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SOLARWINDS, INC. - 10-Q - : Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the Condensed Consolidated Financial Statements and related notes thereto included elsewhere in this quarterly report on Form 10-Q. In addition to historical condensed consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially and adversely from those anticipated in the forward-looking statements. Please see the section entitled "Safe Harbor Cautionary Statement" above and the risk factors discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 for a discussion of the uncertainties, risks and assumptions associated with these statements. Overview We design, develop, market, sell and support powerful yet easy-to-use enterprise-class IT infrastructure management software to IT professionals in organizations of all sizes. Our product offerings range from individual software tools to more comprehensive software products that solve problems encountered every day by IT professionals and help to enable efficient and effective management of their network, systems and application infrastructure. Our products are ready-to-use, featuring intuitive and easily customized user interfaces and built-in workflows. Most of our products can be downloaded directly from our websites and installed and configured by our end-users in a matter of hours. Our customers include small- and mid-size businesses, large enterprises, managed service providers, and local, state and federal government entities that have purchased our products. Key Financial Highlights Key financial highlights for the first three quarters of 2014 include the following: • Total revenue was $310.3 million in the first three quarters of 2014 compared to $238.3 million in the first three quarters of 2013, representing an increase of 30.2%; • Combined maintenance and subscription revenue in the first three quarters of 2014 was $193.5 million compared to $142.0 million in the first three quarters of 2013, representing 36.3% year-over-year growth in recurring revenue; • Net income was $55.1 million in the first three quarters of 2014 compared to $68.6 million in the first three quarters of 2013, representing a decrease of 19.6%; • Net income was $0.72 per share on a fully diluted basis for the first three quarters of 2014 compared to $0.90 per share on a fully diluted basis for the first three quarters of 2013, resulting in a decrease of 20.0%; and • Cash flow from operating activities was $147.8 million in the first three quarters of 2014 compared to $113.6 million in the first three quarters of 2013, representing an increase of 30.1%. In 2013 and the first three quarters of 2014, we invested across our business and, in particular, invested in areas that we believe are an important foundation for our long term growth. For example: • We increased our investment in our sales function in an effort to better convert the demand that we capture through our marketing activities, to expand our sales efforts within our existing customer base and to expand our sales team focused on the MSP market; • We increased our investment in our marketing programs, team and systems, in an effort to increase the awareness of SolarWinds and our products as well as to better capture demand, and specifically to accomplish those goals more consistently for our different products and in our different geographies; • We increased our investment in product development in an effort to accelerate new product releases and enhancements for our products in order to improve the usability and add features our customers rely on daily; and • We invested in the expansion of our facilities and IT infrastructure to support the growth of our operations. We are committed to our business model and have continued to focus on ways to leverage and refine our model. We have made investments in our business over the last several quarters and believe that we are beginning to see the impact of those efforts in the acceleration of total revenue. Our strategic focus in 2014 is centered around the following initiatives: • Improving the competitive positioning of our products by investing in new product features and infrastructure; • Acquiring and internally developing products that will expand our presence in our current markets or new markets; 16-------------------------------------------------------------------------------- Table of Contents • Expanding our web presence, brand awareness and improving our communication with prospects and our current customer base both domestically and internationally; • Increasing our presence in several key geographic markets including Asia-Pacific, Latin America, Europe, Middle East and Africa through demand generation activity, marketing awareness, localized marketing material and new relationships with distributors and resellers; • Accelerating the rate at which we are selling additional products into our install base; and • Expanding our international operations company-wide at lower cost locations to drive our competitive advantage. We expect to continue to generate solid growth while delivering strong operating income and to increase our cash flows from operating activities with our disciplined approach to investing in our business combined with our large market opportunity. Acquisitions We have made multiple acquisitions of businesses as part of our