“Enter through the narrow gate. For wide is the gate and broad is the road that leads to destruction, and many enter through it. But small is the gate and narrow the road that leads to life, and only a few find it.”
– Mathew 7:13
(Thanks @rileynewport for the wonderful quote)
The founders of Guidewire seem to have taken this precept to heart.
Guidewire is the dominant Property & Casualty (P&C) insurance software vendor in the world today. The company was established in 2001 and founded by: Ken Branson, James Kwak, John Raguin, and Marcus Ryu from Ariba (and McKinsey, where James and Marcus had met); and John Seybold and Mark Shaw from Kana Software. The founders shared a common philosophy - to target the narrowest road possible in their entrepreneurial journey. This is articulated beautifully by Marcus Ryu here.
To understand the audacity of Guidewire’s founders, it would first help to understand the ridiculously difficult characteristics that is arrayed against the success of a fledgling insurance software product company. It would have been extremely difficult for them to come up with another industry where it would have been harder to succeed.
First, There is The Product: The founders at Guidewire wanted to provide core insurance software to the P&C industry. The core insurance software is THE mission-critical software for any insurance company. It unifies the core operations of an insurance company and serves as the transaction system-of-record (the authoritative data source for a given data element or piece of information). Thus, unlike other software companies that came up with viral adoption business models at the time like Facebook, LinkedIn, etcetera, insurance software was more binary. That is, while the former concepts could be released with 10%-20% functionality in the beginning and then scaled up, in insurance software either you had the complete end-product or you did not. You could not sell 25% of a product to an insurance company.
Also, the insurers operated firmly entrenched legacy systems, some of which had been in operation for decades. The expenses and associated operating risks attendant on any significant process of re-engineering and technology implementation exercise would certainly cause customers to prefer maintaining legacy systems.
Which Requires Domain Expertise: People with the relevant technology skills were available in the market. What was difficult was the availability of people in the intersection of technology and domain expertise. Insurance business is complex and requires specific domain knowledge of the business logic, workflows and such, which takes years to develop. And it is not exactly an industry which would fire someone’s imagination.
And Takes Time to Build: The minimum viable product in insurance takes anywhere around two years or more to build. Some products can take up to five years as well. Even incumbents require around this time period to launch new products. In recent times, due to this time requirement even market leaders like Guidewire have acquired companies rather than trying to build the capability themselves.
We are not done with the ridiculousness yet.
There is the Long Sales and Implementation Cycle: Even for established players with strong brand names the sales cycle is quite long - depending on the size of the customer, it can be anywhere between one to two years and at times more. This is due to the mission-critical nature of the product which requires approval that goes all the way up to the Board of Directors. Given the fact that the software is the central piece to the business, it needs buy-in from employees across the organization.
Once selected, the implementation cycle also can take many months to complete - at times even more than 24 months.
Brand is Extremely Important: Given the extremely high risk of failure due to the nature of the product, the brand of the insurance software provider becomes vital. We would think that the importance of perception here is higher on average relative to other industries.
And so is the Survival of the Firm: As the software once installed is used for years together, the survival of the software provider is paramount. It is not just the survival, but even the perception of survival is extremely important. If the software provider goes out of business, it would create a considerable problem for the insurance customer.
Thus the Incentive for the Decision-Maker is Asymmetric to the Downside: Let us try and empathize with the management team or the Board deciding on which software to implement. Given the high cost of failure, their incentive would be to play it as safe as possible. Let us consider a hypothetical situation with two alternatives - 1) Cheaper option from a relatively less well-known player, 2) Costlier option but with a industry leader.
If the cheaper option is chosen, the company saves some money but the decision maker(s) run the risk of losing their jobs if there is an issue. If the popular option is chosen, then in case of an issue they could claim, “Hey, we chose the best in the business. Even the industry leaders are using the software.” Their jobs remain safe. The incentives of the human being(s) taking decisions is quite powerfully aligned to choosing the leading software provider(s). And well, incentives drive the world.
Leading to Inertia: Due to the above, once a software is implemented it is not changed for years at a stretch due to the pain in retraining the entire employee base. This leads to huge customer stickiness and insurance product software are not changed for years and decades at times.
And then there is the Partnership Advantage: Once an insurance software player is reasonably successful, they tend to form a symbiotic partnership with a system integrator to sell their products. A systems integrator (SI) is an individual or business that builds computing systems for clients by combining hardware, software, networking and storage products from multiple vendors. The leading SIs (IBM, Capgemini, Deloitte, etcetera) have strong sales networks and a large client base. Partnership thus further strengthens the competitive position of the insurance software as it gets access to the sales machinery of behemoths.
