My recommendation for Clearwater Analytics Holdings (NYSE:CWAN) is a Buy rating. Based on my peer comparison, it has outperformed them in terms of margins, while their growth outlook is in line. I expect its current share price to increase to reflect its improved performance over the next few quarters. With its developments in AI, new product launches and continued effort to enhance its existing solutions, I expect this to be a driver for its future growth and net revenue retention. [NRR] Because it creates more value and features for end users.
CWAN is a software company that develops cloud-based SaaS solutions in-house that cater to businesses in the areas of investment accounting and reporting, compliance and risk analysis. Since 2020, CWAN’s revenue has been growing strongly at almost more than 20%. For 2023 and 2024, it is expected to grow at 21% and 22%. Looking at the gross margin, it has remained consistent at 72% for the last 3 years. It is also growing strongly in terms of net income. In 2020, its net margin was reported to be negative 21.76%, but it has since recovered to negative 2.63% in 2022. To get a better look at its profitability, it is better to look at the adjusted EBITDA margin which excludes one-time charges. Since 2020, its adjusted EBITDA margin has been consistent and at a healthy range of around 26%. Overall, CWAN’s revenue growth has been strong while its gross and adjusted EBITDA margins have been consistent.
Recent results and updates
For Q3 2023, CWAN reported revenue of $94.7 million, up 23.7% year over year. Reported gross profit was $67.7 million, or about 71% of revenues. Adjusted EBITDA was $28.6 million, or 30.2% of revenue. This is a strong improvement compared to the adjusted EBITDA margin of approximately 25% in the same quarter last year.
CWAN reported a strong NRR of 108% in Q3 2023, but this was down slightly from the 109% reported in the previous quarter. When compared to Q3 2022, this increased from the reported NRR of 103%. This year-on-year improvement in NRR can be attributed to two strategies: The successful deployment of a new pricing model that effectively counters the volatility associated with assets under management. [AUM] and the introduction of a more adaptable pricing system that allows additional fees for the use of additional functionalities by customers. Despite not expecting to reach its ambitious NRR target of 115% until 2024, the management has expressed a strong intention to achieve this milestone over the next few years.
The strong growth in revenues and NRR can be attributed to CWAN’s dominance in the market in which it operates. And I think one of the reasons CWAN dominates is its expertise in handling options, global reporting and regulatory compliance in local GAAP that has led them to become a top investment accounting solutions firm. This strong reputation drives adoption of CWAN’s platform, thus providing it with upsell opportunities and further strengthening its market position in the region. Being a leader in the markets in which it operates, it reinforces my view that CWAN will be able to maintain its strong growth in the future.
In the cloud-based SaaS solutions market, competition is extremely intense due to the scalability of software businesses, which has attracted many companies into the market. To stay ahead of the competition and capture market share, companies have to constantly innovate and improve their products to attract users. As of now, CWAN has started to venture into AI. CWAN’s in-house Zen AI solution facilitates rapid data consolidation and generates actionable insights. As a result of these additional benefits, it unlocks value for users. Thus, it is likely that their entry into the General AI space with Clearwater-GPT has contributed to the growth seen this quarter as users are getting more benefits and features from the existing products. For the upcoming quarters, I expect General AI to continue to gain popularity and contribute more to its revenue growth and NRR as it gains popularity, attracts new users and also retains existing users.
In addition to General AI, CWAN recently announced new product launches and enhancements at its CWAN Connect conference. This reflects its commitment to product innovation, which is vital for long-term growth. Its CWAN platform has been upgraded and now includes advanced self-service capabilities, ESG data and reporting, and income forecasting for non-fixed income assets. These upgrades enhance the capabilities of the platform, thus adding more value to the end user, which I believe will increase the NRR as users are getting more value from the products. CWAN also introduced a new product called Clearwater MLX, which aims to monitor the entire mortgage loan lifecycle. Additionally, it also added two new features to its Clearwater Prism, including improved EU support and a web-based editor. These innovations clearly reflect its expansion effort and commitment to provide the best solutions to its users. I believe CWAN’s continued technological innovation and product enhancements will help it stay ahead of the competition and maintain its strong market position, as evidenced by its NRR and revenue growth in the quarter. In the long run, I expect these initiatives to further increase NRR, supporting management’s NRR target of 115%.
valuation and risk
According to my model, my target price for CWAN in FY24 is $26.60, representing a potential 26% upside. This target price is based on my growth forecast of 21% and 22% over the next two years. The growth outlook is supported by CWAN’s full-year 2023 revenue guidance of $367.6 million and adjusted EBITDA of $104 million, representing a margin of 29%. It’s clear that in the third quarter, revenues were growing strongly at a high double-digit rate. Additionally, its adjusted EBITDA margin also increased by nearly 5% year-on-year. With its venture into AI and new product launches and enhancements, I expect these initiatives to drive NRR even higher, making management’s target of 115% NRR seem highly achievable.
Currently, CWAN’s Forward EV/EBITDA is 36.38x, which is in line with its peers’ average of 35.69x. When I compare the EBITDA margins, CWAN clearly outperforms them, as its margins are 5.49% while peers are negative 8%. This is also true for the net margin portion, where CWAN has reported a negative 2.63% while peers have reported a negative 13.69%. Please note that my EBITDA and net margin comparisons are based on current results while my multiple comparisons are based on forward metrics (based on consensus). This explains why some competitors’ margins are negative today but their valuation multiples are positive. The consensus may be right that margins may explain their expectations, however, CWAN is the clear performer today and is one of the few that has positive EBITDA margins.
When it comes to 1-year expected growth rates, they are in line at ~22%. With CWAN’s improved margins, I believe it should trade at a higher forward EV/EBITDA. However, to be conservative, even at its current multiple, it is still an upside of 26%.
There are two risks I would like to mention. First, even for older service providers that may not have the most cutting-edge cloud-native technology, industry consolidation can still increase customer stickiness, which puts CWANs at risk. When larger players acquire smaller firms, end users prefer larger companies because of their stability and reliability. This is very important for business software as it is vital to the operation of the business.
Second, revaluation may lead to churn due to budget constraints leading them to source other options. CWAN has begun implementing a new pricing strategy for both current and potential customers. The new pricing structure may cause a negative reaction from some customers.
With its strong third quarter and historic performance, I expect CWAN to continue its current strength in the coming quarters and into 2024, given its strong market leadership in the region. With its investments in AI as well as continued product launches and enhancements, I expect these innovations to support its long-term growth and NRR goals. Additionally, I also expect its multiples to improve, given the fact that it has better margins than peers. With these factors in mind, I am recommending a Buy rating for CWAN.