Richard Hart - CFO Marcus Ryu - CEO

Justin Furby - William Blair and Company Tom Roderick - Stifel Ian Strgar - UBS Jesse Hulsing - Goldman Sachs Alex Zukin - Piper Jaffray Rishi Jaluria - JMP Securities

Welcome to Guidewire's Second Quarter FY '17 Financial Results Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Richard Hart, Chief Financial Officer. Please go ahead, sir.

Good afternoon and welcome to Guidwire Software's earnings conference call for the second quarter of the FY '17 which ended on January 31, 2017. My name is Richard Hart. I am the 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 form 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, including developments in connection with our recent acquisition activity. 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 obligation 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 the supplement on our 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 second quarter financial results and our outlook for the third quarter and the FY '17.

Thanks, Richard. We had a successful second quarter, based in our key measures. We delivered financial results that were above the high-end of our guidance ranges and we made substantial progress on our new products and strategic initiatives. Total revenue in the second quarter was $115.6 million and non-GAAP operating income was $28.4 million. Total license revenue was $64.1 million. Recurring term license and maintenance revenue for the previous 12 months, totaled $285 million, an increase of 20% from a year ago. As always, we strove both to earn new customer wins and expand existing customer relationships. In the second quarter we saw a strong cross-section of deals around the world. Among them in North America, we expanded our relationship with California Casualty, a ClaimCenter customer who now licensed PolicyCenter, BillingCenter, Data Management and Digital Portals for their enterprise. We initiated a new relationship with the second largest AAA club, Auto Club Group, in Michigan, whose $2.2 billion insurance operation serves 8.5 million members in 11 states in the midwest and who licensed PolicyCenter, BillingCenter, Data Management and Digital Portals. Also, a U.S. Tier 2 insurer selected ClaimCenter and our Data Management products for their entire book of personal and commercial lines and NYSIR licensed all of InsuranceSuite to support their insuring half the school districts in New York with auto, property, liability and other insurance. In Europe, we earned a mandate from $600 million insurance operations of Saga Services, a UK company serving 2.7 million members, aged 50 and older, to replace their legacy platforms with PolicyCenter, BillingCenter and DataHub. And alongside IBM, we also won our first customer in Austria, UNIQA, a multi-national insurer with EUR1.9 billion in premium. UNIQA will be implementing PolicyCenter, ClaimCenter, DataHub and Digital Portals for their Austrian business, as well as for multiple countries in Central and Eastern Europe. Overall, we're witnessing noticeably stronger motivation in larger continental European insurers to invest in core system replacements and digital transformation which we take as a validation of our investments in European sales and implementation personnel, as well as in country-specific product content. Also validated, have been our investments in digital and data products. We're seeing more core-system decisions motivated by or accelerated by, the competitive necessity of virtually every insurer to create or enhance digital engagement with policyholders and agents. During the quarter we added seven new Digital Portal customers, including Direct Line Group in the UK, the Co-operators in Canada, Self Insurance Corporation in Australia and Seguros SURA Argentina, in addition to all the customers mentioned earlier. Customers also continued to adopt our Data Management product, with six new customers. The success of products we've brought to market more recently, supports our belief that there are other opportunities to deliver value to customers, including with new products we have acquired this year and are investing to integrate into InsuranceSuite and InsuranceNow. For example, we're now in the process of embedding the scoring algorithms of Predictive Analytics, directly into the user interface of both ClaimCenter and PolicyCenter. We believe this will transform the appeal of Predictive Analytics, from school for insurance data scientists, into business solutions for adjustors and underwriters, who can now make machine-learning informed decisions, at key points in the claims and policy processes. And now, obviously, we're integrating the product we acquired in the first quarter, Underwriting Management, in the PolicyCenter, creating a unified offering which we believe will drive greater adoption of both products. It's also worth noting, that this quarter we completed our first post-acquisition sale of Underwriting Management to the U.S. subsidiary of natuis and matomo. We also increased our addressable market through the acquisition of ISCS. Guidewire and ISCS have much in common, including an exclusive focus on P&C primary insurers, our cultures and headquarters based in the Bay Area. This has eased the challenge of integrating the two organizations, a task we have undertaken with urgency, since the close of the acquisition on February 16. While we still have much work to do, we're excited by this combination and believe it represents a very worthwhile investment. We have rebranded ISCS's offering as InsuranceNow, an all-in-one, cloud-based core platform for P&C insurers. While we anticipate that the market for InsuranceNow will naturally align with the needs of Tier 4 and Tier 5 U.S. insurers, ISCS's traditional market segments, we see opportunities to internationalize InsuranceNow, as well as offer it as an alternative to smaller or completely new divisions of large insurers, whose needs generally align with InsuranceSuite for their primary books of business. Going forward, we believe that these two core offerings, InsuranceSuite and InsuranceNow, will broaden the foundation for our core-data and digital platform and will span the preferences of insurers of all types of sizes, advancing our mission to provide a standard platform for the entire P&C industry. Finally, it is worth noting that we anticipate that the Digital Greenfield project will go live in April or May. The delivery of InsuranceSuite in the cloud on a subscription basis, with a large insurer, where Guidewire takes full responsibility for the solution and production, is a significant step toward redefining how we deliver our software. We believe that we're at the outset of a transition in market preference, that will take some years to unfold. And we intend to increase our investments in cloud-based products over the next several years, accordingly. Is important to underscore though, however delivered, InsuranceSuite will continue to be the heart of our offerings. We take very seriously the obligation to maintain a compelling roadmap of continuous innovation for all our current and new InsuranceSuite customers. Indeed, a large majority of our research and development investments continue to be focused on enhancing our core transactional applications. The efforts of our development team were recognized last month, when we won three awards from the industry research Celent, in their recent survey of P&C claim systems, in the areas of breadth of functionality, customer base and best of service. This is a uniquely exciting time to be serving the global P&C industry, as both incumbents and would be disruptors are investing in technology to transform how insurance products are defined, priced, distributed, serviced and fulfilled. We're investing to advance our position as the technology company, best situated to help shape this transformation. I now turn the call over to Richard, to review our second quarter results in more detail and to provide our financial outlook for the third quarter and the year.

