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SWI > SEC Filings for SWI > Form 10-Q on 6-Aug-2014All Recent SEC Filings

Show all filings for SOLARWINDS, INC.

Form 10-Q for SOLARWINDS, INC.


Quarterly Report

Item 2: Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the Condensed Consolidated Financial Statements and related notes thereto included elsewhere in this quarterly report on Form 10-Q. In addition to historical condensed consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially and adversely from those anticipated in the forward-looking statements. Please see the section entitled "Safe Harbor Cautionary Statement" above and the risk factors discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 for a discussion of the uncertainties, risks and assumptions associated with these statements. Overview
We design, develop, market, sell and support powerful yet easy-to-use enterprise-class IT infrastructure management software to IT professionals in organizations of all sizes. Our product offerings range from individual software tools to more comprehensive software products that solve problems encountered every day by IT professionals and help to enable efficient and effective management of their network, systems and application infrastructure. Our products are ready-to-use, featuring intuitive and easily customized user interfaces and built-in workflows. Most of our products can be downloaded directly from our websites and installed and configured by our end-users in a matter of hours. Our customers include small- and mid-size businesses, large enterprises, managed service providers, and local, state and federal government entities that have purchased our products. Key Financial Highlights
Key financial highlights for the first half of 2014 include the following:
Total revenue was $197.4 million in the first half of 2014 compared to $150.4 million in the first half of 2013, representing an increase of 31.2%;

Combined maintenance and subscription revenue in the first half of 2014 was $123.4 million compared to $88.5 million in the first half of 2013, representing 39.5% year-over-year growth in recurring revenue;

Net income was $31.0 million in the first half of 2014 compared to $45.8 million in the first half of 2013, representing a decrease of 32.3%;

Net income was $0.41 per share on a fully diluted basis for the first half of 2014 compared to $0.60 per share on a fully diluted basis for the first half of 2013, resulting in a decrease of 31.7%; and

Cash flow from operating activities was $93.5 million in the first half of 2014 compared to $71.6 million in the first half of 2013, representing an increase of 30.6%.

In 2013 and the first half of 2014, we invested across our business and, in particular, in areas that we believe are an important foundation for our long term growth such as:
We continued investing in product development allowing us to accelerate new product releases and enhancements for our products. We released key new versions of our network and systems and application management products, which continued to improve the usability and add features our customers rely on daily. We also built upon our managed service provider suite of products with the addition of N-able Help Desk Manager;

We invested in brand awareness in markets that we have entered more recently, such as security and systems management, and geographies where we believe there exist key opportunities, like Germany, UK, Australia and Brazil. This investment was designed to place us front and center as companies search for information and solutions for their IT management challenges; and

We invested in the expansion of our facilities and IT infrastructure to support the growth of our operations.

We are committed to our business model and have continued to focus on ways to leverage and refine our model. We have made investments in our business over the last several quarters and believe that we are beginning to see the impact of those efforts in the acceleration of total revenue. Our strategic focus in 2014 is centered around the following initiatives:
Improving the competitive positioning of our products by investing in new product features and infrastructure;

Acquiring and internally developing products that will expand our presence in our current markets or new markets;

Expanding our web presence, brand awareness and improving our communication with prospects and our current

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customer base both domestically and internationally;
Increasing our presence in several key geographic markets including Asia-Pacific, Latin America, Europe, Middle East and Africa by expanding our product portfolio, localizing marketing material and establishing new relationships with distributors and resellers;

Accelerating the rate at which we are selling additional products into our install base; and

Expanding our international operations company-wide at lower cost locations to drive our competitive advantage.

