SolarWinds Corporation

Ladies and gentlemen, thank you for standing by and welcome to the SolarWinds third quarter 2020 earnings conference call. At this time, all participants are in a listen only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star one in your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star zero. I would now like to hand the comments over to your speaker today, Howard Knox, Senior Director of Investor Relations. Thank you. Please go ahead.

Thank you, Operator. Good afternoon, everyone, and welcome to SolarWinds' third quarter 2020 earnings call. With me today are Kevin Thompson, our President and CEO, Mark Kaltu, EVP and Chief Financial Officer, and John Paliuca, EVP and President of RMSP Business. Following prepared remarks, we'll have a brief question and answer session. This call is being simultaneously webcast on our industrial relations website at investors.solarwinds.com. On our industrial 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, the impact of the global economic environment on our business, and the updates of the potential spinoff of our MSA business. 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 also subject to a number of risks and uncertainties, including the numerous risks related to the potential spinoff of our MSP business into a newly created and separately traded public company. Additional information concerning these statements and the risks and uncertainties associated with them is highlighted in today's earnings release and in our filings with the SEC. Copies are available from the SEC or on our investor relations website. Furthermore, we will discuss various non-GAAP financial measures on today's call. Unless otherwise specified, when we refer to these financial measures, we will be referring to non-GAAP financial measures. Reconciliation of differences between GAAP and non-GAAP financial measures discussed on today's call are available in our earnings press release and summary slide deck on the investor relations page of our website. And with that, I'll now turn the call over to Kevin. Thanks, Howard. I'm pleased to report that we were able to deliver strong performance in the third quarter, exceeding the high end of our outlook for total revenue and EBITDA, in addition to delivering solid year-over-year top-line growth of 8% in the face of what has continued to be a volatile and uncertain economic environment. Total non-gap revenue for the third quarter, which was driven by improved sales to new customers over the second quarter and solid customer retention rate, was approximately $261 million. we delivered an exceptional quarter of profitability, generating approximately $133 million in adjusted EBITDA, meaningfully exceeding the height of our outlook and reflecting a 51% adjusted EBITDA margin, which is the highest level of non-GAAP profitability we have delivered in the last 11 quarters. As we saw in the second quarter, the volatility of the economic environment has resulted in a business rhythm that is less linear than our historical average. However, we did see signs of improvement in linearity and in stabilization of performance in the third quarter across selected geographies and areas of the market as compared to the second quarter. From a geographic region perspective in the third quarter, we saw the most meaningful improvement in performance in EMEA, followed by North America. We had several operational highlights in the third quarter that I want to briefly mention. First, as you should remember, in late April, we launched subscription pricing options for each of the key offerings in our Orion family of network systems and database management products. And we had a good initial quarter of subscription sales of these products in the second quarter. The momentum continued into the third quarter with a sequential doubling of the dollar amount of subscriptions sold of these products. We currently believe we will see another strong quarter of sequential growth in subscription sales of the Orion product family in the fourth quarter. Second, we were able to drive solid ARR growth in the third quarter, with total ARR reaching approximately $887 million as of September 30, 2020, reflecting year-over-year growth of 11%. Subscription ARR grew at a meaningfully faster rate of 20%, reaching $411 million at the end of the quarter. Third, we continue to see solid growth in the number of our large customer relationships, despite the difficult economic environment. This is illustrated by the number of customers who spent over $100,000 with us on a TradeLink 12-month basis, increasing on a year-over-year basis by 17% to 1,004 customers. And finally, customer retention rates across our product portfolio have remained strong, with maintenance renewal rates of 92% for the third quarter and subscription net retention rates stable at 105%. The last item we'll cover before turning the call over to Bart is of a more strategic nature related to our database management product portfolio. As I have indicated on several occasions over the last year, we believe that database management and operations is a large market opportunity for SolarWinds. This opportunity is being driven by digital transformation and the move to hybrid cloud infrastructures and the recognition by database administrators as well as DevOps pros of the need for greater visibility or observability into the performance of the critical applications upon which the business relies. In order to get a complete view of application performance, visibility in the database performance is required. We moved into the database management market in 2013 and have created a meaningful presence in this market for SolarWinds during the last seven years. Over the last year, we've been investing in broadening our capabilities to monitor and manage the performance of databases of all types, including the historical Oracle, Microsoft SQL, and MySQL traditional databases, as well as the newer databases such as MongoDB, Cassandra, Redis, and Microsoft Azure SQL, to name a few. This increased investment in database management started with the acquisition of Divi Cortex in December 2019, a leading cloud-based provider of database performance management technology, which brought us the ability to manage many of the cloud-native databases, which we manage today, as well as the ability to provide these management services from the cloud. As I assume most of you saw, on last Friday after market closed, we announced that we have continued to build on these capabilities through the planned acquisition of Century One, a leading technology provider of database performance monitoring and data operation solutions for