SolarWinds Corporation (NYSE:SWI) Q4 2022 Earnings Call Transcript

SolarWinds Corporation (NYSE:SWI) Q4 2022 Earnings Call Transcript February 9, 2023

Operator: Good morning, and welcome to the SolarWinds Fourth Quarter 2022 Earnings Call. All participants are in a listen-only mode. As a reminder, this conference call is being recorded. I would now like to turn the call over to Tim Karaca, Group Vice President of Finance. Thank you. Please go ahead, sir.

Tim Karaca : Thank you. Good morning, everyone, and welcome to the SolarWinds fourth quarter 2022 earnings call. With me today is Sudhakar Ramakrishna, our President and CEO; and Bart Kalsu, our CFO. Following the 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. On our Investor Relations website, 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 evolution to subscription first mentality and the timing of the phases of fashion evolution, the impact of the global economic and geopolitical environment on our business and our gross level of debt.

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. As a reminder, the financial results presented on this call reflect SolarWinds as a stand-alone business, and do not include any contribution from the N-able business we spun-off in July 2021. Furthermore, 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 discussed on today’s call is available in our earnings press release and summary slide deck on the Investor Relations page of our website. As a reminder, beginning with the first quarter of 2022, we no longer adjust our revenue for the impact of purchase accounting. For the fourth quarter of 2022, non-GAAP total revenue is equivalent to our GAAP total revenue. Finally, we note that financial results discussed on today’s call and in our earnings release are preliminary and pending final review by our external auditors and us and will be only be final once we file our annual report on Form 10-K. With that, I will now turn the call over to Sudhakar.

Sudhakar Ramakrishna: Thank you, Tim. Good morning, everyone, and thank you for joining us today. As always, I’d like to thank our employees, customers, partners and shareholders for their ongoing commitment to SolarWinds. Looking back at 2022, I’m incredibly proud that our team delivered top-line growth in a challenging macro environment. We believe these results are a testament to our business model resiliency, the value we provide to our customers and the entire SolarWinds team’s confidence, commitment and attitude. We had several highlights in the fourth quarter, including strong subscription revenue growth in line with our subscription-first strategy; continued execution on customer retention, demonstrating the value proposition of our solutions; growing traction with our observability solutions representing the superior value that we believe we deliver to customers; continued innovation in our service management, ITSM and database product lines, representing an increasingly diverse portfolio participating in growing markets; healthy cash flow generation and adjusted EBITDA margins, reflecting our commitment to our expense and operating discipline; delevering our balance sheet, which Bart will discuss further; and continued progress with our partners and global system integrators as we extend our reach to customers through our partners in a scalable and cost-effective manner.

I will now touch on some of these before turning it over to Bart for more color on the quarter and our financial outlook for Q1 2023 and the full year 2023. In Q4 2022, we delivered total revenues of $187 million, above the high end of the range we provided and a slight increase year-over-year. On a constant currency basis, we delivered 2% year-over-year growth. I’m excited to report that in Q4, our in-quarter maintenance renewal rate was 92%, and our trailing 12-month renewal rates are now at 93%. Both of these metrics were negatively impacted by currency headwinds. But even with that, I’m happy to report our strong execution. I attribute these results to the commitment of our team, the relevancy of our solutions, the resiliency of our business model and the trust that our customers place in us.

We continue to make significant progress with our subscription-first strategy and delivered fourth quarter subscription revenue growth of 45% year-over-year. As I’ve said before, I consider our evolution to subscription, not just as a business model change, but as a way of delivering greater value to customers. While shifting to this strategy has resulted in some total revenue headwinds, we continue to believe it is the right way to deliver customer value and focus on growing annual recurring revenues to over $1 billion in the coming years. We believe the conversion from maintenance to subscription; lay the foundation for even more predictable revenue and the opportunity to expand our lifetime value with customers. We ended the fourth quarter of 2022 with 889 customers who have spent more than $100,000 with us in the last 12 months, an increase of 7% over the comparable period in the previous years.

We’re increasingly helping our customers reduce tools strong, achieve comprehensive visibility across multi-cloud environments, eliminate alert fatigue and accelerate their digital transformation, all while improving their productivity. Doing so has enabled us to win larger deals. Adjusted EBITDA was $74.5 million, representing an adjusted EBITDA margin of 40%, which is above the 38% to 39% outlook we gave for the quarter. Now, I’d like to take a step back and reflect on what we accomplished in 2022 and how this sets us up for 2023. 2022 was a transformational year for SolarWinds as we accelerated our progress on the SolarWinds’ platform and reached significant milestones in observability, service management and database monitoring. Simultaneously, we expanded our customer reach via our Transform Partner Program, critical GSI relationships and the ongoing evolution of our internal teams.