We expect to continue to generate solid growth while delivering strong operating income and to increase our cash flows from operating activities with our disciplined approach to investing in our business combined with our large market opportunity.
We have made multiple acquisitions of businesses as part of our growth strategy and expect to continue to pursue acquisitions that will enable us to enter new markets, or new segments of our existing markets, by bringing new product offerings to market more quickly than we can develop them.
In the second quarter of 2014, we acquired Pingdom, a provider of website monitoring and performance management solutions. The acquisition increased our product offerings and we believe will allow us to leverage the opportunity associated with performance management for critical websites and web applications. Pingdom is based in Vasteras, Sweden.
We account for our acquisitions using the acquisition method of accounting. Accordingly, the financial results of our acquisitions are included in our condensed consolidated financial results since the applicable acquisition dates. See Note 2, Acquisitions, in the Notes to the Condensed Consolidated Financial Statements for additional details.
Key Business Metrics
We review a number of key business metrics to help us monitor the performance of our business model and to identify trends affecting our business. The measures that we believe are the primary indicators of our quarterly and annual performance are as follows:
Revenue Growth
Revenue growth includes the growth in our license, maintenance and subscription revenue, which are critical to our long-term success. We have employed a differentiated business model for marketing and selling high volumes of enterprise-class software, which is focused on revenue growth at high operating margins. We regularly review our total revenue growth to measure the success of our investments and strategic business decisions. We have built a financial and operational model that focuses on the long-term value of our customer relationships. After the initial new license or subscription purchase, our goal is to create opportunities for sales of additional products, license or subscription upgrades and renewal purchases from the customer. This is an important component of our financial model and future revenue growth. This model is based on the premise that we will be able to deliver ongoing value to our customers and maintain a long-term financial relationship with the users of our IT management products. Our recurring revenue, which consists of maintenance and subscription revenue, is reflective of the relationship we have built with our customers. Our revenue growth percentages were 31.2% and 21.6% for the first half of 2014 and 2013, respectively, as compared to the same periods of the previous years. We expect our total revenue growth to be approximately 25-27% for the fiscal year 2014.
Non-GAAP Operating Income and Non-GAAP Operating Margin Our management uses non-GAAP operating income and non-GAAP operating margin as key measures of our performance. Because our non-GAAP operating income excludes certain items such as amortization of intangible assets, stock-based compensation and related employer-paid payroll taxes, certain acquisition related adjustments and restructuring charges that may not be indicative of our core business, we believe that this measure provides us with additional useful information to measure and understand our performance, particularly with respect to changes in performance from period to period. We use non-GAAP operating income and non-GAAP operating margin in the preparation of our budgets and to measure and monitor our performance. Non-GAAP operating income and non-GAAP operating margin is not determined in accordance with GAAP and is not a substitute for, or superior to, financial measures determined in accordance with GAAP. We increased our investments in the business in the last half of 2013 and during the first half of 2014 and we expect our non-GAAP operating margin to be approximately 42% for fiscal year 2014.
For further discussion regarding non-GAAP financial measures including non-GAAP operating income, see "Non-GAAP Financial Measures" below.

