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Edited Transcript of SWI.N earnings conference call or presentation 24-Apr-19 9:00pm GMT

Q1 2019 SolarWinds Corp Earnings Call

May 8, 2019 (Thomson StreetEvents) -- Edited Transcript of Solarwinds Corp earnings conference call or presentation Wednesday, April 24, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* David Hafner

SolarWinds Corporation - VP of IR

* J. Barton Kalsu

SolarWinds Corporation - Executive VP, CFO, CAO &Treasurer

* Kevin B. Thompson

SolarWinds Corporation - President, CEO & Director

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Conference Call Participants

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* Brad Alan Zelnick

Crédit Suisse AG, Research Division - MD

* David Fenno Hoffman

Evercore ISI Institutional Equities, Research Division - Analyst

* Hamza Fodderwala

Morgan Stanley, Research Division - Research Associate

* John Stephen DiFucci

Jefferies LLC, Research Division - Equity Analyst

* Matthew Ryan Wells

Citigroup Inc, Research Division - Associate

* Michael H. Berg

JMP Securities LLC, Research Division - Research Analyst

* Mohit Gogia

Barclays Bank PLC, Research Division - Research Analyst

* Terrell Frederick Tillman

SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst

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Presentation

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Operator [1]

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Good afternoon. My name is Rob, and I will be your conference operator today. At this time, I would like to welcome everyone to the SolarWinds First Quarter 2019 Earnings Conference Call. (Operator Instructions) Thank you. Mr. Dave Hafner, VP of Investor Relations, you may begin your conference.

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David Hafner, SolarWinds Corporation - VP of IR [2]

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Thank you, Rob. Good afternoon, everyone, and welcome to SolarWinds' First Quarter 2019 Earnings Call. With me today are Kevin Thompson, our President and CEO; and Bart Kalsu, our Executive Vice President and CFO. Following prepared remarks from Kevin and Bart, we'll have a brief question-and-answer session. Please note that this call is being simultaneously webcast on our Investor Relations website at investors.solarwinds.com.

Please remember that certain statements made during this call, including those concerning our financial outlook, our expectations regarding growth and profitability, our expectations regarding the completion timing and impact of the Samanage acquisition, our market opportunities and market share, areas of focus for our business and our product plans and releases, are forward-looking statements. These statements are subject to a number of risks, uncertainties and assumptions described in our SEC filings, including the risk factors discussed in our Form 10-K that was filed on February 25, 2019 and the Form 10-Q that we plan to file by May 15, 2019.

Should any of these risks or uncertainties materialize or should any of our assumptions prove to be incorrect, actual company results could differ materially and adversely from those anticipated in these forward-looking statements. These statements are also based on currently available information, and we undertake no duty to update this information except as required by law. The cautionary statements regarding these forward-looking statements are further described in today's press release.

Unless otherwise noted, all first quarter 2019 results that will be discussed on today's call will be on an ASC 605 basis. This includes references to first quarter revenue and adjusted EBITDA. We will also provide our results and outlook for our revenue growth rates on a constant currency basis to provide a framework for assessing our performance and how we expect our business to perform, excluding the effect of foreign currency fluctuations.

Our use and calculation of these non-GAAP financial measures are further explained in today's press release, and a full reconciliation between each non-GAAP measure and its corresponding GAAP measure is provided in the tables accompanying the press release, including adjustments from the impact of ASC 606. However, each non-GAAP item in our forward-looking financial outlook that we will provide today has not been reconciled to the comparable GAAP outlook item because providing projections of changes in individual balance sheet and income statement amounts is not possible without unreasonable effort and release of such reconciliations would imply an inappropriate degree of precision. Unless otherwise indicated, references to profitability and comparable measures refer to such measures on a non-GAAP basis.

With that, I'll now turn the call over to Kevin.

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [3]

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Thanks, Dave, and thanks to everyone joining us for today's call. I'm pleased to report that we had a solid start to 2019. And in addition, we believe we have positioned ourselves well to deliver a year of accelerating growth, strong profitability and cash flows. Our first quarter results were consistent with our expectations across each of our product lines and geographies, and the quarter unfolded much the way we believed it would when we prepared our outlook.

First quarter revenues totaled $216 million, which reflects year-over-year growth for the first quarter of 9%. However, in the first quarter of 2019, we had strong foreign currency headwinds compared to the first quarter of 2018. The constant currency revenue growth in the first quarter of 2019 was meaningfully higher at 11%.

We also had a strong start to the year in terms of profitability with adjusted EBITDA for the first quarter of $103.6 million, which reflects 9% year-over-year growth and a very healthy first quarter adjusted EBITDA margin of 48%.

We have stated that new products will be an important ingredient in our ability to take full advantage of the opportunity we have to leverage the great relationships we have developed with the more than 300,000 customers who own or have an active subscription for a SolarWinds product. We continue to believe that there are additional markets inside of IT operations where our model will give us a competitive advantage.

We have also discussed on numerous occasions our view that we are in a hybrid IT infrastructure world and that we have been focused on positioning SolarWinds as the only IT management company with the ability to comprehensively manage infrastructure and applications in any computing location, either separately or through an integrated set of products based on the needs of the individual technology pro. As you probably saw from our press release on April 11, we have continued our focus on and investment in creating a unique position for SolarWinds in the hybrid IT infrastructure market through the signing of a definitive agreement to acquire Samanage, an up-and-coming challenger in the IT service management market.

We've been studying the ITSM market for over 4 years, and in fact, have known the Samanage team for almost that entire period. We believe that a powerful market-leading ITSM solution offers us another compelling product to enhance our ability to serve IT professionals and organizations of all sizes while meaningfully expanding our total addressable market, including creating additional cross-sell opportunities within our large and expanding customer base.

