Earnings Transcript for SWI - Q2 Fiscal Year 2023

Operator: Good morning and welcome to the SolarWinds Second Quarter 2023 Earnings Call. My name is Breanna and I will be your conference operator today. Please note that this call is being recorded. [Operator Instructions]. I will now turn the call over to Tim Karaca, Group President of Finance. You may begin your conference.

Tim Karaca: Good morning, everyone, and welcome to the SolarWinds second 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 evolution to a subscription-first mentality and the timing of the phases of such evolution, our expectations regarding our partner ecosystem, the impact of the global economic and geopolitical environment on our business and our growth 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. 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 as well as 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. 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. We had another strong quarter building off the momentum we saw at the end of 2022 and into Q1 and positioning us well as we look to the second half of the year. I attribute the results to our broad portfolio of solutions, the compelling value we deliver to customers, the resiliency of our business model, and our continued execution of our priorities. Second quarter highlights include strong subscription revenue and ARR growth, demonstrating the compounding positive effects of our subscription-first strategy; growing contribution from our observability solutions, in addition to growth in our service management and database monitoring product lines; continued solid customer retention, demonstrating the value proposition and stickiness 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 and operating discipline. I'll now touch on some of these before turning it over to Bart for more color on the quarter and our financial outlook for Q3 and the full year 2023. In Q2 2023, we delivered total revenues of $185 million above the high-end of the guidance range we provided and representing a 5% increase year-over-year. We're seeing the benefits of our subscription-first transformation and delivered second quarter subscription revenue growth of 44% and subscription ARR growth of 33%. As I've said before, our evolution to subscription is not just a business model change, but a way of delivering greater value to customers. Now that we are over a year into this transformation, we continue to see the benefits of this evolution. In Q2, our end quarter maintenance renewal rate was 93%, and our trailing 12-month renewal rate is now 94%. The trailing 12-month rate continues to be the highest since Q4 of 2019, showing continued improvement and reflecting the value of our solutions. We ended the second quarter of 2023 with 933 customers who have spent more than a $100,000 with us in the last 12 months, an increase of 6% over the comparable period in the previous year. We are increasingly helping customers accelerate business transformation initiatives while improving productivity. In doing so, our customers continue to grow with us. Adjusted EBITDA grew 18% year-over-year to $79.1 million, representing an adjusted EBITDA margin of 43%, and about the $69.5 million to $72.5 million outlook we gave for the quarter. Turning to some business highlights this quarter, I want to focus on a topic I'm sure is on many of your minds. Artificial intelligence or AI, and the highlight, some recent industry recognitions, our SolarWinds Day

Bart Kalsu : Thanks, Sudhakar. We embarked on our subscription-first strategy in 2021. Historically, we sold on-premises licenses and maintenance to our customers. An important phase in our subscription transformation involves converting existing maintenance relationships to our Hybrid Cloud Observability product, which offers a continuum to customers to adopt SaaS solutions as their business needs dictate. We started pushing hard on this strategy in the second half of last year and continue to build momentum on these conversions in 2023, coupled with new subscription sales. The second phase began with the launch of SolarWinds observability, our SaaS solution. So whether we sell Hybrid Cloud Observability, which is an on-premises subscription or SolarWinds observability, which is the SaaS version of the product, we believe this lays the foundation for even more recurring and predictable revenue and the opportunity to expand our lifetime value with customers. We now have 92% of our total revenue as recurring revenue. Turning to the numbers, we finished the second quarter with total revenue of $185 million, which is a 5% increase compared to the prior year and above the total revenue range of outlook we provided of $177 million to $182 million. You'll notice a meaningful shift in our revenue mix, which reflects our subscription transformation. We continue to have a larger percentage of our sales as subscription products. We ended the second quarter with total ARR of $657 million, up 6% year-over-year. Our subscription ARR as of June 30th was $198 million, which is an increase of 33% year-over-year. This growth is mainly due to the execution of our subscription-first strategy and the continued conversion of a portion of our maintenance base to the Hybrid Cloud Observability solution. Digging into the revenue details, our second quarter subscription revenue was $53 million, up 44% year-over-year. Our subscription revenue growth reflects the ongoing success of our subscription-first efforts. We are also seeing the results of converting a portion of our maintenance base to the Hybrid Cloud Observability product. We continue to convert maintenance customers at a higher than 1

