SolarWinds Corporation (NYSE:SWI) Q3 2023 Earnings Call Transcript

SolarWinds Corporation (NYSE:SWI) Q3 2023 Earnings Call Transcript November 2, 2023

SolarWinds Corporation beats earnings expectations. Reported EPS is $0.23, expectations were $0.19.

Operator: Good morning. My name is Jeanie, and I will be your conference operator today. At this time, I would like to welcome everyone to the SolarWinds Third Quarter 2023 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]. Thank you. Tim Karaca, Group Vice President of Finance, you may begin your conference.

Tim Karaca: Thank you. Good morning, everyone, and welcome to the SolarWinds third quarter 2023 earnings call. With me today are Sudhakar Ramakrishna, our President and CEO; and Bart Kalsu, our CFO. Following our prepared remarks, we will have a question-and-answer session. This call is being simultaneously webcast on our Investor Relations website at investors.solarwinds.com. You can also find our earnings press release and a summary slide deck, which is intended to supplement our prepared remarks during today's call. Please remember that certain statements made during this call are forward-looking statements, including those concerning our financial outlook, our market opportunities, our expectations regarding customer retention, our continued evolution to a subscription-first mentality and the timing of the phases of such evolution, our expectations regarding our partner ecosystem, the SEC enforcement action, the impact of the global economic and geopolitical environment on our business and our growth level of debt.

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These statements are based on currently available information and assumptions, and we undertake no duty to update this information except as required by law. These statements are subject to a number of risks and uncertainties, including the numerous risks and uncertainties highlighted in today's earnings release and our filings with the SEC. Copies are available from the SEC on our Investor Relations website. We will discuss various non-GAAP financial measures on today's call. Unless otherwise specified, when we refer to financial measures, we will be referring to non-GAAP financial measures. A reconciliation of the differences between GAAP and non-GAAP financial measures and the definition of other financial metrics discussed on today's call are available in our earnings press release and summary slide deck on the Investor Relations page of our website.

Finally, we note that financial results discussed on today's call and in our earnings release are preliminary, and pending final review by us and our external auditors and will only be final once we file our quarterly report on Form 10-Q. With that, I will now turn the call over to Sudhakar.

Sudhakar Ramakrishna: Thank you, Tim, and good morning, everyone. Thank you for joining us today. As always, I would like to thank our employees, customers, partners and shareholders for their ongoing commitment to SolarWinds. We delivered another strong quarter, once again beating our guidance across our key metrics, demonstrating the compelling value we deliver to customers and the strength of our business model. I am especially pleased with our team's execution across many aspects of our business, resulting in top-line growth, while driving adjusted EBITDA that exceeded the high-end of our guidance range, all in an uncertain macro environment. Third quarter results include strong subscription revenue and ARR growth, demonstrating the positive effects of our subscription-first strategy, growing revenue and adoption from our observability solutions, coupled with continued product innovation, growth in the sales of our service management and database monitoring offerings, continued strong customer retention, demonstrating our focused execution as well as the value proposition of our solutions and double-digit year-over-year adjusted EBITDA growth, along with increased margins, highlighting the operating leverage in our business and our commitment to expense management and operating discipline.

I will now touch some of these highlights before turning the call over to Bart for more color on the quarter and our financial outlook for the balance of the year. In Q3 2023, we delivered total revenues of a $190 million, above the high range we provided, representing 6% growth year-over-year and our highest quarterly revenue growth since the first quarter of 2020. We continue to see the benefits of our subscription-first transformation and delivered third quarter subscription revenue growth of 39% and subscription ARR growth of 34%. This evolution to subscription is not only contributing to our overall improved financial performance and revenue predictability with more than 92% of recurring revenue, but we believe it enables us to deliver greater value to customers.

In the third quarter, our in-quarter maintenance renewal rate was 96% and our trailing 12 month maintenance renewal rate is now 95%, up from 94% last quarter and 91% in the prior year. This increase is another reflection of the value of our solutions to our customers. We ended the third quarter of 2023 with 955 customers, who have spent more than a $100,000 with us in the last 12 months, an increase of 8% over the comparable period in the previous year. These results are indicative of our focus on helping our customers to reduce tool sprawl, reduce alert fatigue and reduce costs, while improving productivity. We delivered an adjusted EBITDA of $85 million, representing an adjusted EBITDA margin of 45%, and a 21% increase year-over-year, driven by revenue growth and maintaining investment and expense discipline.