Now, let us recap the barriers a new entrant would face in the insurance software industry. The entrant would first have to bring together a team which understands the domain and then spend a couple of years or more to develop a minimum viable product. After developing the product, it would have to spend a couple of years or more to convince an insurance company to buy and implement the product. While attempting to sell the product they have to hope and pray that the decision-maker(s) are not too rational and have relatively less developed self-preservation instincts. And then there is the asymmetric bargaining power heavily skewed towards the insurer and against the fledgling product company.
Once a sale is done, there is the implementation period which can once again take anywhere between 6 to 24 months. Then, once the implementation is done, the product has to run successfully for a year or so before others would be willing to test it.
And then, this cycle has to be repeated many times to ensure survival (let alone success). It would have to do this against incumbents enjoying strong market position and partnerships.
Thus a new insurance software products company would not generate revenues for at least four to five years after beginning operations but they would have very real costs. And even after the investment of this time, effort and capital there is no guarantee of success - either due to the entry barriers or the changes in the environment. Thus the company would need really patient capital or investors who are not very clear on exactly how daunting the task at hand is. And patience, more than ever, is a major competitive advantage. Rather, patience is perhaps one of the biggest barriers to entry today.
PS: There is Autocatalysis Advantage:
We believe the industry leaders in the insurance software industry harness the power of autocatalysis. An autocatalytic chemical reaction is one where the end-product is a catalyst for the reaction itself. In case of insurance software industry, a sale to a tier 1 or 2 insurance customer would hugely increase the chances of more sales in the future as other insurers choose the path of least resistance due to reasons enumerated above. It leads to more partnerships with large SIs which lead to better market access. It results in a sort of winner-take-a-lot (not necessarily all) scenario that is also visible in other industries like banking product software as well. Success thus breeds more success.
There are not many industries which enjoy this particular characteristic that is dear to Charlie Munger.
It is countering the above forces arrayed against them that Guidewire succeeded. As Marcus Ryu has explained in the interview, it is exactly these set of characteristics that led the founders to choose the P&C industry. It also helped that the industry size itself was not that large - today, the global P&C industry is ~$8 billion in size.
They believed the market was ripe for disruption. And unlike the common misaligned incentive in most entrenched businesses, Guidewire did not have a legacy business that would be cannibalized. Most existing software vendors had their products on legacy platforms, and due to inertia as well as the phenomenon of ‘why mess with something that is working well?’ they really had no interest in upsetting the state of things.
Guidewire was also probably helped by being a late mover. In certain industries, it pays to be a late entrant as then one is able to harness the latest available technology which the incumbent is unable to because of the organizational reasons. It is similar to what we see in life, the young are better able to adapt in comparison to the old. Think Walmart and Amazon or IBM and Microsoft.When Guidewire decided to enter the insurance software industry, the software used was years old, built on old technology and was not flexible. Computing capabilities and coding practices had evolved considerably and it is here that the founders spotted the opportunity.
The insurance industry has three broad main segments within in its business - Policy, Billing and Claims. After beginning operations in 2001, Guidewire sold the initial versions of ClaimCenter in 2003, PolicyCenter in 2004 and BillingCenter in 2006. The business was slowly picking up and building momentum when disaster struck.
Accenture vs Guidewire:
A question we ask of any business or entrepreneur we work on is - “What pains have they gone through in the past?”. This is because, as advised by Taleb, we believe Time to be the ultimate fragilizer - given enough time every business goes through trouble. So, it pays to know how the pains of the past were dealt with.
Guidewire’s chosen path for success is itself a good enough answer to the above question. But in the latter half of the previous decade they went through a traumatic event, which interestingly made them stronger.
In Dec 2007, Guidewire was sued by Accenture, a competitor, over alleged infringement of certain of their intellectual property rights. This was a potential deathblow as Accenture was a giant with all the resources at their disposal while Guidewire was still a loss making startup with losses of $29 million in 2007. In fact, it would eventually become profitable only in 2010. Also, remember that insurance software tends to be used for years by customers, and thus the perception of survival is extremely important. So, when the lawsuit was filed, the business for Guidewire dried up - the merits of the case did not matter.
The truly successful companies are those that convert seemingly crushing blows to opportunities. In the case of Guidewire, as Marcus Ryu said,
" It distilled the energies of the company into this white hot rage in those days. This is one of my proud moments in the company where I said, “We thought that we were starting a company that was going to achieve all of this and maybe make us wealthy, et cetera. Well, maybe our destiny was to create a company and just to stand up to this bully. That’s our existence. That’s our purpose. Because I sure as hell am not going to capitulate now. From now henceforth, we’re not going to call them Accenture. We’re going to call them the enemy.”
