talked about a 7x fold increase in the number of renewals processed this year. I'm just curious, I wanted to clarify that, overall renewal rates hadn't changed meaningfully, you just saw an uptick in the churn, given the high growth in the number of renewals processed.

I guess quick clarification there, first..

Yeah, that's correct. And we -- just to be super explicit about it, it's about adjusting the economics of ongoing relationships where there is no intention to discontinue the relationship.

But sometimes, there's a case or a claim to be made that the numbers should be different in the customer’s favor for a variety of reasons, M&A being one of the clearest cases..

And then as we think about the margin progression as you work your way through the cloud transition, and I know you gave some initial comments on next year, but just how should we think about the trajectory of operating margins going forward is, should we think of next year as a trough as you kind of reach those targets that you set out at Analyst Day, just help us understand that because sounds like the subscription and cloud mix is coming in higher than you expected.

Thanks..

I think that's one of the key drivers for next year that we talked about, right, having downward pressure on the margin. So ultimately, a good thing if we see more subscription than initially expected, but there's lower margin associated with it versus our term licenses where there's going to be higher margin.

So that was one of them that we pointed to as impacting our gross margin, operating margin in 2020. We also noted, given the increased demand that we're seeing that we're trying to hire in front of that to be able to support the needs, and absolutely guarantee customer success of our initial cloud customers here.

And so from a cloud operation standpoint, share and services standpoint, or trying to hire in front of that increased demand that we're seeing now, which is showing up in the operating margin in 2020. And then, the last thing we talked about is Q4 is always a big quarter for us.

We get a lot of data on the go to market side of things on, in this case, in the cloud operations side of things. And so, coming out of Q4, we should have a better indicator of where we think the impact on the five year plan will be.

And to your specific question, is 2020 going to be the low point in how we think about profitability going forward here..

[Operator Instructions] We'll go next to Brad Sills with Bank of America Merrill Lynch..

The comments earlier you made on getting to profit and getting to scale in your cloud operation and gross margin, what would the shape of that look like? What would be the drivers for that getting to scale? And what might margin look like longer term for your cloud business?.

Long-term we aspire Brad to have the best in class margins of what the example has been set by other cloud companies. There's no reason not to aspire to that. And we're recruiting accordingly. And we're -- that's the aspiration. I think, we're a long ways off from that.

We're still talking about a single digit number of total cloud customers right now and we're long ways off from what we would call, like full operational scale or full customer adoption scale.

I think what's kind of interesting about our position, however, is that we have, I hesitate to use the term captive, but we have a large, kind of, let's say, primed set of prospective customers, where we have long standing trust relationship, that for whom we are, I think, an advantaged position to be their partner in this mode, right.

And the acceleration that we're seeing now, if it continues over multiple years, leads to a pretty rapid on-boarding of very large enterprises into a cloud operations and our primary focus now, while we, of course care about the financial harness that we have to operate within, though, is to make sure that we deliver successfully against that promise so we can really be a platform to the entire industry when we have a large portion, maybe eventually even the majority of the total global industry's premium running through our cloud based platform.

And that's the kind of fixed point on the horizon that we're aiming for. And if we get there, I think there would be no excuse not to be at the kind of operational efficiency and therefore margins that other successful cloud companies have gotten to..

And then one more if I may please, it looked like some nice results out of digital and data. Any update on perhaps some trends you're seeing, some common use cases there, any color on kind of what customers are deploying digital and data for? Thank you so much..

Sure. Yeah, as I said earlier, I think digital is the overwhelm -- the primary catalyst that ensures with size for why they're making IT investment of any sort. It's to support a direct intuitive consumer grade interaction modality with how they sell insurance products, how they service them, how they deal with claims.

Everything that they do with any other kind of enterprise or customer, they want to happen digitally. And there's a long ways off from the status quo to that ideal future state. So there's going to be robust demand for digital enablement across every insurance process for many years to come.

And the current portfolio of digital products we have, I think it's just the start of what our customers will want us to do in the digital arena. The main things -- focus right now to your question are about the sales process, about quoting and in transacting that initial sale, but there are many other use cases and variations that go beyond that.

I think we're just scratching the surface of what data will represent for the industry.

There are the kind of core use cases of operational and operational reporting, and the like, but because insurance is so data driven, we're just at the cusp, I think of many other use cases where large Internet scale data, data collection and sophisticated machine learning AI based approaches to finding signal beyond just conventional actuarial approaches to make a very big difference in the industry.

So we're investing accordingly for that as well. Our efforts there are loss making today for Guidewire, but that's just how it is, if you're trying to develop a fundamentally new approach for an industry.

And that's hence the science acquisition and our sustained commitment to that despite the fact that it has not been a positive and probably will not be a very meaningfully positive contributor to our financials for a while..

We’ll take our next question from Sterling Auty with JP Morgan..

Just a follow up on the ramp deals.

So if you hypothetically take a customer that's currently a self managed customer on InsuranceSuite and they decided to do the migration to the cloud option, is that one of the ramp deals? And does the dollar amount that they pay you, go from a steady state under what they had done previously, and then ramp up to a new level or is there maybe a step down before it steps higher?.

[indiscernible] every negotiation, but in general, it's the former of the two options that you describe – of the two scenarios you described. A customer is using our software in a self managed mode, they're going to transition to the cloud.

And that number, the annual amount to us now coming in subscription form is going to ramp up to a materially higher number over a couple of years, that's the nature of what we call a conversion deal.

And even in the net new customer relationship, there's still some element of ramp because again, there is an intuitive expectation that they will -- the customer pays more as they get more of their premium into production use on the platform, whether or not, it's cloud. So that ramp is true for existing and net new customers.

But generally, we are increasing from an existing term amount in the case of a conversion..

Ladies and gentlemen, this concludes today's question-and-answer session. I will now turn the conference back to Marcus Ryu, CEO, for closing remarks..

No further remarks. We look forward to seeing and speaking with you soon and thank you for participating on the call today. Bye..

Ladies and gentlemen, this does conclude today's conference. We appreciate your participation..