growth strategy and expect to continue to pursue acquisitions that will enable us to enter new markets, or new segments of our existing markets, by bringing new product offerings to market more quickly than we can develop them. In the second quarter of 2014, we acquired Pingdom, a provider of website monitoring and performance management solutions. The acquisition increased our product offerings and we believe will allow us to leverage the opportunity associated with performance management for critical websites and web applications. Pingdom is based in Vasteras, Sweden. We account for our acquisitions using the acquisition method of accounting. Accordingly, the financial results of our acquisitions are included in our condensed consolidated financial results since the applicable acquisition dates. See Note 2, Acquisitions, in the Notes to the Condensed Consolidated Financial Statements for additional details. Key Business Metrics We review a number of key business metrics to help us monitor the performance of our business model and to identify trends affecting our business. The measures that we believe are the primary indicators of our quarterly and annual performance are as follows: Revenue Growth Revenue growth includes the growth in our license, maintenance and subscription revenue, which are critical to our long-term success. We have employed a differentiated business model for marketing and selling high volumes of enterprise-class software, which is focused on revenue growth at high operating margins. We have built a financial and operational model that focuses on the long-term value of our customer relationships. After the initial new license or subscription purchase, our goal is to create opportunities for sales of additional products, license or subscription upgrades and renewal purchases from the customer. This is an important component of our financial model and future revenue growth. This model is based on the premise that we will be able to deliver ongoing value to our customers and maintain a long-term financial relationship with the users of our IT management products. Our recurring revenue, which consists of maintenance and subscription revenue, is reflective of the relationship we have built with our customers. We regularly review our total revenue growth to measure the success of our investments and strategic business decisions. Our year over year revenue growth percentages were 30.2% and 21.9% for the first three quarters of 2014 and 2013, respectively. We expect our total revenue growth to be approximately 27-28% for the fiscal year 2014. Non-GAAP Operating Income and Non-GAAP Operating Margin Our management uses non-GAAP operating income and non-GAAP operating margin as key measures of our performance. Because our non-GAAP operating income excludes certain items such as amortization of intangible assets, stock-based compensation and related employer-paid payroll taxes, certain acquisition related adjustments and restructuring charges that may not be indicative of our core business, we believe that this measure provides us with additional useful information to measure and understand our performance, particularly with respect to changes in performance from period to period. We use non-GAAP operating income and non-GAAP operating margin in the preparation of our budgets and to measure and monitor our performance. Non-GAAP operating income and non-GAAP operating margin is not determined in accordance with GAAP and is not a substitute for, or superior to, financial measures determined in accordance with GAAP. We increased our investments in the business in the last half of 2013 and during the first three quarters of 2014 and we expect our non-GAAP operating margin to be approximately 42.5% for fiscal year 2014. 17-------------------------------------------------------------------------------- Table of Contents For further discussion regarding non-GAAP financial measures including non-GAAP operating income, see "Non-GAAP Financial Measures" below. Opportunities, Trends and Uncertainties Businesses, governments and other organizations are increasingly relying on networks, systems, and applications to execute their operations, facilitate their internal and external communications and transact business with their customers and partners. The size of these networks, the number of applications and servers, and the complexity of physical and virtual server environments are increasing as organizations place more reliance on them. In addition, business initiatives to capture, store, and analyze an increasing amount of organizational data are creating new IT management challenges. Furthermore, the adoption of cloud computing technologies, which is shifting a growing number of critical workloads off premises, is also creating new IT management complexities and placing increasing importance on the performance of IT assets as compute resources become more distributed. The development and evolution of cloud computing technologies is also allowing a growing number of small and medium-sized organizations to rely upon third parties, known as managed service providers, or MSPs, for their IT management needs. These MSPs need powerful, yet easy-to-use and affordable solutions in order to address a wide range of IT management issues for the thousands of small and medium-sized organizations they serve. In order to address