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Introduction

Duck Creek Technologies (NASDAQ: DCT) is a software-as-a-service (SaaS) provider to the Property & Casualty (P&C) insurance industry. Its mission is (broadly) to empower insurance carriers to transform their business by embracing its technology.

The Boston-based company was founded in 2000 and initially provided on premise solutions to the P&C industry. It was acquired by the consultancy firm Accenture in 2011 and five years later, Accenture sold a majority stake to Apax Partners, a private equity firm. Today, the firm counts about 150 insurance carriers as customers and has 1,200 employees across five countries.

Description

Insurance is one of the oldest and largest global industries, generating more than $5 trillion in annual revenue according to McKinsey. The P&C insurance industry represents approximately one third of this, at roughly $1.6 trillion in written premiums. 

Apart from its size, the P&C industry is also complex. There are a myriad of regulations and locals laws that insurance companies must abide by. These regulate everything from an insurance company’s solvency position to the way that insurance products are marketed and sold to customers.  There is also the small matter of accurately pricing risk – especially for long tail risks. Insurance companies need to price risk with a broad range of possible outcomes and, in some cases, with very limited historical data (e.g. cybersecurity risk or the sharing economy where cars are used for personal and commercial use). 

Partly as a result of this complexity, there has been a significant amount of industry consolidation. Consolidation has helped achieve economies of scale in a number of areas from underwriting to meeting compliance obligations. Larger companies are also better able to provide a more diversified product line, that they can then cross-sell to existing customers. 

However, consolidation has also brought with it a number of challenges, particularly with regard to the core systems within an insurance company. The table below shows a conceptual overview of the types of core systems that are common across product lines:

So regardless of what product line an insurance company offers, it needs to have systems that provide for (1) Policy (2) Billing (3) Claims. The problem is that many insurance companies have multiple systems for say, claims, that may differ across product lines, geographic areas and customer type. This is particularly the case for companies that have grown through acquisition as they inherit new legacy setups that they then stack on existing architecture like a plate of dirty dishes. (Think technology heap rather than technology stack).

These ‘legacy setups’ are problematic for a number of reasons. Firstly, it makes it incredibly difficult for systems to talk to each other. This is a major obstacle to being able to provide a truly digital end-to-end experience to customers. Secondly, it impedes the ability of an insurance company to bring new products to market (since they need to figure out how to plug-in a new product into an existing architecture first which can take months even years). Finally, it also impairs a company’s ability to generate insight from its value chain through advanced data analytics.

Whereas previously these problems were a nuisance that companies could ‘manage’, I think over the next decade these challenges could pose survival risks to companies that don’t address their technical debt. Without the ability to deploy a truly digital experience, how can insurance companies expect to stay relevant? Without a strong systems and data foundation, how can they expect to deploy, say, effective machine learning techniques to detect fraud? Or deploy ‘test and learn’ techniques that continuously aim to improve the customer experience? Or price new risks like climate or pandemic risks?

Against this backdrop, Duck Creek technologies offers 3 main products:

1. 1. Duck Creek Policy – provides a lifecycle solution for developing products, quoting, binding and servicing of policies (shown by the blue icons above).
   2. Duck Creek Billing – provides core payments and invoicing capabilities (shown by the green icons above)
   3. Duck Creek Claims – supports the claims lifecycle from the first-notice of loss (FNOL) to investigation, evaluation and settlement. 

In addition, the company provides “Duck Creek Rating” (provides an ability for carriers to create new rates and models to change the way they price risk), “Duck Creek Insights” a business intelligence tool and various modules that assist distribution, marketing and re-insurance.

The architecture of the platform allows for inheritance, so that companies can build off existing products and re-use integrations that are common across systems. It is also an open platform that allows for REST APIs that is an important part of integrating the technology into an insurance company’s overall architecture and processes.

Financials

In 2019, the company’s total revenue was $171.3 million, of which only one third ($56m) came directly from subscription revenue. In other words, its products sold through perpetual and term licenses are still a substantial part of its business.

Exactly how much of its revenue comes from these products is difficult to say, because the company does not split its largest component of revenue – professional services – between subscription and licensed products. (Professional services revenue mainly comes from fees it charges customers in order to implement its products).

However, we can say that non-SaaS revenue was at least $37.7 million in 2019 (taking the sum of licence and maintenance & support revenue). This is good to be aware of when using revenue multiples.

Overall gross margins for 2019 was 57.9%, although this has dropped to 56% for the first nine months of 2020. Interestingly, gross margins for perpetual and term licenses seem to be higher than the subscription gross margins. This is probably the result of scaling down personnel working in these areas and the fact that many of the upfront costs of these products have already been realised. Subscription gross margins should also improve as the company achieves scale.

In terms of growth rates, it has realised a total revenue CAGR of just 4.54% between 2017 and 2019. However, its important to remember the company is actively shrinking its license business and moving these customers to subscription based products. Taking just its subscription revenue business, this is growing at a CAGR of 29.3% over the same period. Additionally between the first nine months of 2020 and 2019, growth has accelerated to 48.7%.

Key Features of the IPO

• • The IPO is expected to price today and begin trading by the end of the week. It’s price range has increased from $19-$21 per share to $23-$25 per share.
  • 15,000,000 shares are being offered of a total 128,314,016 shares outstanding.
  • Using the mid point of the range ($24), this values the company at slightly north of $3 billion.
  • In addition, the underwriters have an over allotment option of 2,250,000 additional shares of common stock.
  • The company expects to net approximately $333 million from the IPO, of which it mainly use for general corporate purposes but also redeem some existing unit holders.
  • Assuming no exercise of the over-allotment option, public investors will own 11.7% of the company, Apax Partners 33.8% and Accenture 22.5%. 

Valuation

In terms of valuation, I’ll use recent IPOs as benchmarks. There are interesting parallels between Duck Creek’s offering to the insurance industry,  and nCino’s offering to the banking industry. Both are SaaS that target core systems within their respective industries. Although the comparison is a bit more stretched, I’ve included  Vertex for reference since it too is a SaaS that provides mission critical solutions (indirect tax solutions) to large corporations:

Despite Duck Creek having a larger total revenue than nCino, its valuation should surely be lower. This is mainly because its growth rate of its subscription business is lower (48.7% versus 60%), its net revenue retention rate is much lower (119% versus 147%) and non-SaaS revenue still makes up a substantial part of its total revenue. But a valuation between 15 and 20 times FY ’19 sales, seems appropriate given the current environment.

Conclusion

Overall an interesting company, with a strong business model operating in a resilient industry and positioned in a sweet spot to ride the wave of increasing digitalisation.

Near term, there may be some headwinds from the low interest rate environment (low interest rates reduce investment income for insurance companies). This could introduce cost-cutting measures at insurance companies, who may choose to delay or cancel costly IT integrations to protect margins. However, longer term, consumer preferences and expectations for a digital experience are not going away.

I also suspect there might be an ‘overhang’ of stock from Apax Funds, the private equity holder that owns about 33.8% of the stock. An excerpt of Apax Fund’s investment approach is shown below:

“The average length of an investment by Apax Funds is around five years. Once the initial investment thesis has been realised, an exit committee is called to begin discussions about the future ownership of the business in question.”

– Apax Funds Website

Since Apax Funds first invested in the company in 2016 and its average length of investments is five years, it seems likely that the private equity firm would want to exit its investment (perhaps entirely) in order to realise its returns.

One to watch, especially when the lock up agreement for existing shareholders expires in mid-February 2021.

Source: https://ipohawk.com/duck-creek-technologies-ipo/?utm_source=rss&utm_medium=rss&utm_campaign=duck-creek-technologies-ipo