SolarWinds Corp

NYSE:SWI

Earnings Call Transcript 2018-Q4

[Operator]

Good afternoon. My name is Chantelle, and I will be your conference operator today. At this time, I would like to welcome everyone to the SolarWinds Fourth Quarter 2018 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question-and-answer session [Operator Instructions].

Dave Hafner, Head of Investor Relations, you may begin your conference.

[Dave Hafner, Head of Investor Relations]

Thank you, Chantelle. Good afternoon, everyone, and welcome to SolarWinds' fourth quarter 2018 earnings call. With me today are Kevin Thompson, our President and CEO; and Bart Kalsu, our Executive Vice President and CFO. Following prepared remarks from Kevin and Bart, we'll have a brief question-and-answer session. Please note that this call is being simultaneously webcast on our Investor Relations website at investors.solarwinds.com.

Please remember that certain statements made during this call, including those concerning our financial outlook, our expectations regarding growth and profitability, our expectations regarding the impact of our adoption of the new revenue recognition standard ASC 606, our market opportunity to market share, areas of focus for our business and our product plans and releases are forward-looking statements. These statements are subject to a number of risks, uncertainties and assumptions described in our SEC filings, including the risk factors discussed in our final prospectus dated October 18, 2018, and filed with the SEC on October 22, 2018, and the Form 10-K that we anticipate filing on or before April 1, 2019. Should any of these risks or uncertainties materialize or should any of our assumptions prove to be incorrect, actual company results could differ materially and adversely from those anticipated in these forward-looking statements. These statements are also based on currently available information, and we undertake no duty to update these information except as required by law. The cautionary statements regarding these forward-looking statements are further described in today's press release.

In addition, some of the numbers during this call will be presented on a non-GAAP basis. This includes references to non-GAAP revenue. Our use of non-GAAP revenue reflects our adjustments to GAAP revenue for the purchase accounting-related impact to revenue following our take private transaction in February 2016. This adjustment to GAAP revenue impacted our revenue through the fourth quarter of 2018. Our 2019 results will no longer be impacted by this adjustment. We will also provide our financial outlook for revenue growth rates on a constant currency basis to provide a framework for assessing how we expect our business to perform, excluding the effect of foreign currency fluctuations.

Our use in calculation of these non-GAAP financial measures are further explained in today's press release, and a full reconciliation between each non-GAAP measure and its corresponding GAAP measure is provided in the tables accompanying the press release. However, each non-GAAP item in our forward-looking financial outlook that we provide today has not been reconciled to the comparable GAAP outlook item because providing projections of changes in individual balance sheet and income statement amounts is not possible without unreasonable effort, and release of such reconciliations would imply an inappropriate degree of precision. Unless otherwise indicated, references to profitability and comparable measures refer to such measures on a non-GAAP basis.

With that, I'll now turn the call over to Kevin.

[Kevin Thompson, President and CEO]

Thanks, Dave. And thanks to everyone joining us for today's call. We have a lot to share today, so I hope none of you have early dinner plans. It's going to take a few minutes, but hopefully you'll find the remarks and comments we're going to share helpful as you think about not only how our fourth quarter went but also maybe more importantly how we're looking at 2019.

I'm pleased to report that we had a good finish to a strong 2018, exceeding our outlook for the fourth quarter and the year, delivering total non-GAAP revenue of $222 million in the fourth quarter, which was a record quarter for SolarWinds. In total, non-GAAP revenue of $837 million for the full year represent a year-over-year growth of 13%. We also increased the recurring revenue to 80% of total revenue during 2018 from 79% in 2017, driven primarily by continued rapid growth in our subscription revenue, which grew at a rate of 24% for the year.

During 2018, we focused on a few key areas of expansion and improvement in our business. First, as we stated publicly on several occasions, we believe that we are in and will continue to be in a hybrid IT infrastructure world. This means that IT infrastructure and applications will be deployed in many locations including on-premise, in hosted data centers, in the private cloud and in multiple public clouds. Most companies, both small and large, will leverage multiple of these environments to build a technology infrastructure to give them the optimal combination of flexibility, speed of deployment, performance, cloud and security.

In 2018, we focused on positioning SolarWinds as the only IT management company with the ability to comprehensively manage infrastructure and applications in any of these competing locations, either separately or through an integrated set of products based on the needs of the individual technology probe. We drove this positioning by listening to and speaking with our massive user community about their needs and have been rapidly bringing new products to market through organic development and M&A activity as well as expanding the capabilities of our existing product suite to meet those needs.

Second, we believe that meaningful growth opportunities remain for SolarWinds in managing the large and still growing volume of IT infrastructure deployed on-premise, behind traditional firewall and hosted data centers and private data centers. We continued to invest in this on-premise opportunity over the last several years, and we entered 2018 with three goals for our on-premise product portfolio: one, exceeding the growth in license sales of our on-premise product portfolio; two, improving our already strong maintenance renewal rates; and three, increasing our market share in on-premise IT infrastructure management. We accomplished all three of these goals in 2018. We saw acceleration in license sales of our on-premise products in each of our geographic regions, resulting in 5% year-over-year license revenue growth in 2018. And we delivered 4 consecutive quarters of license revenue growth.

Our maintenance renewal rates for 2018 improved to over 95% for the year, which when combined with our license revenue growth, resulted in SolarWinds once again running at a pace faster than the network management and IT operations management markets. In fact, since ascending to the number one position in the network management market in 2016, we have widened the gap, reaching 24.1% market share in 2018 as measured by IDC.

In addition to increasing our market share network management, according to the latest Gartner market share report released in 2018, we improved our market share position from sixth to fourth in IT operations management performance analysis, which includes the management of servers and applications. We believe the strength of our on-premise IT infrastructure and application management products, coupled with the advantages of our high velocity go-to-market approach and powerful economic model, provide us the ability to continue to increase our market share in both network and IT operations management. This will remain a key area of focus for us in 2019 and beyond.

Third, it was our plan to strengthen and expand our public cloud management capabilities in 2018. We added a major piece to the puzzle through the addition of log and analytics management for IT operations in January 2018. We believe we now have the most comprehensive set of capabilities to manage public cloud infrastructure on all major platforms and applications to pull it on that infrastructure in the market.

The focus in 2019, as it relates to cloud management, will be creating a higher level of awareness of our capability, expanding the distribution of these products into international markets and driving a high volume of transactions, which is the hallmark of our approach.

