SolarWinds Corp

NYSE:SWI

Earnings Call Transcript 2021-Q2

[Operator]

Ladies and gentlemen, thank you for standing by, and welcome to the SolarWinds Second Quarter 2021 Earnings Call. All lines are currently in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions]

It is now my pleasure to hand the conference over to Ashley Hook.

[Ashley Hook, Investor Relations]

Thank you, Nicole. Good morning, everyone, and welcome to the SolarWinds' second quarter 2021 earnings call. With me today are Sudhakar Ramakrishna, our President and CEO; and Bart Kalsu, our EVP and Chief Financial Officer. Following prepared remarks, we'll have a brief question-and-answer session. This call is being simultaneously webcast on our Investor Relations website at investors.solarwinds.com. On our Investor Relations website, you can also find our earnings press release and a summary slide deck, which is intended to supplement our prepared remarks during today's call.

Please remember that certain statements made during this call are forward-looking statements, including those concerning our financial outlook, the impact of the cyber incident on our business, our market opportunities, the impact of the global economic environment on our business and the related – the recently completed spinoff of the N-able business. These statements are based on currently available information and assumptions, so we undertake no duty to update this information, except as required by law.

These statements are also subject to a number of risks and uncertainties, including the numerous risks related to the cyber incident and the recently completed spinoff of the N-able business. Additional information concerning these statements and the risks and uncertainties associated with them is highlighted in today's earnings release and in our filings with the SEC. Copies are available from the SEC or on our Investor Relations website.

In addition, we note that our financial results for the second quarter include the impact of the N-able business for the entirety of the quarter, since the spinoff was not completed until July 19, 2021. In today's remarks, when we reference our ongoing SolarWinds business, this will reference to our core IT management business, excluding N-able. Furthermore, we will discuss various non-GAAP financial measures on today's call, unless otherwise specified. When we refer to financial measures, we will be referring to the non-GAAP financial measures. A reconciliation of the differences between GAAP and non-GAAP financial measures discussed on today's call are available in our earnings press release and the summary slide deck on our Investor Relations website. Going forward, we will begin to present certain financial measures on a GAAP basis only.

With that, I’ll now turn the call over to Sudhakar.

[Sudhakar Ramakrishna, President and Chief Executive Officer]

Thank you, Ashley. Good morning, everyone, and thank you for joining us today. I hope you're doing well and staying safe. I want to start by first thanking our employees, customers, partners and our shareholders for their ongoing commitment to SolarWinds. Our employees, we call ourselves Solarians, continue to demonstrate excellent commitment to our customers. As I outlined in the Q4 2020 earnings call, customer retention is our number one priority in 2021, and we made great progress towards this goal in Q2. I attribute the progress to the dedication of our employees, the relevance of our solutions to address customer needs and the commitment of our partners and customers to SolarWinds.

We substantially completed our investigation into the cyber incident and published our findings in May, and continue to apply the learnings via our Secure by Design initiatives. I have also had the opportunity to share our findings in public forums such as the RSA, the CYBERSEC Global and UK Cybersecurity Conferences as well as with industry peers and government authorities around the world. It is an unfortunate fact that no company, regardless of its size, competency and resources seems immune to cyber-attacks as evidenced by the recent high-profile breaches. In this environment, our pledge of transparency and industry collaboration remains strong and has been well received by customers, partners and the broader industry as we accelerate our journey to deliver simple, powerful and secure solutions.

As a reminder, our Secure by Design initiative focuses on three core areas; first is to enhance the security of our internal environment and infrastructure; two is to enhance the security of our software build systems and environment; and third is innovating to enhance software supply chain build processes. We've devised a unique software build process that's performed across three discrete environments with different characteristics and permissions. This build process results in a changing threat surface and a compressing threat window, thereby making it more difficult for threat access to break in and, therefore, enhancing the integrity of our software supply chain. This approach has resonated well with our customers, many of whom are also developers of software, and we are winning significant deals with customers as a direct result of this aspect of our Secure by Design initiative. Also, as part of our ongoing efforts to make customer environments more safe and secure, we plan to publish white papers and other materials to help the industry at large.

I will now touch on a few financial and operational highlights in Q2 for our consolidated business. For the second quarter, we delivered revenue well above the high end of the range of our outlook with total consolidated non-GAAP revenue ending the quarter at $262 million, representing year-over-year growth of 6%. Our consolidated results include N-able for the second quarter, which we successfully spun-out last month.