We recently surveyed our THWACK community of over 150,000 registered users on the topic of ITSM. Of the respondents, 10% indicated that they are actively searching for and are planning to procure an ITSM solution within the next 12 months. However, they are struggling to find a product that meets their needs as the existing products in the market are either old and cumbersome or too complicated and expensive. We believe this illustrates that there is strong demand within our own customer base for an affordable, easy to try, deploy, use and maintain ITSM solution.

In our opinion, the Samanage Service Platform, also known as SSP, which we plan to launch at SolarWinds service desk shortly after the close of the acquisition, will meet this need and allow IT departments to improve the operations of their businesses. Based on assumptions regarding planned pricing for SolarWinds Service Desk, the number of customers we have and the size of those customers' IT departments, we estimate that there is an annual recurring ITSM cross-sell opportunity just within our own installed base of over $2 billion.

In addition, according to IDC, ITSM represents an over $6 billion annual market today and is forecasted to be an $8.5 billion market by 2023, growing at a CAGR of 9%. We believe that the ITSM market opportunity is potentially much larger than this estimate as historical ITSM products have not been able to be leveraged by the midmarket and small businesses given their high cost and level of complexity. ITSM is no longer the domain of just large enterprises. Businesses of all sizes increasingly depend on technology to achieve optimal levels of productivity and efficiency and drive business outcomes and success. Therefore, they need a product that allows them to successfully manage the process of IT at a level of cost and complexity they can handle.

Based on this, we believe ITSM continues to be a market which is still largely a greenfield opportunity. In fact, according to a recent Samanage survey, the great majority of IT departments still are using phone and e-mail as their main support channels.

In addition, in the recent SolarWinds survey of THWACK members, respondents indicated that over 75% of the time, cost and ease of use were the critical driving factors in the selection of an ITSM offering. This highlights the need for the SolarWinds approach in the ITSM market: powerful, affordable and easy to try, implement and use products designed to solve problems the way that IT Pros want them to be solved. As with many other areas of IT management that we support, there are very few software companies who are positioned to serve the entire market from small businesses to the Fortune 500 the way that SolarWinds and Samanage can and do.

Turning to a discussion of Samanage Service Platform, which is the key product we are getting from the combination with Samanage, SSP is a cloud-based, multi-tenant, ITIL-compliant service management product designed to be a one-stop shop for all services an IT organization might offer their business. SSP has the important features necessary to meet the service support needs within IT operations, including asset, incident, problem and change management on top of standard ticketing. SSP currently integrates with over 200 business applications, including Google Apps, Jira, Active Directory and Salesforce, allowing IT Pros to use SSP as a hub for getting more work done faster.

Overall, Samanage has worked to build and deliver a product that meets the needs of a wide range of IT environments, from the SMB to the large enterprise, in a range of IT environments with varying degrees of maturity, from those needing a cloud-based helpdesk tool to a full business-wide employee service management platform. In fact, SSP is currently being used by over 2,000 companies of all sizes to manage the process of IT.

We believe that the ITSM market has reached a level of maturity that it is now ripe for our disruptive approach. And with the great product that the Samanage team has developed supported by the power of the SolarWinds go-to-market engine, we believe we will have all of the pieces of the puzzle necessary to create meaningful market share in the ITSM market.

I will now briefly comment on a few of the key highlights from the first quarter of 2019. Mark will then expand on the discussion of our first quarter performance in his remarks.

We entered 2019 with solid momentum in the sale of our on-premise products, which are sold in a license and maintenance model. We continued that momentum in the first quarter, delivering year-over-year constant currency growth in license revenue of approximately 4%. This marks our fifth consecutive quarter of license revenue growth. We believe that this growth is driven by several factors, including the continued growth in spending on IT infrastructure deployed behind corporate firewalls and in private data centers, our growth and market share as we continue to take share from some of the large and legacy vendors in IT operations management and the increasing use of our on-premise deployed products to manage the performance of IT infrastructure and applications deployed in the public cloud. We believe these dynamics give us the ability to continue to deliver license revenue growth in the coming quarters.

We also continue to see very strong maintenance renewal rates for our on-premise product portfolio with the first quarter 2019 renewal rate coming in at an all-time high, which raised our trailing 12-month maintenance renewal rate to a robust 97%. As an additional bonus, we booked our first ever 8-figure maintenance renewal at the end of the first quarter, which demonstrates the unique power of our model. Who says that the SolarWinds go-to-market motion cannot result in large customer relationships?

Our subscription businesses performed well in the first quarter of 2019, delivering a strong net retention rate for the trailing 12-month period of 105%, strong new customer acquisition numbers with a continued increase in ASP of these new customers and an exit MRR rate at March 31 that was consistent with our outlook. Our digital marketing motion coupled with our high-velocity sales motion also paid dividends in the first quarter of 2019, resulting in our 13th consecutive quarter with new customer adds of over 6,000. We believe based on the large and expanding market opportunity in front of us that we can continue to add a meaningful number of new customers each quarter given our unique ability to successfully reach and profitably sell to organizations of all sizes.

We also did a good job of expanding our relationships with existing customers in the first quarter with a number of our customers spending more than $100,000 with us over the trailing 12-month period, increasing to over 760.

With that, I'll now turn the call over to Bart.

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J. Barton Kalsu, SolarWinds Corporation - Executive VP, CFO, CAO &Treasurer [4]

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Thanks, Kevin, and thanks again to everyone joining us on today's call. Before I begin my remarks, I want to provide a little context. First, our GAAP results for the first quarter are presented in detail in our first quarter press release. For comparability purposes, however, we will discuss the first quarter financial information on this call on a non-GAAP basis and will exclude adjustments required under ASC 606 as we provided our first quarter outlook under ASC 605.