these challenges, we offer a cohesive portfolio of powerful, yet easy-to-use and affordably priced IT management products spanning networks, systems, application and web performance management. This includes software that we have either developed or acquired that allows IT professionals to manage the performance, health, and configurations of network devices, firewalls, applications, websites and web applications, physical and virtual servers, storage devices, as well as software for log and security information management. It also includes software that provides IT professionals with mobile and remote access to their IT infrastructure and software to help them track and resolve IT issues along with their IT assets. Lastly, our portfolio includes a set of remote monitoring and management products that allow MSPs to remotely access and address a broad range of IT issues faced by their customers in order to ensure the performance and security of their networks, desktops, servers, and other proprietary systems. We believe that IT-related trends and the limitations of existing offerings present a significant market opportunity for our products and starting in 2013, we began to increase our investment as a percentage of revenue to take advantage of this market opportunity. We expect our revenue to continue to grow as we capitalize on these and other market opportunities through acquisitions and development. Our ability to grow revenue will depend on a number of factors and assumptions, many of which are outside of our control. Further, any revenue growth and operating synergies of our acquired products and businesses depends on our ability to successfully integrate those products and businesses and may be lower than expected if we are unable to do so in the future. In the third quarter of 2014, we recognized 25.9% of our revenue from sales by our international subsidiaries, which includes all subsidiaries outside of North America. We believe there is a substantial opportunity for additional sales of our software in the Europe, Middle East and Africa, or EMEA, region, the Asian-Pacific region, and the Latin American region. We intend to increase our sales, marketing and support operations in these regions. However, we believe there is significant uncertainty regarding the economic conditions in certain of these geographic regions. While we believe that any difficult economic conditions may adversely affect the sales of our products, this could also offer us an opportunity to market and sell our products to mid-size businesses and enterprise customers at compelling prices compared to the prices of some competing products. We expect the U.S. federal government to continue to be a significant market opportunity, as we believe the ease of deployment, power and scalability of our products gives us a competitive advantage to sell to various agencies and departments of the U.S. federal government. We have experienced and continue to expect inconsistency in the buying pattern of the U.S. federal government for larger transactions with our products. We believe that many of our larger transactions, both new licenses and maintenance renewals, with the U.S. federal government are dependent on specific projects that may not be continued at the same scale in the future due to budgetary cuts or other reasons, and the reduction or cancellation of specific projects such as these could result in our sales to the U.S. federal government growing less rapidly than expected or even decreasing. In addition, our sales, both new licenses and maintenance renewals, to the U.S. federal government are largely dependent on systems integrators, distributors and resellers whose purchases from us have been difficult to predict. Key Components of Our Results of Operations Sources of Revenue Our revenue is primarily comprised of license, maintenance and subscription revenue. License, Maintenance and Other Revenue. We primarily license our software under perpetual licenses, which ordinarily include one year of maintenance as part of the initial purchase price of the product. License revenue reflects the revenue recognized from sales of new perpetual licenses and upgrades of license size to our software. We have experienced annual 18-------------------------------------------------------------------------------- Table of Contents growth in license revenue. Maintenance revenue is an important source of our future revenue. Customers can renew, and generally have renewed, their maintenance agreements at our standard list maintenance renewal pricing for their software products. Current customers with maintenance agreements are entitled to receive unspecified upgrades or enhancements when and if they become available. We have experienced strong and consistent annual and quarterly growth in maintenance and other revenue. Because our maintenance base has continued to grow each year due to new license sales, high customer retention and acquisitions, we expect maintenance revenue to continue to increase in absolute dollars in future periods. Subscription Revenue. We primarily derive subscription revenue from fees received from our MSP customers for time-based license arrangements and software-as-a-service, or SaaS, offerings. We also include the fees from sales of the Pingdom cloud products, acquired in late June 2014, in our subscription revenue. We currently sell