Thank you, Marcus. As Marcus indicated, we exceeded our guidance for the second quarter, in both revenue and earnings. Total revenue in the quarter was $115.6 million, up 13% from a year ago. Within revenue, license and other revenue of $64.1 million, represented an increase of 20% from a year ago. License and other revenue was more than $4 million above the high-end of our guidance range, primarily due to the closing of transactions that we had anticipated and planned to close in the third quarter. You'll note that we're now referring to license and other revenues. We have adopted this convention in anticipation of the subscription revenue from sales of our cloud-delivered solutions. As of today, those amounts are too modest to note and report on separately. Maintenance revenue of $16.6 million, was within our guidance range and increased 16% from a year ago. Services revenue was $35 million, an increase of 1% from a year ago and was slightly above our guidance range. Turning to profitability, we will discuss these metrics on a non-GAAP basis and we have provided the comparable GAAP metrics and the reconciliation of GAAP to non-GAAP measures, in our earnings press release, issued today, with the primary difference being stock-based compensation expense and costs related to the amortization of intangible assets. Non-GAAP gross profit in the second quarter was $81.3 million, an increase of 12% from a year ago and representing a non-GAAP gross margin of 70.3%, a decrease from 71.2% in the year-ago quarter. This decrease was primarily due to the lower services margins we anticipated would result from the deferral of services revenue associated with our Digital Greenfield project. Total non-GAAP operating expenses were $52.9 million in the second quarter, an increase of 10% compared to a year ago. Non-GAAP operating income was $28.4 million or over $10 million above the high-end of our guidance range, due to the combination of $4 million in license revenue upside and lower-than-expected expenses, in part due to delayed project starts, slower than anticipated hiring and lower than anticipated costs related to the acquisition of ISCS. With non-GAAP operating income above expectations, non-GAAP net income of $20.6 million or $0.28 per diluted share, was also above the top end of our guidance range. Turning to our balance sheet, we ended the second quarter with $728.9 million in cash and cash equivalents and investments, up from $686.2 million at the end of the first quarter, primarily due to operating cash inflow of $42.6 million in the quarter. Year-To-Date operating cash flow was $29.6 million, reflecting normal cash flow seasonality. Note that cash balances at the end of the second quarter, do not include the impact of approximately $160 million used to acquire ISCS, an acquisition that was completed early in the third quarter. Total deferred revenue was $89.3 million at the end of the second quarter, while deferred revenue has grown over historical norms as a result of the Digital Greenfield project, we expect to begin recognizing such deferred amounts by the fourth quarter. Deferred revenue in the second quarter associated with the Digital Greenfield project was approximately $5 million of services deferred revenue. As a reminder, our deferred revenue balance can vary significantly from quarter to quarter and should not be relied upon as a meaningful indicator of business activity, since we typically bill term-license contracts annually and recognize the full annual payment upon the due date, however, in the future, deferred revenue will be impacted by sales of InsuranceNow software and related services. Such revenues will be deferred until project completion and then recognized ratably thereafter. I would like to refresh and update the impact we expect from the acquisition of ISCS which we announced on December 19, 2016 and we closed on February 16, 2017. As you may recall, ISCS primarily licensed its all-in-one software suite on a perpetual basis, to maximize near term cash receipts so that it can fund its growth. However, it deferred such ratable revenues until project completion. We noted upon announcement of the transaction, that deferred amounts were approximately $35.6 million as of September 30, 2016. According to ISCS's audited balance sheet as of December 31, 2016, that deferred balance had grown to $43.8 million, approximately 2/3 of which was different license revenue. Due to the purchase accounting impact on acquired deferred revenue, substantially all of the amount will not be recognized in future periods by Guidewire. In addition, while we intend to shift InsuranceNow towards a ratable subscription model, we anticipate having to defer revenue on new InsuranceNow sales until projects for the new sales or completed which we expect that average to take about 12 to 15 months. Following go live, associated revenues will be recognized ratably. As a result of our need to defer revenues on new sales, as I've described and the impact of purchase accounting on acquired deferred revenue, we expect to recognize no license revenue from ISCS for the remainder of this fiscal year. In this fiscal year, revenue contribution will be limited to ISCS's implementation services revenue and revenue from existing cloud-hosted customers, that are or will be, live before the end of the fiscal year. Currently, we anticipate that these services and hosting revenues which will all be presented as service revenues, will total $14 million to $16 million, $1 million less than we had anticipated on announcement, as certain go-live dates have shifted incrementally. Our updated guidance for the year reflects the effective cost of revenue and operating expenses for ISCS, now that the acquisition is completed. We will be welcoming approximately 190 full-time