The adjustments to revenue in the first quarter of 2019 required by ASC 606 totaled less than $200,000, and the only meaningful difference in expenses between the 2 accounting standards for us related to the capitalization and related amortization of sales commissions. The difference in expenses and adjusted EBITDA as a result of the adoption of ASC 606 in the first quarter was less than $2 million.

As Kevin indicated in his comments, we feel good about our start to 2019. Total revenue for the first quarter was $216 million, reflecting year-over-year growth of 9%. Foreign currency headwinds also had a higher-than-expected impact in the first quarter since the date we provided our outlook. If we use the foreign currency rates that we assumed in providing our first quarter outlook, total revenue for the first quarter would have been $216.6 million.

First quarter revenue growth was led by non-GAAP subscription revenue of $71.7 million, which grew 13% year-over-year, reflecting consistent growth within both our public cloud management and MSP product lines. On our last call, we talked about price increases within our MSP business. We rolled out the first of those increases late in the first quarter with very little noise from our customer base. And as a result of strong sales execution in the first quarter coupled with the impact of the price increases, we exited the quarter with monthly recurring revenue slightly above our expectations.

Our success at landing, expanding and retaining customers translated into a solid increase in monthly recurring revenue in the first quarter of 2019, and our average subscription net retention rate was consistent with 2018 at 105% for the trailing 12 months. We believe that the continued focus on high-quality new customer growth in MSP combined with planned price increases and strong net retention rates will result in an acceleration of subscription revenue growth throughout 2019.

Total non-GAAP license and maintenance revenue increased by 7% to $144.3 million in the first quarter. Our license and maintenance revenue growth resulted from the combination of very strong maintenance renewal rates and solid marketing and sales execution across each of our -- of the geographies in which we operate and led to our fifth consecutive quarter of license revenue growth.

For the first quarter, non-GAAP maintenance revenue was $106.5 million, which was a 9% increase over the prior year first quarter amount of $97.8 million. This was another quarter of sequential acceleration in our non-GAAP maintenance revenue growth rate, reflecting the impact on maintenance revenue from the growth we have seen in license revenue for the past 5 quarters as well as our continued strong renewal rate, which was 97% on a trailing 12-month basis. Our maintenance revenue growth highlights the power of our unique product and maintenance pricing model, whereby we defer and then recognize approximately 40% of the initial license revenue value as maintenance revenue over the first year of a customer's relationship with us. And even more importantly, we bill list price for maintenance renewals each year a customer renews their maintenance, which on average equals that same 40% of the license value.

We also had a very strong quarter of non-GAAP profitability in the first quarter of 2019. First quarter adjusted EBITDA was $103.6 million, representing an adjusted EBITDA margin of 48% and year-over-year growth of 9%.

It is probably a good time to remind everyone that approximately 35% of our revenue is from outside the United States so we have a meaningful level of exposure to changes in foreign currency rates on our revenues. However, at the EBITDA level, we are naturally hedged for over half of that foreign currency exposure as a result of the global distribution of both our revenue and expenses with almost 40% of our expenses being outside the United States. Our reported revenue results in the first quarter of 2019 as compared to the first quarter of 2018 were negatively impacted by the strengthening of the U.S. dollar against certain currencies, primarily the euro and British pound. Therefore, I am going to quickly provide a view of the year-over-year operational growth of our first quarter revenues on a constant currency basis.

On a constant currency basis, total revenue for the first quarter was approximately $221 million and grew by 11% year-over-year. Subscription revenue, which is our fastest-growing revenue stream was $74.3 million on a constant currency basis reflecting growth of 17%, which is 4 percentage points higher than growth on a reported basis. And finally, total license and maintenance revenue on a constant currency basis was $146.4 million in the quarter, which reflects 9% growth.

Now turning to cash flows for the first quarter. We continue to convert an extremely high percentage of our adjusted EBITDA into cash flow. First quarter 2019 unlevered free cash flow was approximately $81 million. Our unlevered free cash flow conversion rate is generally at its lowest level in the first quarter primarily due to annual bonus payments made only in the first quarter, which are related to prior year performance. These payments impact first quarter cash flow but have no impact on our current quarter expenses.

Our conversion rate in the first quarter of 2019 was 78%, which was consistent with prior year first quarters and with our expectations. Normalizing for the impact of the 2018 annual bonus payments made in the first quarter, our unlevered free cash conversion rate in the first quarter of 2019 would have been over 90%.

DSOs at March 31, 2019 were a bit higher than typical due to the 8-figure maintenance renewal we booked in the last week of the quarter, which caused a spike in our quarter-end accounts receivable balance. We expect this receivable to be collected before the end of the second quarter.

Turning to expenses. Non-GAAP expenses were approximately $116.6 million in the first quarter of 2019, which includes $17.7 million of non-GAAP cost of revenue and $98.9 million in non-GAAP operating expenses, which reflects an 8% increase -- year-over-year increase for the quarter. Other than the increase in general and administrative expenses in the first quarter, which grew by 13% year-over-year, with the amount of that increase in excess of revenue growth primarily driven by public company costs, the rest of our non-GAAP operating expenses grew at a rate slower than our reported revenue growth in the quarter, reflecting the operating leverage that we have in our model.

And finally, we ended the quarter with $434 million in cash. Our net leverage dropped to 3.7x trailing 12-month adjusted EBITDA at the end of the first quarter from 3.9x at December 31. Our first lien debt is currently at $1.97 billion and the interest rate is at LIBOR plus 2.75%. We are comfortable with our ability to service our existing debt at its current cost level while also growing our cash balance.