This event rather than demoralizing the company, galvanized it and the team at Guidewire came out stronger. This incident has strong parallels as seen in the case of Marico and Southwest covered here.
A short comment on Commitment bias: In his awesome book Influence, Robert Cialdini describes a particular flavor of commitment bias seen in the extraordinary and bizarre initiation ceremonies of school fraternities.
During the traditional “Hell Week” held yearly on college campuses, fraternity pledges must persevere through a variety of activities designed by the older members to test the limits of physical exertion, psychological strain, and social embarrassment. At week’s end, the boys who have persisted through the ordeal are accepted for full group membership. At times, the negative effects of the ceremonies are quite serious - fractures, traumas and in certain cases deaths (suffocation in a grave for example) have also occurred.
The surprising thing about the rituals is that they simply refuse to die despite the authorities (ranging from governments to university administration) trying threats, social pressures, legal actions, banishments, bribes, and bans. In one case, a new code that required all hazing activities be reviewed by school authorities and that adult advisers be present during initiation ceremonies sparked of off a riot so violent that city police and fire detachments were afraid to enter campus.
Why are hazing practices so difficult to be rid of? Contrary to the first conclusion many would reach the perpetrators of hazing practices are normal individuals who tend to be psychologically stable and socially concerned but who become aberrantly harsh as a group at only one time - at the time of the hazing.
The real reason that was found was interesting - “persons who go through a great deal of trouble or pain to attain something tend to value it more highly than persons who attain the same thing with a minimum of effort.”
Different students, who went through a much milder initiation ceremony or went through no initiation at all, were decidedly less positive about the “worthless” new group they had joined.
Now the harassments, the exertions, even the beatings of initiation rituals begin to make sense. These are not acts of sadism. They are acts of group survival. They function, oddly enough, to spur future society members to find the group more attractive and worthwhile. As long as it is the case that people like and believe in what they have struggled to get, these groups will continue to arrange effortful and troublesome initiation rites. The loyalty and dedication of those who emerge will increase to a great degree the chances of group cohesiveness and survival. Indeed, one study of fifty-four tribal cultures found that those with the most dramatic and stringent initiation ceremonies were those with the greatest group solidarity.
Now let us come back to Guidewire. The similarities between the above and the story of Guidewire vs Accenture are interesting. When Marcus Ryu and the senior management gave the rousing speech to the employees of Guidewire they was intuitively harnessing the powerful psychological forces of commitment bias and the sense of righteousness and justice. The employees of Guidewire had struggled for years to reach where they had reached and the episode with Accenture was yet another troublesome initiation rite, as far as they were concerned, to enter the world of business.
Then there was also the deprival super reaction syndrome. Note the comment by Marcus Ryu above, “We thought that we were starting a company that was going to achieve all of this and maybe make us wealthy, et cetera." The software had been built and it was seeing traction and the team was quite close to finally achieving profitability. And when Accenture’s lawsuit threatened to take it away, it “distilled the energies of the company into a white hot rage.”
Eventually the lawsuit went away. Around Oct 2011 Guidewire paid Accenture $ 10 million to settle the lawsuit. The interesting thing is to this day Accenture is referred to as the “enemy” at Guidewire.
Driven by the relentless focus on just a single niche - the P&C industry, Guidewire grew leaps and bounds over the years. Certain operational metrics below indicate the strength of the company in its chosen area.
The number of customer increased 7x in the last 10 years. The number of countries of operations increased from 12 in 2011 to 39 by 2019.
The total premiums in the P&C insurance industry is around $2 trillion. The premiums under license for Guidewire (Total of licensed premiums, across all customers that are licensing one or more products) is ~$450 billion indicating ~25% market share.
The above chart indicates the brand strength and strong customer relationships they enjoy. Of the 50+ tier 1 insurers, 30 are already customers of Guidewire one way or the other. Of the 250+ tier 2 insurers, 99 are customers. The market share by customer as indicate has only grown over the last few years.
Slowly the set of factors that were arrayed against them became the set of factors that protected the Guidewire castle from attack.
In the chart below, except for Metlife, all other names are the acquisitions made by Guidewire in the past.
As is clear the company has seen a non-linear growth in its revenues as its products’ adoption rate increased. Each segment of the revenue - license, maintenance and service has a different gross margin profile.