employees from ISCS. As a reminder ISCS, had been operating at a loss in calendar 2016, as they had invested to scale their business through an essential increase in the size of their services organization. In total, when combined with deferred recognition factors that I have described, ISCS is expected to dilute our operating income by approximately $11 million to $13 million in fiscal year 2017 or 2.2% to 2.6% of revenue. We anticipate that the acquisition of ISCS will also reduce the cash generated from operations by approximately $5 million to $10 million in FY '17. The difference between the transaction's effect on operating probability and cash flow is derived from the requirement that we defer revenues, as I've already noted. Let me turn now to a detailed outlook for the full year our pre-ISCS business, in order to be more clearly communicate changes to our full-year outlook. Let me speak to the full year so that you can more easily compare -- and let me then discuss changes in our full-year outlook first and then we will discuss the third quarter. We're increasing the mid-point of our license-revenue guidance for the full year to reflect our modestly increased visibility for activity in remainder of the year. As we communicated on our first quarter call, we expect FY '17 to be characterized by historical patterns of sales seasonality, in which the fourth quarter represents a significant portion of the sales. In fact, we anticipate that activity in Q4 will be even more pronounced this year than in the past. As a result, we must be mindful in our guidance of the uncertainties attendant in any of our transactions because of the variability of structure and therefore revenue recognition; the size of in scope direct-written premium that can influence the size of an initial license; and the timing of large complex transactions which are sometimes difficult to predict. In this year, the combination deal volume in the fourth quarter and the size and timing of certain large transactions that are still being negotiated, increases the difficulty of guiding for the year. Nevertheless, we feel sufficiently confident, to raise the lower-end of our license and services revenue guidance, in each case by $2 million. With regard to maintenance, we're keeping the range unchanged and we do not anticipate material maintenance revenue from ISCS for the remainder of the year. We're increasing our guidance for operating income, again, not taking into account the losses associated with ISCS by $4 million at the mid-point, as a result of savings in the first half which will carry through for the remainder of the fiscal year. We're raising our outlook on a pre-ISCS basis for free cash flow by $5 million, to $75 million to $90 million for the fiscal year. When we combine our outlook with the effects of the ISCS transaction, we offer the following updated guidance. We anticipate total revenue to be in the range of $491 million to $499 million, representing an increase of 16% to 18% over FY16. Within revenue, we anticipate that license revenue will be in the range of $256 million to $262 million, an increase of 16% to 19% from FY16. We expect maintenance revenue to be in the range of $66 million to $68 million, representing an increase of 10% to 13. And we expect services revenue to be in the range of $166 million to $172 million. We expect non-GAAP operating income to be in the range of $70 million to $78 million, resulting in full-year non-GAAP operating margin of approximately 15% at the mid-point. We also anticipate non-GAAP net income in the range of $50.1 million to $55.6 million or $0.67 to $0.74 per diluted share, based on approximately 75.1 million diluted shares. We anticipate a non-GAAP tax rate of approximately 31% and an effective tax rate of approximately 26% for the full year. Looking at cash flows, we're revising expectations to reflect the impact of costs associated with our ISCS transaction. We now expect free cash flow between $70 million to $85 million and operating cash flow of $78 million to $93 million, with anticipated capital expenditures of approximately $8 million. Turning now to the third quarter, our outlook for the third quarter reflects the acceleration into Q2 of certain transactions. It also reflects a conservative assessment of deal timing for several transactions that we now expect in Q4, that had originally been scheduled for Q3. Some of these transactions, including the larger ones we've noted, may well end up being completed in accordance with our initial assessments on timing. Nevertheless, while we don't anticipate this variability to impact our full-year results, our third quarter outlook reflects greater than normal seasonality. With that background in the third quarter, we anticipate total revenue to be in the range of $102 million to $106 million. Within revenue, license revenue will be in the range of $43 million to $45 million, with a de minimus amount of perpetual license revenue for the quarter. We anticipate maintenance revenue of $16 million to $17 million and services revenue of $42 million to $45 million. For the third quarter, we anticipate a non-GAAP operating loss of between $2 million and $6 million and non-GAAP net loss of between $3.7 million and $1.2 million or a loss of $0.02 to $0.05 per diluted share, based on approximately 74.3 million basic shares. We anticipate and non-GAAP tax rate of approximately 39% and an effective GAAP tax rate of 19%, for the third quarter. In summary, we had a strong second quarter that exceeded our guidance. We're excited about our expanded capabilities from ISCS as we continue to execute towards our vision of enabling the P&C insurance industry to deliver advanced, engaging solutions for employees, agents and policyholders. Operators, you can now open the call for questions.