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Opportunities, Trends and Uncertainties
Businesses, governments and other organizations are increasingly relying on networks, systems, and applications to execute their operations, facilitate their internal and external communications and transact business with their customers and partners. The size of these networks, the number of applications and servers, and the complexity of physical and virtual server environments are increasing as organizations place more reliance on them. In addition, business initiatives to capture, store, and analyze an increasing amount of organizational data are creating new IT management challenges. Furthermore, the adoption of cloud computing technologies, which is shifting a growing number of critical workloads off premises, is also creating new IT management complexities and placing increasing importance on the performance of IT assets as compute resources become more distributed. The development and evolution of cloud computing technologies is also allowing a growing number of small and medium-sized organizations to rely upon third parties, known as managed service providers, or MSPs, for their IT management needs. These MSPs need powerful, yet easy-to-use and affordable solutions in order to address a wide range of IT management issues for the thousands of small and medium-sized organizations they serve.
In order to address these challenges, we offer a cohesive portfolio of powerful, yet easy-to-use and affordably priced IT management products spanning networks, systems, application and web performance management. This includes software that we have either developed or acquired that allows IT professionals to manage the performance, health, and configurations of network devices, firewalls, applications, websites and web applications, physical and virtual servers, storage devices, as well as software for log and security information management. It also includes software that provides IT professionals with mobile and remote access to their IT infrastructure and software to help them track and resolve IT issues along with their IT assets. Lastly, our portfolio includes a set of cloud-based remote monitoring and management products that allow MSPs to remotely access and address a broad range of IT issues faced by their customers in order to ensure the performance and security of their networks, desktops, servers, and other proprietary systems. We believe that IT-related trends and the limitations of existing offerings present a significant market opportunity for our products and starting in 2013, we began to increase our investment as a percentage of revenue to take advantage of this market opportunity. We expect our revenue to continue to grow as we capitalize on these and other market opportunities through acquisitions and development. Our ability to grow revenue will depend on a number of factors and assumptions, many of which are outside of our control. Further, any revenue growth and operating synergies of our acquired products and businesses depends on our ability to successfully integrate those products and businesses and may be lower than expected if we are unable to do so in the future.
In the second quarter of 2014, we recognized 27.5% of our revenue from sales by our international subsidiaries, which includes all subsidiaries outside of North America. We believe there is a substantial opportunity for additional sales of our software in the Europe, Middle East and Africa, or EMEA, region, the Asian-Pacific region, and the Latin American region. We intend to increase our sales, marketing and support operations in these regions. However, we believe there is significant uncertainty regarding the economic conditions in certain of these geographic regions. While we believe that any difficult economic conditions may adversely affect the sales of our products, this could also offer us an opportunity to market and sell our products to mid-size businesses and enterprise customers at compelling prices compared to the prices of some competing products.
We expect the U.S. federal government to continue to be a significant market opportunity, as we believe the ease of deployment, power and scalability of our products gives us a competitive advantage to sell to various agencies and departments of the U.S. federal government. The U.S. federal government new business sales, including both direct sales and sales through distributors and resellers, were 6.7% of our total new business sales in both the second quarter of 2014 and the first half of 2014 as compared to 9.8% of our total new business sales in the second quarter of 2013 and 7.7% of our new business sales in the first half of 2013. We have experienced and continue to expect inconsistency in the buying pattern of the U.S. federal government for larger transactions with our products. We believe that many of our larger transactions, both new licenses and maintenance renewals, with the U.S. federal government are dependent on specific projects that may not be continued at the same scale in the future due to budgetary cuts or other reasons, and the reduction or cancellation of specific projects such as these could result in our sales to the U.S. federal government growing less rapidly than expected or even decreasing. In addition, our sales, both new licenses and maintenance renewals, to the U.S. federal government are largely dependent on systems integrators, distributors and resellers whose purchases from us have been difficult to predict. Key Components of Our Results of Operations Sources of Revenue
Our revenue is primarily comprised of license, maintenance and subscription revenue.
License, Maintenance and Other Revenue. We primarily license our software under perpetual licenses, which ordinarily include one year of maintenance as part of the initial purchase price of the product. License revenue reflects the revenue recognized from sales of new perpetual licenses and upgrades of license size to our software. We have experienced annual growth in license revenue. Maintenance revenue is an important source of our future revenue. Customers can renew, and

