GWRE - Duck Creek Technologies: Outlook Is Encouraging Despite Weak Macro Backdrop

Summary

• The P&C industry is large, which means multiple players can coexist.
• Duck Creek Technologies' software addresses the challenges faced by legacy systems.
• The Duck Creek Technologies management outlook for FY23 seems good, despite the challenging macro environment.

Overview

I believe Duck Creek Technologies, Inc. ( DCT ) has a 19% upside. The global P&C insurance market is valued at $1.8 trillion and is expected to grow to $4.5 trillion by 2040. It is also highly fragmented, with large insurance companies operating branches worldwide and offering a variety of coverage options, and smaller carriers focusing on specific regions or types of coverage. DCT's software can help carriers overcome challenges such as the need for digital distribution and servicing capabilities to meet customer expectations, competition from new startups, and the need to make use of data to more accurately assess risk and streamline processes.

Business description

Duck Creek Technologies, Inc. is a cloud-based service that offers core systems to the P&C insurance sector. DCT offers carriers a full suite of enterprise-level core system software made specifically for use as a SaaS solution.

P&C industry is large, complex, and resilient

There is a lot of regulation and complexity in the P&C insurance sector. As a point of reference, the global P&C insurance market is estimated to be worth $1.8 trillion in 2021 and is expected to grow to $4.5 trillion by 2040. In my opinion, this sector of the economy is not only significant in size but is also among the most resilient. For most companies and people, insurance is not a luxury but a necessity. Because of this, even during times of economic uncertainty, spending on insurance has been relatively stable. Due to differences in location, customer focus, and distribution methods, the P&C insurance market is highly fragmented.

Most major insurers operate on a global scale and provide a comprehensive suite of policy choices. Large insurance firms must also report their financial data at the national and, in some cases, the regional level. This has resulted in a diverse selection of insurance plans, each with its own terms and conditions.

As a result, there is a wide range of insurance options available, each with its own set of rules and restrictions. As for smaller carriers, although they may only sell insurance in a specific region or focus on one type of coverage, smaller carriers still often need more complex tools to function effectively. This is where the DCT value proposition shines, as the Duck Creek Suite is flexible enough to meet the budgetary requirements of smaller carriers while still meeting the complex and advanced technology requirements of the largest carriers.

That said, a carrier may partner with more than one vendor to provide core systems for various insurance products or regions, or to support various processes within a single insurance product or region. Even within a single carrier, it is not uncommon for a combination of in-house developed and externally provided systems to be in use. As such, I believe DCT could potentially grow its customer base by expanding its services to reach a wider range of potential customers and by increasing its market share with existing clients.

Duck Creek addresses the need for digital distribution and servicing capabilities

In my opinion, the carriers' inability to adapt to the many pressing issues plaguing their sector is a direct result of their continued reliance on legacy and other on-premise systems. Primarily, today's users have greater expectations of the quality of the overall user experience. This has led to a greater need for digital distribution and servicing capabilities, as today's consumers expect consistent, individualized experiences across all touchpoints. As a result, a slew of upstarts known as "Insurtech" have entered the market with the intention of shaking up the established insurance industry with their cutting-edge products. In order to keep up with the increasing level of competition, I think carriers should invest in innovative technological solutions to speed up time to market and cut down on overhead costs.

In addition, today we have access to much more information than in the past. Historically, carriers have relied on tried-and-true methods of gathering information. However, the proliferation of IoT gadgets is vastly expanding carriers' data reserves. Consequently, insurance companies can more accurately gauge risk, more rapidly detect losses, streamline claim processing, and cut down on fraud. If carriers are going to make the most of the new data streams, I believe they need open and flexible core systems that will let them act swiftly and make informed decisions based on the data at hand.

Because of these difficulties, carriers are under increasing pressure to enhance the quality of their services, their business's adaptability, and their rate of market entry. However, many carriers still use inflexible, expensive-to-upgrade on-premise or legacy systems. As a result, carriers using these systems typically lack the capacity to manage and analyze data at the speeds required to properly inform operational and risk decisions.

Over the course of more than two decades, DCT has built up extensive domain expertise in the property and casualty insurance sector. Thanks to this, they can offer carriers a wide variety of comprehensive solutions . Moreover, DCT software addresses the integration problem with legacy systems by integrating with relevant third parties and regulatory bodies. With DCT's help, carriers can quickly compile a complete picture of their operations from a wide variety of data sources, provide essential data for the implementation of strategic decisions, and utilize novel forms of automated decision-making.

Low-code technology

I should also mention that Duck Creek Technologies, Inc. developed a cloud-native product from scratch, without inheriting any technological debt from its existing, on-premise offerings. The result was that DCT could use low-code architecture based on open-source tools, allowing for faster implementation and simpler self-configuration by end users. The latter is crucial because insurance firms regularly apply thousand lines of rules to their core systems, permitting for adjustments to be made without requiring the coding skills of IT engineers. In other words, accelerating time-to-market while simultaneously enhancing satisfaction among target audiences.

Sticky product due to mission-critical nature of product

DCT products, as might be expected, are thoroughly ingrained in the inner workings of carrier core systems and the routines of individual workers. A carrier's business operations will be interrupted for weeks or months if the company decides to rip and replace the DCT software. Another way to think of this stickiness is that many property and casualty insurers have invested heavily in outdated mainframes that have been in use for decades. As such, I believe it takes insurance companies a long time to decide whether or not to switch platform replacement providers, but once they do, they tend to stick with that company for decades.

Consequently, this also means that DCT has a good amount of pricing power as underlying clients cannot switch out as easily.

Q4 2022 results were better than expected

Both the top and bottom lines for DCT's 4Q 2022 results were better than expected. As carriers made necessary adjustments to the difficult macro environment and made progress with technology investments, deal activity increased during the quarter. As a result of continued solid execution, both ARR and net dollar retention grew by 25% and 108%, respectively.

Even with the volatile macro environment adding uncertainty to estimates across the board, I thought the outlook was positive. In 1FQ23, DCT forecasts total revenue of $75.5 to $77.5 million, with subscription revenue accounting for $40.5 to $41.5 of this total. For the upcoming fiscal year 2023, management expects revenue between $328 and $336 million. Subscription fees and other recurring income add another $175 to $179 million to this total. It is anticipated that the EBITDA will be between $25 and $27 million, with a gross margin of 60%. I remain optimistic about Duck Creek Technologies, Inc. due to the long-term trends that are increasing the need for cutting-edge insurance software as P&C carriers move their core IT infrastructures to the cloud.

Forecast

While there is a strong competitive risk from Guidewire ( GWRE ), I believe the total addressable market ("TAM") is extremely huge, such that there will be enough opportunities for many players to coexist. In addition, I am encouraged by management confidence when they gave their outlook for FY23. As such, I believe DCT should continue to grow and perform well.

Assuming DCT continues to trade at the current valuation (3.6x forward revenue), it is worth $13.44 in FY24, which is a 19% upside.

Key risk

Competition

Despite getting started on the cloud late, GWRE was able to introduce their cloud offering in 2020 thanks to the leadership of seasoned industry veterans. They came in late, but they were able to grow their cloud ARR to be much larger than DCTs. Everything taken together makes it harder for DCT to win a large chunk of share in the market.

Conclusion

To put it simply, Duck Creek Technologies, Inc. is a cloud-based provider of core systems for the P&C insurance industry. Since the TAM is so massive, I think DCT has a lot of room to grow by winning over new clients and doing more business with its existing ones.

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