[Operator Instructions]. We will now take our first question from Sterling Auty with JPMorgan.

This is Lina Costa [ph] in for Sterling. I want to start by asking for an update on the Q1 pipeline. Can you talk a little bit about aspects for the second half?

Sorry. I missed the additive in front of pipeline. Can you say -- do you see Q3 or Q2 pipeline. I was Acura what you were asking. The net can you hear me talk

Yes. I was asking for an update for the second half on the pipeline and the process for Tier 1.

Oh tier 1 pipeline. I would say that continues to strengthen. There are a number of tier 1 conversations that will be important for us this year and next year that's pretty much always the case. They are pretty important part of the they're not the -- some of the their abilities that were Richard was alluding to in his guided remarks refers to a phenomenon that we called about on a multiple of other calls which is that it is not only a matter of specific timing and the certitude of closing transactions -- the larger tier once, it is also a matter of deal structure scope of the additional elements of variability that we always have to factor into our Outlook and guidance in that is the case this year especially since some of those transactions are likely to close in the fourth quarter.

And a follow-up -- for the tier 4 and tier 5 opportunity following the ISCS acquisition, how shall we think about that geographically? Are you focusing on anything specific with geography? Any particular benefit? Can you talk little bit about that?

We're definitely focusing on the same geography they percent mainly tier 4 and tier 5 insurers in the U.S. We have a longer term ambition to internationalize our product and potentially take it to a different category of conversation with very large insurers and they typically have been involved in. But the bulk of sales activity that we anticipate for let's call it the next 12 months will definitely be to the tier 4 and tier by a insurer. We think we can bring the product market effectively as it is today with our substantial large sales organization as well as the other assets we have in terms of brand and presents and existing relationships and so forth. And we do have pretty strong ambitions for how many transactions over the next 12 months. Now the accounting associated with that is a bit more complicated as you heard Richard describe models will the revenue be rateable in the long term, these are cloud-based subscription but we have some things to demonstrate to our auditors with respect to DSO eat will result in deferral of revenue for some time as we accumulate bookings.

We will now take our next question from Kenneth Wong from Citigroup

This is [indiscernible] sitting in for Ken. Just a quick one on my end here, I am wondering -- I know when you discuss guidance you talk about the down and help ISCS brings it down and how some of the deals are going to land in Q4. I am wondering if there are any other moving pieces you can help clarify particularly around the lower margin guide?

Sure. As we mentioned at the beginning of the year, the Digital Greenfield project that we have undertaken which requires us to defer all services revenue and direct services cost had in impact of about 6% on services gross margin. That impact is actually enhanced a little bit on the negative side by lower services margins for predictive analytics and underwriting management where we're maintaining a group of professionals in place as we try to build sales and improve utilization of those teams over time.

So that is one. The other one is what we said is the impact of ISCS on the year is about to point to percent to 2.6%. When you combine that with the impact of which we close at the beginning of the year it is about 1.5% all told over the year the impact on margins is up five-point 5% to 6%.

And then I guess a quick follow-up. Can you give us little more color on any progress with the Greenfield project? If there has been any changes in timing or magnitude? Or if there is a chance if it comes sooner than expected? Thank you so much.

Naturally we're trying to drive project forward as quickly as possible that I think we're going to be very satisfied to have a come in on time which is definitely our current outlook on the program whether it is exactly in April or May -- I think is still a little bit in question but we feel and the customer feels highly confident that we will achieve go live.

