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SolarWinds, Inc. (NYSE:SWI)

Morgan Stanley Technology, Media & Telecom Conference

February 26, 2013 16:55 ET

Executives

Mike Berry - Chief Financial Officer

Dave Hafner - Investor Relations

Analysts

Adam Holt - Morgan Stanley

Adam Holt - Morgan Stanley

Alright, I will go ahead and get started. My name is Adam Holt. For those of you that I don’t know, I run the enterprise software practice at Morgan Stanley in Equity Research. And I am thrilled to have SolarWinds with us for our next presentation, Mike Berry and Dave Hafner. As you have heard in some of the presentations that we have done, I’ll lead the Q&A to start with, but want to make sure you all get all of your questions answered and just raise your hand, I’ll get you a microphone to the webcast. So, with that, guys thanks so much for braving the weather and the travel to get here to see us.

Mike Berry - Chief Financial Officer

Thank you, Adam. Happy to be here.

Adam Holt - Morgan Stanley

So, why don’t I start with a recap question, you are off another strong year, a lot of good metrics in the fourth quarter. The strategy really seems to be coming together. If you look at the recent results, what are you most pleased by and what do you think has really driven the strength in your license revenue?

Mike Berry - Chief Financial Officer

So, I think we are most pleased by really, a couple of years ago when we decoupled our NPM products, where we could sell them standalone. And then we also moved into the system and application space. It really took our addressable market and increased it by multiple times. So, I think we are most, we are happiest with our ability to continue to penetrate network management, but also just a strong growth that we have seen in system as well and to be able to build that awareness. So, we are happiest with that. We have also continued to focus hard on our cross-sell opportunity. And the international markets I mean our EMEA group really had a great year last year, and so we are very happy with that even in the phase of all the economic issues. So, we are very happy with that as well. So, you have bundled all those together. We think we had a very strong year main as renewals continued to do well. Earnings and cash did very well. So, it’s a very strong year financially.

Adam Holt - Morgan Stanley

Why don’t we drill down into each of those areas? So, EMEA was up 56% year-on-year in calendar ‘12, the environment might have stabilized for most people, but it certainly didn’t get a whole lot better. What are you doing differently in that GO to drive those kind of results?

Mike Berry - Chief Financial Officer

So, our team there has done a really great job of diversifying out of just Western Europe into the Africa, Middle East and Eastern Europe region as well plus they have just executed so much better in those home markets. We talk about a lot our average transaction size excluding a couple of smaller price, we average about $8500. And so we are really able to get in there. Again, we are talking to the end user not to the CIO, so even when there are budget issues, we like to think that kind of fly under the radar in those areas. So, even in the parts of Western Europe that have really struggled we did well, but a lot of the growth was in again in Africa and Middle East and Eastern Europe, where we have really seen a nice uptick in that business.

Adam Holt - Morgan Stanley

And if you were to sort of bring your lens up a little bit on the international business in general, you’ve got some localization efforts that are starting to take hold, can you talk about what those are? What kind of impact you have seen?

Mike Berry - Chief Financial Officer

Sure. So, to take a step back for a second, if you look at our products and we view products as not only what the user uses, but certainly our website which is our marketing engine. Virtually, everywhere across the world, the websites that we use to support our international business are all English-based as well as our products are largely English-based as well. So, to Adam’s question, we have embarked now for the last couple of years on localizing not only our products, which the end user uses, but more importantly our websites, because our biggest issue internationally is to continue to build that awareness in those markets that we have just gotten started it. And the localized presence is a huge piece of that.

So, the markets that we have already started in the Japanese market, we have NPM which is our core network performance management product and NTA, which was our net flow product. Those are actually localized in Japanese as well as localized in German. We will continue to localize products within network and system as we see that needs. And then the next countries we are looking hard at is the Brazilian market and China as well. So, we think that, that’s really important to build that awareness. We do, we can pretty much round it to zero. We do basically no business in the Japanese markets and it’s the second largest IT market in the world. We do pretty well in the German market, but we think we can do a lot better. And then China is actually a pretty good market for us and as well as the Brazilian market. So, we see a lot of upside in that, but it’s really incumbent upon us Adam to build that awareness first to get those wesbites up to make sure that those IT users know who we are and get comfortable with our products, because a lot of folks will use an English-based products, but we do think that, that’s really one of the next drivers for growth.