Our adjusted EBITDA margins are the highest quarterly results since the fourth quarter of 2020 for both adjusted EBITDA and adjusted EBITDA margin. The results testify to our progress towards continued robust growth and operating discipline. Now turning to some business highlights from this quarter, I want to share updates on our product portfolio and partner ecosystem and the broad industry recognition we have received. Our product and engineering team continue to deliver capabilities rapidly on our SolarWinds Platform and recently delivered network and infrastructure availability to give customers a SaaS option in addition to our self-hosted Hybrid Cloud Observability. Our solutions try to deliver the best time to value, time to detect, and time to remediate issues in our customers' multi-cloud environments.

Our Hybrid Cloud Observability solution continues to gain widespread customer adoption, as it helps customers to reduce tool sprawl, reduce alert fatigue through AIOps services, achieve deployment flexibility and prepare for a hybrid multi-cloud world. Central to our Hybrid Cloud Observability strategy is the ability to support and interoperate with a wide range of assets inherent in heterogeneous environments. And in Q3, we added significant capabilities to support modern SD-WAN solutions. We believe the combination of Hybrid Cloud Observability and SolarWinds Observability provides the most comprehensive AI-powered full stack observability solution in the industry across networks, infrastructure, applications and databases. As I have described in previous calls, we intend to make the SolarWinds Platform the foundation for all future innovation.

Additionally, at our SolarWinds Day: The Virtual Summit in September, we announced new product enhancements to our Service Management and Database Observability solutions. Our new Enterprise Service Management solution extends the value of our service management capabilities beyond IT teams, allowing enterprises to improve the management, efficiency, interactions and user experience across any department of their organization. With our new solution, customers who currently rely on disparate and disconnected tools across departments to manage workflows and service requests can greatly improve response time and employee experience. We also announced an upgraded version of our comprehensive Database Performance Monitoring and DataOps solution, SQL Sentry.

The extension aims to significantly enhance our customers' ability to identify and prevent database performance issues, avoid outages and enjoy the most out of their databases while lowering risk. Turning to our partner ecosystem, we announced updates to our Transform Partner Program in August. Designed to accelerate growth and revenue for our partners, these updates provide greater flexibility for our partners to achieve their targets, new opportunities for channel offering improvements and specialized options for database and ITSM products. As you've heard me discuss in recent quarters, our partners and global system integrators are an increasingly important element of our go-to-market motion that can help us expand our reach to customers in a scalable, efficient, and cost-effective manner.

Lastly, I'm pleased that we have earned multiple product and industry awards this quarter, including the SolarWinds Next-Generation Build System won the 2023 Cloud Security Award for the best security infrastructure in enterprise. SolarWinds won the Gold Global Award as Most Innovative Company of the Year in the cloud SaaS category. SolarWinds Observability won the 2023 Cloud SaaS Award for Best SaaS Product for IT Management. In closing, we had another strong quarter and we are making excellent progress against the priorities we laid out for 2023. First, we continue to seek to drive subscription adoptions across our business, which is seen in our strong subscription revenue and ARR gross results. We believe this is consistent with how our customers want to consume our products and that an increase in our subscription base provides an even more solid foundation for our revenue and margin expansion efforts.

Second, we continue to exercise expense discipline in a challenging macro environment by investing selectively while managing costs and improving our operating margins as reflected in our 21% adjusted EBITDA year-over-year growth in Q3. Third, we remain very focused on customer retention and expansion efforts as evidenced by our improved renewal rates. And fourth, we continue to innovate on our SolarWinds Platform organically and with our expanding ecosystem to bring even greater value to our customers. While there is much work left to do, we believe we are in a great position to achieve what we had hoped to accomplish this fiscal year and enter 2024 with strong momentum. We believe IT environments continue to grow in complexity while budgets remain constrained and therefore customers value solutions that improve productivity and lower costs.

I believe our comprehensive observability, service management, and database products and services are ideally suited to address these growing challenges and we are becoming an even more relevant to our customers' current and future needs. Our Q3 results reflect our increasing relevance to our customers. With that, I will turn it over to Bart to expand on our financial performance, and provide a full year outlook. Bart?

Bart Kalsu: Thanks, Sudhakar. Our subscription-first strategy continues to make solid progress. As you know, historically, we sold on-premises licenses and maintenance to our customers. The first phase of our subscription transformation involves converting our existing maintenance base to subscription via our self-hosted Hybrid Cloud Observability product. We are now seeing a bigger shift in new sales to our subscription offerings driven by our observability solution and our database and service desk products. The second phase began with the launch of SolarWinds Observability, our SaaS solution. So whether we sell Hybrid Cloud Observability or SolarWinds Observability, we believe this lays the foundation for even more predictable recurring revenue and the opportunity to expand the lifetime value with customers.