Second quarter consolidated adjusted EBITDA was $111.1 million, representing an adjusted EBITDA margin of 42%, exceeding the high end of our outlook for the second quarter. Our Q2 ongoing SolarWinds maintenance renewal rate of 86% is above the low to mid-80s renewal rates we noted we expected in 2021. We continue to focus on customer retention as a key priority and hope to go back to our historical and best-in-class renewal rates of over 90%. We secured the largest on-premises term subscription deal in the company's history from a large healthcare provider in the United States. This further validates our transition to our business with a higher subscription mix and the confidence that customers place in our portfolio road map. Our consolidated subscription revenues grew 17 % year-over-year with our ongoing SolarWinds subscription revenue growing 16% year-over-year, and this area of our business will continue to be a key focus of mine on an ongoing basis.

We are winning large public sector deals throughout the world. In many of these customer engagements, our Secure by Design initiative features prominently. We are seeing that the comprehensiveness of our initiative, as described earlier in my comments, and its applicability to a broad range of customer environment is a key differentiator. During the second quarter of 2021, we launched SolarWinds Database Insights for SQL Server, expanding our comprehensive database performance management portfolio. Uniting the features and functionality of the award-winning SolarWinds Database Performance Analyzer and SolarWinds SQL Sentry Database Insights for SQL Server provides the in-depth performance and environmental data teams need to optimize the performance of Microsoft SQL Server and other leading database platforms running on-premises, in the cloud or in hybrid environments.

Our products and services received more than 35 industry and customer awards in the first half of 2021. Notably, TrustRadius named nine SolarWinds IT operation management products as 2021 Top Rated award winners across 13 categories, and the company's commitment to customer support and success was honored through five Stevie Awards. We continue to attract excellent talent across all functions of our organization. People see the opportunity we have with our mission and strategy to address what we believe will be a $100 billion market opportunity.

Last but not the least, we reached another significant milestone by completing the spinoff of our managed services business, now known as N-able, on July 19, 2021. By operating as two independent publicly-traded companies, we believe that SolarWinds and N-able will be better positioned to align with each other's market needs and customer requirements, enhancing the successful operations of both companies in the future.

With that, I will turn it over to Bart to provide more details on our financial performance and outlook.

[Bart Kalsu]

Thanks, Sudhakar, and thanks again to everyone joining us on today's call. I will discuss our second quarter results on a consolidated basis, consistent with what we have discussed in the past. I will also provide some supplemental information related to the ongoing SolarWinds business. As most of you know, our spin-off of the N-able business occurred last month on July 19. Therefore, N-able's results are included in our second quarter financial results, and our second quarter guidance assumed N-able results for the full quarter. We are in the process of preparing carve-out financial statements. And in future periods, our public filings will present N-able as discontinued operations.

Our second quarter financial results reflect solid execution while demonstrating the resiliency of our model. That execution led to another quarter of better-than-expected results, and finished well above the high end of the range of our outlook for the second quarter with total non-GAAP revenue ending the quarter at $262 million, representing year-over-year growth of 6%.

Total N-able revenue for the second quarter was $85 million, representing year-over-year growth of 16%. The N-able management team will talk about their results in a separate earnings call on August 12. Excluding N-able, total ongoing SolarWinds revenue was $177 million, above the high end of our second quarter revenue outlook of $170.5 million to $174 million. Total license and maintenance revenue was $149.5 million in the second quarter, which is flat with prior year. Maintenance revenue was $123 million in the second quarter, up 5% versus the prior year. We typically disclosed the maintenance renewal rate for our perpetual license products on a trailing 12 months basis, which was 90% through the end of the second quarter. This includes more than two quarters of renewals since the cyber incident. Also consistent with the first quarter, we wanted to provide the in-quarter renewal rate for the most recent quarter. Our second quarter in-quarter renewal rate is currently at approximately 86%, which again is above our expectations at start of the year. Our primary focus for the first half of the year was to ensure that our customers recognize our efforts related to our Secure by Design commitment and trust us to help them transform faster in increasingly hybrid IT world. And we believe our renewal rates so far in 2021, demonstrate that trust.

For the second quarter, license revenue was $26.7 million, which represents a decline of approximately 21% as compared to the second quarter of 2020. On-premises subscription sales resulted in an approximately nine percentage point headwind to our license revenue for the quarter. The remainder of the decline in license revenue reflects the combination of the impact of the security incident, including our decision to pause demand generation and customer acquisition activities from December through the first quarter, as well as the continuing impact of the COVID-19 pandemic.

That said, we improved our new license sales performance sequentially, and the year-over-year decline in the second quarter is an improvement from the year-over-year decline in the first. We saw acceleration in new license sales in our commercial business in the second quarter. We are working to continue that trend as we move through the rest of the year.

Total ARR reached approximately $992 million as of June 30, reflecting year-over-year growth at 14%. Our ongoing SolarWinds ARR represented $640 million out of that total at the end of the second quarter. Ongoing SolarWinds ARR grew 12% year-over-year due to the incremental revenue from SentryOne. The SentryOne acquisition in the fourth quarter of last year and our continued focus on retaining our maintenance base.