our subscription products separately from our perpetual license offerings. Cost of Revenue Cost of revenue primarily consists of amortization of acquired developed product technologies, personnel costs related to providing technical support services and royalty fees and server and hosting fees. Personnel costs include salaries, bonuses and stock-based compensation and related employer-paid payroll taxes for technical support personnel, as well as an allocation of our facilities, information technology, employee benefit and other overhead costs. We allocate stock-based compensation expense and related employer-paid payroll taxes to personnel costs based on the expense category in which the option or restricted stock unit holder works. We allocate overhead, such as rent, computer and other technology costs, and employee benefit costs to personnel costs in each expense category based on worldwide headcount in that category. The amortization of developed product technologies can vary significantly each period based on the size and timing of our acquisitions. We expect our cost of revenue to increase in absolute dollars and to fluctuate as a percentage of revenue as we acquire additional companies or technologies and as we increase our headcount to support new customers and product offerings. Operating Expenses We classify our operating expenses into three categories: sales and marketing, research and development and general and administrative. Our operating expenses primarily consist of personnel costs, contract research and development costs, marketing program costs and legal, accounting, consulting and other professional service fees. Personnel costs for each category of operating expenses primarily include employee compensation costs and facility overhead costs. We include restructuring charges related to severance and relocation in the employee's respective department. Our operating expenses increased in absolute dollars and as a percentage of revenue in the first three quarters of 2014 compared to the first three quarters of 2013, as we have continued to build infrastructure and add employees through acquisitions and organic growth across all departments in order to accelerate and support our growth. We increased our investment in product development, marketing and sales in late 2013 for initiatives we believe are important to our long-term goals. These investments are focused on the development of new products and strategic releases to our current products and streamlining our demand generation process in our marketing and sales organizations. The number of full-time employees as of September 30, 2014 was 1,589, as compared to 1,203 as of September 30, 2013. We expect our operating expenses to continue to increase in absolute dollars as we make long-term investments in our business both domestically and internationally. Our operating expenses in future periods also may increase in absolute dollars and fluctuate as a percentage of revenue as a result of any future acquisitions and any further decisions to increase our investment in our business. In addition, we intend to continue to grant equity awards to our current executives and employees and those who join us in the future through acquisitions or otherwise, which will result in additional stock-based compensation expense. Sales and Marketing. Sales and marketing expenses primarily consist of personnel costs for our sales, marketing and business development employees and executives, commissions earned by our sales personnel, the cost of marketing programs such as paid search, search engine optimization and management, trade shows, website maintenance and design and the cost of business development programs. We expect to continue to hire sales personnel in the United States and in our international sales offices to drive new license sales growth. We also expect to continue to invest in our websites, online user community site, brand awareness initiatives and marketing programs to drive customer downloads and support our new product launches. Research and Development. Research and development expenses primarily consist of personnel costs for our product development employees and executives and, to a lesser extent, contractor fees. We have devoted our development efforts primarily to expanding our product line and increasing the functionality and enhancing the ease-of-use of our software products. We have significantly increased our research and development employee headcount through the continued expansion 19-------------------------------------------------------------------------------- Table of Contents of our research and development centers in the Czech Republic and India and through acquisitions. We expect to continue to invest in our research and development activities by hiring engineers in our international locations and supplementing our internal research and development activities with additional contract services, which will allow us to continue our research and development growth strategy internationally. General and Administrative. General and administrative expenses primarily consist of personnel costs for our executive, finance, legal, human resources and other administrative personnel and the amortization of acquired intangible assets. Legal, accounting and other professional service fees, restructuring charges, along with general corporate expenses