Sudhakar Ramakrishna: Thank you, Bart. I'm very excited about our team's progress, as evidenced by another strong quarterly performance on both revenue and adjusted EBITDA. Following the transformational changes we made across our organization and product portfolio in 2022, we believe we are emerging as a much stronger player. We're making significant progress in our initiatives to deliver compelling ongoing value to customers via our subscription-first mindset; solutions built to deliver the best time to value, best time to detect issues, and best time to remediate issues in their multi-cloud environments via simple, powerful and secure solutions; expanding 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 that our strategy, portfolio and customer success orientation will appeal to customers across all geographies and verticals. We will continue to exercise expense discipline, invest selectively and strive to deliver revenue growth and expanding margins. We are increasing our guidance for 2023 across total revenue and adjusted EBITDA, as you heard from Bart, on the heels of a strong Q2 and first half 2023 performance. In fact, our revised low end of outlook for the year is at or above 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.

Operator: [Operator Instructions] Your first question comes from Sanjit Singh with Morgan Stanley.

Sanjit Singh: Thank you for taking the questions, and nice to see you guys reasserting the historical renewal rates and the guidance coming up. It's definitely nice to see. I had a couple questions on the macro environment. In your script, you guys are pointing to what seems like continued challenges in the spend environment. As you compare Q2 versus Q1, did the environment sort of -- was it more and more of the same? Did things sort of tick down or did you see any sort of improvement with respect to new business?

Sudhakar Ramakrishna: Sanjit, thanks for the question. Between Q1 and Q2, for the most part, I would say, the macro environment has been similar. What I can say about our business is that the business and the demand, as I've indicated previously, is robust. In fact, the pipeline that we all measure continues to improve. And as I've stated previously, the only variability that we see in this broader macro environment is some of the larger deals take a little longer to close. However, the diversity and the breadth of our business is what gives us the foundation for the strong performance because we have a large number of mid-market customers. We have the larger customers. So we participate in a broad spectrum of the customer base resulting in the solid foundation that we are building.

Sanjit Singh : If I take that comment on the execution and the economic backdrop you guys are operating in, if I looked at the a 100K customer cohort this quarter, that did decline, I think by a 12 quarter-on-quarter. What sort of the factors associated with such a decline in the 100K customer cohort?

Sudhakar Ramakrishna: Absolutely. I'll highlight a couple of factors that will be fairly straightforward to digest. One is, Sanjit, as we convert more and more customers to the subscription arrangements, what you'll notice is that the size of the subscription deals tend to be a little smaller than the perpetual deals, especially in the first year. So that is one factor that is contributing to it. As you pointed out, it's a fairly small number. The other point I would highlight is, while it has gone down from the previous quarter, it is still 6% up from last year. So that's another way to think about that. We continue to be largely a mid-market customer, as a mid-market vendor as I've highlighted previously from a strategic standpoint. But we've been going upmarket with our GSI partners and channel partners. So some of the deals tend to be lumpy, especially the larger ones, but the overall trend is very positive for us.

Operator: Your next question comes from Rob Oliver with Baird.

Rob Oliver: Sudhakar, just first for you. In your prepared remarks, you talked a little bit about some of the products getting traction, the subscription, database management, ITSM and observability. I was wondering if you could give us a little bit more color and granularity around where you're seeing the most traction among those products, the most early success and what we might expect in terms of trajectory of adoption of those products? And then I had a quick follow-up for Bart. Thank you.