We will now take our next question from Justin Furby from William Blair.

Marcus, I was wondering if you could give an update in terms of any changes you notice competitively over the last quarter to particularly Duck Creek in North America and I would love to drill into your comments around Europe and the [indiscernible] there, do you think that’s truly a market mentality shift or also maybe something competitively that is changing in your favor and any update on Accenture and IBM and how they are impacting things over there would be very helpful. So a multi-part question, sorry.

I follow you Justin. So on the first part of your question about competitive landscape no material change over the past quarter we always highlight Duck Creek as our primary in our first and foremost margin important competitive globally and dies the case in really the main geography was counter them if you are in the U.S. and that has not changed and they continue to be a commendable competitor that we take very seriously across wide major transactions and a large insurer. Now with respect to Europe, the enthusiasm you may have heard in my remarks and have been magnified. Larger companies have been a few years later to a sense of urgency about the transformation then you would find in the U.S. and the Commonwealth countries but it is now definitely there. You would see some of the indices come from a new wave of Intertec investments in the box region and multiple new attacker brands that have been emerging in the countries that they did not exist before like France and Germany etc. and in the Nordics. So that is all very welcome. And I think we're pleased with the fact that we continue to believe in Europe even through the lean years. They Study and even increased our investment about the sales and delivery side and now we have a team that is really much more utilized member on both counts. We still have the transactions very challenging over there because our credentials aren't quite as strong as they are here in North America. But -- and they are also local requirement that we have to demonstrate our worthiness. On the whole I think we're really well situated in the competitive landscape there is favorable over the long term as it is here.

Marcus, if you can hit on Accenture as a partner and I think you mentioned IBM is helping in the deal in Europe in Q2. Can you talk about what you are seeing from that in Europe and helping you guys win deals over there?

They are both partners in very good standing with us in Europe. As we talked about before, more complex relationship with them in Latin America for that matter because we're straightforwardly partners. They are in our enablement program. We go to market together and we're engaged projects. Together right now and have a few early wins and go lives under our belts together. I think that relationship is doing quite well. Is not transformative overnight but it definitely has been a positive and its delivery as hoped. IBM I think it has been a bit more opportunistic with that Unicode relationship is Ashley quite as meaningful win for us especially in Eastern Europe. Unicode is one of the largest if not the largest players in the region and they are undergoing a huge transformation program across like in general insurance and that is led by IBM. That's a great example of partnership to be part of that program. We're really IBM is taking the lead of both sales and delivery.

And then quickly for Richard -- a lot of moving pieces for the model in things like cash flow is increasingly divest metric at least over the next couple years. I'm wondering if you look at to fiscal 18, do you think operating cash flow should outpace revenue growth or what is the right framework for that looking out for 18? Thanks.

If operating cash flow diverges from revenue it is because the and some transactions that we can build and collect cash but we cannot recognize revenue. So for example if we sell a license of ISCS or now what we call InsuranceNOW we will no doubt collect both services and license billings and therefore that will improve cash flow but we will not see that effect on the P&L until we can start recognizing those revenues and so the more of that kind of dynamic speaks into fiscal year '18 the more operating cash flow should outpace the revenue.

We will now take our next question from Tom Roderick, Stifel.

Marcus, now that you have had a few more months under your belt to assess and examine what you've got and with ISCS and certainly rebranding it looks like a good place to be going can you talk a little bit about how some of your other clients maybe tier 2 and tier 1 are starting to assess what a cloud-based solution might look like for them? I understand this has been historically a solution more embraced at the lower end of the market are you are rolling more and more out from a cloud-based. I am just curious how the upper end of the market might be aching about that and when you might start to see a little more demand or how they are thinking about it. Thanks.

I appreciate the question. It is an interesting one. I think overall as I said in my remarks we're very enthusiastic about the transaction you know our nature is not to be usually exuberant until we have demonstrable achievements in that is still ahead of us but we're at work right now in engage in as many conversations as possible. As we mentioned as you noted by merely with tier 4 and tier 5 insurers where it is a very natural fit, the reference is very clear match in the offering and requirements. But what we're seeing is that even with the very largest insurers that are often Greenfield intention and the digital project we have is sort of an example of this where they want to move very quickly in a different geography or different line of business or with different branding strategy or different pricing strategy and they may be starting with premiums but they have had [indiscernible] opportunity. For some of those the attributes of the insurance now value proposition might be a great match. We have had enough discussions early on in an acid during the that they are suggesting this and we think there may be other cases where that is so. But we don't think we're going to see at least not for the next year or two are examples of large insurers who want the full insurance now proposition with our core book of business right off the bat. Their scalability considerations but rate their need often for a loss of configuration flexibility in the offering and the essence of the insurance now proposition at a timely standardize. You don't configure it very dense at all and you have a complete solution that can fly as quickly as possible at the longest long term possible. I think down the road it is an inevitability that UCS investing accordingly that more and more of the market including the very high and, the very largest insurers will want more and more of the functionality delivered as a standard company service and that is definitely the long term future and we're investing accordingly.

