Solar Winds Corporation Exploring Potential Spin-Off Of MSP Business

Deal Overview

On August 6, 2020, SolarWinds Corporation SWI (NYSE: SWI, $19.91, $6.2 billion), a provider of powerful and affordable IT management software, announced that its Board of Directors has authorized the company’s management to explore a potential spin-off of its managed service providers (MSP) business into a separately traded public company. Post separation, the MSP business (spin-off entity) will provide broad and scalable IT service management solutions designed to MSPs to deliver outsourced IT services for their small and medium size business end-customers and more efficiently manage their own businesses. On the other hand, SolarWinds will retain its Core IT Management business, focused primarily on corporate IT organizations.

In case the spin-off is finalized, it would be structured as a tax-free, pro-rata distribution to all SolarWinds shareholders as of a record date to be determined by the Board of Directors of SolarWinds. The spin-off completion is subject to various conditions, including final approval from the Board of Directors. If the company proceeds with the spin-off, it is not expected to be completed before the end of 1Q21. Post completion, SolarWinds shareholders will own shares of both companies.

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DLA Piper LLP (US) is serving as legal advisor to the company.

For the MSP business, management expects modest leverage which is below that of the current business but in-line with the technology peers of similar scale. Given the cash flow generation of the Core IT Management unit, management expects a higher level of leverage than the current business for the unit, which can be used for growth initiatives and returning capital to shareholders. Essentially, the Core IT Management unit is expected to distribute a meaningful portion of its profits annually and potentially pursue free cash flow accretive mergers and acquisitions, the MSP unit may reinvest its profits for growth or to drive mergers and acquisitions. In 2020, the MSP unit is expected to generate ~$300 million non-GAAP revenue (~$100 million recurring), while the Core IT Management unit is expected to generate more than $700 million non-GAAP revenue.

SWI entered the MSP business in 2013 with the acquisition of N-able and expanded through the LOGICnow acquisition in 2016. As of Dec 2019, the company served 27,000 MSPs which extend the company’s products to 450,000 organizations all over the world.

In February 2016, private equity investors Thoma Bravo and Silver Lake Partners completed the acquisition of SolarWinds for ~$4.5 billion in cash. The deal was announced in October 2015. Private equity investors currently own majority stake in SWI and are likely to continue to remain major stakeholders in both the companies post separation.

In October 2018, SolarWinds again went public. SWI sold and issued 25 million shares of common stock in an IPO at an issue price of $15.00 per share. The company raised ~$375 million in gross proceeds from the offering or ~$353 million in net proceeds. The shares began trading from October 19, 2018 on the New York Stock Exchange (NYSE) under the ticker symbol “SWI”. The company used these proceeds to repay the $315 million in borrowings outstanding under second lien term loan. In May 2019, SWI completed a follow-on offering for 15 million shares of common stock at a price of $18.00 per share. The offering closed on May 28, 2019.

Acquisitions

On April 30, 2019, SWI acquired Samanage, an IT service desk solution company, for ~$342.1 million. With this acquisition, the company entered the IT service management (ITSM) market and introduced the SaaS-based service desk solution, SolarWinds Service Desk.

On December 10, 2019, SWI acquired VividCortex, a SaaS-based database performance management solution company, for ~$117.6 million in an all cash transaction.

Deal Rationale

The company believes that the strategic rationale for the separation is compelling as it will create two independent market leaders, with each focusing on its individual business, customers and strategic initiatives. Overall, management expects the transaction to be transformational in nature, enabling to drive higher future growth in the MSP business and allowing for optimization of operating performance at the Core IT Management business. Additionally, each business could have its distinct capital structure according to maturity, growth and profit levels. Moreover, shareholders of each business can value each business independently based on each company’s assets, operations and future growth potential. In case SWI proceeds with the spin-off, management expects the Core IT Management unit to focus on maintaining its best in-class profit margins, while the MSP business can focus on long-term growth, along with differentiated margins as a SaaS business.