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I believe these vital foundations help us to be the vendor of choice to help customers accelerate their digital transformations in an increasingly multi-cloud world and to deliver the best time to value, time to detect issues and time to remediate them with simple AI-powered solutions. We are increasingly helping customers eliminate tools trawl, significantly reduce alert fatigue, improve productivity and reduce costs. In 2022, we evolved from a monitoring vendor to an observability solutions provider. We launched key new solutions last year. Our Hybrid Cloud Observability and cloud-native SolarWinds observability solutions. We introduced our Hybrid Cloud Observability solution in April and have since launched enhanced detection capabilities powered by artificial intelligence and machine learning.

We believe our Hybrid Cloud Observability solution is the only true hybrid solution that allows customers to migrate from on-premises to SaaS at their own pace. We are seeing a healthy traction with Hybrid Cloud Observability and a long runway for growth. We believe that customers appreciate the simplicity of packaging and pricing along with the future richness of Hybrid Cloud Observability. We followed our Hybrid Cloud Observability launch with our cloud-native SolarWinds observability solutions in October, available on Azure and AWS clouds. As we evolve the SolarWinds’ platform, we aim to deliver observability solutions across network, infrastructure, systems, applications, databases, digital experiences and log monitoring in one platform across private and public clouds with single pane of glass visibility.

While it is early days, we are excited about SolarWinds’ observability’s ability to support every customer regardless of where they are in their cloud journey with the flexibility to deploy on our private cloud, public cloud or as a service. Our observability solutions have already earned multiple industry awards and recognitions in recent months. As we look to 2023, we believe IT environment will continue to grow in complexity and budgets will remain constrained. Customers will value solutions that improve their productivity and lower their costs. I believe our products and services offerings are ideally suited to address these challenges with our compelling observability, service management and database solutions. It’s also my belief by establishing all our ongoing innovations on the SolarWinds’ platform, we can deliver even greater simplicity to our customers while creating the ability to expand the lifetime value of our customer relationships.

With that, we invite you to hear more about our solutions at our upcoming virtual SolarWinds Day on Wednesday, February 15. During the event, industry experts and customers will share practical advice on solving today’s IT problems. We are also showcasing new AI-powered observability capabilities using a real-world customer use cases. Lastly, our channel partners are vital in helping customers accelerate their digital transformation with our solutions. Recall that in October, we announced the launch of our SolarWinds Transform Program, representing our enhanced focus on channel growth and development across distribution, global system integrators, managed service providers and cloud partners. As an example of our progress, during the quarter, we announced an expanded partnership with DRYiCE, a division of HCL Software.

HCL Software powers millions of apps at over 20,000 organizations, including over half of the Fortune 1000 and Global 2000 companies. We believe the expanded partnership will focus on bringing together the best-in-class advanced AI ops, end-to-end observability and service management platforms from both companies. Now, I want to take a moment to address the macro environment. As we all know, 2022 was a challenging year for the technology industry and the broader community. Although we generally continue to see healthy demand and commitments from our customers, we are cognizant of the headwinds being across €“ experienced across the IT spending industry while focusing on our strategy and what we can control. And while we are not immune, we believe our highly cost-effective solution, compelling time to value proposition, diversified customer base across sizes and industries and high-velocity transaction model enable us to operate successfully through challenging macro environment.

This is reflected in our Q4 results, including our consistently strong customer retention as demonstrated by our strong renewal rates and our ability to deliver year-over-year revenue growth in 2022. As I’ve said many times, our ability to deliver revenue growth and generate healthy cash flow while remaining focused on profitability is a solid testament to the resiliency of our business model and stickiness of our solutions particularly during challenging periods. We are and always have been focused on capital allocation, disciplined expense management and driving operational efficiencies across all aspects of our business while focusing on growth and our broader subscription transition. Given the uncertain macro outlook for 2023, we made further optimizations to our expense structure last month as part of our ongoing focus on improving operating margins.

Looking ahead, we will continue to monitor the environment closely and we plan to hire selectively while seeking to improve profitability in 2023. We’ve worked hard to build a sturdy business model and are unwavering in our belief in our strategy, market and ability to execute. With that, I will turn it over to Bart to expand on our financial performance and provide a Q1 and full year outlook. Bart?