are also recorded in general and administrative expenses. Restructuring charges include the expenses related to the closing of certain offices such as severance, relocation and the estimated costs of exiting and terminating facility lease commitments. We expect to incur higher administrative costs in future periods as our business continues to grow both organically and through acquisitions. Other Income (Expense) Other income (expense) primarily consists of interest income, interest expense, transactional foreign exchange gains (losses), foreign exchange contracts gains (losses) and grant income. Income Tax Expense Income tax expense primarily consists of corporate income taxes related to profits resulting from the sale of our software offerings by our four entities that sell our software, one in the United States, one in Canada, one in Ireland and one in Sweden. The rate of taxation on income earned by our U.S. entity is higher than the rate of taxation on income earned by our Canadian, Irish and Swedish entities. If our international income, as a percentage of total income, increases as we expect, then our effective income tax rate should correspondingly decline. However, our effective tax rate may be affected by many other factors, such as changes in tax laws, regulations or rates, new interpretations of existing laws or regulations, the impact of accounting for stock-based compensation, the impact of accounting for business combinations, the impact of accounting for uncertain tax positions, changes in our international structure, shifts in the amount of taxable income earned in the United States, as compared with other regions in the world, and changes in overall levels of income before tax. We benefited from the tax credit incentives under the U.S. research and experimentation credit extended to taxpayers engaged in qualified research and experimental activities while carrying on a trade or business. The tax credit expired on December 31, 2013, and if not renewed under similar terms as in prior years the result could have a material impact on our financial results. 20-------------------------------------------------------------------------------- Table of Contents Comparison of the Three Months Ended September 30, 2014 and 2013 The following table sets forth our condensed consolidated statements of income data for the periods indicated: Three months ended September 30, % of % of 2014 Revenue 2013 Revenue Change (in thousands) (in thousands) (in thousands) Revenue: License $ 42,756 37.9 % $ 34,358 39.1 % $ 8,398 Maintenance and other 61,844 54.8 50,283 57.2 11,561 Subscription 8,262 7.3 3,222 3.7 5,040 Total revenue 112,862 100.0 87,863 100.0 24,999 Cost of revenue 11,578 10.3 7,099 8.1 4,479 Gross profit 101,284 89.7 80,764 91.9 20,520 Operating expenses: Sales and marketing 37,538 33.3 25,962 29.5 11,576 Research and development 13,761 12.2 9,558 10.9 4,203 General and administrative 18,274 16.2 13,383 15.2 4,891 Total operating expenses 69,573 61.6 48,903 55.7 20,670 Operating income 31,711 28.1 31,861 36.3 (150 ) Other income (expense): Interest income 85 0.1 91 0.1 (6 ) Interest expense (142 ) (0.1 ) - - (142 ) Other income (expense), net 238 0.2 (6 ) - 244 Total other income (expense) 181 0.2 85 0.1 96 Income before income taxes 31,892 28.3 31,946 36.4 (54 ) Income tax expense 7,771 6.9 9,123 10.4 (1,352 ) Net income $ 24,121 21.4 % $ 22,823 26.0 % $ 1,298 Revenue Revenue increased $25.0 million, or 28.5%, in the quarter ended September 30, 2014 compared to the quarter ended September 30, 2013. Total revenue by product group was $66.4 million and $57.8 million for network management, $34.8 million and $23.8 million for systems and application management and $11.6 million and $6.3 million for our MSP and subscription products for the quarters ended September 30, 2014 and 2013, respectively. Our revenue from our international subsidiaries was 25.9% of total revenue in both the third quarter of 2014 and 2013. Other than the United States, no single country accounted for 10% or more of our total revenues during these periods. We expect international sales as a percentage of our total sales in 2014 to increase slightly as compared to 2013. We plan to continue expanding our sales and marketing efforts outside of the U.S. License, Maintenance and Other Revenue License revenue increased $8.4 million primarily due to increased sales of our systems and application management products and network management products. In the fourth quarter of 2013, we changed the methodology for calculating our average transaction size and product transaction volume growth metrics. We now calculate these metrics using commercial core transactions only, which exclude any transactions that consist solely of our transactional products sold on a stand-alone basis or our MSP and subscription products. In addition, we no longer calculate these metrics using a trailing 12-month average. We have recalculated the metrics disclosed below from prior period filings based on the new methodology. 