And finally, in 2018, we began bringing many of the capabilities for the SolarWinds on-premise IT product portfolio to our MSP customers by extending their capabilities and integrating them into our MSP platform, where they can be delivered as a service to the hundreds of thousands of customers that rely on MSPs for IT management services. As an example, during 2018, we expanded our remote monitoring and management capability for MSP by adding deeper network device monitoring that leverages IP from our network management product to providing MSPs with the ability to monitor switches, routers and firewalls from a single pane of glass.

We also added NetPath analysis to our MSP platform, lifted from our flagship on-premise network performance monitoring product, which analyzes the performance of data movement along the path between user and application wherever the user and the application happen to be. Features like these provide our MSP customers the ability to add new revenue streams through expanded offerings for their customers.

To quote, in true solid fashion, we did all of this while generating best-in-class levels of profitability and cash flow. For the year, we delivered approximately $408 million in adjusted EBITDA, representing an adjusted EBITDA margin of 48.7%, which was 30 basis points higher than our outlook that we provided in November. We also converted 91% of that adjusted EBITDA into unlevered free cash flow of $371 million, which grew at a rate of 19% year-over-year in 2018. This level of cash flow conversion is well ahead of where we expected to be for 2018. It is a testament to the profit and cash flow leverage in our model.

I'll now briefly comment on a few of the key highlights of the fourth quarter 2018 as well as the full year. Bart will expand on our fourth quarter performance in his remarks as well as discuss in greater detail more of the full year 2018 highlights.

We closed out 2018 on a solid note as our results for the fourth quarter exceeded the high end of our revenue and adjusted EBITDA outlook. Fourth quarter non-GAAP total revenue of $222 million increased 11% year-over-year. Adjusting for the negative impact of foreign currency on the fourth quarter of 2018 using rates from the fourth quarter of 2017, total revenue growth for the fourth quarter would have been approximately 1% higher.

As we walk towards achieving annual revenue of $1 billion and beyond, we remain committed to the key tenets of the SolarWinds model, including building technology specifically for the technology pros to use our products; providing that technology at a very affordable price; making our products intuitive and easy to use, which allows companies of all sizes to leverage them to improve the performance of their IT infrastructure and applications; and using a differentiated go-to-market model, which increases sales velocity and allows us to reach the entire market. The powerful model illustrated by our profit results in the fourth quarter as we delivered $112 million in adjusted EBITDA, which represented an adjusted EBITDA margin of almost 51%. It was well ahead of the high end of our outlook for the fourth quarter.

For the fourth quarter of 2018, we also converted 99% of adjusted EBITDA into unlevered free cash flow of $111 million, reflecting 21% year-over-year growth and representing 50% of total non-GAAP revenue for the quarter. I'm sure those of you on the call with us today can appreciate from those results how unique and powerful this model can be. Most importantly, our strong performance in 2018 reflects a tremendous effort by our team, continue coming to work every day, focused on the task at hand, and not allowing anything, even exciting and time-consuming events like our IPO, to distract them from our goal of making SolarWinds the only player in the IT infrastructure and operations management market who can provide all of the visibility necessary to allow technology pros to build and operate an IT infrastructure designed to give their companies competitive advantage, expanding that public cloud infrastructure management capabilities, increasing market share by accelerating the growth of our on-premise IT management business and leveraging the substantial breadth and depth of our technology platforms across all of our product lines. I'm extremely proud of what our team accomplished in 2018 and excited about how well we are positioned going into 2019.

With that, I'll now turn the call over to Bart.

[Bart Kalsu, Executive Vice President and CFO]

Thanks, Kevin. And thanks again to everyone joining us on today's call. Our fourth quarter financial results reflect another strong quarter of execution across all key areas of our business while demonstrating the leverage that we have in our model. Our goal continues to be consistent revenue growth with best-in-class profitability.

Total non-GAAP revenue for the fourth quarter was $221.6 million, reflecting year-over-year growth of 11% on a reported basis and which would have been 1% higher on a constant currency basis. Total non-GAAP revenue for the year ended December 31, 2018, was 836.8 million, which is a 13% increase over the prior year amount of 741 million.

As Kevin indicated in his remarks, we drove solid year-over-year revenue growth in the fourth quarter despite the impact from foreign currency headwinds, which, as I just stated, had a negative impact of approximately 1 percentage point on total revenue growth. And in fact, subscription revenue growth, which was 19% on a reported basis in the fourth quarter, would have been approximately 2 percentage points higher had rates been consistent with those in the fourth quarter of 2017.

For the year, total non-GAAP recurring revenue grew 15% year-over-year and reached 80% of total revenue. We also had a very strong quarter of non-GAAP profitability and cash flow generation in the fourth quarter of 2018 with both exceeding our outlook for the quarter and for the full year.

Fourth quarter adjusted EBITDA was 111.9 million, representing an adjusted EBITDA margin of 50.5% and year-over-year growth of 12%. And for the year ended December 31, 2018, adjusted EBITDA was 407.5 million, representing an adjusted EBITDA margin of 48.7%, reflecting 13% year-over-year growth over 2017. Our results once again demonstrated the unique leverage of the SolarWinds model and highlighted our ability to far exceed the rule of 40, with one more quarter in a long string of consecutive quarters where a combination of revenue growth and adjusted EBITDA margin was over 60%.

We also continued to convert an extremely high percentage of our adjusted EBITDA into cash flow. Fourth quarter 2018 unlevered free cash flow was 111 million, increasing by 21% over the fourth quarter of 2017 and reflecting a 99% cash conversion rate of our fourth quarter adjusted EBITDA. The fourth quarter performance contributed to unlevered free cash flow of 371 million for the year ended December 31, 2018, which increased 19% year-over-year and represented conversion of 91% of adjusted EBITDA to unlevered free cash flow, which exceeded our expectations on our cash flow conversion rate for the year.

Digging a bit deeper into the details of our revenue results. Fourth quarter revenue growth was led by non-GAAP subscription revenue of 69.6 million, which grew 19% year-over-year, reflecting solid growth within both our public cloud management and MSP product lines. And as I mentioned earlier in my remarks, subscription revenue growth would have been approximately 2 percentage points higher on a constant currency basis, reflecting the foreign currency headwinds that impacted subscription revenue, which has a higher percentage of revenue coming from outside North America compared to our on-premise license and maintenance business.