Sudhakar Ramakrishna: Rob, first of all thanks for your question. Hope you're doing well. In terms of -- let's take -- I'll take segment by segment at a high-level and provide some color. If you have a follow on, happy to answer as well. The database portfolio, the database monitoring portfolio has been doing well across the spectrum. When I say across the spectrum, we have some very large customers who are adopting it as well as the mid-market base, including our cloud motions with our partnerships, with the cloud service providers. The second part I'd highlight on the observability piece is, we outlined a Hybrid Cloud Observability solution, which we launched in fact almost a year ago now. That's been gaining a very fast traction, largely with customers who are looking for tools consolidation, hybrid cloud deployment options, continuum to SaaS-based solutions, because we are unique in the sense that we can help a customer self-host the solution and convert them into SaaS over time as their business needs dictate, which becomes increasingly compelling in this macro environment. So that's driving a lot of the traction. And then the service management solution is a 100% SaaS-based solution that is ideal for the mid-market and the value prop really there is, unlike other service management solution where the time to value takes many quarters; and in some cases, years. We are able to deliver value to customers in days. So that's what's driving the stickiness of it. But the most interesting and exciting thing that we are doing, Rob, is not looking at them as discreet products, which of course they are and can continue to be for a long period of time, but they all reside increasingly on the SolarWinds platform. That gives us the ability to land and expand and provide customers more unified solutions and experiences, which then reduces their cost and increases their productivity.

Operator: Your next question comes from Matt Hedberg with RBC Capital Markets.

Matt Hedberg: I had a question about maintenance conversion. Maybe Bart you might have mentioned it's converting at a higher to 1

Sudhakar Ramakrishna: Matt, I'll take that as well and give you some color. When Bart describes it as converting at a higher rate, what it is, is we are not converting like-for-like. So let me give you an example. Let's say you are a network monitoring customer of ours with $1 of maintenance coming up due. Typically when you convert, you're converting to our Hybrid Cloud Observability solution, which not only gives you network monitoring, but also let's say systems monitoring. So typically when we convert, we are converting to higher value add, which is the reason why I don't look at our subscription transformation as simply a business model transformation. It is more a value model transformation. Customers get more capability, are able to consolidate more tools, are able to experience lower overall costs and improve their productivity. So that's what's driving our conversion factors. And my belief is that we will continue to show that given the large size of the maintenance base for several years to come.

Matt Hedberg: And then, Sudhakar, you started a lot of your prepared remarks with the investments that you guys have been making with AI, within AIOps the past two years. I'm curious, where are you on that investment spectrum? I assume it's sort of an ongoing initiative. But a year's time from now, how much more do you think AI will be infused in the total product stack? I have to imagine, particularly for your customer base, it has to be a huge opportunity for efficiency gains and whether it's even in security efficacy side? So just kind of curious about where we are on that investment cycle?

Sudhakar Ramakrishna: Absolutely. The way I would describe it is, in 2021, it started at zero and we bootstrapped it. These days and going forward, I expect it to be much more in a steady state mode. I don't think we have the need to pour a lot more money into it, but most likely we'll just maintain it at this point and continually add capabilities. And the reason for being able to do that was '21 and '22 was a heavy lift in setting up our platform capabilities. Now it's a matter of, what I'd call a flywheel motion in terms of ongoing innovations across the spectrum.

Operator: Your next question comes from Erik Suppiger with JMP Securities.

Erik Suppiger: First off, good to see the debt ratio, the net leverage ratio coming down. Do you have a target for that and any change in terms -- or any update in terms of timing for that? And then secondly, you're talking about transitioning your -- the breadth of products onto your SaaS platform. Where are you in terms of that development process? Clearly you've got the observability working, but where are you in terms of the breadth of your portfolio?

Bart Kalsu: Hey, Erik, thanks for the questions. I'll take the first one real quick on the leverage. Yes, good improvement this quarter, it's due to a couple things. Our continued growth and our cash balance brought our net leverage down. And then EBITDA expansion obviously helps as well. So, you combine those things in 3.5x is where we ended the second quarter. We've spoken publicly, our goal is to get down below 3x over the -- in the next week, I think we said over the next couple of years. Obviously, if we continue to perform as we have, that'll happen sooner rather than later.

Sudhakar Ramakrishna: Hi, Erik. Our strategy and main use of cash continues to be focused on debt paydown because the organic portfolio that we have built should serve our growth objectives. Of course, we'll continue to stay open for inorganic as well, but the primary focus is debt paydown. Now, coming to your question about the platform. As I've indicated previously, our service management platform is a 100% SaaS platform. We've released our observability as SaaS October of 2022, and we continue to expand its capabilities. And as this year progresses, more of our solutions will reside on the SolarWinds platform. When I say more of our solutions, that already includes today our database observability, our application monitoring and observability solutions, increasingly our security network and infrastructure solutions as well. So the team is on a fairly rapid pace towards building all of our future capabilities on our SolarWinds platform. And that will continue to serve as a great foundation for us to not only evolve customers, but also acquire new customers as we continually have been doing.