We expect to close our acquisition of Samanage later in the second quarter. The purchase price net of fees and cash acquired will be approximately $332 million. We plan to finance the acquisition primarily with cash off the balance sheet, and this will put our net leverage ratio at approximately 4.5x. We expect our organic operations based on our outlook to result in net leverage ratio in the range of 3.5x to 3.7x our 2019 adjusted EBITDA at the end of 2019, showing how quickly we are able to delever.

I will now walk you through our updated outlook for the full year and our outlook for the second quarter of 2019 before turning it over to Kevin for some final thoughts. Please note that the revenue, adjusted EBITDA and EPS outlook we are providing today will be based on ASC 606. We will continue to also provide our quarterly results under ASC 605 for the remainder of 2019 for comparison purposes to prior year.

However, we are shifting to providing our outlook on ASC 606 given our full adoption of ASC 606 from a systems and processes perspective, the acquisition of Samanage as well as the immaterial difference in revenue between the 2 standards. That said, we will make sure to describe how our outlook has been impacted by the move to ASC 606. To quickly make a point, our total revenue outlook for the full year is the exact same under ASC 606 as it is under ASC 605.

Okay. I'll walk you through our updated outlook for the full year, which includes a view of Samanage's contribution to our expectations before turning our outlook -- before turning to our outlook for the second quarter. Our outlook now assumes a euro to USD exchange rate of $1.12 versus our prior assumption of $1.14 and assumes that other key foreign currency exchange rates such as the British pound and Australian dollar are within their current trading ranges, which are slightly lower against the U.S. dollar than they were in February. We are raising our revenue outlook for the full year of 2019, despite the negative impact on our international revenues of the strength in the U.S. dollars as follows:

We now expect our full year 2019 non-GAAP total revenue to be $934 million to $949 million, representing growth of 12% to 13% over total non-GAAP revenue in 2018. This outlook includes an expected $11.5 million to $12.5 million of contribution to subscription revenue on a non-GAAP basis from the acquisition of Samanage, assuming we close the acquisition prior to the end of May. Adjusting our full year 2019 outlook using the same foreign currency rates that we experienced in 2018 results in 2019 constant currency growth of 13% to 15%. Note that our revenue outlook for Samanage is on a non-GAAP basis and excludes the purchase accounting-related reduction in Samanage's deferred revenue required by GAAP.

Excluding the impact of Samanage acquisition on our outlook, we expect our non-GAAP total revenue to be $922.5 million to $936.5 million, which is slightly higher than our prior outlook range of $921 million to $936 million, reflecting our first quarter performance and this despite our expectation of facing approximately $4 million of incremental FX headwinds since we gave our original outlook for 2019 in early February primarily due to the U.S. dollar's strengthening versus the euro, the British pound and the Australian dollar.

Total license and maintenance revenue growth is expected to be in the range of 6.4% to 8.1% on a reported basis, increasing to approximately 7.5% to 9.2% on a constant currency basis. Including the approximate $11.5 million to $12.5 million contribution from Samanage, non-GAAP subscription revenue growth is expected to be approximately 22.7% to 24.8% on a reported basis and approximately 24.7% to 26.9% on a constant currency basis.

Adjusted EBITDA is expected to be in the range of $446 million to $453 million, representing an estimated adjusted EBITDA margin of approximately 48%. Our outlook for adjusted EBITDA reflects an approximate $1.5 million increase to our original outlook for Q1 outperformance along with an approximately $5 million benefit from a reduction in recognized commissions expense associated with the adoption of ASC 606. Those increases to adjusted EBITDA are offset by the impact of our Samanage acquisition, which is expected to negatively impact adjusted EBITDA by $8 million to $10 million for the year.

Non-GAAP fully diluted earnings per share is expected to be in a range of $0.80 to $0.82 per share assuming an estimated 312.5 million diluted shares outstanding for 2019. Our EPS outlook reflects an assumed 21% non-GAAP tax rate.

Before I provide the details of our second quarter outlook, I also wanted to provide you with some incremental thoughts on how we are thinking about ITSM's contribution beyond this year. Given Samanage's traction in the market, strong cohort growth from their existing customer base and the cross-sell opportunities within our customer base, we expect ITSM to grow in the range of 35% in 2020 versus the annualized 2019 revenue for Samanage implied by our outlook.

Turning to our thoughts on the ITSM EBITDA contribution in 2020. We expect to continue to invest for growth in the ITSM market in 2020, while carefully but steadily improving the ITSM product line's efficiency and cost profile. For 2020, this means we expect to run ITSM product line at close to breakeven on a full year basis.

Now turning to our outlook for the second quarter. For the second quarter of 2019, we expect total revenue to be in the range of $224 million to $229 million, representing year-over-year growth of 10% to 13% on a reported basis or 12% to 15% on a constant currency basis. Total license and maintenance revenues for the second quarter are expected to grow by approximately 7% to 9% on a reported basis or 8% to 11% on a constant currency basis. Subscription revenue is expected to grow in the range of 18% to 21% on a reported basis or 21% to 24% on a constant currency basis.

Adjusted EBITDA is expected to be in the range of $107 million to $109 million for the second quarter, representing an adjusted EBITDA margin of approximately 48%. Non-GAAP fully diluted earnings per share is expected to be between $0.18 and $0.19 per share, assuming an estimated 311.5 million diluted shares outstanding for the full quarter.

Our outlook for the second quarter assumes a non-GAAP tax rate of 22%. And we expect to pay approximately $16.5 million in cash taxes during the second quarter of 2019, including an approximately $6 million in transition tax payments.