Within both our MSP and public cloud management product lines, we continue to do a good job of landing a large number of new customers, both in the fourth quarter as well as the full year and also in retaining existing customers and expanding their usage of our products. Our success at landing, expanding and retaining customers translated into an increase in monthly recurring revenue in 2018 and an average subscription net retention rate of 105% for the year.

Digging further into our subscription results by product line, we believe the fourth quarter growth in our MSP product line reflected our success in capitalizing on a large market opportunity in MSP, driven by the combination of strong new customer acquisition and solid customer net retention rate, resulting from the hard work put forth by our MSP sales and marketing team during the fourth quarter and throughout all of 2018. We have seen an acceleration in the value of new MSP customers added in 2018 as compared to 2017 as our MSP team placed an emphasis on improving the quality of new customers added in 2018. We believe this increase in customer quality will result in accelerated growth in this part of our business over the course of 2019 as the stronger cohort of these new 2018 customers will expand their usage of our MSP products more rapidly than the expansion of the prior year cohort.

Turning to our public cloud management product line. Our cloud infrastructure and application management products continue to lead our subscription revenue growth in the fourth quarter. We saw solid traction across digital experience management, log management and infrastructure and application management. However, within this portfolio of products, our log management product, which provides application developers and IT operations pros with the ability to use log data to analyze and improve the performance of infrastructure and applications as they are being developed as well as was once they're in production environment showed the most significant level of momentum. We believe that this part of the cloud management market has reached a level of adoption, activity and volume where our go-to-market approach based on digital marketing and selling from the inside can begin to create disruption in a high volume of transactions.

And finally, total non-GAAP license and maintenance revenue increased by 8% to $152 million in the fourth quarter, which was a record quarter. We believe our license and maintenance revenue growth reflects the combination of strong maintenance renewal rate and solid marketing and sales execution across all the geographies in which we operate. This strong execution contributed to year-over-year license revenue growth of 6% in the fourth quarter of 2018 and represents our fourth consecutive quarter of license revenue growth.

For the fourth quarter, non-GAAP maintenance revenue was $105.7 million, which was an 8.7% increase over the prior year fourth quarter amount of 900 -- of $97.3 million. This was a sequential acceleration in our non-GAAP maintenance revenue growth rate compared to the third quarter, reflecting the impact on maintenance revenue of the growth we have seen in license revenue for the past four quarters as well as our continued strong renewal rates. We believe that our high maintenance renewal rates highlight how much our customers value our products and the loyalty of our large customer base.

Our maintenance revenue growth also highlights the power of our unique product and maintenance pricing model, whereby we defer and then recognize approximately 40% of the initial license revenue value as maintenance revenue over the first year of the customer's relationship with us.

Turning to expenses and profitability. Non-GAAP expenses were approximately $114 million in the fourth quarter of 2018, which includes $96 million in non-GAAP operating expenses and approximately $18 million of non-GAAP cost of revenue, which reflects a 10% year-over-year increase for the quarter. For the year ended December 31, 2018, total non-GAAP expenses were up 13% year-over-year, which was in line with total revenue growth. The expenses in the fourth quarter and the year were impacted by an increase in general and administrative expenses primarily for public company costs, which are once again -- which we are, once again, incurring.

Finally, as I mentioned earlier, we finished 2018 with very strong profitability and cash flow metrics. Unlevered free cash flow conversion for the full year in 2018 was at 91% of our adjusted EBITDA, which was higher than our outlook. We ended the year with $383 million of cash. After paying off the second lien debt with IPO proceeds in our strong 2018 operating performance, our net leverage dropped to 3.9x trailing 12-month adjusted EBITDA, which is a lower leverage ratio than what we provided as our outlook on our third quarter earnings call in November.

Our first lien debt is currently at $1.97 billion, and the interest rate is at LIBOR plus 2.75. We monitor movements in interest rates and we opportunistically take advantage of refinancing opportunities if advantageous. However, we are comfortable with our ability to service our existing debt at its current cost level while also growing our cash balance. Our high level of cash flow provides us with a tremendous amount of flexibility to continue to delever while still making important investments in our business, including M&A opportunities if and when they become available.

I will now walk you through our expectations for the full year of 2019 as well as the first quarter of 2019 before turning it over to Kevin for some final thoughts. Please note that the revenue, adjusted EBITDA and EPS guidance we are providing today will be based on ASC 605. Beginning in the first quarter of 2019, we will begin reporting our results on an ASC 606 basis alongside numbers based on ASC 605 for comparability purposes. That said, we expect the adoption of ASC 606 to have an immaterial impact on total revenue and expenses in 2019 as compared to results under ASC 605.

In addition, beginning in 2019, we will no longer have a difference between GAAP and non-GAAP revenue as the purchase accounting-related impacts of our 2016 take private transaction rolled off at the end of the fourth quarter of 2018. Note that the growth rates we are providing today compare our 2019 revenue outlook to our 2018 non-GAAP revenue.

Okay. With that said, let's turn to our outlook. Based on our strong performance in 2018 and the momentum that we ended the year with, we are raising our outlook for the full year of 2019 as follows. Our full year 2019 total revenue outlook on an ASC 605 basis has increased to $921 million to $936 million, representing growth of 10% to 12% over total non-GAAP revenue in 2018. This assumes a euro to USD exchange rate of $1.14 and assumes that other key rates such as the British pound and Aussie dollar are within their current trading ranges. Adjusting the full year guidance of 2019 using the same foreign currency exchange rates as those we experienced in 2018, the constant currency growth rate in total revenue would increase to 11% to 13%.

Total license and maintenance revenue growth is expected to be approximately 7%, increasing to approximately 8% on a constant currency basis. Subscription revenue growth is expected to be in the range of 19% on a reported basis and approximately 20% on a constant currency basis. Adjusted EBITDA is expected to be in the range of $448 million to $456 million, representing an estimated adjusted EBITDA margin of approximately 48.7%.

Non-GAAP fully diluted earnings per share is expected to be in the range of $0.78 to $0.80 per share, assuming an estimated 311.5 million shares outstanding for 2019. Our EPS guidance reflects an assumed 22% non-GAAP tax rate, which is a slight increase compared to the previously provided rate of 21%, reflecting a refinement of our tax estimates under the new U.S. tax code.