Adam Holt - Morgan Stanley

And focusing on the German market and the Japanese market, just remind us what the chronology is there in terms of when the key dates are for getting everything localized?

Mike Berry - Chief Financial Officer

Sure. So, we already in the Japanese market, we are already localized again as with NPM and NTA and we are also localized in German as well. For the Japanese market, what we are doing now is we are really focused on awareness building those programs. So, we will kind of – so we say step back on localizing the product and focus more on the websites and awareness in the Japanese markets in 2013. And then for the German market, we will continue to localize. We’ll look at our system and application management as well as other network modules. We haven’t announced the dates for those, but that will continue throughout 2013.

Adam Holt - Morgan Stanley

And in both of those markets though, those two elements came together in the second half of last year, so that’s really a – that really is an incremental impact, if you will, in calendar ‘13 as well? I guess that’s what I’m driving at.

Mike Berry - Chief Financial Officer

Yeah, it should be.

Adam Holt - Morgan Stanley

Okay. And then if I were to shift gears to the cross-selling opportunity, I mean you are now close to 20 core products, your attaches of the Analyst Day was about 2 to 3 products per customer, I believe. Can you talk about what you are doing to drive that up and how we should expect that to evolve over the next 12 to 18 months?

Mike Berry - Chief Financial Officer

Sure. So, let’s talk about the cross-selling opportunity. So, as Adam mentioned, we have about 19 core products spread throughout network and systems. On average, one of our customers will have between 2 to 3 core products and that stretches across the customer base. So, we, in taking a look at the customers that have a product, they could buy other ones of our product. We have defined that opportunity at about $11 billion. Now, we realized some of that’s harder to get than others. And if you go to our Analyst Day slides, we have this great concentric circle slide that lays out in terms of what we think the opportunities are to cross-sell in that group. So, in order to get at that market, we have now created a group in the U.S. first through sole responsibility pipeline, commissions, everything is based on them cross-selling into that group. It is a different process for us, because we are so used to dealing with downloads, where a user will go try our product that will raise their hand. And then our sales and marketing folks react to that. This is getting that person to reengage, but it’s also one of the easier things to do, because they know our products. They are comfortable with us. So, we feel great about that opportunity. We’ll get those processes really buttoned down first in the U.S. and then we will roll that out to Europe and Asia-Pacific as well during 2013.

Adam Holt - Morgan Stanley

And so as you think about the average value, I mean that average value per customer has remained relatively constant to that $8500 range, is that something you would expect to see increase on a going forward basis or just the guidance, I assume that, that really holds comps in?

Mike Berry - Chief Financial Officer

Yeah. So, for 2013, there is two drivers to our growth there. The growth in core product transactions that have been grown by 25% plus each quarter, I believe in 2012. our average transaction size which is in average – what is the average ticket is to Adam’s point about $8500. We expect that to stay right around there. Some quarters, it may drop a little. Some quarters, it may go up a little bit. And really, that’s driven by this is a dichotomy we would like to talk about, because keep in mind that the SolarWinds model is really based on bringing new folks into the fold. And that is still new to franchise. It’s still the biggest driver to grow. It’s people that are buying the product, their first product from SolarWinds, they tend to buy smaller versions, a little bit less than $8500, they will sometimes attach, but usually not. And then over time they will buy bigger upgrades inside. They will also buy more modules. At the same time, we are selling more bigger deals. So, those two things kind of fight against each other as it relates to that. So, as you look at the $8500, we expect that to stay right around that. It may even drop a little bit if we do acquisitions that bring in more new to franchise, but that’s okay, we expect. We expect the growth to be driven by transaction volume not sized certainly for 2013.

Adam Holt - Morgan Stanley

Got it. And just on that front, you mentioned 25% plus growth, but you actually saw 40% growth in the transactional side in the fourth quarter, what were some of the elements that caused that spike, if you will in the transactional growth?

Mike Berry - Chief Financial Officer

So, the transaction growth on our systems product was great going in the end of the year. Network, we talked about did accelerate offer of Q3, and then a lot of the newer products, especially the acquisitions kicked in as well. So, that really drove that growth up.