Marcus, one more follow-up for you thinking about the Digital Greenfield, if I heard you right, it sounds like the timing for delivery of that product is at least on time if not even ahead of where you guys had originally thought about it. I am curious about -- I know you can't talk about what it is just the you are doing it for but as you get this to market with one particular customer what is the opportunity as you look down the road one or two years whatever it is to sort of remarket or rebrand what you are doing there for other customers and when can you make them aware of that development?

We're active in the market right now. I think we made enough progress and had committed ourselves sufficiently in an irreversible way that we're starting other conversations and we're receptive to other conversations about similar projects with others generally tier 1 and tier 2 lip insurers. And I think that there may be other activity to announce over the coming months, nothing very specific that can be more specific about now but it is not a one off scenario. We're thinking along similar lines and this kind of approach makes a lot of sense. Out there is a lot -- we have always emphasized there is a lot we have to do as a company to be prepared to execute. Is not just a matter of responding to the demand. We have had to develop some competencies most importantly he competency of managing a large scale production environment, a transactional core, entirely on our watch. At-bats are responsibility in that is not something we have done for our history and at least not for the core system and so it is a big deal for us to pull that competency and we still have a lot to prove ahead but we're committed to it and have hired accordingly and have set goals accordingly with that ambition.

We will now take our next question from Ian Strgar with UBS.

If I could just tagalong onto the prior question -- Marcus, could you address the unit economics of that delivery model relative to your traditional model and just how delivering more transactions under that structure -- like the Digital Greenfield project where you are managing the probe production go live can impact your long term operating margin target of 20% to 30% over time?

Let me speak a little bit -- and Richard can add additional thoughts it is quite a complicated question because there are a couple moving parts and their on both the revenue and expense in the margin side. That really require us taking a look at the model together to get the full quality responses in we have -- I think we have a hypotheses based on what other cloud and hybrid offerings look like that still have to play out in the market and our experience but broadly speaking, in terms of revenue capture, we're pretty confident that the pattern is something like 2X the recurring subscription revenue per unit of customer premium is I think a very reasonable target maybe more overtime but we're taking in terms of 2X level there. Now of course that is somewhat grower -- lower gross margin. But there is every reason to expect that you could do it significantly more efficiently and build upscale along that and we have of course model that out in our pricing proposals and the like and in fact ISCS, their experience over the last few years is particularly because they have got such a to add cloud-based delivery model and they had the economic expressed to go along with that. We look relied in that and our own model. As we mature the solutions we think on a more work cloud basis and more and more I should say less and less of the solution actually is delivered or I should say more and more solution is a delivery cloud service than those economics continue to improve and there is also an evolution in what the model looks like over time and I think right off the bat there is a customer expectation or a customer willingness to pay materially more per unit of revenue and premium then they do on a traditional on premise model. Richard has a few other thoughts too.

I think there are a couple things that we still need to do a lot of discovery around and our modeling right now has a number of questions that we have to fine-tune and become a little bit more in terms of all the infrastructure cost that we now have to absorb having said that. I think that the way that investors should understand this is that this represents it to maybe a little bit more in terms of revenues for DWP and margin at scale for each customer and that scale for the operation but we believe should be able to get to somewhere between 55% to 60% and it competes with revenue right now hearing closer to 70% margin for a business that has accrued over time and that annuity business will continue to carry that margin and it is very hard to try to determine what the impact of that blend will be over the next two or three years. But the impact will be minimal. And the impact should actually be lessened over time as the investments we're making today get amortize with more customers both insurance now customers and potentially some additional insurance the customers that might decide to consume our software like the customer that is part of the Digital Greenfield project that we initiated.

And secondly, if we're looking at roughly 21% operating margin this year normalized -- if we take it all the diluted M& A and other diluted items you guys are seeing -- Richard, I know you are not guiding. You have not given any guidance for 2018 but I am wondering if you could update us on how quick you expect operating margins to snapback in fiscal 18 as you guys execute and work through some of the items that are impacting margins this year.