Unlevered free cash flow as a percentage of adjusted EBITDA is expected to be strong once again in 2019. However, we do not expect a meaningful improvement in our strong cash flow conversion rate in 2019 due to an increase in cash taxes paid to approximately 40 million in 2019, which includes 9 million in expected total tax payments compared to a total of only 9 million in cash tax payments in 2018.

Before I provide the details of our first quarter outlook, I also wanted to provide you with some incremental thoughts on how we expect recurring revenue growth, which includes subscription and maintenance to trend throughout the year in 2019. As it relates to maintenance revenue, we expect to see sequential improvement in year-over-year growth as we move through each quarter of 2019, reflecting the impact on maintenance revenue from the license bookings growth we drove in 2018 coupled with our forecast of maintaining strong renewal rates in the low to mid 90% range, bolstered by the positive impact we expect to see from our 2018 and 2019 maintenance price increases on 2019 maintenance revenue.

Subscription revenue is expected to be at a similar trend as maintenance with year-over-year growth accelerating as we move forward throughout each quarter of the year. This reflects the impact of higher forecasted cohort growth in 2019 based on current trends from the new cohort of MSP customers we added in 2018. In addition, we are rolling out price increases across specific products in our MSP product lines during the first half of 2019 that are expected to have a positive impact on the subscription revenue growth throughout the year, particularly in the second half of the year.

Finally, with our cloud management product line, we expect subscription revenue growth from these products to also accelerate as we move through each quarter of 2019, benefiting from the momentum in cohort growth we have created in our log management product for developers and for IT operations teams, an acceleration in growth of our digital experience monitoring products in addition to an increasing contribution from AppOptics, our application performance management product released in late 2017.

Now turning to our outlook for the first quarter of 2019. For the first quarter of 2019, we expect total revenue to be in the range of 215 million to 218 million, representing year-over-year growth of 8% to 10% on a reported basis and 11% to 12% on a constant currency basis. Total license and maintenance revenues are expected to grow by approximately 7.5% on a reported basis and approximately 9% on a constant currency basis. Subscription revenue is expected to grow in the range of 12.5% on a reported basis and 16% on a constant currency basis.

Adjusted EBITDA is expected to be in the range of 101 million to 103 million, representing an adjusted EBITDA margin of approximately 47%. Keep in mind that our adjusted EBITDA historically follows a very similar trend each year whereby the adjusted EBITDA margin will increase sequentially each quarter as we move through the year.

Non-GAAP fully diluted earnings per share is expected to be between $0.16 and $0.18 per share, assuming an estimated 309.8 million pro forma fully diluted shares outstanding for the full quarter. As with the full year, our guidance for the first quarter assumes a non-GAAP tax rate of 22%, but we only expect to pay approximately 7 million in cash taxes during the first quarter of 2019.

With that, I will now turn the call back over to Kevin.

[Kevin Thompson, President and CEO]

Thanks, Bart. 2018 is behind us. We are well underway in executing our strategic plans for 2019. These plans are designed to land a greater number of new customers, accelerate the pace of existing customer expansion and drive higher levels of customer retention. We believe we are entering the year poised to exploit several positive market dynamics to play in our favor. First, while on-premise IT infrastructure spending has continued to grow, the competitive landscape in on-premise IT management has experienced a high degree of disruption in recent years as legacy IT framework vendors reduce their focus on and investment in on-premise IT management. In addition, a number of these legacy IT management vendors have undergone significant transitions over the last 12 months, forcing them to rationalize product lines and levels of investment, which has made them even more vulnerable to our disruptive model.

We believe this has created an opportunity for us right now, an opportunity to accelerate the pace in which we capture market share by displacing legacy vendors inside customers where our products are already deployed as well as continuing to land new customers that have not historically used the SolarWinds product. We will adopt a more aggressive external competitive stance in 2019 as our product and our marketing and selling from the inside motion have developed to the point that we are successfully managing the performance of some of the largest IT environments in the world, and we plan to tell that story much more broadly.

New products will also be an important ingredient in our ability to take full advantage of the opportunity we have to leverage the great relationships we have developed with more than 300,000 customers who own or have an active subscription for a SolarWinds product. As we continue to expand our product footprint, you should expect us to not only bring new products to markets to fill gaps in our existing portfolio but also to extend our portfolio into new segments of the IT operations market where we believe we can use these relationships with technology pros and our differentiated approach to enterprise software to create a competitive advantage.

Second, demand for public cloud-focused IT management solutions has continued to be strong, reflecting trends in public cloud IT spending. Through the work we have done to build a comprehensive portfolio of public cloud management functionality that works across all major public cloud environments, we believe our public cloud management product portfolio as well as our on-premise product portfolio positions us well to serve the needs of IT operations and DevOps teams who are still in the early stages of adopting monitoring and management technologies to improve the performance and stability of the structures and apps deployed in the public cloud.

While the opportunity to run AWS represents an important avenue of growth for us, we're also well positioned to capitalize on the opportunity to manage the health and performance of Azure-based applications and the underlying infrastructure. Our strong reputation for monitoring and managing Microsoft technologies has helped us gain a solid early foothold in Azure. In fact, we already manage over 15,000 devices and applications deployed at Azure environments today. We plan to increase our focus on this opportunity during 2019.

Shifting gears, we also see strong momentum within our MSP product line. The MSP market is continuing to grow, and that growth was dominated in a big way in 2018 as we saw a large amount of private equity and venture capital money pour into the space. Venture capital and private equity funds have finally caught on to what we believe is our first investment in the MSP market in 2013, which is with the explosion in the amount of technology being leveraged by companies of all sizes and in all industries, small businesses must have help to leverage and manage the infrastructure and applications their businesses rely on and that an increasing number of these small businesses will turn to MSPs to manage this complexity for them.

We believe we are the company best positioned to attack this MSP opportunity due to our leading position in remote monitoring and management; our expanding presence in backup and security for the MSP market, and in addition, we have the power of the SolarWinds brand and a deep technology portfolio that we believe will allow us to extend our lead, adding new technologies that MSPs need at a pace our competitors will be unable to match. In fact, as a proof point of the speed with which we can bring new technology to market, in 2019, we plan to release several new industry offerings, including private cloud backup as well as disaster recovery as a service as part of our backup offering, allowing MSPs to protect and recover their customers' data and application from the cloud.