Adam Holt - Morgan Stanley

Got it. And one of the things that I get asked about quite a bit is your acquisition strategy and how you’ve been able to bring such a breadth of products into a model that is a high-velocity low-touch model. Can you talk a little bit about your philosophy on M&A and how you have been able to consistently execute so well?

Mike Berry - Chief Financial Officer

Sure. So, we did five acquisitions in 2012. And I think four in 2011. And our acquisition strategy is pretty different than other folks. And in this, we’ll talk about how we look at organic versus inorganic. So, when we look at acquisitions as Kevin Thompson, our CEO likes to say we are shopping with an intent to buy, when we look at acquisitions, for us it’s really – it’s a time to market issue. We either will try to build it internally or if we find a great product that we think will fit in our business model. Then we will look at doing the acquisition. So, when we acquire these companies, we first and foremost look at how it’s the product. Is it easy to download, is that easy to evaluate, does it show value right out of the box and that’s really the key. If they have enterprise sales people and they doing big end marketing that stuff we can fix, but a product it doesn’t fit into the business model it’s harder to fix.

So, everything that we look at is can we take that product, what we will typically do is we will simplify. They will have multiple SKUs will typically up one. We will almost always lower the price, sometimes pretty significantly. We generally don’t hire any of their sales people, we take that product then and we put it right into our sales and marketing engine. And what ends up happening there is that any pipeline that exists typically just goes away because they’ve been sold something different than what we’re going market, but we take that and we fit it in the back office piece to us is very important because we want a sell everything the same way.

So, we make sure that that fits in as well. And then it’s basically we give it to sales and marketing we say go. And we will typically hit our base first in terms of because if someone buys something SolarWinds they’re very likely to buy something else. So, we’ve been able to do that almost in all of our deals very successfully and that’s a very different strategy we are not trying to buy a customer base, we’re not trying to buy revenue. We want products that we can sell through our sales of marketing engine and the nice part is not only do we bring the folks that are looking for that product, have helped us, we have secured file transfer, but then we can also cross sell them on our respect as well.

Adam Holt - Morgan Stanley

As you look at some of the markets that you are in now virt management, network management, app management, some of these storage – I mean some of the markets traditionally have been sold to different people. How does your sales team adjust to being able to take on what effectively is sort of new calling responsibility as an inside sales person?

Mike Berry - Chief Financial Officer

So, we have a very sophisticated routing system in terms of how we set it up and we now actually have even though we have we call it selling from the inside. We do have separate group, so if there is a network download, that will typically go to one group, if it’s a systems management that will go to separate group. Yet even within that we will route virtualization of storage to a different group because they will have a little bit more specialty. They don’t have to be terribly technical, but they do need to know little bit about it. Now it doesn’t, now keep in mind sales guys consult everything. So, if somebody does an NPM download and they want to buy virtualization management they can also sell their map. It’s how we route those leads based on the initial if and when that person raises hand their initial interest. The term is where that goes. We’ve also done that in Europe and Asia-Pacific as well to make sure that there is some product specialization, but we don’t want to get into any of those folks cross-selling as well.

Adam Holt - Morgan Stanley

And could you update us on some of the recent cross-sell metrics? So, we talked about from a number of usage perspectives, but in terms I think one interim things is some of the attach metrics about how you are attaching one product to the next?

Mike Berry - Chief Financial Officer

Sure. So, every year at Analyst Day we go through our attaching. We look at it two ways. One is how often do we attach another module to a core NPM and that has been increasing for the last three or four years and its right around that 60% to 70%. So, what that says is every time somebody buys core NPM, they also buy another module at the same time. And we have also started to disclose the attach rate to SAM which is our system and application management product and that was in ‘12 remember.

Adam Holt - Morgan Stanley

It’s probably in the high teens or…?

Mike Berry - Chief Financial Officer

High teens, yeah, still going up but high-teens, low-20s. The great part about that is there is a huge amount of growth to get where we are with network, it will take a little bit of time and let’s keep our mind too on the attach. The largest attach to NPM is NTA, which is the network product. But right up there is SAM, so we actually cross-sell those quite a bit even though it’s to Adam’s point, sometimes it appears that it’s a different user, but a lot of times within the companies we sell to that person will be responsible for multiple products, multiple issues. So, thereby not only network product, but also a systems product as well.

