SolarWinds Inc. ( SWI - Snapshot Report ) reported third quarter 2012 non-GAAP earnings of 37 cents per share, which increased 19.4% from the previous-year quarter. Including stock based compensation, earnings came at 32 cents per share, ahead of the Zacks Consensus Estimate of 28 cents per share. The upside in the earnings was driven by robust top-line growth and margin expansion.

Quarter Details

Revenue for quarter increased 33% from the previous-year quarter to $71.7 million and exceeded management’s revenue guidance of $66-$68.5 million. Moreover, reported revenue also surpassed the Zacks Consensus Estimate of $68 million.

The encouraging top-line expansion was aided by higher license and maintenance revenue. License revenue, which accounted for 47% of the total revenue, increased 33.3% year on year primarily due to the robust performance of the commercial business.

Maintenance revenue, which accounted for the remaining 53% of revenues, increased 32.7% from the previous-year quarter. The higher maintenance revenue was primarily attributed to strong customer retention.

Gross profit (including stock based compensation) increased 33.5% from the previous-year quarter to $68.9 million. Gross margin for the quarter expanded approximately 50 basis points from the previous-year quarter to 96.1% due to higher revenue base.

Operating expenses (including stock based compensation) increased 29.6% from the previous-year quarter to $33.3 million due to 34.5% increase in the sales and marketing expense, 28.6% jump in the research and development expense and 17% rise in the general and administrative expense. However, as a percentage of revenue, operating expenses contracted 130 basis points from the previous-year quarter to 46.4%.

Operating income (including stock based compensation) increased 37.5% from the previous-year quarter to $35.6 million. Operating margin increased 150 basis points to 49.6% primarily due to the decline in operating expenses as a percentage of revenue.

Non-GAAP net income increased from $23 million or 31 cents to $28.4 million or 37 cents. However, including stock based compensation, net income came at $24.4 million or 32 cents.

SolarWinds exited the quarter with cash, cash equivalents and short-term investments of $195.7 million versus $183.1 million in the previous quarter. Cash from operations increased sequentially from $34.1 million to $35 million. Free cash flow for the quarter was $37.2 million, which improved from $35.2 million in the previous quarter.

Outlook

For the fourth quarter, SolarWinds expects revenues in the range of $69.3-$70.8 million, reflecting a 25%-27% upside from the previous-year quarter. Management expects non-GAAP diluted earnings per share to be in the range of 31-33 cents. The Zacks Consensus Estimate expects SolarWinds to report 28 cents per share in the fourth quarter.

For fiscal 2012, management expects revenues in the range of $264.7-$266.2 million and non-GAAP diluted earnings per share between $1.31 and $1.32.

Recommendation

We believe that SolarWinds is well positioned to grow based on its recurring maintenance revenue stream. Moreover, strategic acquisitions are expected to be incrementally beneficial over the long run.

However, volatile macroeconomic environment and competition from bellwethers such as IBM Corp. ( IBM - Analyst Report ) and Hewlett Packard Company ( HPQ - Analyst Report ) are the major headwinds going forward.

We have a Neutral recommendation on SolarWinds over the long term. Currently, SolarWinds has a Zacks #3 Rank, which implies a short-term Hold rating.