Guidewire Software: Sell as Part of Buyout (NYSE: GWRE)

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Introduction

As interest rates rise and the tide of easy money recedes, companies that have grown at any cost are taking it on the chin. The era of profitless prosperity is coming to an end. Over the past few months, I have emphasized a number of them, We work (WE) at GitLab (GTLB).

Corporate management facing a halving in their stock price and a restless workforce watching their holdings decline in value have a choice. They can focus on profitability by reducing costs and showing the market that they are actually delivering economic value to their customers. Or they can use the cash balance they’ve accumulated during the good times to do a bit of financial engineering and buy back their shares. Alas, the latter is only a temporary solution. At some point, the cash balance will be exhausted and the focus will once again be on profits. This is the path that Guidewire Software (NYSE: GWRE) chose, with the announcement of a $400 million share buyback.

Usually when a company announces a takeover it is an opportunity to buy the stock because you know the company will be a buyer for some time. In this case, I think a contrarian approach of selling or shorting the stock will pay dividends (although I’m pretty sure the company won’t).

Company history

Based in San Mateo, Calif., Guidewire develops software products for P&C insurers. The company also provides implementation and related professional services. The company is trying to move to a subscription model from selling licenses. It has not been profitable for the past three years, with losses increasing every year. The stock has fallen more than 40% in the past year, compared to a 15% decline in the S&P 500.

Financial overview

For the most recent quarter ending July 31, 2022, the company generated $245 million in revenue, up 7% year-on-year. Operating profit was a loss of $32 million (-13% operating margin) and net profit was a loss of $31 million or $0.37 per share. This quarter also marked the end of its fiscal year and the company recorded revenue of $813 million, up 9% year-on-year. Operating profit was a loss of $199 million (-24% operating margin) and net profit was a loss of $180 million or $2.16 per share.

The company currently holds 84 million shares and a market capitalization of $5.1 billion. It has $358 million in debt and $1.16 billion in cash for net cash of $0.8 billion. It thus has an enterprise value of 4.3 billion dollars, or 4.6 times its annual turnover.

Analysts expect the company continue to grow at a rate of 10%, with its losses maintained. The company’s forecast is around $900 million in revenue for the coming year. The company has not offered a path to profitability under GAAP.

Valuation and recommendation

Consistent with the conservative way I evaluate loss-making businesses, I assume Guidewire will eventually become profitable. I’m modeling an operating margin of 10%, compared to -24% in its last fiscal year. An important point is that I am not ignorant of equity compensation. If you don’t think this is a real expense, you can stop reading now! Most management teams still have their heads in the sand thinking that they can reward their employees with as many shares as they want without adverse effects. This presents an opportunity for bearish investors, as employees will constantly sell their stocks.

A 10% margin on $900 million in annual revenue would mean an annualized profit of $90 million per year. I value the company at a multiple of 28x on that earnings. I believe that is reasonable. A high-quality company like Microsoft (MSFT) with a similar growth rate is trading at 24 times this year’s EPS. I don’t apply tax rates to profits to be conservative because the company has an accumulated deficit of $284 million which can protect profits for a few years.

So I value the business at $2.5 billion and add net cash back for a total net worth of $3.3 billion. The split by 84 million shares gives a fair value of $39 for the stock, against its current price of $61, for a decline of 35%. I recommend selling or shorting the stock. You can also choose to sell call options or buy put options instead. I think most of this decline will happen over time as employees continue to sell their shares and no new money will enter the market.

Short interest and cost of borrowing

It would be dangerous to short a stock that already has high short interest, with the possibility of a short squeeze driving the price much higher. Nor would it be profitable to pay a high cost of borrowing that potentially absorbs all the downside on the equity side. GTLB has little short interest in 5% of outstanding shares.

GWRE shares are easy to borrow with minimal borrowing cost. Depending on your agreement with your broker, you may get a short discount for the funds generated from the sale of the stocks you borrow (usually a discount of 50 to 100 basis points from the Fed Funds rate, currently at 3- 3.25%). So you could earn 2% per year on any short product.

External ratings

Seeking Alpha’s AI warns that GWRE is at high risk of performing poorly based on its quantitative ratings. It has a composite rating of 1.64, which equates to a sell. Unsurprisingly, Wall Street analysts are more positive, with a combined rating of 3.6, between a hold and a buy. Their price targets have followed the stock price lower.

The risks are high but manageable

Shorting stocks is inherently risky, since the potential losses are theoretically infinite. I would recommend having a short portfolio only in conjunction with long positions. You can reduce the risk somewhat by selling put options against short positions, at around 20% below the current price, generating income, but capping profits.

If investors fell in love with a company, there could be a short squeeze. However, with the money crunch, I would consider the chances of this happening on an extended basis not very high. The company would also likely issue shares in such a scenario. However, if it issues shares at an inflated value, it increases the intrinsic value of the company.

The company could be acquired at a premium by another company or a private equity fund. This is a risk that can be diversified by holding a large number of short positions, each of which is small. With a market capitalization of $5 billion, an acquisition here is certainly doable.

The gap between the company’s intrinsic value and the stock price could widen over time.

The company could boost its stock price by buying back its shares. However, I believe this will only be temporary as he will buy his shares above their intrinsic value.

Preventive disclosure

Writing a short thesis on an action on a public forum is an invitation to blowback for employees and holders of the action. I welcome respectful comments from eponymous readers. If you are a shareholder or an employee, it is better to direct your energies towards the profitability of your company.

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