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generally have renewed, their maintenance agreements at our standard list maintenance renewal pricing for their software products. Current customers with maintenance agreements are entitled to receive unspecified upgrades or enhancements when and if they become available. We have experienced strong and consistent annual and quarterly growth in maintenance and other revenue. Because our maintenance base has continued to grow each year due to new license sales, high customer retention and acquisitions, we expect maintenance revenue to continue to increase in absolute dollars in future periods.
Subscription Revenue. We primarily derive subscription revenue from fees received from our MSP customers for time-based license arrangements and software-as-a-service, or SaaS, offerings. We also include the fees from sales of the Pingdom cloud products, acquired in late June 2014, in our subscription revenue. We currently sell our subscription products separately from our perpetual license offerings.
Cost of Revenue
Cost of revenue primarily consists of amortization of acquired developed product technologies, personnel costs related to providing technical support services and royalty fees and server and hosting fees. Personnel costs include salaries, bonuses and stock-based compensation and related employer-paid payroll taxes for technical support personnel, as well as an allocation of our facilities, information technology, employee benefit and other overhead costs. We allocate stock-based compensation expense and related employer-paid payroll taxes to personnel costs based on the expense category in which the option or restricted stock unit holder works. We allocate overhead, such as rent, computer and other technology costs, and employee benefit costs to personnel costs in each expense category based on worldwide headcount in that category.
The amortization of developed product technologies can vary significantly each period based on the size and timing of our acquisitions. We expect our cost of revenue to increase in absolute dollars and to fluctuate as a percentage of revenue as we acquire additional companies or technologies and as we increase our headcount to support new customers and product offerings. Operating Expenses
We classify our operating expenses into three categories: sales and marketing, research and development and general and administrative.
Our operating expenses primarily consist of personnel costs, contract research and development costs, marketing program costs and legal, accounting, consulting and other professional service fees. Personnel costs for each category of operating expenses primarily include employee compensation costs and facility overhead costs. We include restructuring charges related to severance and relocation in the employee's respective department.
Our operating expenses increased in absolute dollars and as a percentage of revenue in the first half of 2014 compared to the first half of 2013, as we have continued to build infrastructure and add employees through acquisitions and organic growth across all departments in order to accelerate and support our growth. We increased our investment in product development, marketing and sales in late 2013 for initiatives we believe are important to our long-term goals. These investments are focused on the development of new products and strategic releases to our current products and streamlining our demand generation process in our marketing and sales organizations. The number of full-time employees as of June 30, 2014 was 1,492, as compared to 1,142 as of June 30, 2013. We expect our operating expenses to continue to increase in absolute dollars as we make long-term investments in our business both domestically and internationally. Our operating expenses in future periods may increase in absolute dollars and fluctuate as a percentage of revenue as a result of any future acquisitions and any further decisions to increase our investment in our business. In addition, we intend to continue to grant equity awards to our current executives and employees and those who join us in the future through acquisitions or otherwise, which will result in additional stock-based compensation expense.
Sales and Marketing. Sales and marketing expenses primarily consist of personnel costs for our sales, marketing and business development employees and executives, commissions earned by our sales personnel, the cost of marketing programs such as paid search, search engine optimization and management, trade shows, website maintenance and design and the cost of business development programs. We will continue to hire sales personnel in the United States and in our international sales offices to drive new license sales growth. We also expect to continue to invest in our websites, online user community site, brand awareness initiatives and marketing programs to drive customer downloads and support our new product launches.
Research and Development. Research and development expenses primarily consist of personnel costs for our product development employees and executives and, to a lesser extent, contractor fees. We have devoted our development efforts primarily to expanding our product line and increasing the functionality and enhancing the ease-of-use of our software products. We have significantly increased our research and development employee headcount through the continued expansion of our research and development centers in the Czech Republic and India and through acquisitions. We expect to continue to invest in our research and development activities by hiring engineers in our international locations and supplementing our