I will now quickly walk through the differences between the outlook under 606 and 605 for the second quarter and the full year. From a revenue perspective, there is no difference between our total revenue for 2019. However, the adoption of ASC 606 creates an approximately $1.5 million shift of revenue to license from maintenance for the full year. As I indicated earlier, full year EBITDA outlook under 605 would be approximately $5 million lower than our EBITDA outlook under 606 due to the impact of capitalization and amortization of sales commission expense under ASC 606.

And with that, I'll now turn the call back over to Kevin.

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [5]

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Thanks, Bart. As you can hear from our comments, we feel positive about our start to 2019 and believe that we are positioned to deliver strong performance for the full year. We expect to deliver a year with results that continue to comprise a unique combination of growth coupled with high profit and strong free cash flow generation while at the same time, investing in meaningful growth opportunities for the company. As a result, as Bart shared in his comments, we have raised our 2019 revenue outlook to total revenue of $934 million to $949 million, reflecting growth of 11.6% to 13.4% and on a constant currency basis, our forecasted annual growth rate increased to 13% to 15%. This increase in outlook reflects both the momentum we have seen in our existing business and the expected contribution to revenue from our new ITSM product line.

Consistent with the outlook we provided at the beginning of the year, we expect to see the momentum of our business accelerate sequentially each quarter as we move through the remainder of 2019. This acceleration will be reflected in our revenue growth, earnings, cash flow and cash flow conversion rates. As our business continues its move toward an even higher percentage of recurring revenue than the 83% of total revenue which we delivered in the first quarter, we expect the math of our model to drive this acceleration in a relatively predictable manner.

We believe that the ITSM business can become a meaningful contributor to long-term sustainable subscription revenue growth for us. As Bart indicated in his comments, we expect growth in 2020 compared to 2019 on an annualized basis for ITSM subscription revenue to be in the range of 35%.

Looking even further into the future, given the sheer size of the ITSM market opportunity and the large cross-sell opportunity inside of our own installed base, coupled with our disruptive go-to-market approach, we also believe that we will be able to maintain a high subscription revenue growth rate for our ITSM product line in the range of 30% for the next 4 to 5 years. And while there is some initial investment required to get the ITSM subscription revenue stream to scale and to bring the power of the SolarWinds model fully to bear on the ITSM market, which is reflected in our earnings outlook for 2019, we are forecasting that in the slightly longer term, this product line should be able to deliver EBITDA margins of over 40%, which is in line with our existing cloud-based MSP subscription offerings.

We're also focused on expanding the number of solutions we provide to our MSP customers to enable them to address the broad set of challenges they face as they manage the IT environments for the hundreds of thousands of small and midsize business customers which they serve. We are doing this by bringing additional products to market through organic development and strategic M&A that will expand the portfolio of products that our MSP customers can buy from us.

Over time, it is our goal to provide as much of the technology that small and midsize MSPs use to manage, monitor and secure their customers' IT environments as it logically makes sense for us to provide. In response to demand from our MSP customers, we have recently launched an integrated cloud to cloud backup solution for Office 365 and One Drive and plan to quickly add backup capabilities for additional cloud-based applications like SharePoint to provide protection to our MSPs and their customers for all of the key cloud-based applications on which they rely.

In addition, we are planning to launch an advanced endpoint protection offering before the end of the second quarter, which will allow our MSPs to move beyond just providing antivirus to their customers to providing protection against a broad range of attacks, including ransomware and 0-day attacks that all companies are facing in today's threat-laden IT infrastructure world. We have partnered with industry leader SentinelOne to be able to deliver SolarWinds endpoint protection in response to the MSP market.

New offerings such as these are intended to expand our market opportunity, both in the MSP market at large and even more importantly, within our existing MSP customer base. Done well, this strategy of addressing a broader set of challenges for MSPs should drive stronger, long-term cohort growth and improved net retention rates.

Our cash flow engine has continued to run at a high level. As Bart indicated in his comments, despite the approximately $332 million used for the Samanage acquisition, we are currently projecting to end 2019 at a lower net leverage ratio than the 3.9x ratio we had at the end of 2018. Our ability to convert earnings to cash at very high conversion rates provides us with a tremendous amount of flexibility to continue to delever while still making important investments in our business aimed at accelerating our growth and increasing our TAM.

And finally, to address the topic I'm sure is on many people's minds, we expect to continue to search for strategic M&A opportunities where we believe we could add technology that meets our criteria of being easy to try, easy to implement and use and easy to maintain in markets where we believe we can create competitive advantage through our go-to-market motion. Most of the deals we have done historically have been relatively small as we need modern products designed to solve real-world problems that are well understood by tech pros. However, we are also open to considering additional opportunities like Samanage where we can get a great product, great team and market momentum that we can build on.

We believe we have demonstrated our ability to successfully make acquisitions of all sizes and quickly implement the SolarWinds model, driving high volume and high profits in a relatively short period of time. And we plan to continue to follow this playbook.

With that, we'll open up the call for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Brad Zelnick from Credit Suisse.

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Brad Alan Zelnick, Crédit Suisse AG, Research Division - MD [2]

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We really appreciate the disclosures, especially bridging us back to 605 accounting for the full year. I want to try to sneak in 2, if I may. The first is the multiyear view that you've given us for greater than 30% growth in ITSM is pretty exciting. I think you said that was 3 to 4 years. What gives you the confidence to take that long of a view? And how much of that is displacement versus greenfield opportunities, taking the benefits of ITSM to customers that were never using a solution? And I've got a quick follow-up.

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [3]

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Okay. So I said 4 to 5 years, so even a little more bold than the 3 to 4. And if you guys hear rumbling, we're not doing this call from a train. We have a pretty strong set of thunderstorms rolling through Austin tonight. So don't worry, we're not on a train doing this call. So what gives us the confidence is a couple of things.

One, some of you may not remember but we actually have a product called Web Help Desk. So we've been in the help desk market now for a number of years, and so we've gotten a very good understanding of the dynamics of that market and of the need of different sizes of buyers. As I indicated, we've also been studying this market for over 4 years. We've been watching the Samanage team grow and be successful for almost that entire period of time. And so this isn't one of those things I woke up one morning and said, hey, let's go buy a company in the ITSM space. It's something we've been studying for a long time, which is what we normally do when we move into new markets.

And when we look at the market, I do believe there's a really large greenfield opportunity because so many of our customers that we talk to and so many of our community members that we survey are telling us they're actively looking for a solution. They're not using one today. And maybe they're using a really basic help desk product. They need something to really manage their operations much more effectively, but they really can't find a product that meets the requirements they have. Number one, it's got to be relatively low cost. Two, it's got to be easy to use and something they can implement quickly and it can show value immediately.

So based on the research we've done, the work we've done over the last 4 years, the size of the opportunity inside our own installed base, there's over $2 billion in total with over 10% of the customers we surveyed, which you could extrapolate to the population of our users actively looking for a solution right now, gives us a tremendous degree of confidence that we can accelerate the Samanage business. And it's been growing in that mid-30% range or faster ever since the company was founded. So they've got a really good track record of growth, and we're just going to put our go-to-market engine on top of it, which is obviously much more mature than our -- more mature than theirs and then really aim not only at our own installed base but also at those customers that are not customers of ours yet and make sure we're bringing them in also.

And so we've got a lot of confidence this product line will grow. It will grow fast. It will grow profitably. We're going to have to make a little bit of investment at first, but we've done this before where we've bought companies that were losing money and that were in a subscription revenue model. In a relatively short window of time, we get them to be very, very profitable and generating cash at a very high level. And we believe we'll be able to do this with Samanage also.

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Brad Alan Zelnick, Crédit Suisse AG, Research Division - MD [4]

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That's great context. And just with license growth decelerating to 2% year-on-year in Q1 off of what optically looked like a reasonable compare as we look at the model, how should we think about license growth through the remainder of the year? And has your visibility and predictability there changed at all?

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [5]

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So I think it's important to note, Brad, that on a constant currency basis, it grew by 4%. So we are facing a pretty big headwind compared to Q1 of 2018 from a currency perspective and 35% of our business is outside the U.S. And that's pretty consistent on the license side also. So the performance in this -- in the first quarter was pretty consistent with what we've seen, kind of 4% to 6% growth over the last 5 quarters. We think the demand in that market continues to be stable. We're continuing to take share in the market. We are, I think, doing a good job of increasing the size of our customers, not the size on the day we add them as a customer, we're doing a good job of increasing the growth rate.

As I indicated in my comments, we now have over 760 customers in the last 12 months who spent over $100,000 with us. Last quarter, that was a little over 725. So we're growing those relationships with our customers in a pretty predictable manner. So I feel good about our ability to continue to drive license revenue growth in that single-digit range that we've talked about for a number of quarters as we look into the future. So I think that the predictability is very good between when you look at kind of 3%, 4% growth, 5%, 6% growth, which has been the range we've been in. I think that's a place we believe we can stay.

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Operator [6]

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Your next question comes from the line of Kirk Materne from Evercore ISI.

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David Fenno Hoffman, Evercore ISI Institutional Equities, Research Division - Analyst [7]

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This is actually Fenn Hoffman on for Kirk. First, can you just expand a little bit on the opportunity for Samanage in your MSP segment? Is there a potential there for the MSPs to not only sell the Samanage product but also buy it in order to make their own operations more effective? Then I have a follow-up.

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [8]

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Yes, that's a good question. And the answer is there is. We have not sized that opportunity. I'm excited about it, but I didn't want to get you guys excited about it too quickly. I've been saying for a long time that I believe that the professional services automation market, which is one of the key pieces of technology that MSPs buy to manage their back office and manage the delivery of their services to their customers that that technology is old. I don't believe it works very well. I think they try to do everything for everyone, and as a result, those products do nothing very well. I think the companies that are in that space are not aggressive. They're not creative. They're not thinking about what MSPs really need to really run their business effectively. And I do believe that a great ITSM product integrated with our remote monitoring and management product is that solution. But that's going to require a little bit more work, a little bit more definition before we want to launch that product into that market. But it is something you should expect us to do. It's something our MSP customers should expect that we'll do over time, and it's something our MSP competitors should really worry about.

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David Fenno Hoffman, Evercore ISI Institutional Equities, Research Division - Analyst [9]

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Okay. Great. And then can you just talk about how the sales team in Germany is ramping? And any plans for continuing to strengthen the international go-to-market?

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [10]

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Yes. So we are working very hard to continue to make that a really robust and strong office for us. We've made good progress. We've got a good team in Germany that has bought into our mission and our motion. We're excited to have them on board. And we are now looking to add leadership to that location and then add resources that sell all of our products into Germany so we're not trying to sell into Germany from outside Germany.

Now we'll still do it over the phone like we do everywhere else in the world, but we'll do it with people that really understand that market. They're obviously native to Germany, native German speakers. And we think as we get that team built out, that it will allow us to accelerate growth in that country. And it is one of the areas of major focus for us in 2019.