Moving to our subscription revenue second quarter consolidated non-GAAP subscription revenue was $112.5 million up 17% year-over-year of which $82.8 million was from the N-able business. Our ongoing SolarWinds subscription revenue was $30 million in the second quarter, which reflects 60% year-over-year growth. This is an area of our business, which is expected to overcome [Technical Difficulty] we finished the second quarter of 2021 with 1,107 customers that spent more than $100,000 with us in the last 12 months, which has a 60% improvement over the previous year. We are continuing our efforts to build larger relationships with our enterprise customers in our ongoing SolarWinds business.

We also had a solid second quarter of non-GAAP profitability. Second quarter consolidated adjusted EBITDA was $111 million representing an adjusted EBITDA margin of 42% exceeding the higher-end of the outlook for the second quarter. And unlevered free cash flow improved in the second quarter totaled $80 million. Excluded from EBITDA and unlevered free cash flow, our one-time cost of approximately $24 million, including $13 million of spinoff related costs and $11 million of cyber related remediation containment, investigation, and professional fees net attributable.

I do want to clarify that these cyber related costs not included in adjusted EBITDA are onetime and nonrecurring. They are separate and distinct from the Design initiatives, which are aimed at enhancing our IT security and supply chain process. Costs related to our Secure by Design initiatives are and will remain part of our recurring cost structure on a go-forward basis. We expect onetime cyber-related costs to fluctuate in the future quarters, but to be less in future periods as the amount incurred in the first half of the year.

These onetime cyber costs are, however, difficult to predict. They not only include the significant costs of the forensic investigation efforts, which we substantially completed in May, but also costs associated with our ongoing litigation, government investigations, any potential judgments or fines and related professional fees. We expect our insurance coverage to offset a portion of these expenses and will be presented net of any insurance proceeds received.

Our onetime spin-related costs will continue through the third quarter as we finish the legal and accounting compliance work associated with the spin as well as the ongoing work associated with separating our internal systems in connection. Net leverage at June 30 was 3.2 times, our trailing 12-month adjusted EBITDA. SolarWinds will retain the full amount of the $1.9 billion in term debt. On July 30, we completed a two-for-one reverse stock split, and declared a dividend of $1.50 per share on a post-split basis, which will be paid on August 24, primarily from the approximately $263 million of cash that was distributed by N-able in connection with the spinoff.

In addition, N-able will repay $325 million of intercompany debt. SolarWinds will retain that cash on our balance sheet for the foreseeable future. And as a result of this repayment, we expect our cash balance to be approximately $680 million at the end of the third quarter, bringing our net debt to approximately $1.2 billion on a post-spin basis.

I will now walk you through our ongoing SolarWinds outlook before turning it back over to Sudhakar for some final thoughts. Consistent with our guidance for the past year, we will only provide third quarter 2021 outlook for total revenue, adjusted EBITDA and earnings per share. We are also only providing guidance as it relates to our ongoing SolarWinds business, which is what remained after the spin-off of N-able. For the third quarter of 2021, we expect ongoing SolarWinds total non-GAAP revenue to be in the range of $176 million to $180 million, representing a year-over-year decline of 3% to 5%. Adjusted EBITDA for the ongoing SolarWinds business for the third quarter is expected to be approximately $70.5 million to $72 million, which implies an approximately 40% adjusted EBITDA margin.

As a reminder, our EBITDA margin forecast includes the incremental spending associated with our Secure by Design initiatives, our ongoing investments in our international sales teams and database management products, and the continued evolution of our subscription model. Non-GAAP fully diluted earnings per share is projected to be approximately $0.27 per share, assuming an estimated $150.2 million fully diluted shares outstanding, which reflects the reverse stock split completed on July 30.

Finally, our outlook for the third quarter assumes a non-GAAP tax rate of 22%, and we expect to pay approximately $7.5 million in cash taxes during the third quarter of 2021. The third quarter outlook incorporates a few factors. First, as we discussed during our third quarter 2020 earnings call, our federal business had one of the stronger quarters in our history, creating a tough compare. For that reason, while we continue to grow sequentially in new license sales to our federal customers in 2021, we are not expecting results like the prior year.

The second is that maintenance revenue reflects the impact of lower new license sales since the start of the pandemic in early 2020 as well as our expectation that the renewal rates in 2021 will be in the mid-80s. And finally, our third quarter outlook reflects the continued transition of a portion of our new sales to on-premises subscriptions. While we are not providing full year outlook, I will say that we expect new license and subscription sales in our commercial business to continue to improve in the third quarter, and as we move into the fourth quarter, which is usually our strongest quarter of the year for new bookings.