21-------------------------------------------------------------------------------- Table of Contents Our commercial core product transaction volume growth was 24.6% in the third quarter of 2014 as compared to the third quarter of 2013. The overall growth in commercial core product transaction volume in the third quarter of 2014 was attributed to increased sales of our systems and application management and network management products. In the third quarter of 2014 and 2013, the commercial core average size for new license transactions was approximately $7,900. Our commercial core average transaction size was consistent year over year due to a similar number of products sold on each transaction along with a comparable number of larger transactions. Maintenance and other revenue increased $11.6 million due to a growing maintenance renewal customer base and an increase in new license sales, which drives new maintenance revenue. We have maintained high customer retention and have continued to increase our renewal base each quarter as we have begun to renew and recognize the maintenance revenue associated with our acquired products. Subscription Revenue Subscription revenue increased $5.0 million primarily due to the growth in sales of subscriptions of our MSP products and to a lesser extent, our Pingdom cloud products. Cost of Revenue Cost of revenue increased $4.5 million, or 63.1%, in the quarter ended September 30, 2014 compared to the quarter ended September 30, 2013. Cost of license revenue increased by $1.5 million in the third quarter of 2014 compared to the third quarter of 2013, primarily due to the amortization of acquired product technologies associated with our acquisitions. Cost of maintenance revenue also increased $1.0 million primarily due to increased personnel costs, which include stock-based compensation expense, to support new customers, additional product offerings from acquisitions and internal product development. Cost of subscription revenue increased by $2.0 million in the third quarter of 2014 compared to the third quarter of 2013, primarily due to increased amortization of acquired developed product technologies, personnel costs and other direct costs, including royalty fees and hosting and server fees, related to our subscription products and services. Operating Expenses Sales and Marketing. Sales and marketing expenses increased $11.6 million, or 44.6%, in the quarter ended September 30, 2014 compared to the quarter ended September 30, 2013. Our sales and marketing personnel costs, which include stock-based compensation expense, increased $8.2 million. We have increased employee headcount in our sales, marketing and maintenance renewal teams as a result of organic growth and through acquisitions. Marketing program costs increased $3.3 million due to the increased investment around demand generation and brand awareness. Our sales expense as a percentage of revenue increased slightly in the third quarter of 2014 as compared to the same period in 2013 primarily due to our 2013 acquisitions. Research and Development. Research and development expenses increased $4.2 million, or 44.0%, in the quarter ended September 30, 2014 compared to the quarter ended September 30, 2013 due to our increased investment in product development. In order to support the ongoing development of new products and our current products, we continued to increase the size of our Czech Republic and India research and development centers during 2013 and the first three quarters of 2014 and supplemented our internal product development activities with additional contract services. We also increased our research and development headcount through our acquisitions. Due to this growth, our personnel costs, which include stock-based compensation expense, increased by $3.0 million and contract services increased $1.0 million in the third quarter of 2014 as compared to the third quarter of 2013. Contract services increased due to additional product development work that was completed by our offshore development vendors. General and Administrative. General and administrative expenses increased $4.9 million, or 36.5%, in the quarter ended September 30, 2014 compared to the quarter ended September 30, 2013. This increase was primarily due to a $2.9 million increase in personnel costs, which include stock-based compensation expense and a $2.1 million increase in acquisition related costs. Income Tax Expense Our income tax expense decreased by $1.4 million in the quarter ended September 30, 2014 as compared to the same period in 2013. Our effective tax rate decreased from 28.6% in the quarter ended September 30, 2013 to 24.4% in the quarter ended September 30, 2014. These decreases were primarily attributable to an increase in international earnings as a percentage of total earnings, which are generally taxed at lower tax rates, partially offset by the expiration of the U.S. federal research and experimental tax credit. 