Clearwater Analytics (CWAN) Thesis

Setup

Clearwater Analytics (CWAN) as a SHORT presents an interesting risk/reward opportunity as we believe management has overpromised investors short-term and long-term growth targets that are likely unachievable, thus consensus estimates are likely unattainable in FY’23 and beyond. Management would have missed their previous FY’22 topline guidance of $302m-$304m ($303m midpoint) had CWAN not acquired JUMP Technology in December 2022, which contributed $2.7m to the $303.4m revenue reported in FY’22. Without the acquired JUMP revenue, management would have narrowly missed the low end of their guidance range. Additionally, we believe management would have failed to deliver their FY’23 revenue guidance of 20% without the benefit of the JUMP acquisition, which had annual revenue of approximately $12m per management disclosure. If we assume no growth in JUMP’s revenue in FY’23 and subtract the $12m from the FY’23 revenue guidance of $361m-$364m ($362.5m midpoint), organic revenue growth would have been 15%, well below management’s long-term revenue guidance of 20% that is baked into consensus numbers for the next 3 years.

We believe management is attempting to obfuscate the true organic growth by not separately breaking out the acquisition's contribution to FY’23 results. This is concerning as management’s compensation targets are directly linked to revenue growth and makes us question whether the JUMP acquisition was in the best interest of shareholders or was intentionally done to allow management to achieve their 20% revenue target and collect an additional 20% of the RSUs they would have otherwise been ineligible for had they not closed the acquisition.

Welsh, Carson, Anderson & Stowe (WCAS), Clearwater's current largest shareholder and majority PE-owner pre-IPO, filed on March 8th, 2023, to sell 13 million shares with an underwriter option of 2 million shares that was exercised for a total of 15 million shares at $14.50 per share. We think investors could potentially be cautious of bidding up CWAN's share price significantly above the previous transaction price of $14.50, which may limit upside risk as investors could be weary of acquiring a full position while the majority shareholders have recently sold shares at that price. Additionally, we believe any future sale filings could present uncorrelated alpha capture opportunities in the event the share price falls post-filing, potentially allowing shorts to monetize their positions in the interim of EPS prints, further skewing the risk/reward.

Where could we be wrong? We are pretty confident in the direction of our numbers; however, we believe the real question lies in how management will attempt to plug the revenue hole. The obvious answer would be more acquisitions, but what would be the subsequent investor reaction? Would the street be satisfied with management just hitting their numbers, regardless of whether it is done organically or via M&A? Management has previously stated that their 20% revenue target is based on "organic growth," but if investors are willing to accept inorganic growth to achieve the 20% topline target while continuing to ascribe a premium multiple, our thesis would likely prove invalid.

The catalyst path to monetizing a short position would most likely be via EPS prints and any interim sale filings of the existing PE-owners selling shares. Our base case assumes -19% downside, the upside case -29% downside, and the downside case +12%. Our thesis depends on the market realizing the organic growth profile of CWAN is closer to mid-teens than +20% and re-rating the shares to a more reasonable level while still maintaining a 4x EBITDA turn premium to our comps in our base case and an EBITDA multiple in line with the group average in our upside case.

Company Overview

Clearwater Analytics (CWAN) is a SaaS-based investment accounting and analytics provider primarily for insurance companies, asset management firms, and large corporations. The solution offering is rather straightforward: a cloud-based platform that provides a centralized view of a client's entire portfolio with cleaned and reconciled data for portfolio management, risk management, compliance and regulatory, and client reporting. CWAN allows customers to efficiently consolidate what is typically a sprawl of legacy portfolio accounting systems that might specialize in a specific asset class or country onto a single platform with one web portal for all their portfolio accounting needs.

Clients’ rationale for buying Clearwater is largely dependent on the client's industry. Insurance clients tend to buy for two reasons: 1. Regulatory Reporting simplifies complexity as customers expand to new asset classes and countries that require new reporting systems. 2. Daily Soft Close, which allows insurance clients to speed up the process of closing their books to just a few days after the reporting period vs. up to 30 days for legacy systems. Asset Management clients primarily purchase CWAN for their client reporting, as end-clients require their investment managers to provide comprehensive reporting capabilities. With CWAN, customers can provide their clients with a single source to view their investments and reports, rather than having to receive multiple reports and use a variety of systems to get the same view. Corporations tend to buy CWAN to have a single, comprehensive view of all their money managers and investments. The typical buyer persona is either the CFO, CIO, or COO.