Bart Kalsu: Thanks, Sudhakar and thanks again for joining us today. I want to remind everyone of our 2022 strategic focus on growing with a subscription-first mentality. With this, it is essential to emphasize that our subscription transition will be multifaceted. The first phase of the evolution entails selling subscriptions for our existing on-premises products and our Hybrid Cloud Observability product. The second phase of the transition began with the recent launch of SolarWinds Observability, our SaaS solution. We believe that these two models of subscription growth will persist in our business and our overall focus is to grow subscription ARR, while exercising operating discipline. These efforts, when combined with our other subscription products have resulted in a subscription business with close to $175 million of ARR, and our fourth quarter results reflect our ongoing progress with this transition and another quarter of solid execution.

Turning to the numbers. We finished the fourth quarter with total revenue of $187 million, which is a slight increase compared to the prior year and above the total revenue range of outlook we provided of $178 million to $183 million. On a full year basis for 2022, revenue finished at $719 million, which was slightly higher than the prior year and well above the total revenue range of the outlook we provided of $710 million to $715 million in our Q3 earnings release. Like other companies with foreign currency exposure, we felt the impact of the decrease in the value of the euro compared to the U.S. dollar. On a constant currency basis, our fourth quarter total revenue would have been approximately $191 million, which is an increase of 2% year-over-year.

On a full year basis for 2022, constant currency revenue would have been approximately $733 million, which is also a 2% growth compared to the prior year. We ended the fourth quarter with total ARR of $636 million, also up 2% year-over-year. And on a constant currency basis, our total ARR would have increased over 3% versus the prior year. Beginning in Q4, we revised the methodology used to calculate total ARR. We now exclude the impact of price increases enacted during the maintenance contract renewal and only recognize the price increase impact to ARR upon the renewal of the maintenance contract. While this change does not have a material impact to ARR given our high renewal rates, we felt €“ this was a change that would bring our definition more in line with others in the industry.

We recalculated prior year total ARR to conform to the revised methodology, which is reflected in the year-over-year growth rates. Our subscription ARR as of December 31 was $175 million, which is an increase of 30% year-over-year. This growth is mainly due to the execution of our subscription-first strategy and the conversion of a portion of our maintenance base to the Hybrid Cloud Observability solution. Digging into the revenue details, our fourth quarter subscription revenue was $50 million, up 45% year-over-year, with full year subscription revenue of $168 million, up 35% year-over-year. Our subscription revenue growth reflects the ongoing success of our subscription-first efforts. The transition to a subscription-first strategy creates headwinds in the current quarter’s total revenue.

However, we believe that an increasing percentage of new deals made on a subscription basis will result in higher recurring revenue in the future. Maintenance revenue was $115 million in the fourth quarter, which is a decrease of 3% from the prior year and $459 million in 2022, which is a decrease of 4% from the prior year. As we have discussed recently, our maintenance revenue has been impacted by the conversion of a portion of our maintenance customers to subscription and the lower euro to U.S. dollar conversion rate in 2022 compared to the prior year. Our maintenance renewal rate is 93% on a trailing 12-month basis and 92% in-quarter renewal rate for the fourth quarter. These rates are consistent with our historical performance and currency headwinds impact both.

The return in 2022 to our historical renewal rates is a testament to the loyalty of our customer base and our focused customer retention and expansion efforts. Note that as we convert maintenance customers to subscription arrangements, we exclude those customers from the renewal rate calculation. For the fourth quarter, license revenue was $22 million, representing a decline of approximately 34% compared to the fourth quarter of 2021 and $93 million in 2022, which is a decrease of 19% from the prior year. Remember that our new perpetual license sales performance will continue to be impacted by our subscription-first focus. As noted previously, our increased subscription sales offset the decline in license revenue in the quarter. We finished the fourth quarter of 2022 with 889 customers who have spent more than $100,000 with us in the last 12 months, which is another quarter of improvement over the previous year.

I’m pleased to report that we delivered another quarter of strong non-GAAP profitability. Fourth quarter adjusted EBITDA was $74.5 million, representing an adjusted EBITDA margin of 40%, which is above the 38% to 39% outlook we gave for the quarter. On a full year basis, adjusted EBITDA was $280 million, representing an adjusted EBITDA margin of 39%, which is in line with the outlook we gave for the year. Excluded from adjusted EBITDA in the fourth quarter, our onetime cost of approximately $5.9 million of litigation and governmental investigation costs and other professional fees related to the December cyber incident. We expect onetime cyber incident- related costs to fluctuate in future quarters, and these onetime cyber costs are difficult to predict.