Adam Holt - Morgan Stanley

As we think about the organic growth and the mix between acquisitions and organic growth going forward. How would you like to see that or like to see that mix look like?

Mike Berry - Chief Financial Officer

Going forward into 2013?

Adam Holt - Morgan Stanley

Yes or in general you don’t after be almost painting to one year.

Mike Berry - Chief Financial Officer

So, what we guided for the year for 2013 is call it revenue growth 23% to 26% that does not include any new acquisitions and because DameWare which is really one of the only acquisitions where we had as we call it inorganic that has its own momentum. So, we didn’t really have to create that’s in both of the years, so we really look at that as organic growth going forward. We would like to and again that we don’t have a limit or a goal in terms of acquisitions that we would like to able to add growth. Last year we came at about the same number about 25 at the beginning we ended up closer to the mid-30s. Some of that was the core products did better, some of that was the contribution from acquisition. So, if it’s a couple of points in a year because we can’t find them that’s okay or may be more really depends on what we find, we don’t have a budget for acquisitions, but we are certainly actively looking at.

Adam Holt - Morgan Stanley

What do you think the delta was between reported growth and organic growth last year?

Mike Berry - Chief Financial Officer

Well, I know we vary a little bit on the definition on this one, we do look at DameWare had a couple of points of growth call it inorganic, but we do look at most of the growth last year being organic because again we took those acquisitions, we changed the way we – they operate and we ran to our sales and marketing motion. We had this great pride in the Analyst Day to talk about where that stands and we did that acquisition in Q3. We did exactly when we talked about, simplified the SKUs, lowered the pricing, put it in our sales and marketing motion. We didn’t bring out any sales folks over, 90% of the new license sales in the third quarter that we did in Web Helpdesk came from demand we created only 10% was from the existing pipeline. But that’s an illustration of taking those products and really putting them into the engine that we have, but we think organic in total were pretty darn close.

Adam Holt - Morgan Stanley

One other model question, I don’t want to move to the market a little bit, operating margins have been over 50% now for 10 quarters in a row. So, you don’t like I could say that about as we think about on a margin going forward, you’ve guided the margins being a little bit compressed over the next 12 months. But I guess two things, one how do you sort of seeing margins over time? And two how are you able to do the acquisitions and get them to margins that are sort of effectively not dilutive so quickly?

Mike Berry - Chief Financial Officer

Okay. So, let’s talk about the outlook that we gave. So, in 2012, the operating margins were right about 54%. We entered the year guiding right around 50% and what ended up happening likely each quarter is that when we do the plan when Dave and I set it out, we do plan on it and right around that 50% number for 2012. To the extent that we exceed the revenue line either license or maintenance, so there is a good chance that our revenue is going to fall for the bottom line because we don’t have a lot of variable costs associated with that new revenue and that’s exactly what happened in each of the four quarters. So, we did much better than we initially set out. The maintenance model and we don’t have time to go in order placing, it’s actually about 55% of our revenue and it grows faster than license because of the way we call it maintenance and how much goes to the balance sheet.

So, that has been such a benefit to the margin that we actually pulled it up this year to our goal. Let’s say hey we think we are going to now target between 51% and 52% certainly to the extent that we exceed hopefully we do the revenue line, you will see that hits the bottom line as well. So, hopefully margins come where they were last year, but we are going to plan the business right around that 51% to 52% because we want to make sure we are investing in growth. And that’s a big thing, we could let the margin slide up, we don’t want to because we want to make sure that we were taking that profit and investing in new things to continue to drive growth.

Adam Holt - Morgan Stanley

You have a different maintenance philosophy than some do, you are able to drive higher values and higher tax rates for maintenance. Can you talk a little bit of more broadly about what your philosophy is on maintenance?