Microsoft SQL Server, Microsoft Azure SQL, and the Microsoft Data Platform for a cash purchase price of approximately $142 million. The Century One offerings complement and broaden the on-premise, native cloud, and hybrid database management offerings that we currently have and are a great fit with our product portfolio. I want to take this opportunity to welcome the Century One team to the SolarWinds family. We're excited about the expertise that you bring to this fast-growth part of our business. We believe after this acquisition closes, which is expected to occur this week, we will provide the broadest and deepest level of database monitoring and management coverage in the on-premise, hybrid IT, in native cloud infrastructure and application management markets. With that, I will turn the call over to Bart, who will provide some additional details on our third quarter performance, as well as our outlook for the fourth quarter and full year. Thanks, Kevin, and thanks again to everyone joining us on today's call. The third quarter was solid across our key performance metrics, given the volatility of the current economic environment, and reflected a sequential improvement from the second quarter. The combination of our uniquely high level of profitability and focus on conversion of adjusted EBITDA to free cash flow continues to pay dividends in the third quarter as our total cash balance reached $425 million at September 30th as compared to $173 million at December 31st, reflecting an increase of over $250 million. Our net leverage has consistently declined over the first nine months of 2020 and is now at 3.1 times our trailing 12 months adjusted EBITDA. Moving on to our financial results, we had a very strong quarter of profitability, as Kevin said, in the third quarter. Adjusted EBITDA was $132.7 million, reflecting year-over-year growth of 15%, and was nearly $11 million better than the high end of our outlook for the third quarter. The sequential increase of approximately three percentage points of adjusted EBITDA margin from the second quarter and six percentage points compared to the first quarter was driven by continued disciplined expense management across our global business, lower than planned variable sales and marketing expenses, lower headcount numbers than planned as a result of a slowdown in hiring due to the pandemic, and strong cash collection activity, which resulted in minimal bad debt expense. We do not expect adjusted EBITDA margins to remain at quite this high of a level in the fourth quarter as we are planning to reaccelerate our go-to-market spending and hiring across the business as economic activity improves. We drove approximately $108 million in unlevered free cash flow in the third quarter, which puts our unlevered free cash flow for the nine months ended September 30th at $312 million and reflects a year-to-date conversion rate of 86%. Our conversion rate declined sequentially compared to the second quarter, primarily as a result of U.S. federal income tax payments totaling $24 million, which were made in the third quarter. Earnings per share on a non-GAAP basis for the third quarter totaled 28 cents per share, based on 316.7 million fully diluted shares outstanding. Switching over to revenue for the quarter, total non-GAAP revenue was $261.3 million, which was an increase of 8% compared to the prior year, and above the outlook that we provided for the third quarter of 254 to $259 million of total non-GAAP revenue. Total non-GAAP license and maintenance revenue in the third quarter grew by 2% year-over-year, reaching $160.4 million on a reported basis. This growth was led by non-GAAP maintenance revenue, which increased by approximately 7%, reaching $121.1 million. Non-GAAP license revenue in the third quarter totaled $39.3 million, reflecting a year-over-year decrease of approximately 10%. Our license sales performance was a meaningful improvement from the second quarter. When you adjust for the subscription sales of our on-premise base products, license revenue would have been down only 5% on a year-over-year basis for the third quarter. We expect the economic environment in the fourth quarter to be similar to that in the third quarter, and as a result, we do continue to expect some year-over-year decline in license revenue in the fourth quarter. In addition, Orion's product portfolio subscription sales are expected to be a headwind to license revenue growth of approximately 4% in the fourth quarter. During the third quarter, 85% of our total revenue was recurring and recognized as either maintenance or subscription revenue. Total non-GAAP recurring revenue for the third quarter grew at 12%, reaching $222 million. Third quarter recurring revenue growth was led by non-GAAP subscription revenue of $101 million, which grew 18% year-over-year and was approximately $100 million on a constant currency basis, reflecting year-over-year growth of 17%. As we have communicated in the past, well over 50% of our subscription revenue is attributable to our MSP business. As we explore the potential spinoff of this business, we want to give John Paliuca, who has led our MSP business over the last four and a half years, and who would assume the CEO role of the standalone entity if the spinoff is completed, an opportunity to give more context around the 2020 operating trend of our MSP business. I will now turn the call over to John. Thanks, Mark. I'll spend the next few minutes discussing our Q3 year-to-date performance and key trends in the industry. I believe most of the research analysts and investors on this call are familiar with our MSP business. For those listeners who are less familiar, our MSP business refers to our technology platform and purely software-based solution that we provide to MSPs. MSPs, or managed service providers, are a critical type of IT service provider that assume responsibility for managing and protecting the customer's IT system and services. and in many cases act as outsourced IT departments for millions of businesses around the world.

These MSPs use our technology to manage the IT environments of over 500,000 small and medium-sized businesses in all parts of the world, monitoring, managing, and securing their customers' devices and applications, as well as managing disparate end-user environments through our centralized dashboard. But by nature of our business, we operate behind the scenes of our MSP partners. And as part of a larger SolarWinds parent, we've thrived under relative obscurity to those outside of the MSP market. We currently expect our MSP business to generate slightly over $300 million of non-GAAP revenue in 2020, about half of which is outside of the U.S.