Customers typically land heavy, especially with Insurance and Corporate clients, where CWAN will typically win "100% of the book," i.e., the entire AUM base of the client, as the value of CWAN is only realized if the customer has 100% visibility across their portfolio, requiring all assets to run on the platform. It takes approximately 3–9 months to onboard the client's assets onto the platform. Asset Management clients are much more likely to land and expand, with CWAN typically starting with one business unit "desk" and expanding to other desks as the customer has success. If an Insurance client expands, it is usually due to M&A, where they acquire a new portfolio and bring those assets onto the CWAN platform. Net-net, the ultimate dollar value of a heavy land vs. a land and expand deal will be minimal, as insurance deals are notably larger, offsetting the lack of expansion. Corporate clients are almost all new logos with little to no expansion.

Competition is primarily from legacy providers, including SS&C, State Street, SAP, BNY Mellon, SimCorp, and BlackRock. Next-generation competitors include Enfusion, among others. Management has reported an 80% win rate on proposals, highlighting that they rarely lose to legacy providers in bake-offs. In addition, next-gen competitors such as Enfusion are primarily focused on a single sector that is usually non-core to CWAN, such as hedge funds or alternative asset managers. The 20% of lost RFPs are primarily due to customers opting to stick with either their existing internal systems/custodians or legacy solutions instead of switching systems due to CWAN not properly conveying the value of the platform, thus rarely losing to competitors head-to-head. When CWAN wins replacement deals, the incumbent is a 50/50 split between legacy providers, where the client could have been with the provider for decades or just a few years after a failed implementation. The other is internal systems using a combination of data warehouses and Excel, or a variety of custodian platforms. Greenfield RFPs are very rare and mostly limited to Corporates that are about to IPO and will need to manage the raised cash.

The company segments revenue by customer vertical, where Insurance is the largest vertical at 51%, Asset Management at 34%, and Corporations at 15% of total revenue in FY’22. CWAN estimates their TAM at $11bn split between $5.9bn in core markets (Asset Managers $4bn, Insurance $1.6bn, Corporations $0.3bn) with the remainder split between adjacent markets at $2.7bn (hedge funds, government, WM, alts, family offices, and pension funds), $1.1bn Clearwater Prism (add-on modules), and $1.3bn APAC. Management derived the TAM from a bottom-up analysis by applying CWAN’s prior pricing model of BPS take-rate x average client assets. Pricing being previously directly tied to average client assets on the platform, led to CWAN experiencing periods of volatility in revenue due to fluctuations in market prices; historically, this was rather minimal as clients primarily ran strict mandates with conservative holdings, with approximately 80% of client holdings in high-grade fixed income products. Management recently updated their pricing in order to reduce the downside volatility of the former model by transitioning to a new pricing model called Base+. Base+ is a contract framework that includes a fixed base fee for the existing assets on the platform plus an incremental fee for increased assets on the platform. Additionally, Base+ pricing includes annual price increases of approximately 4-5% and enables CWAN to also charge additional fees for add-on modules and services. 80% of existing customers have successfully transitioned to the new pricing model, with the balance mostly remaining on the previous model.

Consensus View

Clearwater is viewed as a mission-critical sticky software solution, as evident by their 98% retention rate and 60 NPS score. Competition is viewed as minimal due to CWAN's 80% win rate, as most competitors are either legacy solutions or next-gen providers normally only serving one of the many verticals CWAN operates in. Management is viewed favorably as having delivered a strong track record of growth and profitability, best demonstrated by their track record of +20% growth and +20% EBITDA margins over the last handful of years. Additionally, CWAN is a story of efficiency, where NG S&M spend has remained under 15% of revenue historically, allowing the company to plough excess profits into R&D by spending approx. 25% of revenue per year on product development to strengthen their competitive position against the incumbents and upstarts. CWAN's TAM of $11bn provides the runway necessary to deliver consistent 20% topline growth for the long term while seeing incremental margin upside from efficiencies in R&D as the product suite matures.

