SolarWinds Corporation (SWI) has had a strong financial performance, even during Q2 during the pandemic, with 8% YoY revenue growth and 106% subscription net retention.
In fact, the CEO has coined the term “The Rule of 50”, implying that the company revenue growth plus profitability is 50%, at least for the core IT management products, the part that would likely remain in case the company spins off a portion of its business. The Rule of 50 is of course a take-off on the Rule of 40, a metric that readers of my work may be familiar with.
Stock Market Performance
But while the company is strong financially, this has not translated into stock market performance. The company went public in 2017 at $15 and even now is only trading at less than $21. Over the last year alone, the stock has underperformed the software industry by more than 30%.
(Source: Portfolio123/MS Paint)
In the Q2 2020 earnings call, the company management indicated that they are exploring the possibility of spinning off the MSP products into a separate company, allowing this division to pursue a high-growth trajectory without being saddled with a massive debt load. SolarWinds currently has ~$2 billion in debt versus ~$330 million in cash.
Management realizes that it has two conflicting business models and is looking to split them apart while hopefully improving the value proposition for each entity. From the latest quarterly report:
If completed, the standalone entity would provide broad and scalable IT service management solutions designed to enable managed service providers, or MSPs, to deliver outsourced IT services for their small and medium size business end-customers and more efficiently manage their own businesses.
SolarWinds would retain its Core IT Management business focused primarily on corporate IT organizations. We believe that, if completed, the potential spin-off would enable shareholders to more clearly evaluate the performance and future potential of each entity on a standalone basis, while allowing each to pursue its own distinct business strategy and capital allocation policy.”
In conjunction with this announcement, the CEO has announced his intention to retire from SolarWinds. It is possible (if not likely) that he did not promote the suggestion of splitting the company apart and my speculation is that someone else is pulling the strings, possibly the board of directors. Remember that the stock performance has been unimpressive to date and the board is probably getting impatient.
Although, this path forward is not cast in stone, I believe it to be positive and may be the catalyst that causes the stock price to be propelled higher. The stock is already making moves.
(Source: Yahoo Finance/MS Paint)
The plot below illustrates how SolarWinds stacks up against the other stocks on a relative basis based on forward EV/Sales versus forward revenue growth. Note: Please refer to a recent article for more information on the scatter plot relative valuation technique.
(Source: Portfolio123/private software)
SolarWinds is situated slightly above the best-fit line on the scatter plot, suggesting that the stock is fairly valued on a relative basis relative to its peers based on expected future revenue growth and its forward sales multiple.
The Rule Of 40
I haven’t had much opportunity to dig out this software industry metric lately, given the pandemic and all. The industry metric that is often used for software companies is the Rule of 40. It is an industry rule of thumb that attempts to help companies ascertain how to balance growth and profitability. For a further description of the rule and calculation, please refer to one of my previous articles.
(Source: Portfolio123/MS Paint)
In SolarWinds’ case:
Revenue Growth + FCF margin = 12% + 32% = 43%
SolarWinds scores above the 40% needed to fulfill the Rule of 40, suggesting that it has a healthy balance between growth and profitability.
Note that SolarWinds management referred to the Rule of 50 (above). They are likely using earnings in their calculation, whereas I use free cash flow margin.
It seems unlikely that we will see a vaccine until at least the spring of 2021 and that depends on everything going well in Phase 3 trials for vaccine candidates. I am ignoring the apparent release/approval of the Russian vaccine as I don’t believe that it will be accepted by the western world. It will be at least a year (in my opinion) before we see a return to some kind of normalcy.
While we wait, the government and the Federal Reserve are being generous with handouts and stimulus. But how long will this last? The handouts are a heavy burden for taxpayers, and I can’t see such handouts persisting for much longer, certainly not past the November election. When the handouts stop, I expect that the stock market may become very bearish.
We are in the midst of a recession, if not a depression. Government employment statistics do not really capture the true extent of the state of the economy. SolarWinds’ future performance along with most other stocks depends on economic recovery.
SolarWinds has an extremely large debt load of ~$2 billion while it only has $330 million in cash and cash equivalents. The huge debt load could become an issue in a prolonged recession. The huge debt load makes it difficult to refinance or make acquisitions.
SolarWinds may not go forward with the potential spin-off. This could depress the stock price if the spinoff is built into the stock price.
Summary and Conclusions
SolarWinds is a leader in digital transformation providing companies with the “power to monitor and manage the performance of their IT environments, whether on-premise, in the cloud, or in hybrid infrastructure models.”
Revenue guidance for Q3 2020 issued by company management is for 8% YoY growth. Keep in mind that SolarWinds is actually providing guidance whereas many companies have withdrawn guidance completely. YoY growth of 8% is not too shabby in this difficult economic environment. I expect that growth will rebound once we emerge from the pandemic, hopefully within the next year.
The stock price has been stagnant since the company went public in 2017. I believe that changes are necessary in order to put some life into the stock, and I believe that these changes are happening and are positive. This involves splitting the company into two separate entities, one being a high-growth SaaS not saddled with a high debt load, and the other business consisting of legacy operations that are very profitable. As a single company, the two business models are in conflict. Apart, their true value can be unlocked.
I consider the stock to be fairly valued, and the stock appears to be poised to break out, although there have been head fakes in the stock chart previously. I am giving this company a speculative buy rating.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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.