Mike Berry - Chief Financial Officer

Sure, so the way we price is when I will give you an example somebody buys a new license from us and it’s $100,000 to buy that license, they get maintenance included for free in that $100,000. We will then that cause about 30% of that amount to maintenance. And then we will recognize about 70% of that as license. So, actually that 30% of that piece comes out to about 43% of the license value. So, it’s much higher than other competitors. Then at the after the first year the customer will then get a bill for that $3,000. Our maintenance retention rates have been low to mid-90s with very, very strong. We have also benefited as well especially as our core product license growth has grown, it has added the maintenance, but that’s why think about four years ago maintenance was about 45% of the revenue. Today, it’s about 55% and it should continue to grow faster than license because of that high COGS that we do with maintenance, it’s very different from other folks. And so we do expect that to continue to grow faster. Actually in one quarter last year license comp maintenance was great, but we don’t expect that to continue in the future.

Adam Holt - Morgan Stanley

Terrific. I am going to open it up to the floor for any questions that you all might have. We’ve got time for a couple. Got one in the back on my right?

Question-and-Answer Session

Unidentified Analyst

What’s the typical profile of a customer, they buy one product download it, they are going to then pay maintenance after the first year, but you talk about from taking second and third product. So, sort of give me a lifecycle of a customer will stay 5 years than an optimal case?

Mike Berry

Sure. So, I am hopefully if they come in and buy something again, they typically will buy one of the lowest SKUs. Most of our products are based on size, how many devices are you managing, what does that environment look like. And then what you will typically see is hopefully sometimes they will come in and they will do an upgrade of size. So, they will go from monitoring 250 devices up to 500 or an unlimited. And then hopefully during that time, they become comfortable and they become raving SolarWinds fans. They have been on thwack.com. They talk to their other folks that use our products. And then they will buy another product, and then hopefully they just keep adding products and then they will increase in size as well. During that time, then hopefully there is certainly all their maintenance renewals are flowing as well. So, over five years, hopefully that person has started with a smaller product, and then not only increased in size, but also added breadth. And then if it’s a bigger company hopefully, we can expand within that to even, so if we are in one department level of a company, hopefully the word gets out and we can expand within it. So, over five years, they can take multiple paths, but that’s certainly an optimal one.

Adam Holt - Morgan Stanley

Any other questions?

Unidentified Analyst

Hi. Can you maybe talk just about the scalability of the model that you guys have done such a nice job of buying companies and getting them to buy your way. I mean, do you see a limit that or is that something that you and the team sit around and say look we can just continue to sell this way as we integrate products?

Mike Berry

So, certainly we sit around and think hey, this is the great model and there are lot of product areas that we can expand through. We have realized there are some that we don’t think the model plays it. There are some products that are top-down driven, CIO-driven, that we look at and say okay, the user doesn’t have discretionary budget. They are not out looking for a solution. Their boss is telling them what to do. Our model doesn’t play. We do think though that there are and increasingly, there are more markets that our model plays, especially as some people do the SolarWinds model. And as IT folks, development folks, any technical person gets more use to buying from somebody that doesn’t come visit them and drive around in a tourist. So, we feel that there are multiple areas for us to expand as well as the international group. And candidly at least for the near term, we don’t see that hitting the wall anytime soon.

Adam Holt - Morgan Stanley

How do you think about the competitive landscape? Now that you’ve got such a broader product metrics and are you starting to see some of that, there is a whole another kind of generation of companies that want to be like SolarWinds now that have free to pay or high-velocity low-touch business models, are you seeing anybody more or less in the competitive landscape?

Mike Berry

So, the competitive landscape really hasn’t changed much, certainly with the bigger guys and we don’t Dave and I don’t prefer to know what goes on in their buildings, but it’s awfully tough for them to come down market and especially when they are so services oriented and big deal oriented. We do see now a lot of newer companies using the SolarWinds model and then in areas that I think are new that you see DEP tools and things like that, that for MSP tools that we think is really interesting. We really like that for a couple reasons. One is that it brings a little bit of credibility. And as I just answered on the other questions, it gets that user so much more used to buying that way, that it’s not a barrier to selling to them. The other thing that we really like is it’s a great fertile ground for us to do acquisitions. And that’s typically where we’ll look first, because the only way I worked in the SolarWinds model is if they have a product, that’s easy to download, easy to evaluate. And if they have that, then we can look at that as an acquisition candidate.

Adam Holt - Morgan Stanley

Got time for one more. One more question. Alright, that’s it. Thank you so much guys.

Mike Berry - Chief Financial Officer

Thank you, Adam. Thanks everybody.

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