We've seen great progress with this transformation, and we believe we are in a position to continue our momentum through the fourth quarter. It is worth noting that our third quarter performance puts us back in the position of being a rule of 50 company. We believe that with our focus on investment and operating discipline and a broadly diversified portfolio of solutions participating in growing markets, we can be a rule of 50 company on a sustained basis. Turning to the numbers. We finished the third quarter with total revenue of $190 million, a 6% increase compared to the prior year and above the total revenue range of outlook we provided of $182 million to $186 million. You'll notice that a meaningful shift in our revenue mix, which reflects our subscription transformation.

We continue to have a larger percentage of our new sales as subscription products. We ended the third quarter with total ARR of $668 million, up 8% year over year. Our subscription ARR as of September 30th was $213 million, an increase of 34% year over year. This growth is primarily due to the execution of our subscription first strategy, the continued conversion of a portion of our maintenance base to the Hybrid Cloud Observability solution and growth in our database and service desk subscription products. Digging into the revenue details, our third quarter subscription revenue was $59 million, up 39% year over year. Our subscription revenue growth reflects the ongoing success of our subscription-first efforts. We continue to convert maintenance customers at a higher than 1:1 ratio as they see the value of our observability products and the need to manage their hybrid IT environments.

In addition, a higher percentage of our new deals are being sold as subscription arrangements. Subscription revenue was also positively impacted by multi-year arrangements in the third quarter. Maintenance revenue was $116 million in the third quarter, an increase of 2% from the prior year. The increase is attributed to our high renewal rates and the higher than normal price increase we implemented at the start of the year. As previously discussed, our maintenance revenue has been impacted by converting a portion of our maintenance customers to subscriptions and by selling a larger percentage of new sales as subscription products, in line with our subscription-first strategy. Our maintenance renewal rate is 95% on a trailing 12 month basis and was 96% for the third quarter.

The trailing 12 month rate was the highest rate since the fourth quarter of 2019. We believe this testifies to the loyalty of our customer base, the value of our solutions, and our focus on customer retention and expansion efforts. Note that as we convert maintenance customers to subscription arrangements, we exclude those customers from our renewal rate calculation. As a result of the growth in subscription revenue and strong maintenance renewal rates, we now have 92% of our total revenue as recurring revenue. For the third quarter, license revenue was $14 million, representing a decline of approximately 37%, compared to the third quarter of 2022. Remember that, with our increased efforts on subscription transformation, we expect new perpetual license sales performance will continue to be negatively impacted.

This is by design and the increased subscription sales continue to more than offset the decline in license revenue. We finished the third quarter of 2023 with 955 customers, who have spent more than $100,000 with us in the last 12 months, which is another quarter of year-over-year improvement over the third quarter of 2022 as well as a sequential increase over the second quarter of this year. I am pleased to report that we delivered another quarter of strong non-GAAP profitability. Third quarter adjusted EBITDA was $85 million, growing 21% year-over-year, representing an adjusted EBITDA margin of 45% and coming in $8.5 million above the high-end of the outlook we gave for the quarter. Excluded from adjusted EBITDA in the third quarter are one-time expenses of approximately $2.9 million related to December's cyber incident, net of insurance reimbursements.

We continue to expect one-time cyber incident related costs to fluctuate and increase in future quarters related to the litigation with the SEC. As we discussed in our earnings call in May, we are focused on our capital allocation, disciplined expense management, and driving operational efficiencies across our business, while focusing on growth and our broader subscription transition. Given the uncertain macro outlook for 2023, we optimized our expense structure as part of our ongoing focus on improving operating margins in the first half of the year. During 2023, these optimizations resulted in $20 million of restructuring charges, primarily associated with $14 million of lease impairments for certain office locations and costs related to headcount reductions.

Looking ahead, we will continue to monitor the environment closely, and we plan to hire selectively and continue to manage our costs in a disciplined manner. Turning to our balance sheet. We have made significant progress reducing our net leverage ratio which at September 30th was approximately 3.2x our trailing 12 months adjusted EBITDA. This compares to 3.9x at the end of last year. We have significantly improved our leverage position in 2023 through improved performance and our ability to convert non-GAAP profitability to cash flow. As communicated before, we will continue to execute our plans to get below 3x net leverage. Our cash and cash equivalents and short-term investments balance was $235 million at the end of the third quarter, bringing our net debt to approximately $1 billion.