Operator: Your next question comes from Terry Tillman with Truist Securities.

Connor Passarella: This is Connor Passarella on for Terry. First one, I just wanted to come back to the AI topic. So on the AI virtual agent, that's going to be included in the service desk. I know it's early on the lifecycle, but I'm just curious on how we should think about the monetization of an opportunity in a product like this and maybe what the initial feedback has been from your customer base since the announcement? Then I have a follow-up.

Sudhakar Ramakrishna: Yes. I'll step back a little bit and reinforce a couple of other points as well. While we added that to the service desk and announced it more recently as one of our AI extensions, the AI extensions that we've been building relate back to our broader monitoring and observability solution set as well. In fact, one of the very first releases of AIOps that we created was to support the alert stacking capabilities of our customers. All of us have heard of the term alert fatigue. Customers are getting alerts left, right and center and do not know how to prioritize, creating both productivity and cost headaches as well as security headaches. Two, we are all focused on how do we improve alert stacking, how do we help them get to the right issues faster? How do we do better issue resolution, improve productivity and security? So think of what we do -- we've just done with the digital assistant as an extension of our AI roadmap. And while it's early days, the feedback from our customers has been very positive because increasingly what we are doing is that our service management solution becomes a full and integrated capability for the mid-market. The other fact I would highlight here is that we are a vendor that's uniquely combining some of the observability capabilities with our service management portfolio, where we are not only able to detect issues for customers, but also automatically remediate them. So that's a unique value proposition that will resonate very strongly in the mid-market from my perspective.

Connor Passarella: Maybe just as a follow-up, on the international side with Europe and APJ, I'm just curious in how that opportunity has continued to progress both with the opening of the new data centers we talked about last quarter, and maybe what would some continued investment look like in these regions?

Sudhakar Ramakrishna: Yes. I would say we are well staffed to capture the opportunity in EMEA and APJ, both through our own people as well as a increasing and expanding set of channel partners through our transform channel program. Many of our large GSI customers are also, as you know, based in the APJ region. What I can also highlight is that our pipeline continues to grow at an accelerated pace in EMEA. And the only variability that I will refer to is what I have previously alluded to, which is because of the macro situation in EMEA, some of the deal conversion cycles have been a bit more protracted. But what's helping us is the diversity of our customer base, the reach that we have now built both with our people as well as our channel partners.

Operator: Your next question comes from Kash Rangan with Goldman Sachs.

Jeffrey Luo: Jeff Luo on for Kash Rangan. I wanted to ask about the approach you're taking to hiring. You've said that you've taken a little bit more of a prudent approach to investments and maybe adding headcount. So can you give any directional guidance around where headcount might be specifically like quota carrying reps is maybe like on a year-over-year or a quarter-over-quarter basis?

Sudhakar Ramakrishna: [Jacob], I'll give you a broader response to it. We were committed to selective investments and ongoing operational discipline. I believe we are staying true to that, at the same time, making the investments needed to capture the process, have been able to show both revenue growth and significant EBITDA expansion. So that will continue to be our strategy going forward, which is selective is the operative term and discipline across the board. In terms of where we are making investments, we will continue to look for investments in expanding and accelerating our product portfolio as well as the go-to-market capabilities, although increasingly we are leveraging our channel partners as well to get increased leverage.

Jeffrey Luo: Awesome. Okay. And then another question around the sequential decline in large customers. You mentioned that there's the dynamic at play of when they convert to subscription, that deal might be smaller than a 100K like applied to in 2Q?

Sudhakar Ramakrishna: I don't have the exact specifics, [Jacob]. We may have to come back to you on that.

Operator: There are no further questions at this time. I will now turn the call back over to Sudhakar Ramakrishna.

Sudhakar Ramakrishna: Thanks again and thank you all for joining our call and we look forward to continuing to be in touch.

Operator: This concludes today's conference call. Thank you for your participation. You may now disconnect.