It is very hard for me at this vantage point to be in any way specific but let me give you the trends that I think will drive changes in the gross margin and the operating margin. The ISCS transaction will continue to be delivered next year cousin unfortunately we're still in a position where we can't recognize and we're still observing the cost. In fact counterintuitively the more success we have With that platform the more costly have to bear and therefore the dilution is actually incrementally significant. What we have said in the past is we expect 2018 two 28 282.5% diluted. And make it up a little bit but not much. At the same time we think the Digital Greenfield project comes back in snapback a little bit and improves gross margin for services and not in significantly and the diluted affects -- we fully hope to be able to countermand in 2018. Those other drivers, I can't speak now as to what I am going to guide for operating margins next year which is too much between now and our budget planning what I think but you should at least see is about to.5% of the current impact should be initiated over the next course of the 12 to 15 months.

We will now take our next question from Jesse Hulsing with Goldman Sachs.

Marcus, you mentioned embedding predictive analytics capability in InsuranceSuite. I am wondering -- is that something that you think you are going to be able to charge your customers for? And if so relative to your data and digital products -- how much of an uplift do you see both in the near term and longer term as you predictive capabilities.

You grasped the central point here which is our go to market approach with projected analytics is different and you benefited a lot from 6 to 8 months of market activity understanding how customers think about predictive analytics, how they think about our products how they would like them to interact and what has become clear to us is as a business solution as opposed to eight predictable platform as such. It makes all the sense in the world rather than selling a platform, selling it as a set of business solutions that are embedded directly in the process and the question of what you are trying to make better machine run decisions. What we anticipate doing is having a host of predictive analytics driven solutions that can be turned on in claim center and policy centers to start with. We're starting with claims but policy centers are soon to follow, as for 10 to 20 key categories of decisions that you are making those policies and targeting individually for that solution. They range from things like -- brought estimation or segregation or total customer value estimation. Each of which is a totally independent business solution in each demand to fill subscription rights when you turn on the predictive analytics functionality. It is premature to say how much we can capture overall. We don't have any pricing experience at this stage but our hope is that the customer that really embraces the entirety of that at least in terms of the value created, capture some of value would be something up to a third or half of the price of the application itself -- the underlying application. That is the ambition. We don't have expressed to back it up yet that we think it is a value created to support that kind of pricing regime.

And Richard, we started to see some other companies and software provide some initial guidance on the impact of ASC 606. I am wondering if you could give us your updated thoughts on how you are planning to adopt and how that might impact your model?

The net what we have said and what we continue to say is that because of our contracts extending for a significant term and many of them extending past the transition point between the old and the model we're in a position where a must meet remediate the contracts and enter into new contracts actually terminate by our August 18 date, we're at risk of losing revenues with retained earnings. That is if I have a license that extends past that transition point and I still have term license revenues that I could recognize under the contract for years to come, under the new model I would have had to had recognize the revenues at the outset and therefore there is nothing left for me to recognize post that transaction. So we have been doing is we have a going back to our clients and asking them to remediate their contracts with us to shorten their term so that it is coterminous with our current revenue standard and before the transitions of the next revenue standard. We had already started to shorten the term of our contracts. It was not necessarily a shock to our customers. And what we have been doing every quarter is monitoring where in that timeline we're in terms of our remediation efforts. And we're ahead of schedule with regard to our goals in any particular quarter with respect to how many contracts have been remediated and how many contracts are still subject to remediation, that is the operational side. From a revenue side, what we expect will happen is that post this transaction -- post this transition when we're on a two-year automatic renewal you'll not see a significant change for our heartbeat revenue, right? You may see a slight increase in the seasonal nature of those revenues simply because following the transition -- if I start with two year and then I go to one your automatic renewals, my first year I recognize two years' worth of revenue and the next to I don't recognize any and then following that I would recognize on a heartbeat aces again and if you look at what happens if you assume seasonal pattern of bookings, that two-year initial okay will actually increase the seasonal impact of that bookings distribution. Now while we do get a benefit the first year after transition of that two-year booking model, there is no way we can avoid using some of our revenue to retained earnings and when you look at the numbers -- will look at all of our context -- it is also wash. One interesting thing I am looking forward to seeing is what those two topic and loss statements will look like side-by-side which is what we will be reporting in the first fiscal year after the transition. And those differences will likely be modest but -- and it is hard to tell right now has significant a will be that the model long term -- when we look at the model long term we don't necessarily see a significant change in revenue growth rate if we're indeed successful at ameliorating the effects by remediating our contracts.

We will now take our next question from Alex Zukin with Piper Jaffray.

Marcus, first one for you, are you seeing any change in your general customer priority where its actually talking about doing the front-end digital transformation project first and at the risk of putting the core system transformation project may be on hold or on the back burner even though at the end of the day the customer probably realizes that you can't have one without the other?