Based on what we've seen so far in the first half, we expect that the maintenance renewal rates will be in the mid-80s for the rest of 2021, and we are targeting to return to historical performance in 2022. We intend to continue to expand the subscription offerings of our on-premises products in 2021, and 2022 and make new subscription sales a much higher priority with our sales teams. As we think about our EBITDA margins for the rest of the year and into 2022, the costs associated with our Secure by Design initiatives, investment in transitioning our product portfolio to a greater subscription mix and our continued investments in our sales and marketing initiatives are factored into the margins in the short term.

We continue to remain committed to accelerating margins again in 2022 and beyond. With that, I will turn the call over to Sudhakar for his closing remarks.

[Sudhakar Ramakrishna, President and Chief Executive Officer]

Thank you, Bart. Our team's confidence, commitment and attitude continues to be evident as we delivered a strong Q2 performance, and results exceeding our outlook in both revenue and EBITDA. We are executing our mission to help customers accelerate their business transformation via simple, powerful and secure solutions for hybrid IT environments. We believe our consolidated platform, breadth and depth of capabilities and our commitment to customer success will enhance our ability to be relevant to customers and enhance the lifetime value potential of our customer base.

For the remainder of 2021, our focus will continue to be on executing on the initiatives that I outlined during our Q4 2020 earnings call, focusing on customer retention and demonstrating ongoing progress in subscription, license and maintenance growth across all geographies and sectors. Additionally, we continue to hone our long-term strategic portfolio and models. We look forward to hosting you all for an Analyst Day in Q4 of this year. Please stay tuned for additional details.

I'll conclude again by thanking our employees, partners and customers for their commitment to SolarWinds. We hope to continue to demonstrate progress across all dimensions of strategy and operations as we execute our second half plan and into 2022. Bart and I now will be happy to address your questions.

[Operator]

[Operator Instructions] The first question will come from the line of Matt Hedberg with RBC Capital Markets.

[Dan Bergstrom, RBC Capital Markets]

Hey It's Dan Bergstrom for Matt Hedberg. Thanks for taking our question. Could you talk a little bit about customer retention, obviously, a key focus here? The renewal rate continues to track ahead of that kind of the low to mid-80% figure you provided in February. What's behind that? And then what are you focused on doing? Or is it more – just more time needed to move back to that historical 90% range?

[Sudhakar Ramakrishna, President and Chief Executive Officer]

Matt, this is Sudhakar. I'll take that question. The first thing I would highlight is the commitment of our employees to customer success. We have been engaged with customers constantly, and we continue to be engaged with customers constantly. The second is the relevance of our solutions to customers. As they engage with us, understand what happened as well as understand the initiatives that we have taken, that I call Secure by Design, they seem to appreciate not only the value that our products bring to them, but also the commitment that we have to the safety and security of customer environment at large. So those are two contributing factors, I would say, the commitment of our employees, the relevance of our solutions.

In terms of what it would take to get back to historical levels, this is basically going to be a journey, Dan, which is in the first half of this year, quite literally, and also into Q3, customer engagement and customer retention has been our priority. And as customers come back up online, there will be sometimes delays in terms of their evaluation processes, delays in their renewal processes and so on. And so we factored all of those when we came out in the low to mid-80 renewal rate, which, as you noted, are obviously trending better than what we projected. And so our belief is that we’ll continue on that path going forward into 2022 and beyond.

[Dan Bergstrom, RBC Capital Markets]

Great. Thanks. Very helpful. And then could you talk to linearity trends in the quarter? Anything different from what you’d expect as far as building on the first quarter? And then July is complete at this point, anything to note as far as third quarter trends? Thank you.

[Sudhakar Ramakrishna, President and Chief Executive Officer]

So what I’d highlight is reimpose Bart’s comments that quarter-after-quarter, month-after-month, we are seeing progress across biggest parts of our business as well as various geographies. I’ll also highlight that in Q1, for the most part, we did not pursue demand-generation activities because our first priority and the main priority was to help customers stabilize their environments. It was only later into Q1 that we reinitiated, so to speak, our demands and activities, and those are gaining more momentum as we go through the year. And so that has continued to have a meaningful impact into Q3 and Q4.

[Ashley Hook, Investor Relations]

We’ll take the next question.

[Operator]

The next question comes from the line of Sterling Auty with JPMorgan.

[Sterling Auty, JPMorgan]

Yes, thanks. Hi, guys. I apologize if I ask you to repeat some things. We’re juggling multiple calls. But when you talk about the renewal rates, you kind of talked about continuing in the mid-80s. But what I’m curious about is maybe some of the commentary that you heard back from customers, it doesn’t sound like there was a material uptick in the quarter. But how would you characterize what you did see relative to what you expected coming into the quarter?