Turning to our balance sheet. Net leverage at December 31 was approximately 3.9 times our trailing 12 months adjusted EBITDA. Our cash and cash equivalents and short-term investment balance was $149 million at the end of the fourth quarter, bringing our net debt to approximately $1.1 billion. In November, we refinanced our debt and extended the maturity date from February of 2024 to February 2027. In connection with the refinancing, we made a voluntary prepayment of approximately $350 million, which was in addition to the voluntary prepayment of $300 million that we made in September. We are also pleased that S&P Global Ratings upgraded our corporate credit rating from B to B+. We continue to seek to bring down the leverage further with adjusted EBITDA expansion and plan to evaluate opportunities for further debt payments in the coming quarters.

I will now walk you through our outlook before turning it over to Sudhakar for some final thoughts. I will start with our first quarter guidance and then discuss our outlook for the full year. In formulating guidance, we are optimistic that the momentum behind our expanded product portfolio and enhanced go-to-market strategy, in addition to our strong installed base and customer retention, will allow us to grow our top-line in Q1 and the full year. That said, we are mindful of the macro headwinds, which affects all areas of IT spending and have carefully taken into account FX and the impact of our subscription-first business model, transitioning and providing our outlook. Importantly, we’ve increased our focus on our expense optimization efforts and are committed to improving our already strong profitability profile in 2023.

For the first quarter, we expect total revenue to be in the range of $177 million to $182 million, representing a 1% year-over-year growth at the midpoint. Adjusted EBITDA for the first quarter is expected to be approximately $67 million €“ $67 million to $70 million. Non-GAAP fully diluted earnings per share are projected to be $0.15 to $0.17 per share assuming an estimated 163.9 million fully diluted shares outstanding. And finally, our outlook for the first quarter assumes a non-GAAP tax rate of 26%, and we expect to pay approximately $6.8 million in cash taxes during the first quarter. For the full year, we expect total revenue to be in the range of $725 million to $740 million, representing 2% year-over-year growth at the midpoint. Adjusted EBITDA for the year is expected to be approximately $290 million to $300 million, representing a 5% year-over-year growth at the midpoint.

As you will notice, we are now providing adjusted EBITDA guidance in lieu of the previously provided adjusted EBITDA margin aligned with our commitment to deliver EBITDA growth on a dollar basis in 2023. While we continue to manage our expenses prudently, we remain focused on our product road map, robust core execution and subscription-first strategy. We have made meaningful investments in our product portfolio and go-to-market strategy and believe that these investments are starting to pay dividends. We will continue to make selective investments to support our product innovation while prioritizing our commitment to improving efficiency and profitability. Non-GAAP fully diluted earnings per share is projected to be $0.69 to $0.74 per share, assuming an estimated 165.9 million fully diluted shares outstanding.

Our full year and first quarter guidance assumes a euro to dollar exchange rate of 1.05 to 1. With that, I’ll turn the call back over to Sudhakar for his closing remarks.

Sudhakar Ramakrishna: Thank you, Bart. The midpoint of the outlook Bart provided represents year-over-year growth, which reflects our continued belief in the relevance of our solutions, the execution ability of our teams and most critically, the trust, our customers and partners place in us. I’m very pleased with the momentum building for our new innovations, and I’m confident as ever in the long-term trajectory of our business. We continue to maintain the economic conditions in a disciplined manner and make progress across several growth vectors. As we look to 2023, I’d like to reiterate three key near-term priorities for us. First, we have a robust renewal business with over 90% renewal rates. We remain very focused on customer retention and expansion efforts as we have been for the past 18 months.

Second, we continue to aggressively seek to drive subscription adoption across our businesses. While this has resulted and will likely continue to result in some variability in our reported revenue, the accelerated shift to subscription is consistent with how our customers want to consume our products and a key to our long-term strategy to achieve $1 billion in ARR at mid-40s adjusted EBITDA margins in the coming years. We believe the increasing subscription base also provides an even more solid foundation for our revenue and margin expansion efforts. And third, we continue to exercise expense discipline in a challenging macro environment. As we begin 2023, we expect to continue to look for opportunities to invest selectively, managed excesses in a disciplined manner and improve our operating margins.