I wouldn't put it quite that way Alex but yes. I think what we do see is an emphasis or a sense of urgency around digital transformation around activating the digital channel or upgrading digital service self-service and omnichannel kind of capabilities. These are definitely much higher in the priority stack than it would have been a few years ago. I think that we get very, very strong traction with our central pieces which is that -- you cannot do that on the back of an ancient core transactional system because the products are hardcoded and the process is hardcoded, you cannot substantiate highly flexible and contemporary digital customer experience no matter how much work you do on the user interface and with mobile devices and I think that fundamental argument isn’t hard one to make and indeed most of the market already excepts that. But in terms of the motivations for the program, in terms of the business case or the strategic drivers, they are very much digitally oriented and digitally focused. I would say up till now that has been a very positive catalyst for us because we have customers now that are leaving us with a set of ambitions that they have for the future as opposed to us having to evangelize the reason that they need to think deeply about the transformation of their environment.

And then with respect to Tier 1 pipeline, is the uncertainty more calibrated towards the initial size of those transactions or the timing of their closing. I guess it reminds me of the last time that you guys had a spike in Tier 1 deals all I think in the fourth quarter where you were surprised by the volume of the deals as well as the initial size of them. Trying to get more color -- is that the scenario that you are trying to prepare for?

That’s right broadly speaking. One of the rocks in our backpack is that we have to care is not only is the demand concentrated, especially at the upper end of the market and that our growth ambitious require us to close a certain number of these major transactions and that's inherently difficult but that in predicting the exact scope, structure, size of those transactions is a hard thing to do and it's not just a matter of prediction, it's a matter of negotiation and we don't want to -- we never want to mortgage the long term value of these customer relationships in order to maximize the short term financial outcome or reportable outcome for ourselves. So that is our job to manage. I would say that we feel better than ever about our overall competitive position in these kinds of discussions given our scale of stature, size of the customer community, the ability to deliver at these large complex programs. I think we've are getting more and more differentiated by the quarter but that does not make that negotiating task any easier and especially as things just state would have it have kind of concentrated more on the fourth quarter of this year you know there is heightened risks and uncertainties there with respect to the reported outcome.

And then if I could sneak in one more for Richard. Richard piggybacking on the earlier questions around free cash flow and the headwind on operating margins, the move to the cloud deployment model -- I guess the question is, should we start putting a greater focus particularly maybe next year on the free cash flow margin profile as a better proxy for the longer term profitability because it does sound like you might have a perpetual call it two to three-year headwind if the cloud business takes off to a greater extent than what you hadpredicted.

That's a very good question and its aligns with a number of questions we're considering internally which I think will find their expression in our analyst day when we're considering how to maybe revise the metrics that we judge our business on as some of these new models take hold in our business. Having said that its a very difficult [ph] for me right now to have any kind of view as to how fast that transition occurs, how significant it is with large companies versus small and what the cash implications really are. Having said all that, I do think that if you are looking at a model in which revenues need to be deferred more often and more transactions free cash flow and operating cash, cash flow from operations become a more important, maybe a more important or more meaningful metric to understand the health of the business. So we will be taking more time in instantiating maybe some additional processes internally so that we can actually give some formal guidance to cash flow next year as opposed to just simply giving perspective on what cash from operations should be.

We will now take our next question from Rishi Jaluria with JMP Securities.

Just two quick ones, Richard, if I back out the services revenue guidance, there is a steeper ramp than normal from Q3 to Q4. I want to make sure is that upside beyond normal seasonality primarily Digital Greenfield revenue with a little bit of contribution of hosting from ISCS or were there other factors baked into that guidance?

That is really it -- those are by far the two biggest drivers. One is, is that we should now start recognizing some of the revenue that is being differed today and it has been depressing services revenue over the course of the year. And second of all we do have this additional $14 million to $16 million of both hosted and implementation service revenue which finds itself in the services line and that’ going to be causing the growth of that line.

Okay. And follow-up, just thinking about now that ISCS is closed and you have repackaged in, there is going to be a move towards Tier 4 and Tier 5 customers, what is the best way for us as investors to be able to benchmark your success in kind of getting into those new logos where you weren't before?

Well we always disclosed very specific number about all the relationships that we form. I think we should be in a position to announce most if not all of them as they happen and we will certainly every year at analyst day as we have in the past update our market share penetration and pricing metrics based on our experience. The accounting is a complexity at least for the next year or two but I think on all of the other standard business metrics of win rate, price per unit premium, market penetration, share of wallet etcetera. I think we can be very disclosed and specific.

And with no further questions in the queue, I would like to turn the conference back over to Mr. Marcus Ryu for any addition or closing remarks.

No other comments. Thank you all for participating on our call today. Good bye.

Ladies and gentlemen that concludes today's conference call. We thank you for your participation.