[Bart Kalsu]

Yes, Sterling. I mean, as we said, our Q2 in-quarter renewal rate is currently at 86%. This is consistent with what we did in Q1, maybe slightly lower, but not necessarily what we didn’t – what we – it’s not out of line with what we expected. When we send out renewal quote, we send those out 90 days ahead of time. So Q1 was in flight from a renewal standpoint at the time of the cyber incident. So that’s one of the reasons why we expected Q1 to be better maybe than the rest of the year is because we knew that a certain amount of our base had already renewed.

So as we move through the rest of the year, it’s why we continue to say that the renewal rates would be in the mid-80s – low to mid-80s as we move through 2021, even though the first quarter was a little higher. We were very pleased with the fact that we are now at 86% on in-quarter renewals for the second quarter. We also know that the rest of the year is going to be – will be still be a challenge for us, but it is our number one focus, and it’s our number one priority is maintaining our customer base.

[Sudhakar Ramakrishna, President and Chief Executive Officer]

And Sterling, just to add to Bart’s comments, he noted in his prepared remarks that our trailing 12-month renewal rates are at 90%. So one thing I would highlight in this environment, and the reason why we gave a full year outlook in terms of the approach to renewal rates is that every quarter, different set of customers come up for renewal. And as we’ve engaged with them to help their environments become more and more stable, then inevitably, in some cases where customers will take a little bit extra time to renew compared to, call it, historical trends. And so we are trying to factor all of those, and that’s the reason why we sometimes go back and update the renewal rates be it Q1 or previous quarters as well, largely to the upside.

[Sterling Auty, JPMorgan]

Understood. And then on the margin front, you kind of gave the three areas of investment that you’re making, but I want to make sure I understand. What ones of those do you expect to be kind of temporary investments? And maybe give us an order of magnitude where we should see increasing leverage off of whatever spend we’re going to see next quarter? And what ones are going to be kind of continuing to invest maybe at a rate that’s similar to growth, so we don’t get as much leverage?

[Bart Kalsu]

Yes. So Sterling, when we talked about the Secure by Design initiatives on the previous earnings call, we talked about those – the costs associated with those being in the $20 million to $24 million range. We think it’s going to come in maybe at the lower end of that number, but those costs – that incremental cost is going to be in our ongoing cost structure. Those are things like increasing some of our head count in our R&D organization, around our supply chain process, some of the penetration testing and some of the other things that we’re going to do from a system standpoint to enhance our IT structure. Things like that are going to be just part of our ongoing structure. But – and hopefully, the cost – those costs are not going to ramp as our business goes up. So those are just going to be costs that will be built in.

The costs associated with some of the things that we also talked about and that is enhancing our international sales teams, some of where we’ve seen some positive results in 2021 has been outside the U.S., and we’re going to continue to invest in our international go-to-market motion. We also believe that the database market is a market of opportunity for us, not just this year, but as we go into 2022. And so we’re going to continue to invest in that market as well. And we hope that those investments will scale as revenue grows over time.

[Sterling Auty, JPMorgan]

Understood. Thank you.

[Bart Kalsu]

Thanks.

[Operator]

The next question will come from the line of Kingsley Crane with Berenberg.

[Kingsley Crane, Berenberg]

All right. Thanks for taking my question. So on July 9, you released a vulnerability for Serv-U or hot fix for that vulnerability. So could you please tell us about how many customers were impacted by this and how the customer conversations are going since that point?

[Sudhakar Ramakrishna, President and Chief Executive Officer]

I’ll take that. Yes, we did issue a patch for the vulnerability. The way I would characterize that is that it has obviously nothing to do with the SUNBURST breach that we quoted back in December. This is a typical – unfortunately, a typical zero-day vulnerability that affects us and other software vendors. And this will be an example I would cite of the security research community and the vendor community that includes us, working closely together to understand possible vulnerabilities and getting ahead of the curve by patching and releasing that to customers. So the way I would describe the customer support aspects and feedback is like with any issue, whether it’s a quality issue or a security issue, we proactively reach out to customers, help them with any download needs that they had, any upgrade needs that they had. But in terms of customer support volume, I would not say that it was anything unusual for us to handle.

[Kingsley Crane, Berenberg]

Okay, perfect. That’s very helpful. That’s it from me.

[Operator]

The next question will come from the line of Sanjit Singh with Morgan Stanley.

[Sanjit Singh, Morgan Stanley]

Good morning. Thank you for taking the questions, and congrats on the N-able spin. I had some questions on guidance. So if we look at this quarter’s results, total revenue was up 2%. Next quarter, we’re looking for a decline of, I think, 3% to 5%. So wondering if you can help me sort of bridge that given the consistency on the maintenance renewal side that you’re expecting. And then also from a maintenance ARR side, on the core IT business, that was up quite healthy, I think, 11% in Q2. So any sort of context you could provide on why the business would go ex-growth in Q3?