I will now walk you through our outlook before turning it over to Sudhakar for final thoughts. I will start with our fourth quarter guidance and then discuss what that means for the full year. Given the performance we have seen to date, we continue to believe that we will be able to grow our top-line in 2023, driven by our expanded product portfolio and ongoing improvements in execution, as well as our strong customer renewal and retention rates. We believe the diversity of our customer base across sizes and industries, and our focus on attractive growth markets should allow us to weather challenging economic conditions. Our outlook carefully takes into account macroeconomic conditions and the impact of our subscription-first business model transition.

We remain focused on our strategy, and what we can control and are committed to continuing to improve our profitability profile in 2023. For the fourth quarter, we expect total revenue to be in a range of $188.5 million to $192.5 million, representing a 2% year-over-year growth at the mid-point. Adjusted EBITDA Adjusted EBITDA for the fourth quarter is expected to be approximately $80.5 million to $82.5 million, representing 9% year-over-year growth at the midpoint. Non-GAAP fully diluted earnings per share are projected to be $0.20 to $0.22 per share, assuming an estimated 167.4 million fully diluted shares outstanding. Finally, our outlook for the fourth quarter assumes a non-GAAP tax rate of 26%, and we expect to pay approximately 8 million in cash taxes during the fourth quarter.

For the full year, we are again raising our guidance and expect total revenue to be in the range of $749 million to $753 million, representing 4% year-over-year growth at the midpoint. This compares to the previously issued guidance of $740 million to $748 million and the initial range of $725 million to $740 million at the start of the year. We are again raising our full year adjusted EBITDA guidance to be between $322 million and $324 million, representing a 15% year-over-year growth at the midpoint. This is compared to the previously provided guidance for the full year of $308 million to $313 million. We continue to make selective investments, consistent with our priorities and remain very committed to improving efficiency and profitability.

We remain focused on top line growth as we have made meaningful investments in our product portfolio and go-to-market strategies. We believe these investments are starting to pay dividends. Non-GAAP fully diluted earnings per share is projected to be $0.83 to $0.85 per share, assuming an estimated 166.4 million fully diluted shares outstanding. And finally, our full year and fourth quarter guidance assumes a euro to dollar exchange rate of 1.06 to 1. With that, I'll return the call to Sudhakar for his closing remarks.

Sudhakar Ramakrishna: Thank you, Bart. I'm very pleased with the team's progress as evidenced by another strong quarterly performance on both revenue and adjusted EBITDA. Although, our focus today is on the strength of our third quarter results and the progress we have made as a business. I want to spend a few moments talking about the recently announced civil enforcement action brought by the SEC related to the sunburst attack. We find the SEC's allegations very disappointing and believe they're inconsistent with the facts. As difficult as the attack was, we are very proud of how our employees responded and their tireless engagement with our public and private sector customers, partners, and other stakeholders. Through our Secure by Design efforts, we have endeavored to set a new standard in secure software development and infrastructure security, and our approach has received broad recognition in the security and IT industries.

We'll continue to be outspoken advocates and promoters of public-private partnerships to prompt and respond to cyberattacks. I believe this is the only way to improve cybersecurity for public and private entities. We are concerned that the SEC's actions will stand the progress we have made as an industry. Through all this, and most importantly, we deeply appreciate our customers' recognition of the circumstances of the sunburst attack and the opportunity to enjoy greater relevance with them, as evidenced by our growth and retention rates. We are working hard and making significant progress in our initiatives to deliver ongoing compelling value to customers via a subscription-first mindset, build solutions to deliver the best time to value, the best time to detect issues and the best time to remediate issues in their multi-cloud environment by a simple, powerful and secure solution, and to expand our margins even as we deliver top line growth and evolve to a more predictable subscription revenues.

The macro environment continues to present challenges to the broader software industry. Even so, I'm confident our strategy, portfolio and customer success focus will appeal to customers across all geographies and across all verticals. We continue to exercise expense discipline, invest selectively and strive to deliver revenue growth and expanding margin. We are increasing our guidance for 2023 across total revenue and adjusted EBITDA as you heard from Bart on the heels of a strong Q3 and first half 2023 performance. In fact, a revised low end of the outlook for the year is about the previously indicated high end of our guidance ranges on both total revenue and adjusted EBITDA. Again, I thank our employees, partners, customers, and shareholders for their commitment to SolarWinds.

Bart and I are now happy to address your questions.

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