And finally, we'll also focus on increasing our international footprint in 2019. In the last 2 years, we've increased the mix of business we do internationally and we remain underpenetrated in several key markets that we believe offers strong opportunity for growth across each of our product lines. Germany, which is one of the world's largest economies, as well as IT spending markets, will be a key area of focus in 2019. We now have physical presence in Germany for the first time, which we will deploy to expand our sales and marketing efforts across the entire dot market.

We also plan to go international with public cloud log management in the second half of 2019. Today, a great majority of our log management revenues come from North American organizations and all of our sales and marketing efforts have been directed towards the North American market.

As you can hear from our comments, we believe we exited 2018 with strong momentum and that we are positioned to deliver a unique combination of accelerating organic growth coupled with high profit and strong key free cash flow generation in 2019. As a result and as Bart shared in his comments, we have raised our 2019 outlook, reflecting the momentum we see in our business.

In addition, our ability to convert earnings to cash at a very high conversion rate provides us with a tremendous amount of flexibility to continue to delever while still making important investments in our business, including M&A opportunities and technologies that fit our strategic vision.

With that, we'll open up the call for questions.

[Operator]

[Operator Instructions] Your first question comes from Sterling Auty with JPMorgan. Your line is open.

[Sterling Auty, JPMorgan]

One question, one follow-up. First, you talked about being more aggressive taking market share against legacy vendors. What specifically are the targeted strategies? Is it spending more on marketing? Is it hiring additional sales? Is it something on the pricing side? How are you going to go about getting more aggressive against those guys?

[Kevin Thompson, President and CEO]

Yes. It's really 2 things, Sterling. One is we are simply not doing a very good job of telling -- or maybe we are doing the optimal job we can of telling the story of our ability to manage not only small environments and solve very specific problems at very low prices, but also the fact that our technologies, over the years, have gotten to the point that they scale. In fact, we believe they scale better than any of our competitors' products scale. And we've got a large number of customers, as you know, that are very, very large, multinational companies that are in the Global 1000 who are standardized on our technologies but we have not let everyone know we have that capability. So the -- one of the things we'll do is just do a better job of telling that story.

You'll see us continue to tell all the stories we tell in our website today, which is if you got a small problem, you got it in your -- any issue that has your head on fire, we've got a product that you can put that fire out and you can afford to buy it because it doesn't cost you very much. But if you've got a large environment where you -- and you have the need to scale, see one view of performance [Indiscernible] you need to be able to do it, and it costs a fraction of what you're paying today. In fact, our license prices will typically be less than the maintenance renewal prices if they're using one of the old legacy vendors. We want to make sure people know we have that capability.

So we don't have to change our sales motion. We don't have to add sales people. We're already doing this today and having a lot of success at it. We just never have really proactively told that story and we're really at the point now that we need to do that. So it's not a spending thing.

…and we're really at the point now that we need to do that. So it's not a spending thing. It's not a change in marketing or selling. It's simply doing a better job of storytelling.

[Sterling Auty, JPMorgan]

And then one follow-up for Bart. You mentioned the EBITDA to free cash flow conversion kind of given that you don't expect significant improvement. So as a starting point, is it fair to think about that conversion rate being on par with the 91% that you did in 2018?

[Bart Kalsu, Executive Vice President and CFO]

Yes. Somewhat, Sterling. I mean, 91% was more than what we had originally expected coming out of 2018, but that's roughly the range we expected to be working off of in 2019.

[Kevin Thompson, President and CEO]

Yes. The only thing we really can't impact is we can't impact cash tax as much because they are what they are. And the total taxes in particular, they are what they are. And so that's the only change that we made in '18 and '19 as Bart said in his remarks.

[Operator]

Your next question comes from Heather Bellini with Goldman Sachs. Your line is open.

[Heather Bellini, Goldman Sachs]

I just wanted to, Kevin, walk through the price increases that you talked about, just getting a sense of -- and you might have said this, I apologize. I might have missed typing while you were speaking. Which products in particular? How much is pricing going up by on average? And if you can give us a sense for when was the last time these products had an increase? And I guess, when you're talking about that also, like what's the thought process behind the incremental value that you guys feel like you need to deliver before you can do another one?

[Kevin Thompson, President and CEO]

Yes. So we're kind of breaking it into different product lines, Heather. So on the core IT side, the sort of on-premise product into customers, our license and pro maintenance product lines, we have been increasing prices for the last three to four years on a very consistent basis. And the average price increase there is a little less than 2.5% when you've deployed across the entire license and maintenance product portfolio.

In our MSP product lines, we have, on a not quite as regular and consistent basis, increased price on those products. We had increases in prices in specific products, once again, in prior years. We're not going to do a price increase broadly across our entire MSP product portfolio. However, we are looking at the areas where we believe -- to your question, we already deliver a lot more value than what we're charging for. And in fact, looking at areas where our competitors have already increased price substantially over the last six to nine months while we've not done anything with price. And so we'll take that opportunity to raise prices on very specific products kind of in the 2% to 3% or 4% range depending on the product. You will not have a really large impact on 2019 revenues because, as you know, those prices are going to be built quarterly as customers who use the product, we build monthly in arrears on the MSP side. Those price increases, for the most part, are not rolled out.

The maintenance price increase is already rolled out. But it does have a little bit of an impact on growth for the year. And it definitely impacts the way our subscription revenue and maintenance revenue will grow sequentially as we move through the year because as we build more and more customers for that price increase, as they renew on the maintenance side, as they renew their relationships with us on the subscription side, you'll see that impact start to build. So by the fourth quarter, you have a much larger impact from that than you do in the first quarter.

[Heather Bellini, Goldman Sachs]

Yes. Bart, do you have any -- I know you've obviously got it for the quarter and the full year, but based on Kevin's comments about subscription revenue, any high level comments you could give us about thinking about the pace of the seasonality?

[Bart Kalsu, Executive Vice President and CFO]

No. I mean, as we talked about in the script, Heather, we're rolling out the price increases throughout the first half of the year. So it's not like they're all going to hit on Jan 1. So it's just going to be staggered throughout the first six months or so of 2019 and then we'll see the true impact on our revenue line item more on the second half of the year.