22-------------------------------------------------------------------------------- Table of Contents Comparison of the Nine Months Ended September 30, 2014 and 2013 The following table sets forth our condensed consolidated statements of income data for the periods indicated: Nine months ended September 30, % of % of 2014 Revenue 2013 Revenue Change (in thousands) (in thousands) (in thousands) Revenue: License $ 116,743 37.6 % $ 96,300 40.4 % $ 20,443 Maintenance and other 174,800 56.3 137,841 57.8 36,959 Subscription 18,732 6.0 4,151 1.7 14,581 Total revenue 310,275 100.0 238,292 100.0 71,983 Cost of revenue 32,504 10.5 18,887 7.9 13,617 Gross profit 277,771 89.5 219,405 92.1 58,366 Operating expenses: Sales and marketing 106,772 34.4 66,538 27.9 40,234 Research and development 41,784 13.5 25,622 10.8 16,162 General and administrative 57,466 18.5 34,758 14.6 22,708 Total operating expenses 206,022 66.4 126,918 53.3 79,104 Operating income 71,749 23.1 92,487 38.8 (20,738 ) Other income (expense): Interest income 246 0.1 324 0.1 (78 ) Interest expense (577 ) (0.2 ) - - (577 ) Other income (expense), net 446 0.1 (497 ) (0.2 ) 943 Total other income (expense) 115 - (173 ) (0.1 ) 288 Income before income taxes 71,864 23.2 92,314 38.7 (20,450 ) Income tax expense 16,718 5.4 23,695 9.9 (6,977 ) Net income $ 55,146 17.8 % $ 68,619 28.8 % $ (13,473 ) Revenue Revenue increased $72.0 million, or 30.2%, in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. Total revenue by product group was $184.9 million and $163.4 million for network management, $96.3 million and $66.9 million for systems and application management and $29.1 million and $8.0 million for our MSP and subscription products for the nine months ended September 30, 2014 and 2013, respectively. Our revenue from our international subsidiaries was 27.1% and 26.4% of total revenue in the first three quarters of 2014 and 2013, respectively. Other than the United States, no single country accounted for 10% or more of our total revenues during these periods. We expect international sales as a percentage of our total sales in 2014 to increase slightly as compared to 2013. We plan to continue expanding our sales and marketing efforts outside of the U.S. License, Maintenance and Other Revenue License revenue increased $20.4 million primarily due to increased sales of our systems and application management, network management and MSP products. In the fourth quarter of 2013, we changed the methodology for calculating our average transaction size and product transaction volume growth metrics. We now calculate these metrics using commercial core transactions only, which exclude any transactions that consist solely of our transactional products sold on a stand-alone basis or our MSP and subscription products. In addition, we no longer calculate these metrics using a trailing 12-month average. We have recalculated the metrics disclosed below from prior period filings based on the new methodology. 23-------------------------------------------------------------------------------- Table of Contents Our commercial core product transaction volume growth was 14.7% in the first three quarters of 2014 as compared to the first three quarters of 2013. The overall growth in commercial core product transaction volume is attributed to increased sales of our systems and application management and network management products in the first three quarters of 2014. In the first three quarters of 2014, the commercial core average transaction size for new license sales, was approximately $7,900 as compared to approximately $7,500 in the first three quarters of 2013. The increase in our commercial core average transaction size was primarily due to a greater number of transactions over $20,000, across our network management and systems and application management product portfolios during the first three quarters of 2014 as compared to the first three quarters of 2013. Maintenance and other revenue increased $37.0 million due to a growing maintenance renewal customer base and an increase in new license sales, which drives new maintenance revenue. We have maintained high customer retention and have continued to increase our renewal base each quarter as we have begun to renew and recognize the maintenance revenue associated with our acquired products. Subscription Revenue Subscription revenue increased $14.6 million primarily due to the growth in sales of subscriptions of our MSP products. Cost of Revenue Cost of revenue increased $13.6 million, or 72.1%, in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. Cost of license revenue increased by $4.1 million in the first three quarters of 2014 compared to the first three quarters of 2013, primarily due to the amortization of acquired product technologies associated with our acquisitions. Cost of maintenance revenue also increased $2.7 million primarily due to increased personnel costs, which include stock-based compensation expense, to support new customers, additional product offerings from acquisitions and internal product development. Cost of subscription revenue increased by $6.8 million in the first three quarters of 2014 compared to the first three quarters of 2013, primarily due to increased amortization of acquired developed product technologies, personnel costs and other direct costs, including royalty fees and hosting and server fees, related to our subscription products and services. Operating Expenses Sales and Marketing. Sales and marketing expenses increased $40.2 million, or 60.5%, in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. Our sales and marketing personnel costs, which include stock-based compensation expense, increased $27.6 million. We have increased employee headcount in our sales, marketing and maintenance renewal teams as a result of organic growth and through acquisitions. Marketing program costs increased $11.2 million due to the increased investment around demand generation and brand awareness. Our sales expense as a percentage of revenue increased slightly in the first three quarters of 2014 as compared to the same period in 2013 primarily due to our 2013 acquisitions. Research