Management admitted that as part of a larger consolidated entity, investments in the MSP unit have been constrained and focused primarily on driving profitability. However, post separation, investments in the MSP unit can be focused on driving higher revenue growth and an elevated level of profitability. The MSP business can be positioned as a high-growth software entity, and probably acquire companies and technologies which may not have been considered previously by SWI’s management. Since January 2018, the MSP unit has grown at a robust pace of ~17% Compounded Annual Growth Rate (CAGR) in constant currency (cc), establishing a strong position in the global MSP business. SWI reckons that growth investments such as the introduction of new technology offerings and expansion of its global sales force may enable the MSP unit to generate revenue growth in excess of 20%. Based on top-line growth and operating leverage potential of the business, the unit may approach the “Rule of 50” (implies that the summation of sales growth and EBITDA margin equals 50%).

The company’s Core IT Management unit has a highly recurring revenue stream and allows for entering well-established markets and disrupting them, including mature parts of the IT management markets. The unit will be positioned as a levered free cash flow generating entity with meaningful annual capital return potential. Since January 2018, the Core IT Management business has grown at 10% CAGR and at non- GAAP profitability, well above SWI’s average. Management believes that the unit can continue to grow revenue at low-to-mid single digits and also enhance its market share, with the inherent high operating leverage driving a profitability well above the “Rule of 50”. Furthermore, management believes that optimization may provide incremental shareholder value creation opportunity through special dividends at deal closure and annual dividend payments thereafter.

SWI is the leader in network management software according to IDC and at third place in systems and application management according to Gartner IT . We reckon that SWI may be seeking to build further on these strengths post the spin-off. Since there are no pure-play listed MSP companies in our knowledge, the spun-off unit could offer investors exposure to a high-growth and high-margin company in a new space and at a relatively early growth stage. Overall, we believe that a potential spin-off can likely improve each unit’s prospects, thereby creating shareholder value.

In an interview to ChannelE2E in August 2020, SolarWinds’ CEO Kevin Thompson and SolarWinds MSP unit’s President John Pagliuca stated that they do not intend to sell their businesses in the near term. Moreover, given the detailed plan and rationale for the spin-off deal laid out by SWI’s management at the outset, we believe that the chances of the spin-off transaction to progressing successfully are high.

Founded in 1999 and headquartered in Texas, SolarWinds Corporation (SWI) provides information technology (IT) infrastructure management software. The company offers more than 50 infrastructure-location agnostic products to monitor and manage the network, systems, desktop, application, storage, database, website infrastructures, and IT service desks. SWI markets and sells products directly to network and systems engineers, database administrators, storage administrators, DevOps and service desk professionals and MSPs. The company caters to organizations worldwide, irrespective of its type, size, or IT infrastructure complexity, and enables them to monitor and manage their IT environment including on premises, in the cloud, or hybrid models. SWI generates revenue through Subscription, Maintenance and License. Subscription, and Maintenance together comprise the Recurring Revenue business. For FY19, recurring revenue accounted for ~82% of total revenue and license revenue accounted for ~18% of total revenue. For FY19, US generated ~61% of the total revenue and International markets generated ~39% of the revenue. As of December 31, 2019, the company had 1,161 employees in the United States and 2,090 employees outside the United States making it a total of 3,251 employees. As of December 31, 2019, SWI had more than 320,000 customers (Dec 18: More than 300,000).

Subscription Revenue

Subscription revenue is mainly driven by fees received for subscriptions to SaaS offerings and time-based license arrangements. Subscription revenue consists of MSP, application performance management and IT service management, or ITSM products. Company invoice subscription agreements either on a monthly usage basis or on a monthly/annual basis in advance over the subscription period. Subscription revenue for SaaS offerings is recognized once the service is available to the customers or when the company has the right to invoice for services performed over the subscription term. Revenue for the license performance obligation of the time-based license arrangement is recognized at the point in time upon delivery of the license key while revenue for technical support performance obligation is recognized over the contract period.

Maintenance Revenue

Maintenance revenue is derived from the sale of maintenance services associated with perpetual license products. For each perpetual software offerings, the company includes one year of maintenance service as part of the initial purchase price and then generates revenue on renewals of this maintenance agreement. With these maintenance agreements, customers receive technical support and unspecified upgrades or enhancements to new versions of the software products over the contract period on a when-and-if –available basis. Maintenance revenue is recognized on a daily basis over the contract period.

License Revenue

License revenue is derived from the sale of perpetual licenses of products to new and existing customers. Revenue for the license performance obligation of perpetual license arrangements is recognized at a point in time upon delivery of the electronic license key. Perpetual license arrangements are invoiced upon delivery.

FY19 Results

For FY19, Total Non-GAAP revenue grew 12.1% YOY to $938.5 million, primarily driven by 22.5% growth in subscription revenue, 10.1% growth in maintenance revenue and 0.5% increase in license revenue. Non-GAAP Gross Profit rose 12.3% to $860.8 million and corresponding margin expanded ~11 bps to 91.7%. Adjusted EBITDA increased 11.3% to $453.6 million while corresponding margin contracted ~36 bps to 48.3%. Non-GAAP operating income increased 11.6% to $436.2 million while corresponding margin contracted ~23 bps to 46.5%. Non-GAAP Net Income grew 43.3% to $263.8 million (+2.6% vs. consensus) and corresponding margin expanded ~611 bps to 28.1%. Non- GAAP diluted EPS rose 41.7% to $0.85 (FY18: $0.60).

1H20 Results

For 1H20, Total Non-GAAP revenue increased 10.9% YOY to $495 million, primarily driven by 25.9% growth in subscription revenue, 7.3% growth in maintenance revenue and partially offset by 8.4% decrease in license revenue. Non-GAAP Gross Profit rose 10.3% to $451.8 million while corresponding margin contracted ~53 bps to 91.3%. Adjusted EBITDA grew 6.6% to $230 million while corresponding margin contracted ~186 bps to 46.5%. Non- GAAP operating income rose 5.6% to $218.5 million while corresponding margin contracted ~223 bps to 44.1%. Non-GAAP Net Income grew 17.2% to $141.8 million and corresponding margin expanded ~153 bps to 28.6%. Non GAAP diluted EPS rose 15.4% to $0.45 (1H19: $0.39).

Outlook

For 3Q20, Total Non-GAAP revenue is expected in the range of $254 to $259 million representing growth of 5%-7%. Adjusted EBITDA in the range of $119 to $122 million. Non-GAAP diluted EPS of $0.24. For FY20, Total Non-GAAP revenue is expected in the range of $1,008 to $1,018 million representing growth of 7%-8%. Adjusted EBITDA in the range of $470 to $476 million. Non-GAAP diluted EPS of $0.94.

Company Description

SolarWinds Corporation (Parent)

Founded in 1999 and Incorporated in 2015, SolarWinds is a leading provider of information technology (IT) infrastructure management software. The company offers more than 50 infrastructure-location agnostic products to organizations worldwide and irrespective of type, size or IT infrastructure complexity, enables them to monitor and manage the performance of their IT environments on premises, in the cloud or in the hybrid models. The Company offers its products to all types of technology professionals including IT operations professionals, DevOps professionals, and managed service providers (MSPs). Technology professionals use IT Operations Management (ITOM) products to manage their organization’s IT infrastructure and MSP uses company’s products to manage their end clients’ IT infrastructure. As of December 2019, the company had 3,251 employees. The company is headquartered in Texas.

MSP Business (Spin-Off)

SolarWinds entered the MSP business in 2013 with the acquisition of N-able and further expanded through LOGICnow acquisition in 2016 and has continuously grown its Software-as-a-Service (SaaS) business over the last seven years. As of Dec 2019, the company served 27,000 MSPs which extend the company’s products to 450,000 organizations all over the world. For the year 2020, MSP business is expected to generate revenue of ~$300 million.

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