Variant Perception 

Clearwater is a phenomenal business that provides a high-quality solution for their loyal customers. Our issues are NOT related to the value of the product offering or Clearwater’s competitive positioning, as we view both positively. Our concerns are largely related to a management team that we feel overpromised investors unachievable growth targets that are likely unattainable with their current growth algorithm. Thus, investor expectations for CWAN’s future growth prospects are overextended, and we view the recent new business slowdown as structural in nature. Management has reported little macroeconomic-related impact on their business to date, supporting our view that this is a fundamental slowdown vs. one driven by temporary macroeconomic headwinds.

Slowdown in New Customer ARR: New Customer ARR is the primary growth driver for CWAN as it historically comprises approximately +50% of Total NNARR, making this metric the most important growth driver for CWAN’s Total NNARR. Organic New Customer ARR (Annualized), per our estimates, declined -43% YoY last quarter (Q4’22) and was primarily driven by a dramatic slowdown in organic QoQ net new customer additions that declined -58% and -60% YoY in Q3’22 and Q4’22, per our estimates. Additionally, ARR per New Customer declined -20% YoY in Q4’22, per our estimates. We think the slowdown is being primarily driven by CWAN being greatly penetrated in their largest market, NA Insurance Companies, where their reported marketshare went from 19% in FY’21 to 31% in FY’22. In addition, per the companies reported marketshare statistics, it appears CWAN lost marketshare in Corporations where platform AUM declined from $1.3tn FY’21 to $1tn FY’22, per the 10-K filings. Evidence of market saturation in NA Insurance Companies and marketshare declines in Corporations is coming through the numbers in the decline of net new customer additions YoY. Exactly 2/3 of FY’22 revenue came from Insurance Companies (51% of total revenue) and Corporations (15% of revenue), so CWAN will be dependent on their other primary vertical, Asset Management, to deliver outsized growth in order to achieve their 20% topline growth target. Asset Management deals tend to land smaller and are primarily a land-and-expand motion vs. insurance and corporate clients that land heavy with larger deal sizes, thus creating a headwind to ARR per New Customer as the mix of deals moves towards Asset Management. We do want to be fair and balanced by highlighting that Asset Management has been growing like a weed, delivering topline growth of 28% and 27% in FY’21 and FY’22, respectively. However, at only 1/3 of total revenue mix, we believe the strength in AM is not enough to offset the continued softness in Insurance and Corporations that blended grew 22.2% in FY’21 and only 15.8% in FY’22, which we believe will continue to decelerate, causing us to further doubt management's ability to achieve 20% topline guidance in FY’23 and beyond.

NRR Recovery Not Enough: Existing Customer NNARR was negatively impacted in FY’22 due to CWAN’s prior pricing model, which was largely tied to client AUM based on average AUM x BPS take-rate. Rising rates and falling equity prices negatively impacted CWAN’s Existing Customer NNARR with NRR falling from a high of 111% (Q4’21) and bottoming at 103% (Q3’22) before recovering some to 106% (Q4’22) as the fixed pricing model began to positively impact Q4 renewals. We conservatively model a continued recovery in NRR to FY’21 levels, with NRR reaching 110% in Q2'23 as Existing Customer NNARR recovers to FY’21 levels, driven primarily by the new pricing model and, to a lesser extent, continued adoption of add-on modules. Management provided a subtle LT NRR target of 115% that they suggested is at least a few years out and will be primarily driven by getting more leverage out of the add-on product modules, including Prism and LPx, while also partially driven by the pricing change. Additionally, the recent JUMP acquisition brought new capabilities to CWAN, including PMS and OMS, which management suggested would eventually present a cross-sell capability; however, we do not believe this cross-sell opportunity will be realized anytime soon as JUMP’s technology stack still needs to be migrated to the cloud and integrated with CWAN’s platform. Finally, we believe the benefits of the pricing change will be a temporary boost to NRR, which is consistent with management commentary that the new Base + pricing would primarily impact Q4’22/Q1’23; thus, our estimates suggest NRR will top out around 110% in FY’23, requiring New Customer ARR to drive an additional 10% ARR growth to achieve the 20% growth target management has guided, which we believe is unlikely for the aforementioned reasons.