We really have 2 areas of international expansion we're focused on. One is Germany. And the other is, for the first time ever, we're actually going to build an inside sales team this year in Japan because we've decided it's finally time to do a little bit of business in that market and we do almost none. I think that market is ready for us, not only on the core IT side where we're selling technology to customers who want to manage their own environment, but there's a big MSP market in Japan as well as Germany for that matter. In Germany, we're already doing a decent amount of business on the MSP side. We're not doing any business on the MSP side in Japan. So those are 2 big new markets for us. Don't expect tremendous revenue growth in 2019 above what we're already getting from Germany. But I think as you look at 2020 and beyond, those can be additional growth catalysts for us.

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Operator [11]

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And your next question comes from the line of John DiFucci from Jefferies.

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John Stephen DiFucci, Jefferies LLC, Research Division - Equity Analyst [12]

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My question, I think, is for Bart. Bart, that 8-figure maintenance renewal, I assume that's a multiyear deal. And if it is, can you tell us how many years it is? And is that a federal government deal? Because obviously, that's not a normal deal for SolarWinds. And I guess I'm trying to get like all this into one question. But since the long-term deferred revenue didn't really jump that much, I assume that's going to -- even if it was a multiyear deal, you just haven't billed it multiyear. So I assume that's going to benefit billings in the future.

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J. Barton Kalsu, SolarWinds Corporation - Executive VP, CFO, CAO &Treasurer [13]

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Yes, John, I can save you a lot of time. It's actually a single-year renewal. And it is with the federal government. It's a deal we've had that we've talked about before, but it's a single-year renewal.

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John Stephen DiFucci, Jefferies LLC, Research Division - Equity Analyst [14]

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That's great. So was that planned to come in this quarter? Or -- because I know sometimes federal government comes in at -- the end of their fiscal year is the September quarter, but sometimes it will slip a quarter here and there.

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J. Barton Kalsu, SolarWinds Corporation - Executive VP, CFO, CAO &Treasurer [15]

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That's right, yes. So the renewal was actually due at the end of March. You know how it is with the federal government. Sometimes their buying patterns can be a little unpredictable. But for us, it was a renewal that was due at the end of the first quarter and we actually got it at the end of the first quarter.

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Operator [16]

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Your next question comes from the line of Matthew Wells from Citi.

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Matthew Ryan Wells, Citigroup Inc, Research Division - Associate [17]

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So historically, has Samanage, the ITSM solution, been sold through MSPs? And what's the potential to sell the subscription product directly into kind of the small to midsize market?

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [18]

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Yes. So Samanage has a handful of MSP customers. It's not a market that they focus on. It's a -- the MSP market is one you really have to understand, be dedicated to, committed to and have built relationships in, in order to really be successful. So it's been a market where they've got a few customers who bought that solution over time which does tell us that it's relevant to MSPs, but they've not focused on it.

And absolutely, their solution, which is called SSP and we're going to rename it SolarWinds Service Desk because we're really creative that way. We name it SolarWinds and whatever it does with every product we bring to market so we don't have to think too hard. That product can absolutely be sold to organizations of all sizes. In fact, today, SSP has got over 2,000 customers that are using it. And those customers range from very, very small to very, very large. So it's one of our criteria when we look at a product.

We're not going to buy a product or a company where we don't believe that technology can be sold into the entire market. I think what we can bring is the power of our motion, the power of our digital marketing model, our 300,000 customers, our selling from the inside motion. And they sell from the inside also, but obviously, our motion is much more mature. We can bring that power to them and keep their growth rate, which has been very high, very high for a long period of time, is what we believe.

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Operator [19]

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Your next question comes from the line of Sanjit Singh from Morgan Stanley.

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Hamza Fodderwala, Morgan Stanley, Research Division - Research Associate [20]

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This is Hamza Fodderwala in for Sanjit Singh. A couple of questions from me. I'm wondering if I could get any color on what the cloud contribution was in Q1. And from a product standpoint, what drove growth most in that cloud segment?

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [21]

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Yes. So as we've indicated, we're not planning to break the revenue streams out. So I can't tell you what the amount of the revenue was. But what I can say is that we continue to be excited about the opportunity in cloud. In fact, we're seeing more interest and uptake from our on-premise customers who use the product, our license and maintenance product, in those cloud products. We're actually working on some new packaging and pricing to make those products even more compelling and easier to buy and use for our on-premise customers with the products they already own from us. So that opportunity is expanding and growing, and we are working now very actively on attacking it even more aggressively than we have because we really haven't attacked that opportunity yet. We've really been focused on making sure the technology is ready for that, on building the sales motion, the marketing motion. And so we continue to be excited about the portfolio of products.

I said before, I think log management is a really big, today, opportunity for us in cloud management because people -- technology pros, DevOps pros, IT Pros are using log management today. They've been capturing logs for a lot of years. They're just -- they couldn't get all the value they needed to get from them. Splunk has showed us the value that exists in logs but they left so much of the market unable to consume their product. So that's where I've got the highest level of excitement. But I also have a lot of excitement ultimately around application management, particularly as it relates to bringing that capability to our existing on-premise customers who are being faced with managing environments that are more and more hybrid in nature.

So I think those will ultimately be the 2 products that will be the drivers of the biggest part of the growth for us in the cloud portfolio. However, the rest of the portfolio, we think, is important. Those products are all growing also, and they're running at a decent level of profitability and that profitability is increasing. So we continue to be excited about that opportunity and continue to focus on it. So it's building. It will continue to build, as I have indicated. It's one of those revenue streams for us. I think the growth will accelerate as we move forward, not going to decelerate. We haven't seen our best years, I guess, is the way to put in cloud management.

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Hamza Fodderwala, Morgan Stanley, Research Division - Research Associate [22]

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That's helpful. And then a follow-up question perhaps for Bart. I appreciate the color at the top of the call on FX. But I'm just wondering why the Q1 revenue came in a bit below the high end of the guidance range despite the very strong underlying metrics it seems, obviously, the maintenance renewal rates being at a record high and strong customer adds. So just wondering if there's anything offsetting that in Q1, and that's it for me.