[Kevin Thompson, President and CEO]

Yes. And the larger impact on subscription growth, though, is really cohort growth. We mentioned it in our remarks that, in our MSP product line in particular, we thought we really built a very, very strong 2018 cohort, that, that cohort is actually stronger than the cohort of customers we added in 2017. And we measured that base both on the ASP, the initial relationship as well as the growth that we've seen already from those customers we added in 2018. And that cohort is performing at a better level than what we saw the 2017 cohort perform at. And so that improvement will build as we move through the year as that cohort continues to add devices that they're managing, as they add customers, as they add services that they're not using right now from us for those customers. So that will have the largest impact on revenue growth. And based on trends we've been looking at for a number of years, we know how that builds each quarter as we move through the year. And it will build at a pretty consistent pace as we move through the year. Maintenance, obviously, is pretty linear in terms of it will go almost at the same pace. Acceleration will be at the same rate as we move through the year. And you should expect a similar thing on the subscription side.

[Operator]

Your next question comes from Brad Zelnick with Credit Suisse. Your line is now open.

[Brad Zelnick, Credit Suisse]

I've got one for Kevin and a follow-up for Bart. For Kevin, you talked a lot about the -- what's going on in the public cloud. Public cloud is top of mind for everyone and it's good to hear your public cloud management product is doing so well and driving success in Q4. You specifically emphasized what's going on with log management and that use case. But aside from the product, how does the distribution model differ, if at all, from your core products? And how do you think about scaling your presence, especially internationally like you mentioned in your prepared remarks?

[Kevin Thompson, President and CEO]

Yes, so from a sales model perspective right now, the cloud management products are even lower touch than our on-premise IT management products are. So we do a lot of business on the cloud management side. When the customer comes in, tries, puts the credit card in and we start to bill them as they actually use the technology. Most of the products are usage-based. Most of them are billed monthly in arrears. And so it's a very light-touch model. We have added sales people as we moved through 2018, but we still have higher productivity per sales rep in our cloud management business than we see in other -- any other area of our business right now. So I think we'll continue to have higher productivity on the sales side. I don't know if it's going to stay quite at the level that it's at now because it's very, very high, but it's a very low-touch business.

And really, our goal is to let the customer come in, put a quarter in the slot and start to use the technology. Once they start to use and we see their usage start to grow, then we're going to touch them from a sales perspective. We're not really touching them to get them to start using the product. We're touching them when they get to a level of usage where we think we can go and create a larger relationship with them. So it's a little bit different in that we're not touching them immediately. We're letting them start to use the product, spend a little bit of money and then we're going to go out and touch them.

From a marketing point of view, it is highly digital at the moment. I think it will continue to be highly digital. I think we need to do more of what we do well on the SolarWind side, which is invest a little bit more in community, get a little more ground base, groundswell of momentum that we can rely on and do a little bit more awareness marketing because not everyone knows we have all the capabilities that we have put together over the last 24 months. I think that's going to be important.

In terms of how we expand internationally, it's actually pretty simple. We're getting a decent amount of demand, and not really trying, from outside the U.S. right now. We're not spending any real money on search or any of those digital activities outside of North America. We're getting a decent amount of demand, but we're doing a pretty poor job of converting it to business because we don't have anybody outside the U.S. on the sales side that's even thinking about those customers right now. So the simple answer is we'll put a few reps in Europe and we'll put a few reps in Asia.

We already have very strong sales leadership in those markets so we'll just give them to reps and let them start selling these products. We also will give the channel the ability to sell these products in 2019. We haven't done that yet even in North America. So all of our cloud management right now is direct. And so we'll really introduce these products into the channel. We want to make sure we really understood them before we actually introduced them into our channel partners. So we have a lot of levers to pull to get these cloud management products growing for a really long time to come.

[Brad Zelnick, Credit Suisse]

It sounds like a huge opportunity. And just a follow-up for Bart. Bart, as we think about your comments and your strong free cash flow conversion this past year and your thoughts into this year, how much should we think about as coming from a shift to annual billings for MSPs? And how has that trended relative to expectations?

[Barton Kalsu]

So in 2000 -- and for the fourth quarter, a tiny amount was related to the subscription, an increase in term on our subjection rates, Brad. And we don't expect that to improve or to move dramatically in 2019. Like Kevin and I talked about previously, that's going to happen over the next 2 or 3 years for us to get that change in billing terms to really move significantly, but it's one of our primary focuses as we move into 2019.

[Kevin Thompson, President and CEO]

Yes. We see much of that in '19. We should expect better cash flow conversion than what we -- what Bart talked about in his remarks. We really haven't done much of that end at this point, but it will start to come. But we're not going to force any customers to pay us annually. We're going to give them incentive, too. And they'll buy, making the price a lot lower by packaging it in a different way. So don't expect a lot of that in '19. If we get it, then we'll do better than we think. And if we don't, then we'll deliver what we said we'll deliver.

[Operator]

Your next question comes from John DiFucci with Jefferies. Your line is open.

[John DiFucci, Jefferies]

Follow-up for Bart. The first question has to do with the MSP business. In this business, I know you've been at it for quite some time even since the last time you were public, but it's relatively new to a big part of the investment community with the steps we find in our conversation. And you were early with enable and you've more than doubled down plus now. But could you share with us some of the characteristics that we're used to looking at that might help us in really understanding this business? Like some -- even if you don't want to give us exact numbers, like, is the gross renewal rate or retention rate similar to what it is in your other business? You keep talking about the cohort growth. So the net retention, can you give us an idea of what that might be? And then something else that's important, too, is, like, you have visibility here, I think, that's better than some of your other businesses. Like what's -- is the linearity better than it is for other businesses? And I guess, one last thing, because Bart mentioned that you have more international exposure in that business, which is kind of like a newer kind of model, which is kind of surprising because international markets tend to lag the U.S., but if you can talk a little bit about that, too, about how much exposure you have internationally.

[Kevin Thompson, President and CEO]

Yes. Bart this is Kevin. Bart and I will tag team on this a little bit. I'll take some of the maybe higher level market questions and Bart can provide a few of the metrics. So from a market point of view, when you look at the MSP market, the reason it has spread globally at a little faster pace than most technologies have in the past is because we have SMEs all over the world. Those small businesses are trying to adopt a bunch of new technologies that are out there, a new antivirus, new threat protection, threat prevention, trying to make sure that they are able to leverage all the cloud-based technologies. And when I'm saying cloud-based now, I mean more SaaS, less AWS so they can run their businesses more effectively and efficiently. As they've done that, it has created demand to have someone help them because they simply can't manage the complexity of those environments.

