Phiromya Intawongpan
Overview
My recommendation for Clearwater Analytics Holdings (NYSE:CWAN) is a buy rating. Based on my peer comparison, it outperformed them in terms of margins, while their growth outlook is in line. In the next few quarters, I would expect its current share price to increase to reflect this outperformance. With its development in AI, new product launches, and continuous effort to enhance its existing solutions, I expect this to be a driver for its future growth and net revenue retention [NRR] as it creates more value and features for end users.
Business
CWAN is a software company that self-develops cloud-based SAAS solutions that cater to businesses in the areas of investment accounting and reporting, compliance, and risk analytics. Since 2020, CWAN’s revenue has been growing strongly at about 20% plus. For 2023 and 2024, it is expected to be growing at 21% and 22%. Looking at gross margin, it has been consistent at 72% for the last 3 years. In terms of net income, it has been growing strongly as well. In 2020, its net margin reported was negative 21.76% but since then it has recovered to negative 2.63% in 2022. To have a better look at its profitability, it is better to look at adjusted EBITDA margin which excludes one-time charges. Since 2020, its adjusted EBITDA margin has been consistent and at a healthy range of roughly 26%. Overall, CWAN’s revenue growth is strong while its gross and adjusted EBITDA margin has been consistent.
Recent results & updates
For the third quarter of 2023, CWAN reported revenue of $94.7 million, up 23.7% year over year. Gross profit reported was $67.7 million, or approximately 71% of revenue. Adjusted EBITDA was $28.6 million, or 30.2% of revenue. This is a strong improvement when compared to last year same quarter’s adjusted EBITDA margin of about 25%.
CWAN reported a strong third quarter 2023 NRR of 108%, but it was slightly lower than the 109% reported in the previous quarter. When compared with the third quarter of 2022, it increased from the reported NRR of 103%. This year-over-year improvement in NRR can be attributed to two strategies: the successful deployment of a new pricing model that effectively counters the volatility linked to Assets Under Management [AUM] and the introduction of a more adaptable pricing system that allows for additional charges for the use of extra functionalities by clients. Despite not expecting to hit their ambitious NRR target of 115% by 2024, management has articulated a firm intention to achieve this milestone by the next few years.
The strong growth in revenue and NRR can be attributed to CWAN’s dominance in the market in which it operates. And one of the reason I think CWAN is dominates is because of its expertise in handling alternatives, global reporting in local GAAP, and regulatory compliance is what drives them to be the top investment accounting solution firm. This strong reputation drives the adoption of CWAN’s platform, thus presenting it with upsell opportunities and also further solidifying its market position in the sector. Being a leader in the market it operates in, it bolsters my view that CWAN’s will be able to maintain its strong growth in the future.
In the cloud-based SAAS solution market, competition is extremely intense due to the scalability of software businesses, which has attracted many companies to the market. In order to stay ahead of the competition and capture market shares, companies have to consistently innovate and enhance their products in order to attract users. So far, CWAN has started venturing into AI. CWAN’s in-house Gen AI solution facilitates faster data consolidation and produces actionable insights. As a result of these additional benefits, it unlocks value for users. Thus, it is likely that their entry into the Gen AI space with Clearwater-GPT contributed to the growth observed in this quarter as users are getting more benefits and features from the existing products. For the upcoming quarters, I expect GEN AIs to continue gaining traction and will contribute more to its revenue growth and NRR as it gains popularity, attracts new users, and also retains existing users.
In addition to Gen AI, CWAN recently announced new product launches and enhancements at its CWAN Connect conference. This shows its commitment to product innovation, which is crucial for long-term growth. Its CWAN platform has been upgraded and now includes enhanced self-service capabilities, ESG data and reporting, and income forecasting for non-fixed income assets. These upgrades enhance the platform’s capabilities, thus adding more value to the end user, which I believe will drive up NRR as users are getting more value from the products. CWAN also introduced a new product called Clearwater MLx, which is intended to oversee the whole mortgage loan lifecycle. Additionally, it also added two new features to its Clearwater Prism, which include improved EU support and a web-based editor. These innovations clearly show its expansion effort and its commitment to providing the best solution for its users. I believe CWAN’s continuous technological innovation and product enhancement will allow them to stay ahead of competition and maintain its strong market position, as evident by its NRR and revenue growth in the quarter. In the long run, I expect these initiatives to drive the NRR higher, backing up management’s NRR target of 115%.
Valuation and risk
According to my model, my target price for CWAN is $26.60 in FY24, representing a potential 26% increase. This target price is based on my growth forecast of 21% and 22% over the next two years. The growth outlook is backed by CWAN’s full-year 2023 revenue guidance of $367.6 million with adjusted EBITDA of $104 million, which represents a margin of 29%. It’s clear that in the third quarter, revenue was growing strongly at high double-digit rates. On top of that, its adjusted EBITDA margin also expanded by about 5% year-over-year. With its venture into AI and new product launches and enhancements, I expect these initiatives to drive NRR higher, making management’s goal of 115% NRR look highly achievable.
Author’s valuation model
Currently, CWAN’s forward EV/EBITDA stands at 36.38x, which is in line with peers’ medians of 35.69x. When I compare EBITDA margins, CWAN clearly outperforms them, as its margin is 5.49% while peers are negative 8%. This also holds true for the net margin portion, where CWAN’s reported negative 2.63% while peers are negative 13.69%. Please note that my EBITDA and net margin comparison are based on current results while my multiple comparison are based on forward metrics (based on consensus). This explains why some of the peers have negative margins today but have a positive valuation multiple. Consensus might be right that margins could explain to their expectations, however, as of today CWAN is the clear out performer and one of the few that has positive EBITDA margins.
When it comes to the 1-year expected growth rate, they are in line at ~22%. With CWAN’s superior margins, I believe it should be trading at a higher forward EV/EBITDA. However, to be conservative, even at its current multiple, there is still a 26% upside.
Bloomberg
There are two risk that I would like to point out. Firstly, even for legacy service providers who might not have the most cutting-edge cloud-native technology, industry consolidation may still increase customer stickiness, which puts CWAN at risk. When larger players acquire smaller firms, end users tend to prefer the larger firms because of their stability and reliability. This is very important for business software as it is crucial to the business’s operation.
Second, churn could result from repricing due to budget constraints leading them to source for other alternatives. CWAN has started implementing a new pricing strategy for both current and potential customers. The new pricing structure might cause a negative reaction from some customers.
Summary
With its robust third quarter and historical performance, I expect CWAN to continue its current strength for the upcoming quarters and into 2024 given its strong market leadership in the sector. With its investment in AI as well as continuous product launches and enhancements, I expect these innovations to support its long-term growth and NRR targets. In addition, I also expect its multiples to improve given the fact that it has better margins compared to peers. With these factors, I am recommending a buy rating for CWAN.