Aggressive Guidance: On the Q4’22 call, the Goldman SS analyst asked management to clarify the drivers behind the implied back-half acceleration for the FY’23 guide. Management suggested that the 2nd half acceleration was due to the bookings from Q3/Q4 flowing through into revenue as well as upcoming Q1/Q2’23 bookings driving the growth. We believe management’s assumption is aggressive, as sequential bookings growth in Q4 was 4.3% (organic), a decline from Q3’s 4.8% (organic) sequential bookings growth; thus, bookings would have to reaccelerate in Q1/Q2'23 to achieve management’s guidance. We model bookings growth of 16.4% for FY'23, significantly below the required bookings growth to achieve 20% revenue growth, per our estimates.

Risks

M&A to Make Numbers: The biggest risk to our thesis is if investors are willing to accept management using M&A to hit street estimates in lieu of organic growth. Management has stated they are actively evaluating M&A opportunities and will be "aggressive" if the right opportunity is presented. It is our view that management has used M&A in the past to make their numbers, and we wouldn’t be surprised if this becomes a common occurrence. If investors and the street are willing to look the other way and value M&A growth on an equivalent basis, our thesis will likely be impaired. Management has stated their 20% growth target is "organic", but if investors are willing to accept M&A as part of that growth algorithm, we will likely no longer have a thesis.

Limited Float, Short Interest, and ADV: CWAN has a limited float as a sizeable portion of the shares outstanding are still held by the PE group. The limited float has led to CWAN having a short interest that appears to have ranged from mid-high single digits as a percentage of the float. Additionally, the company’s ADV is approximately 700k shares, or $11m at the current share price. This suggests the company could be prone to a squeeze.

Take-Private: We don’t view a take-private as a likely scenario at 10x+ NTM Sales, which would leave little room for an acquirer to pay a premium, in our view. Additionally, as the current PE group has been an active seller of their shares, we do not believe a bid from the existing ownership is likely.

Financials & Forecast

We derive our forecasts using the company's disclosed Annualized Recurring Revenue (ARR) to drive our revenue estimates. We want to highlight that our model makes certain assumptions as it relates to KPIs not disclosed by the company, including logo churn. For example, we use disclosed Gross Retention as a proxy for logo churn, which is likely different from the actual logo churn number that is not reported. The primary drivers of our model include Existing Customer NNARR (Net New ARR), which we derive from the company's Net Retention Rate (NRR) disclosure. New Customer ARR estimates are derived from subtracting Existing Customer NNARR from Total NNARR, which are calculated metrics not specifically reported by the company and are sensitive to our assumptions. For certain quarterly periods prior to Q3'21, where management started breaking out quarterly client counts, we have made certain assumptions for quarterly client additions that we believe align closely to the former annual-only client count disclosures. Finally, other metrics, such as NNARR per Existing Customer or ARR per New Customer are calculated metrics that are not specifically reported by the company and are dependent on our assumptions.

ARR Model:

Our ARR model is driven by Existing Customer NNARR, New Customer ARR, and Churned ARR. Our estimates are primarily derived from the KPIs disclosed by CWAN, including ARR, Gross Retention Rate, and Net Retention Rate. Our ARR assumptions for NNARR are annualized for consistency with the CWAN’s annualized KPI disclosures.

We model a continued recovery in Existing Customer NNARR as the company’s new Base+ pricing model was implemented in Q4’22 and continues to take effect in Q1’23e, per management commentary, before stabilizing in Q2’23 to account for the one-time impact. Existing Customer NNARR is also assumed to grow incrementally through FY’23e to account for the adoption of new add-on solutions.

Gross Retention is held flat at 98% to account for the sticky nature of the solution and the consistency of the 98% retention rate over the past many years. As mentioned, we utilize Gross Retention as a proxy for logo churn.