and Development. Research and development expenses increased $16.2 million, or 63.1%, in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013 due to our increased investment in product development. In order to support the ongoing development of new products and our current products, we continued to increase the size of our Czech Republic and India research and development centers during 2013 and the first three quarters of 2014 and supplemented our internal product development activities with additional contract services. We also increased our research and development headcount through our acquisitions. Due to this growth, our personnel costs, which include stock-based compensation expense, increased by $10.9 million and contract services increased $4.7 million in the first three quarters of 2014 as compared to the first three quarters of 2013. Contract services increased due to additional product development work that was completed by our offshore development vendors. General and Administrative. General and administrative expenses increased $22.7 million, or 65.3%, in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013. This increase was primarily due to a $10.2 million increase in personnel costs, which include stock-based compensation expense, a $2.8 million increase in acquisition related costs, and a $1.7 million increase in amortization of acquired intangibles. Other miscellaneous costs such as professional fees and contractor services increased $0.7 million. In addition, we recorded a $6.8 million lease abandonment charge in the second quarter of 2014 for the estimated fair value of our remaining obligation under the operating lease of our former corporate headquarters. See Note 8, Commitments and Contingencies, in the Notes to the Condensed Consolidated Financial Statements in Item 1 of Part I, for additional information regarding the lease abandonment charge. 24-------------------------------------------------------------------------------- Table of Contents Income Tax Expense Our income tax expense decreased by $7.0 million in the nine months ended September 30, 2014 as compared to the same period in 2013. Our effective tax rate decreased from 25.7% in the nine months ended September 30, 2013 to 23.3% in the nine months ended September 30, 2014. These decreases were primarily attributable to an increase in international earnings as a percentage of total earnings, which are generally taxed at lower tax rates, partially offset by the expiration of the U.S. federal research and experimental tax credit. Non-GAAP Financial Measures In addition to disclosing financial measures prepared in accordance with GAAP, this Form 10-Q includes the following financial measures which are non-GAAP financial measures under SEC rules: (i) non-GAAP operating income; (ii) non-GAAP net income; and (iii) non-GAAP diluted earnings per share. Each of these financial measures excludes the impact of certain items and therefore has not been calculated in accordance with GAAP. In this report, these non-GAAP financial measures typically exclude stock-based compensation expense and related employer-paid payroll taxes; amortization of intangible assets; acquisition related adjustments, including contingent consideration fair value adjustments due to the changes in probability assumptions of achieving the earnout criteria and due to the passage of time; and restructuring charges. Each of these non-GAAP adjustments is described in more detail below. In addition to these adjustments, management may include or exclude additional items from these or similar non-GAAP financial measures in future periods to the extent that management believes such items may not be indicative of our core business. A reconciliation of each of these non-GAAP financial measures to its most comparable GAAP financial measure is also included below. We believe that these non-GAAP financial measures provide meaningful supplemental information regarding our operating results because they exclude certain amounts that our management and Board of Directors do not consider part of core operating results when assessing our operational performance, allocating resources, preparing annual budgets and determining employee incentive compensation. Accordingly, these non-GAAP financial measures may provide insight to investors into the motivation and decision-making of management in operating the business. In addition, by comparing our non-GAAP financial measures in different historical periods, our investors can evaluate our operating results without the additional variations of certain items that may not be indicative of our core operations, including stock-based compensation expense, which is a non-cash expense that we believe is not a key measure of our operations. While we believe that these non-GAAP financial measures provide useful supplemental information, there are limitations associated with the use of these non-GAAP financial measures. These non-GAAP financial measures are not prepared in accordance with GAAP, do not reflect a comprehensive system of accounting and may not be comparable to similarly titled measures of other companies due to potential differences in their financing and accounting methods, the book value of their assets, their capital structures, the method by which their assets were acquired and the manner in which they define non-GAAP measures. