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SWI: SolarWinds a Virtual Winner for Investors

A growing company in a screaming IT segment

One sector that I’m optimistic about in 2014 is enterprise tech stocks, particularly those that have strong business niches in both virtualization and security.

Why? Tech research firm Gartner recently said that global IT spending will grow 3.1% this year. While they may not sound like much at first glance, a closer look gives us plenty to cheer about.

Enterprise spending on technology that makes businesses more efficient – such as supply chain and marketing management software – will grow much faster than the headline number, at about 10% this year.

That tells me that stocks in the analytics space have a real leg up at such a growth rate, as they demonstrate continued popularity and gain new customers while also cross-selling into an entrenched client base.

My favorite play on this trend is SolarWinds (SWI), which has a presence in both virtualization and security, and offers solid profit potential over the next several months thanks to dedicated customers and a growth rate that is already outpacing the overall industry.

SolarWinds (which has nothing to do with solar power or alternative energy!) is an enterprise software company that sells its products to organizations of all shapes and sizes all over the world, including many Fortune 500 companies. Its main goal is to help other businesses cut costs and operate more efficiently. SWI does so through good products that cost less than many of its competitors, providing strong value that has resulted in a big and loyal customer base.

The company has built its niche in providing software that helps IT professionals manage all aspects of their firms’ technology – from networks to servers – through its Orion Network Performance Monitor, SWI’s flagship product. The software can also monitor, troubleshoot and repair remotely. This is done through a process called virtualization, where data and network applications use the cloud to host data, applications and analytics.

Clients can then access whatever they need from their individual machines. Most of us are familiar with pulling data off a network server or a cloud location such as Google (GOOG) docs, but virtualization allows the machines to function in different operating systems as well. The machines in essence become customizable so they can be used for a variety of different purposes. This is simpler and cheaper than every machine functioning on its one operating system and configured for specific purposes.

Virtualization is a big part of technology’s growth outlook, and is also among the trends buoying other  tech names, including NICE Systems (NICE).  IT departments all over the world have adopted this approach rapidly in recent years, and SWI’s competitive pricing makes its products very attractive to midsize companies and smaller organizations.

SolarWinds is a real recession and post-recession success story. It continued to grow through the worst of times, increasing revenues from roughly $60 million before the Great Recession to a run rate of about $300 million today. The company has followed a “buy and build” mentality, which means the company has growth both organically and inorganically at double-digit rates thanks to its own product development and strategic profitable acquisitions – a trend that looks set to continue.

When looking at tech companies, especially software-centric firms, it’s important to take note of the split between license and recurring revenues. License revenues are the initial sales of a software offering, while recurring revenues include maintenance and subscription proceeds. Recurring revenues also carries relatively high margins because it adds to the top line without having to hire additional salespeople, spend more on research and development, or advertise.

SWI has managed to keep its recurring revenues strong through cross selling, wherein a customer adds on new SolarWinds products and features to those it already has in its tech arsenal. That means SWI can keep growing sales without spending additional dollars on operating expenses, while creating a loyal and longtime relationship with clients.

Last November, management said that their products per core customer with the company less than a year have doubled just four years later. They also noted that several hundred customers have spent more than $150,000 on SWI, with an impressive 33 average transactions per customer at an average transaction value of $8,800. As a result, recurring revenues as a percentage of total sales have grown from 40% in the depths of the recession to roughly 60% today.

That’s helped SWI maintain strong total revenue growth at a 29% compounded annual rate since late 2010. That’s an impressive number, especially considering the slowdown in commercial (license) sales through the past few quarters, as international sales fell below expectations. In the third quarter of 2013, there was an unsurprising slowdown in license sales to 5% growth year-over-year that was tied to a 20% decline in government sales (remember that shutdown?).

However, I expect this to increase as security becomes more important, especially given recent data breaches that have been in the news, and management has also said they expect a rebound in license sales moving forward.

The Street currently estimates roughly 22% top-line growth in 2014, alongside flat earnings. However, I believe margin pressure should lift on continued recurring revenue growth, helping it to move toward the mid- to upper-20% range as license sales recover. We could then see $415 million in sales and EPS of as much as $1.80. Even those estimates could be conservative, but only a slight multiple expansion would give us a target of $50, for roughly 30% upside.

SolarWinds has shown impressive growth through harsh conditions, and it is poised to continue this trend given its strong product pipeline and cross-selling abilities to a dedicated customer base. Of course, as with any fast-growing company, there is always the risk of some hiccups in that growth.


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