[Sudhakar Ramakrishna, President and Chief Executive Officer]

Definitely. Sanjit, I’ll provide some color, and Bart will jump in as needed as well. The first component I would highlight is that there is an ongoing focus within our business to evolve to subscription. And so we are going to have some headwinds associated with subscription. So that’s one factor that I’d highlight. Two, as we accounted and modeled for our Q3 bookings, we have to keep in mind the federal sector, where we continue to make progress even on a sequential basis. But last year’s February quarter of Q3 2020 was one of the largest in our company’s history. And so we had a very tough compare year-over-year associated with that.

And then the third factor that we accounted for, although our renewal and maintenance rates continue to improve, is factoring in the fact that in 2020 due to the pandemic, new product license sales were tepid. And so we are modeling our renewal rates and renewal dollars associated with that particular effect. So the combination of these three things is what causes us to present the way we are. And we’ll obviously, as Bart highlighted, continue to focus on our commercial business, continue to demonstrate progress month after month, quarter after quarter.

[Bart Kalsu]

And Sanjit, I just want to reiterate. Maintenance revenue for us is more of a trailing indicator of our business. So we’re somewhat – you’re going to see some slowdown in our maintenance revenue primarily because of the bookings and what’s happened to our license bookings over the last four to six quarters. You’ll start to see that in our maintenance revenue. So you won’t see a reacceleration in our maintenance revenue until we start to factor in more of these quarters where we’re growing license revenue year-over-year.

[Sanjit Singh, Morgan Stanley]

Understood. And Sudhakar, you make a good point on the subscription transition. If you could talk about sort of the unit economics and the subscription transition? It sounds like we’re about $120 million rough-ish in subscription ARR, growing at a pretty healthy clip even if you account for the acquisition. In terms of sort of the year one impact for a customer, what does that revenue headwind look like? And what is the sort of revenue breakeven time frame? Is that sort of a two year or three year? Can you just sort of review the basics of the subscription transition for us, that would be helpful.

[Sudhakar Ramakrishna, President and Chief Executive Officer]

So Sanjit, first of all, we are making significant progress in the subscription part of our business, as we noted. In terms of unit economics and, call it, term, the way we would be looking at our economics is typical of the software industry. So think of it as a two- to three-year term of a return model.

[Sanjit Singh, Morgan Stanley]

Understood.

[Bart Kalsu]

Sanjit, if you remember, when we priced our subscription offering, our on-premises subscription offerings, we looked at the three-year value of a license and maintenance model. We divided that by 2.75, and that’s how we derive what our subscription pricing was going to be. It’s generally the model that we’re following. And then – so subscription booking is going to be obviously less than what a new license and maintenance booking would be in that year one. There is a little bit of an upfront component to the subscription revenue. And we’ll talk about some of these things in more detail at our Analyst Day that Sudhakar talked about earlier. We’ll also be able to talk a little bit more about how that – what we think that impact would be in 2022.

[Sanjit Singh, Morgan Stanley]

Understood. Thank you so much.

[Bart Kalsu]

Thank you.

[Operator]

The next question will come from the line of Kirk Materne with Evercore ISI.

[Kirk Materne, Evercore ISI]

Hi, thanks very much. Sudhakar, can you just talk a little bit about how conversations are going in terms of customers now maybe thinking about on-prem versus cloud mining and management? I was just kind of curious if you’ve seen any real change in that trend. Obviously, new licenses were up sequentially. So that’s good. So it doesn’t seem like it’s changing too fast. But I’m just kind of curious about how those conversations are trending these days. Thanks.

[Sudhakar Ramakrishna, President and Chief Executive Officer]

Definitely. So customers want choice in this particular category. So the way I would describe this is that hybrid is probably the way to think about the world as we move forward. It’s not a matter of premises only or cloud only. And so what customers are really looking for is a platform that can support the evolution of premises to the cloud. As you will see in our upcoming product packaging, pricing of models, we are going to give greater comfort to customers as they traverse this journey of premises to cloud into a hybrid world. And so more and more of our conversations are around that aspect of it.

Without going into too much detail, there's also nuances between even in the cloud context where the things are cloud native versus cloud managed, and we are working on solutions around both of those. In fact, what I would say is that the combination of our Secure by Design initiatives as well as the articulation of our portfolio road map to customers is giving them confidence that we can be a vendor that will not only support their needs in the current context, but also as they evolve more and more towards cloud and containers and hybrid application ecosystems.

[Kirk Materne, Evercore ISI]

Very helpful. And then maybe just one for Bart. Bart, when we think about the third quarter, you mentioned, obviously, you guys have a tough federal comp coming up. I was just wondering how you think about sort of the federal impact maybe on maintenance rates or if you feel better or worse about that particular segment of your population or you can talk about just specifically. But after we get through the third quarter, should we feel like you guys have gone over the – should you have, I guess, a better view of ongoing maintenance rates once we get through this sort of big seasonal quarter for you all?