Our New Customer ARR estimates are consistent with the notable slowdown in Q4’22 due to quarterly net new customer additions declining by -58% YoY in Q3’22 and -60% YoY in Q4’22. We held flat quarterly net new customer additions in FY’23 to reflect what we believe to be market saturation in CWAN’s largest market, NA Insurance Companies, as market share had grown from 19% (FY’21) to 31% (FY'22), which we speculate is directly linked to the slowdown in customer additions. It also appears the company is losing marketshare in Corporations, as our calculations suggest marketshare declined from 37% (FY’21) to 29% (FY’22), likely contributing to the weakness in net new customer additions. ARR per New Customer, per our calculation, fell -20.5% in Q4’22, which we believe could potentially continue to be pressured as the company becomes more dependent on the Asset Management vertical, where deal sizes tend to land smaller than the other verticals. However, to be conservative, we do not model continued weakness in ARR per New Customer as Q4 was the first quarter to show deceleration and has not yet become a trend, unlike the continued softness in quarterly net new customer additions. Thus, we model a slight reacceleration in ARR per New Customer in Q1’23 that continues through FY’23. If the deterioration continues it could present further downside to our estimates that contemplate a reacceleration. The last key part of our ARR Model is the JUMP acquisition ARR contribution, which we model to grow 31% in FY'23, which we believe reflects an acceleration from FY’22 growth as management stated that JUMP had a very similar growth rate to CWAN (20%ish) to account for any cross-selling across the base. Cross-selling in FY’23 will likely be muted as CWAN still has to integrate JUMP. If the cross-selling does not materialize, we believe there could be further downside to our estimates. To summarize, we believe our assumptions are reasonable and arguably conservative. However, our modeling suggests FY’23 ARR will grow 16.4% organically and 16.7% with the contribution of JUMP's acquired ARR, likely not enough to achieve management's 20% revenue guidance for FY’23.

Revenue Model: (Revenue Forecast vs. Consensus)

Our revenue estimates fall slightly below consensus, where we model revenue growth of 18.7% for FY’23, which includes the inorganic contribution of the JUMP acquisition. We highlight the more important factor, YoY organic growth, which, ex. JUMP contribution, would have been 15.5% YoY per our estimates, which is substantially below management's 20% LT organic growth target, which is baked into street estimates for the next 3 years.

Customer Model:

Our customer model is primarily driven by CWAN's standalone quarterly net new customer additions that have continued to be challenged since Q3’22, which we believe is structural in nature due to CWAN’s market share in their largest market, NA Insurance Companies, growing from 19% (FY’21) to 31% (FY'22), which we think may be posing challenges to net new customer additions due to their existing penetration. Additionally, it appears CWAN is losing marketshare in Corporations, which we think is also a factor in the lower net new customer additions. Management has suggested that the company has largely been unaffected by macroeconomic headwinds, and thus we believe holding quarterly net new additions flat is conservative as it does not factor in a deteriorating macro. If the company does begin to experience more notable macroeconomic headwinds, we believe there could be further downside to our estimates.

Valuation and Comps:

CWAN doesn’t have a clean valuation comp set as many of their direct competitors, such as SS&C, are legacy platforms that we view as unsuitable comps due to their mature growth profiles. We believe it is more appropriate to value CWAN relative to software peers with similar topline and EBITDA profiles. The company currently trades at a 40% premium to the group average EBITDA multiple, which we view as unjustified for two primary reasons.

1. True Organic Growth: The company’s true organic growth, in our view, is sub-20%. Consensus is modeling 19-20% growth for the next 3 years, in line with management's long-term growth targets. We believe that number is closer to mid-teens organically, and thus the market will likely re-rate CWAN’s premium multiple more in line with the group average.

2. PE Overhang: Welsh, Carson, Anderson & Stowe (WCAS), Clearwater's current largest shareholder and majority PE-owner pre-IPO, filed on March 8th, 2023, to sell 13 million shares with an underwriter option of 2 million shares that was exercised for a total of 15 million shares at $14.50 per share. We think investors could potentially be cautious of bidding up CWAN's share price significantly above the previous transaction price of $14.50, which may limit upside risk as investors could be weary of acquiring a full position while the majority shareholders have recently sold shares at that price.