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internal research and development activities with additional contract services, which will allow us to continue our research and development growth strategy internationally.
General and Administrative. General and administrative expenses primarily consist of personnel costs for our executive, finance, legal, human resources and other administrative personnel and the amortization of acquired intangible assets. Legal, accounting and other professional service fees, restructuring charges, along with general corporate expenses are also recorded in general and administrative expenses. Restructuring charges include the expenses related to the closing of certain offices such as severance, relocation and the estimated costs of exiting and terminating facility lease commitments. We expect to incur higher administrative costs in future periods as our business continues to grow both organically and through acquisitions. Other Income (Expense)
Other income (expense) primarily consists of interest income, interest expense, transactional foreign exchange gains (losses), foreign exchange contracts gains (losses) and grant income.
Income Tax Expense
Income tax expense primarily consists of corporate income taxes related to profits resulting from the sale of our software offerings by our four entities that sell our software, one in the United States, one in Canada, one in Ireland and one in Sweden. The rate of taxation on income earned by our U.S. entity is higher than the rate of taxation on income earned by our Canadian, Irish and Swedish entities. If our international income, as a percentage of total income, increases as we expect, then our effective income tax rate should correspondingly decline. However, our effective tax rate may be affected by many other factors, such as changes in tax laws, regulations or rates, new interpretations of existing laws or regulations, the impact of accounting for stock-based compensation, the impact of accounting for business combinations, the impact of accounting for uncertain tax positions, changes in our international structure, shifts in the amount of taxable income earned in the United States, as compared with other regions in the world, and changes in overall levels of income before tax.
We benefited from the tax credit incentives under the U.S. research and experimentation credit extended to taxpayers engaged in qualified research and experimental activities while carrying on a trade or business. The tax credit expired on December 31, 2013, and if not renewed under similar terms as in prior years the result could have a material impact on our financial results.

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Comparison of the Three Months Ended June 30, 2014 and 2013 The following table sets forth our condensed consolidated statements of income data for the periods indicated:

                                                            Three months ended June 30,
                                                       % of                             % of
                                       2014           Revenue           2013           Revenue          Change
                                  (in thousands)                   (in thousands)                   (in thousands)
License                          $       37,636         37.1  %   $       31,217         40.3  %   $        6,419
Maintenance and other                    58,035         57.2              45,373         58.5              12,662
Subscription                              5,833          5.7                 929          1.2               4,904
Total revenue                           101,504        100.0              77,519        100.0              23,985
Cost of revenue                          10,898         10.7               6,157          7.9               4,741
Gross profit                             90,606         89.3              71,362         92.1              19,244
Operating expenses:
Sales and marketing                      35,254         34.7              20,276         26.2              14,978
Research and development                 13,883         13.7               8,218         10.6               5,665
General and administrative               23,263         22.9              11,554         14.9              11,709
Total operating expenses                 72,400         71.3              40,048         51.7              32,352
Operating income                         18,206         17.9              31,314         40.4             (13,108 )
Other income (expense):
Interest income                              83          0.1                 110          0.1                 (27 )
Interest expense                           (216 )       (0.2 )                 -            -                (216 )
Other income (expense), net                  13            -                (340 )       (0.4 )               353
Total other income (expense)               (120 )       (0.1 )              (230 )       (0.3 )               110
Income before income taxes               18,086         17.8              31,084         40.1             (12,998 )
Income tax expense                        4,707          4.6               8,287         10.7              (3,580 )
Net income                       $       13,379         13.2  %   $       22,797         29.4  %   $       (9,418 )

Revenue increased $24.0 million, or 30.9%, in the quarter ended June 30, 2014 compared to the quarter ended June 30, 2013. Total revenue by product group was $60.3 million and $54.0 million for network management, $31.7 million and $21.9 million for systems and application management and $9.4 million and $1.7 million for our MSP products for the quarters ended June 30, 2014 and 2013, respectively.
Our revenue from our international subsidiaries was 27.5% and 26.2% of total revenue in the second quarter of 2014 and 2013, respectively. Other than the United States, no single country accounted for 10% or more of our total revenues during these periods. We expect international sales as a percentage of our total sales in 2014 to increase slightly as compared to 2013. We plan to continue expanding our sales and marketing efforts outside of the U.S. License, Maintenance and Other Revenue
License revenue increased $6.4 million primarily due to increased sales of our systems and application management products and due to increased sales of our MSP and network management products.
In the fourth quarter of 2013, we changed the methodology for calculating our average transaction size and product transaction volume growth metrics. We now calculate these metrics using commercial transactions only and excluding any transactions that consist solely of our transactional products sold on a . . .

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