Solarwinds Inc.

In the month since reporting its first-quarter results, Solarwinds Inc. ( SWI - Snapshot Report ) has watched the Zacks Consensus Estimates for 2012 and 2013 advance by 5 cents (+4.9%) and 6 cents (+4.9%), respectively. Shares of this Zacks #2 Rank (Buy), specialized software maker for IT professionals have responded by jumping 26.2%.

Why We Like Solarwinds

• Focus on enterprise IT spending: Solarwinds’ business is leveraged to IT spending trends, which should be very positive this year according to IDC. The research firm expects IT spending to be up in key markets.

• Operation in a niche market: The company directly targets a segment of the enterprise market (IT professionals) that constantly encounters both day-to-day problems and situational problems (shifting to a new system or shifting to the cloud for example). Moreover, since these professionals actually use the software, they are able to take a quick decision as to its effectiveness. To facilitate purchases, the company also offers a limited-version free trial that usually converts to sales without passing through a long and complicated approval system.

• Advantageous product structure: Solarwinds sells its products both as modules and as entire solutions. The advantage of this approach is that modules, being intended to solve specific problems and not take care of the entire IT system of clients, can be priced low, thereby facilitating quick decision-making. Alternatively, the customer could opt for more comprehensive solutions (which would basically mean more modules that work together). This low entry point is one of the biggest advantages, since adoption is quick. It also provides a starting point from which Solarwinds can increase penetration.

• Intelligent sales structure: Given that maintenance (upgrades, customer service, support, etc) is a useful tool for generating customer loyalty and the revenue is generally deferred and recognized over time, Solarwinds makes this the part of the initial sale on which there is no discount. The renewal of these contracts has been gradually increasing the revenue generated through the recurring revenue model, thus lending stability and predictability to the revenue stream.

• Effective marketing strategy: Solarwinds is an Internet company. Most of its advertising and marketing effort is carried out online through online advertising, SEO, blogs, ebooks, etc that IT professionals would naturally encounter in their search for solutions to specific problems. Since the products are easily downloadable and almost immediately usable, IT professionals can evaluate them and the sale can be closed very quickly.

First Quarter Results Were Very Strong

On April 26, Solarwinds reported that first quarter revenue increased 38.8% from the year-ago quarter, with licensing revenue growing 34.7% and maintenance growing 42.6%. The operating margin (including SBC and excluding other one-time items) expanded 125 bps during the year with EPS of 25 cents beating the Zacks Consensus Estimate by 8.7%.

Guidance for 2012 Raised

Revenues are expected to be up 26-31% this year over 2011 levels, with operating margins (excluding SBC and other items) at 50-51% and the tax rate at 29.5%, taking earnings to between $1.14 and $1.19 a share.

The historically weaker second quarter is expected to see year-over-year revenue growth of 29-31% (license revenue up 23-28%, maintenance revenue up 33-34%). Including dilution from the Rove acquisition and excluding SBC and other items, the operating margin is expected to be 50%, the tax rate 30% and the share count 76.5 million, yielding an EPS of 26 to 27 cents.

Premium Valuation is Justified

The application software industry is very diverse, including technology stalwarts such as International Business Machines (IBM) and Hewlett Packard Company (HPQ) that are more broadline suppliers, as well as specialized players, such CA Technologies (CA).

Solarwinds is currently trading at a premium to its peers on the basis of P/E, P/S and expected PEG (next 5 years). Given its solid growth profile, we think a premium valuation is justified and we believe that further upside is on the cards.

Solarwinds provides powerful, simple and affordable network management software to more than 80,000 customers worldwide -- from Fortune 500 enterprises to small businesses. Guided by a global community of network engineers, SolarWinds develops simple and powerful software for managing networks, small or large.