License revenue has no major costs associated with it and is driven by the brand strength of the product. Maintenance of the software is also a high margin business if the product quality is high. Service revenues are low margin as they comprise implementation of the product and training of the customers. The interesting feature to look out for in a good software product company is if the license revenues are increasing faster than service revenues which is the case in Guidewire. The increasing proportion of license revenues and slower growth in service revenues is due to the fact that as the products become popular the license fee that can be levied increases, while the increased popularity of the product leads to higher partnerships with SIs who end up doing the implementation. Thus SIs have the dual advantage of providing both market access and outsourcing of low value portion of the business.
The decreasing service revenues is evident in the gross margins in the business.
The gross margin decline in 2018 is due to the increased adoption of the cloud revenue model. Till recently, majority of the customers preferred on-premise implementation of software.Recently, the trend has shifted to cloud model due to its inherent advantages like faster time to implement, to market and lower total cost of operations. Cloud subscription revenues have lower margins themselves. Also. due to the shift in the business model, the company has once again begun doing more of the implementation itself in order reduce risks. This has led to the lower service revenues. Below is a figure indicating the shift.
The increased popularity and adoption hasallowed the company to harness yet another potent force of the universe - the advantages of scale. Charlie Munger has repeatedly mentioned the importance of scale in why businesses succeed. A couple of metrics indicate how Guidewire is enjoying the benefits of scale.
While the figures as a percentage of revenues have come down considerably for both R&D and sales & marketing expenses, the absolute figure has increased tremendously. In fact, the R&D expense is equal to the revenues generated in 2011 while the S&M expense if 70% of that amount!
While it had only three products at the time of IPO in 2012, it currently has more than 15 products which improves the customer servicing ability and increases the customer switching costs.
It is because of the scale of operations that the company is able to spread these fixed costs on a larger base. Imagine how difficult it would be for a smaller competitor to compete effectively against Guidewire today as opposed to a few years back.
But show me the money!
Below are the PAT margin and pre-tax RoE figures for Guidewire since 2010.
They look pretty sad, don’t they. Not worth the effort at all perhaps? Why on earth is the market valuing the business at more than 11x revenues? Well, the above figures do not paint the full picture.
For example, the free cash flows and cash on books have been extraordinarily strong. The cash on books are a function of both cash generation as well as repeated follow-on offerings of equity to public. The amount of cash is clearly excess to that required for the operations of the business.
Also, let us turn to the major assets of the business are that determine its earning capability. For this, the balance sheet cannot help us. The major assets of the business are - brand, product, customer relationships, SI relationships, and the institutional knowledge of insurance product software. None of these elements appear on the balance sheet.
In fact the company has historically almost entirely expensed the R&D and sales and marketing spends. Think about this, the enduring assets that generate the competitive advantage are expensed as they are incurred. Thus the returns calculated above are not the true returns generated by the business. It would make sense to recast the entire P&L to account for the fact the benefits of the R&D and S&M expenditures are more enduring than that indicated by the financial statements. For example, it might make sense to amortize the above expenses over 2-4 years and then recalculate the profits. The profits thus calculated probably more meaningfully indicates the actual earnings power of the business.
Please note here that we are in no way commenting on whether the current share price makes sense. It could still be overvalued (and probably is). But what we believe is that the financial statements as declared do not show the actual economic earning power of the business.
Something that we have not been able to figure out is the reason for the repeated dilution of equity and the enormous cash on the books.
The management has been pretty generous with the equity, having issued it as options, restricted stock units, currency for acquisition, and follow on public offering. The generosity of dilution is evident in the fact that while the stock price since listing increased from $13 per share to $96 per share today indicating a 7.4x increase, the market cap has increased from $450 million (share count at time of listing multiplied by IPO price) to $7.9 billion today which is an increase of 17.6x.
Overall, Guidewire is an extremely interesting case study of the power of focus on a difficult niche. By entering the narrow gate, trudging down the lonely path and through relentless execution and doggedness the team has built a formidable business with a reasonably long runway ($8 billion opportunity today). Despite the dilution, the journey has been rewarding for shareholders so far with a 7x increase in price since IPO in 7 years.
Guidewire website, IPO Prospectus, Financials
If you enjoyed this article, you should become an Intelligent Fanatics member. As a member, you get our current and future Intelligent Fanatics books and case studies for free, as well as the ability to participate here on our community. Join Us
Disclaimer: We may/may not have positions in the companies mentioned in the blog. This case study/article is not a stock recommendation. We are not SEBI registered investment advisors. Our Intelligent Fanatics Case Studies and Articles are meant to retell the stories and strategies used to create exceptional businesses so that we can learn from them.