And because the MSP market is actually local and regional and not really global, so most MSPs are local to the country and, in many cases, local to a city, they started out as great fix shops, a guy that's hopping in a little car driving around town, fixing a laptop for one of their customers or putting in a new WiFi access point or spinning up a new server, and what those little consulting shops realized is if they had some amount of technology that allows them to do that work remotely, then they could grow their business more quickly and they could more effectively manage their customers' environments, which is what gave the MSP market a foothold outside North America more quickly than you've seen other markets grow outside of North America.

The market use is really not defined by the number of MSPs. It's defined by the number of small businesses that exist in the world today, which is in the millions. We alone manage almost 0.5 million among those -- our MSP customers manage almost 0.5 million small businesses around the world using our products. And while we've got meaningful market share, there are some other players in the space that have a market share that's close to ours, so just to give you a view of just the sheer volume of companies that are out there. And there's a bunch of services, meaning the other technology we can deliver as a service to those MSPs that they can deliver to their customers over time.

We have very good visibility on that side for a couple of reasons. One is SaaS. The great thing about SaaS is we actually can look inside the product literally every day and we can see what the usage patterns of our customers are. So we can see how many devices they're adding, how many devices they're dropping. We can see what new services that they've added, what services maybe they had and they're not using as much today as they used to use. So we're able to reach out to them in a much more proactive way than you can in the license and maintenance world to either influence additional usage or if it looks like they're beginning to reduce their usage of our product, which means maybe they're at risk to churn, we've got an ability to engage with them way before we get to the point that they churn where in the license and maintenance side, we don't have that same level of visibility. Now, we've got great renewal rates because we've built a really wonderful process over the last 13 years that we believe is wonderful. And so while we don't have the same visibility, we have the same effect, but we have much better visibility because we can actually see what's going on inside the product.

[Bart Kalsu, Executive Vice President and CFO]

And yes. And to build off that, what we've seen with our MSPs is that their gross renewal rates, existing customers, they basically renew at the same kind of rates that we see with our license and maintenance business. So low 90s percent renewal rates within our MSP customers is what we see on the growth side and then the new customers and the upgrades is what actually gets us up to that net retention rate of about 105%. And that's what it is on a total basis, including our cloud business.

And one other thing. You asked about the international mix and why it's a little higher for our MSP business. We acquired LOGICnow and LOGICnow had a bigger presence outside of North America. So with that, we inherited a customer base that was a little bit more diverse than what our existing license and maintenance business is.

[John DiFucci, Jefferies]

So Bart, just one quick follow-up. I want to make sure, you said something -- I think you said ASC 606, the effect on revenue and also on expenses would be immaterial. I think you said -- maybe that's not, I don't want to -- some word like that you used. I just want to make sure, with sales commissions, will you have to capitalize and amortize more of that over a longer period of time, especially since a part of your revenue is ratable? I just wonder, like, we've seen that with other companies, especially SaaS companies but even maintenance companies where maintenance and hardware and some revenue -- some of the sales commission has to be recognized over a greater period of time.

[Bart Kalsu, Executive Vice President and CFO]

That's right. So ASC 606 is going to have a bigger impact to us on an EBITDA than it is on revenue. And the biggest reason is, like you said, the commission expense, we're going to have to capitalize commissions on some of our sales reps and we're going to have to amortize that over a six-year period. So you're going to see an uplift in our adjusted EBITDA because of moving to 606, but it's going to be primarily related to the adjustment that we're going to do commission expense as opposed to any adjustment that we're going to make to revenue.

[John DiFucci, Jefferies]

But that will have no effect on cash flow. Is that correct?

[Bart Kalsu, Executive Vice President and CFO]

No. No.

[John DiFucci, Jefferies]

upfront?

[Bart Kalsu, Executive Vice President and CFO]

No impact to cash flow. We're going to continue to operate the same way today whether we're under ASC 605 or ASC 606.

[Operator]

Your next question comes from the line of Sanjit Singh with Morgan Stanley.

[Joshua Baer]

This is Josh Baer on for Sanjit. Can you talk a little bit about customer reception for SolarWinds APM? And how are you thinking about the potential contribution from APM?

[Kevin Thompson, President and CEO]

Yes. So for those of you that maybe don't know, we rolled our -- integrated our cloud management application management capability with our on-premise application server monitoring product late in 2018 and so we're very early in beginning to have our customers try that capability. We've had some decent levels of success so far. We haven't really baked in any significant success into our view in 2019. I think it's very possible that we can see that, but we're really too early to make that a meaningful part of the forecast. We like to know how things are going to behave for a little longer period of time before we really build any meaningful success into a financial outlook.

But the technology today, we think what we can do both with the on-premise product combined with the cloud-based product, no one else can really do. None of the cloud-based vendors have the on-premise visibility that we have. None of our on-premise competitors have the cloud-based visibility that we have, so the integration we've created is pretty unique. And we think our -- the customers we have that are using our on-premise server and application monitoring product are going to find it compelling. And so a little better view as we get into Q1 really into Q2 in terms of the uptick of that, but the initial reception has been very good. Our customers are excited about it. And now, we just got to get them to see the value that it can provide.

And I think it also gives us a pretty differentiated story as we look at some of our customers who have started small and grown to be very large relationships with us. As they think about how they manage their cloud environments and on-premise environments at the same time they're trying to manage that hybrid world, we're doing that a lot already because you may remember that all of our key on-premise products also have cloud visibility. It's why we're already managing over 15,000 devices and applications in Azure because they're using -- our customers are using our on-premise products to manage those environments. So that unique ability we have to give you visibility across all of the areas of your IT infrastructure, I think could be a differentiating point for us as we move particularly into throughout 2019 and into 2020.

[Operator]

Your next question comes from Kirk Materne with Evercore ISI. Your line is now open.

[Kirk Materne, Evercore ISI]

Kevin, I was wondering if you can just talk a little bit about the cross-selling efforts back into the installed base. I think one of the bigger opportunities for you all on the on-prem side was sort of going back into your current installed base and sort of cross-selling and upselling some of your newer solutions. Just wondering how that's going relative to your expectations and sort of your thoughts on that heading into 2019.

[Kevin Thompson, President and CEO]

Yes. So that work continues to be something that we may never be done with doing it as well as ultimately we can. We're doing a good job and the momentum that we've seen continues to build. We're doing more of that now outside North America than we ever have before because we almost always are going to build new processes and approaches. And remember, in North America, in some cases, 12 months, 18 months, maybe even 24 months before we go global. We're seeing a lot of success in Europe right now with our selling efforts. We're starting to see a meaningful level of success in Asia Pac. But I do believe, and we believe as a team, we can still do much better than we're doing today. So I still think that's another growth lever for us.