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [23]

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Yes. This is Kevin. I'll answer it and then Bart can add a little bit, too. I think the Q1 revenue came in right in the middle of the range we provided. I think the only thing in the quarter that wasn't different at all from the way we built our outlook as I mentioned, things really -- the quarter pretty much unfolded the way we thought it would, is our MRR build which was really strong in the quarter, and we actually exited the quarter particularly on the MSP side with a little more MRR growth than we expected to exit the quarter with. It just came a little bit later in the quarter.

So we got a little bit less revenue from it. But you can tell by our outlook, excluding Samanage, that we're actually -- effectively raised our outlook for the year because we have $4 million of ForEx currency headwind that we didn't have when we gave you our original outlook in January. We actually raised our outlook by $1.5 million and we're covering that $4 million headwind. So effectively inside that outlook, there's about a $5.5 million raise because the quarter really did go the way we thought it would in terms of the amount of revenue and MRR and ARR that we built.

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Operator [24]

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Your next question comes from the line of Terry Tillman from SunTrust.

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Terrell Frederick Tillman, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [25]

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Gentlemen, can you hear me okay?

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [26]

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Yes, yes, we can hear you.

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Terrell Frederick Tillman, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [27]

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All right. Well, maybe I should try some German. Guten Tag. Hopefully, I sounded okay. So my question...

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [28]

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You sounded great. Anything sounds good in a foreign language when you're from Oklahoma.

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Terrell Frederick Tillman, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [29]

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Yes, I hear you. I'm from Kentucky, so again -- yes. So in terms of like the MSP business, it's a 2-part question as it relates to -- could you remind us again the magnitude of kind of what you were thinking about on price increases? And maybe this is for Bart. How do we think then about the ramp of the benefit of the price increases through the rest of the year and then maybe even extending into next year?

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J. Barton Kalsu, SolarWinds Corporation - Executive VP, CFO, CAO &Treasurer [30]

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So yes, like Kevin just talked about, the fact that the price increases that we rolled out in the first quarter were definitely later in the quarter, but we exited the quarter with a really good MRR rate, which gives us a lot of confidence going into the rest of the year. And the price increases that we have, Terry, are really built into the back half of the year as well. So we'll have price increases, but they're really more geared towards the back half of the year as opposed to in Q2.

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [31]

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Yes, we really only rolled out the first part of the price increases, kind of the smallest piece in the first quarter. There are other price increases coming late in the second quarter. And those -- the price increases range from kind of 3% to 10%, depending on the product that the customer has purchased and depending on what pricing model they bought under. So there's a lot of different pricing models in our MSP offering. So it's not any one percentage that we can tie things to.

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Operator [32]

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And your next question comes from the line of Raimo Lenschow from Barclays.

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Mohit Gogia, Barclays Bank PLC, Research Division - Research Analyst [33]

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It's Mohit Gogia on for Raimo. I wanted to drill in a bit on the $2 billion cross-sell opportunity that you have mentioned in the ITSM product line. So just wondering if you can give us more color as to how do you think the cross-sell -- that cross-sell will evolve in terms of both the sales motion and also sort of like the -- any integration work that needs to be done with your core Orion platform. So just wondering if you can give us some more color there.

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [34]

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Yes. So look, the way the cross-sell motion is going to work is very similar to the way we cross-sell our other products today. We have, as you guys know, a pretty broad product portfolio that solves a lot of different problems for a technology pro, and we cross-sell as part of our motion every single day. So our expectation is that we will arm our installed base sales team with knowledge of this product, the ability to sell, and we also will create an inside -- an installed base sales team focused on selling into our customers who will just cross-sell this product into that customer base. We also have a dedicated customer marketing motion, and we will start doing messaging after this acquisition closes, out of which we expect, as we said, prior to the end of May to start getting the customers aware that we have the product.

I also indicated in response to one of the other questions, we actually have -- we have a large number of customers that are using our Web Help Desk product. And as those customers get larger, they will outgrow that product in some cases. So we also will take advantage of that opportunity to instead of having them leave us, which is what they would have done in the past, move to the ITSM product. The other thing, important thing to know is ASP of that ITSM product will be less than $10,000, we believe, just like the ASPs of our other products. So it fits right squarely in the middle of our sales motion, of our cross-sell and attach motion. So we really don't have to change anything. We can just do what we've been doing successfully for the last 10 years.

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Operator [35]

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And your final question comes from the line of Erik Suppiger from JMP Securities.

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Michael H. Berg, JMP Securities LLC, Research Division - Research Analyst [36]

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It's Michael Berg on for Erik Suppiger. Quick question. I know you're not guiding for fiscal '20 yet, but given the acquisition of Samanage and your commentary around how you expect it to be eventually profitable, can we still expect a 30 basis point increase in adjusted EBITDA margin looking to 2020? Or how can I think about that moving forward?

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Kevin B. Thompson, SolarWinds Corporation - President, CEO & Director [37]

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Yes. I think that you can continue to think about our long-term margins the way we have been describing them, which is we believe we can get kind of 25 to 30 bps of improvement in EBITDA margin as we move through each year. And we have the ability to do more than that if we decided that that was the right thing to do. But we've committed to that and we remain committed to that. For the next 4 to 5 years, I think you can assume that we'll not change that -- our commitment to that.

Thanks, everyone, for joining us on the call, and we look forward to seeing you guys at different conferences in the future. Thanks.

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Operator [38]

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This concludes today's conference call. You may now disconnect.