[Bart Kalsu]

Yes. I mean the fed business is a big piece of our business, Kirk, but it's not what I would consider significant. It's not massive. It will have an impact on us in the third quarter. It's one of the reasons why even though our renewal rates have more been in the high 80s. We still want to say be somewhat conservative guide renewal rates to be in the mid-80s for the rest of 2021 is because that number is a blend of both our commercial and our federal business.

And so we know there is going to be some impact in the third quarter as it relates to our fed customers. So that's why we've guided, like I said, to the mid-80 s. We are going to push harder, and we hope to do better than that. I think we've ended Q1 at like 89% on the renewal rate – from a renewal rate standpoint. And we think that 86% for the second quarter had some room to improve as well.

So we're going to always push for more, but that's – because of the fed business in the third quarter, that's why we are guiding to that mid-80s for the rest of the year. We do think that this is a one-year phenomenon for us. We do expect to get back to what our historical levels have been when we get into 2022. And we think the move to subscription for us will be positive as well because it will give us the ability to land and expand customers in a much easier fashion.

[Kirk Materne, Evercore ISI]

Thank you.

[Operator]

The next question will come from the line of Rob Oliver with Baird.

[Rob Oliver, Baird]

Great, thank you. Good morning guys. Sudhakar, I was wondering if you could just share a little bit about your philosophy around the product evolution on the platform. You had mentioned that you did plan to call the portfolio a little bit. I know you guys have also been opportunistic, and database seems to be an area where you could continue to be so. But just wondering if you could talk a little bit about your philosophy on how you think about culling that portfolio.

[Sudhakar Ramakrishna, President and Chief Executive Officer]

Sure. I would probably not use the word cull in this context as much as how do we consolidate our capabilities such that our value propositions to customers become more crystal clear and compelling. So in that way, in the near term – when I say near term, let's call it a couple of quarters, our focus will be on better integrations and better packaging and pricing of our portfolio. So on one hand, that will improve our ASPs possibly. But on the other hand, it will deliver more compelling value to customers.

So that's our first step. But continuing on that trend, we are working fast and furious, I would say, on a hybrid platform that will be a singular platform upon which all of our capabilities will be delivered. So in this regard, we can support a land-expand penetrate motion much more successfully with customers as opposed to having them deal with multiple point products. So there's efficiencies for the customers at one level, but there's also internal R&D efficiencies because we'll now be working on one platform, one set of user experiences consistent with our commitment to deliver not only powerful and simple solutions, but also secured solutions.

[Rob Oliver, Baird]

Got it. That's helpful. Thanks. And then just a follow-up on that one. Just on the SentryOne business, in particular, I just was wondering if you could talk about the database opportunity and database trends. And then that – I think at one point, I don't know if this was just public speculation about whether that would stay with you guys or go with N-able. And is N-able going to remain a large customer for SentryOne? And if you could just maybe help us understand that? I'm sure maybe we'll get more color at the Analyst Day, but any thoughts would be appreciated. Thank you.

[Sudhakar Ramakrishna, President and Chief Executive Officer]

Sure. First of all, SentryOne is very much part of ongoing SolarWinds, Step 1. Step 2 is that while SentryOne is very significant to us from a SQL database environment standpoint, SolarWinds also had incredibly powerful database solutions prior to SentryOne as well. And so one of the key strategic things that we have done is integrating our database portfolio such that we have the broadest portfolio to support the most number of platforms out there, be it SQL Server, Oracle, Postgres and others, but also be able to deliver them in such a fashion that customers can deploy them either on-premises or in the cloud.

So that particular set of integrations is already complete. And the most recent thing that I announced in my prepared remarks was extension of those capabilities, called Database Insight, which is an extended motion that our sales teams are engaged with customers, as we speak.

[Rob Oliver, Baird]

Great. Thanks again guys.

[Operator]

The next question will come from the line of Terry Tillman with Truist.

[Terry Tillman, Truist]

Good morning. Thanks for taking my questions. I guess, Sudhakar, the first question is just related to this largest subscription deal to date, I guess, you commented on with the health care provider. Could you shed a little bit more light in terms of what product or products they bought? And how is the pipeline for large subscription deals? And then I have a follow-up.

[Sudhakar Ramakrishna, President and Chief Executive Officer]

On the first part of your question, that was a great example of a customer who was able to leverage a broad swath of our portfolio. So it wasn't like one particular product, let's call it, network performance monitoring as an example, but it was actually a combination of our product elements to support their broader needs. So this also relates back to the point that I was making about in the next couple of quarters, you will see our – packaging our solutions and pricing them in ways that will be more compelling from a customer standpoint.