Our customers still don't own enough of our products. We're still not selling enough of our customers every 90 days more product than they had the 90 days before. So one of the things we've done walking into 2019 is figure out how we can actually touch every customer more often in 2019 than we did in 2018. So we have continued to modify and adjust our approach to make sure that every customer of any size and even smaller customers are getting touched, not just by marketing because not every customer is going to read marketing messages, but they're being touched in a much more individual way.

And whether we're doing that with a sales rep, we're doing that with a very, very customized individualized targeted marketing message. We're trying to touch every customer on a much more frequent basis in 2019 than we did in 2018. If we're successful, we should see better growth out of that customer base in 2019 than we did in 2018. We have that built into our views at this point, but hopefully, that's something we can drive and maybe start to build that in as we move into next year.

[Operator]

Your next question comes from Terry Tillman with SunTrust Robinson. Your line is open.

[Terry Tillman, SunTrust Robinson]

I had 2 questions. The first, I'm shocked it hasn't been asked, either that or I just didn't hear it. But on the fed business, the federal business, Kevin, maybe you could talk about that. And I know some of this is still up in the air what might happen, but what have you been seeing in terms of the volume and velocity in that business? And I understand it's still -- September is a ways out, but just what you can say about the federal business? And then one follow-up.

[Kevin Thompson, President and CEO]

Yes. What I'll say, and this will be more qualitative, not quantitative, is we have a very strong U.S. federal business. We think it's a big market opportunity for us that we've invested in over the years as those of you who have been following us for a long time know. And it's a business that we worked very hard to create a foothold in a very different way without having to do all of the things that others do, pay lobbyists, walk the halls, have a bunch of people with credentials, all that kind of stuff. We've been able to build a really great federal business and an international governments business for that matter outside of North America by doing it in the SolarWinds way.

And so it's a good business rep. It has momentum. It's continuing to grow. We think it should continue to grow. There's a lot of opportunity there. We have not gotten into every agency and every department and every project yet. And until we get there, until Doug Hibberd, who runs our federal practice, he's not done. It's a good market. We like it and we've had good success in it in 2018.

[Terry Tillman, SunTrust Robinson]

Okay. And just a Threat Monitor update. I know that you buy assets or technology and then you want to kind of reshape it, rebuild the website and kind of put your approach, your GTM approach to whatever you buy. Maybe you can just give us an update on how to think about Threat Monitor, that newer product into '19. And could it move the needle? And is it more on the MSSP side? Or is it that a direct to end customers?

[Kevin Thompson, President and CEO]

You phrased it right in terms of what we do. We buy technology. We reshape them. We repackage them, re-price them, in many cases, change how they work, meaning spend a lot of time making them show value very, very quickly, making them intuitive to use, making the user interface really, really slick. And that's where we are on Threat Monitor right now. It is really smart technology, but it needs to be, to use a word, Solarwind's eyes. And so we've got to get in that ease of use, that ability to show value immediately at trials that is super simple, that it curves very, very quickly so that a potential customer can try it quickly, see the value quickly and then buy it. It's not there yet, so, no, you shouldn't expect it to move the needle in 2019. It is a work in progress.

It's an area of the market we're really excited about. As I've shared in the past, we think security is a big opportunity for us. We think threat monitoring, ultimately true vulnerability management is an area where our go-to-market motion can absolutely work, but we've got some work to do before it's really going to really move the needle. So don't expect that in 2019. We're not. But I do believe it will ultimately be a really good area of business for us and will be meaningful at some point. It's just not in 2019.

[Operator]

Your next question comes from Kash Rangan with Bank of America Merrill Lynch. Your line is open.

[Unidentified Analyst]

This is Shankar on behalf of Kash. I have more of a high-level question. I think ending last year, the most concern everybody had was kind of the IT spending environment given the macro backdrop. And I think you kind of highlighted that the spending environment could be weaker in 2019. But how do you see the spending environment as you look at it right now two months later? Has it materially changed? Has any weakness been factored into your guidance? And how should we think about how it's playing out through the year?

[Kevin Thompson, President and CEO]

Yes. I mean, if you look at [indiscernible] we obviously feel good about the business. We feel good about the momentum we have walking into 2019. We've got a lot of confidence in our ability to drive organic growth and high level of profitability in 2019 based on the trends we're seeing in the business and the trends we're seeing in the market. So we try to take a view of what does the market look like today, what's the level of momentum activity that exists, where the opportunities lie for SolarWinds, how much visibility we already have on the recurring revenue side, we're at 80% recurring today, and we've got good visibility into how that recurring revenue grows over time, so all that's baked into our outlook. So I wouldn't say we've seen a really significant negative change in sentiment from customers around the world, whether that's in our MSP product line or in our on-premise IT product line or cloud management product line, but it's the sentiment from buyers that stay relatively constant. There's definitely been noise in the market, and when I say market, I mean stock market, not necessarily IT market, which obviously had some impact on emotion, but we're not seeing that impact buying behavior in any meaningful way.

So we don't assume that the world can be a better place in 2019 than it is in 2018. We're not going to assume that it's going to be a lot worse than it is. What I would say is I've been here 13 years. Bart's been here 12 years. We've been through a lot of good economies and bad economies and I think we've been able to grow no matter what economy we've been in and we've grown at a rate faster than our market that we could be in, in great economies and we've grown faster than our markets in difficult economies. So while we all love great economies, I don't think we really require that to grow. We've got an economic advantage and we solve problems that are have to solve problems, not nice to solve problems, so you have to solve them or your infrastructure doesn't run. Your applications don't run. Your business doesn't perform. You have to manage the performance of that infrastructure. And we have the best prices of almost anyone in the market, definitely the best prices of anyone who could scale the way we can and handle the level of complexity, depth and breadth of problems that we solve. So whatever market we're in, I think we are going to be able to outcompete the others in the market and grow faster than the markets will grow.

And with that, we're going to have to wrap it up. We appreciate everyone attending the call. I warned you, we had a lot to share. So hopefully, you were taking notes fast and you didn't get a cramp writing down all the numbers that Bart shared with you. But we appreciate having you on the call. Bye.

[Operator]

This concludes today's conference call. You may now disconnect.