We have an experienced management team that has led companies through many economic cycles, and we have demonstrated consistent discipline with operational efficiencies while appropriately targeting our investments in attractive growth markets. We believe our resilient business model should allow us to deliver continued healthy levels of growth and profitability. And as you heard from Bart, we are focused on margin expansion and guiding to $290 million to $300 million of adjusted EBITDA for 2023. I’ll conclude again by thanking our employees, partners, customers and shareholders for their commitment to SolarWinds. Bart and I will now be happy to address your questions.

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Q&A Session

Operator: Our first question comes from Matt Hedberg from RBC Capital Markets. Please go ahead. Your line is open.

Matt Hedberg: Great. Thanks guys for the questions. Sudhakar, for you. One of the things that a lot of us are talking about a lot of investors and end users are this whole idea of cloud optimization. With your increased focus on observability, could you talk about maybe how your SME customers are thinking about cloud optimization. Is that impacting spend? Or maybe just a little bit of color on that would be helpful.

Sudhakar Ramakrishna: Absolutely. As I’m sure you have seen more broadly, there is definitely somewhat of a deceleration in cloud spend across public clouds. And here’s where our hybrid cloud solutions have come in really handy because the way we designed the solutions was not force a particular deployment approach on the customer. And instead give them a way where they can choose to deploy wholesale in the cloud, salmon the premises and extend it. So what that has allowed us to do is essentially pace their investments alongside their ability for them to evolve to the cloud. So that’s come in really handy because as is truly a hybrid solution. Now in terms of cloud spend and overall observability itself, as part of our SolarWinds’ platform, we are also able to evolve it such that they can keep an eye on how the infrastructure spending is going in the context of infrastructure observability and optimization.

But that’s more of a future thing. The more immediate benefit that customers get is leveraging of the Hybrid Cloud Observability, which has seen some really good traction in this environment.

Matt Hedberg: Got it. Thanks. And then Bart, you guys had good results €“ 4Q results relative to your guide and expectations. Can you talk €“ and I don’t think you necessarily commented on linearity though. Can you talk about I mean you guys have such an expansive view of a large customer base. How the quarter progressed? Obviously, it’s back-end loaded, but maybe just spending patterns through the end of December and what you’ve seen through January?

Bart Kalsu: So yes, I mean what I’d tell you, Matt, is that the fourth quarter for us is always our biggest quarter on the commercial side of that business. And obviously, that happened again this year. From a linearity perspective, the good thing is that our business model doesn’t have the typical hockey stick. We have bookings progression throughout the quarter, and that held up this year just like it has in the past as well. So all in all, it was a strong quarter for us from a revenue standpoint and from a booking standpoint, definitely compared to what the guide is that we gave back in the third quarter. So, what I would tell you is that for us, we’re continuing to see improvement across the board. You saw that in our results from €“ as they trended throughout the year. And for us, from a seasonality standpoint, 2022 was just like every other year, we saw improved performance as we move throughout the year.

Matt Hedberg: Got it. Thank you.

Operator: Our next question comes from Erik Suppiger from JMP Securities. Please go ahead. Your line is open.

Erik Suppiger: Yes. Thanks for taking the question. Hey first off, what should we be modeling for interest expense given the restructured debt? And then secondly, can you expand a little bit in terms of how we should be modeling for your cost reductions? Can you comment a little bit about what kind of further changes you’ve made? And how we should be thinking of OpEx growth from 2022 into 2023?

Tim Karaca: Erik, sure. Thanks for the question. I’ll take this one. As it comes to interest expense, all model around $110 million of cash interest expense, and this is in line with how we refinance the debt and our base of financing. And also, we have noncash interest expense, as you may expect, as the debt post to par, and we expect that to be, call it, around $8 million to $10 million. But that’s the high-level interest expense assumption. As it comes to expense optimizations to Bart’s and Sudhakar’s points, we will continue to be very prudent as it comes to our investments and be very selective. And we’ll make sure we are making the right investments at the right places where we are expecting the highest return. So as we go through 2023, you may expect to see that same trend of expense management and prudence.

And we will observe expenses very closely and just make sure we are making the right trade-offs with focusing, expanding our margin as well as EBITDA dollar.

Erik Suppiger: Okay, thank you.

Operator: Our next question comes from Patrick Schulz from Baird. Please go ahead. Your line is open.

Patrick Schulz: Hey guys. Yes. Thanks for taking my questions. Just with the two observability solutions launched during 2022, it sounds like initial customer success has been pretty positive. Are you able to provide any customer stats around the success? And what’s embedded for expectations in 2023? Then maybe just any color you can ride on what types of conversations you’re having with customers?