And so what you will see is that more of our packaging will be thematic to customers where they're not only consuming a point product, but are able to solve multiple solutions. And the solutions could be application monitoring integrated with database monitoring, as an example, or a combination of network management and database management in the same environment. So increasingly, you'll see that. And then that will not necessarily culminate, but it will actually evolve into that hybrid IT platform that I mentioned.

With regards to your question on the pipeline, the way I'll address it is that subscription, selling and proposition is a heightened area of focus for our sales teams, including the incentive structures to support and promote that.

[Terry Tillman, Truist]

Okay. And Bart, maybe just to follow up. Thanks for the commentary on the $30 million ongoing subscription business. I think it was up 16% year-over-year. As we look into 3Q and 4Q, I mean, anything at all you can share on how this ramps from $30 million? Thank you.

[Bart Kalsu]

Yes. I mean the – it is being impacted by the SentryOne acquisition that we closed last year in the fourth quarter. So the $30 million is going to have some increase in Q3 just because of the SentryOne deal that closed in November of last year. So you will see a little bit of a slowdown as far as the growth goes because of the acquisition last year. And really, the growth will be driven by what – how effective our sales force is in transitioning some of these opportunities into subscription deals. We're not going to be – it's going to be a customer-led decision. We are going to try to get our sales force incented to push the subscription deals, but the hard shift has yet to occur.

[Ashley Hook, Investor Relations]

We’ll take the next question.

[Operator]

Next, we have a follow-up from Sterling Auty with JPMorgan.

[Sterling Auty, JPMorgan]

Yes. Thanks for letting me back in. I’m getting a number of questions from investors around the fed business. I know you haven't broken out specific, but I'm going to push a little bit. So when you back out the MSP business, how would you characterize the size of the fed business that's left? That's number one. Number two, can you quantify how big is the surge that you saw last year? And three, I think people expect a pretty healthy spending environment out of the government this year as well. Why do you think that perhaps wouldn't repeat itself?

[Bart Kalsu]

So our fed business, Sterling, we've talked about it in the past in the third quarter. I would say it's approximately 10% of our total revenue base. When we're looking at what – annually, what is our available to renew, our fed business is somewhere in that 10% range. As you know, our federal customers are not one individual customer, it's a bunch of individual users within the federal government. We talked about our one big customer in the first quarter, that is our single largest customer by far. The rest of our business is made up of smaller individual agencies within the federal government, like I said. So if you're thinking about it from a total revenue standpoint, it's approximately 10% when you add up all those different customers.

As far as the third quarter goes, I mean for us, the biggest impact to our business from the cyber incident was the noise within the federal government. So therefore, conversations with the federal government and any of the agencies within the federal government has been a little slower for us and has been where we've gotten the most – I would say, if you want to say pushback, it's been within the federal government.

[Sterling Auty, JPMorgan]

Understood. Thank you.

[Ashley Hook, Investor Relations]

We’ll take one more.

[Operator]

The next question comes from the line of Erik Suppiger with JMP Securities.

[Erik Suppiger, JMP Securities]

Yes, thanks for taking the question. Just trying to understand where you are in terms of your focus on lead generation versus customer retention. I understand you restarted your lead generation efforts at the end of Q1. Are you doing all of your traditional campaigns for driving leads and generating incremental business? Or where are you in terms of that ramp? And then, can you talk a little bit about what profile customer is most at risk for churn? You just noted that federal has probably the highest churn of any sector. But what types of customers do you see that are most reluctant to renew?

[Sudhakar Ramakrishna, President and Chief Executive Officer]

Yes. So let me address that. First, I want to provide a point of clarification on the fed churn comment that you made. I don't think we are highlighting that they have the highest propensity for churn as much as they tend to be the most conservative customers as it relates to bringing things back online. So helping them, working with them and stabilizing their environment is priority of ours. So just a point of clarification.

To your point on demand generation, for the most part, in quarter one, we did not have normal demand-generation activities. That was only later into Q1 that we started ramping those back up, and I would characterize them as the steady state today. With regards to what customers are having the highest propensity to churn, the way I'd describe it is that every one of our customers is super important to us, large or small, regardless of sector. But in terms of, are we seeing a specific pattern of churn in a specific customer segment? The short answer is no, quite simply because we do not have a lot of churn based on what we are seeing with customers. And even where we do, there isn't enough of a sample set to give you a trend of various payments.

[Erik Suppiger, JMP Securities]

Okay, very helpful. Thank you.

[Ashley Hook, Investor Relations]

I think that’s it for us. We're going to go ahead and end the call.

[Sudhakar Ramakrishna, President and Chief Executive Officer]

Thank you, everyone, for joining us.

[Operator]

This does conclude today's conference call. We thank you for your participation and ask that you please disconnect your lines.