SolarWinds: Things Are Getting Better, But Still A Hold For Now

Summary

• SolarWinds started FY23 strong, surpassing expectations with robust revenue performance and margin recovery to over a 40% EBITDA margin.
• The addition of 47 new customers who each spent over $100,000 demonstrates improving business prospects.
• I believe market consensus margin estimates may be conservative, creating room for SWI to surpass expectations and trigger a re-rating of the stock.

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Recommendation

I reiterate my recommendation to stay neutral for SolarWinds Corporation (NYSE:SWI). My previous stance was that there are many things to dislike in the short to mid-terms. The slowing customer growth, challenging competitive environment, business transition, and lingering impact from the recent cyber security incident, are key issues that I saw would weigh on the stock and growth prospect. Furthermore, SWI is also facing an increasingly competitive backdrop with larger and cloud-native application and infrastructure monitoring vendors bundling network monitoring into their full-stack platforms. However, contrary to expectations, SWI began FY23 on a high note, as evidenced by the company's unexpectedly strong revenue performance and margin recovery to >40% EBITDA margin in the face of a highly uncertain spend environment. Even though the macro environment has been weak, SWI has shown no major signs of weakness. This makes me think that the company's fundamentals are stronger than I had anticipated. Overall, I do notice some development in SWI, and it does appear to be gaining some traction. I would continue to monitor for a few more quarters to see if the momentum continues. If it does, I would re-evaluate the situation to see if SWI stock deserves a change in rating.

Outlook

What's most intriguing about this 1Q23 outcome is how little evidence there was of any macro impact on performance. Looking at the most important metrics, we see that SWI's maintenance renewal rates have reached an all-time high, with an LTM month maintenance renewal rate of 93% and a quarterly renewal rate of 94%. This is among the highest I've seen in recent memory. In addition, 47 new customers were brought on board who each spent over $100,000 with the company. My initial assumption (that customer additions would be slow) was refuted by this data point. To put that in perspective, the number of new customers adding deals over $100,000 rose from 16 in the previous quarter (31 more new adds). In my opinion, SWI near-term performance should continue to be strong if we consider not only the underlying improvements but also the management's comments that the pipeline for the rest of the year looks healthy. However, the more challenging macro environment is still evident in some areas, such as in the longer sales cycles experienced by large customer deals as businesses takes longer than usual to complete. I do not think this is a major red flag as it is a typical commentary across many other industries. From what I can tell, these transactions are in the works (in the pipeline) and it is only a matter of time before they close in the coming months. The fact that SWI gained 47 new large clients as opposed to 16 shows that business is improving. Given the current economic climate, however (US debt issue, inflation rates still high, interest rates could still increase further), I do agree with management's direction of keeping a conservative guide. I think there are still plenty of ways for SWI to increase its maintenance revenue if we look far enough into the future. SWI could achieve this goal by convincing its core network and systems management customers to switch to the company's Hybrid Cloud Observability offering, the only true hybrid solution that lets customers migrate from on-premises to SaaS at their own pace (1Q23 earnings call). Management is already putting this plan into action, so I anticipate seeing positive financial results in the not-too-distant future.

Margin

Aside from growth, SWI improvement in margin is something to highlight as well. SWI's margins continue to improve, with an EBITDA margin of 41.6% in 1Q23, bringing them back above the 40% mark. Considering that management has increased their EBITDA guidance to a range of $295–$305 million from $290–$300 million, I think this level is sustainable. Looking back at SWI's financials, the company once had a healthy EBITDA margin in the high 40s. I don't think it's impossible for them to reach high 40% margins at the current rate of growth and improvement. Given that tough macro environment and lack of visibility, I expect a lot of consensus estimates to be conservative and modelled little improvement in margins (back to high 40s%). As such, if SWI can improve margin better than what the market expects, that would be a catalyst for the stock to re-rate much higher.

Summary

Despite initial concerns about SWI, the business surprised with strong revenue performance and margin recovery in FY23. The company's fundamentals appear stronger than anticipated, suggesting potential traction. Notably, SWI's margin improvement, with an EBITDA margin above 40% in 1Q23, is worth highlighting. Management's increased guidance and the potential for higher margins than market expectations could act as a catalyst for the stock to re-rate positively. That said, I would still recommend a neutral rating and observe for a few more quarters before confirming this underlying trend.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.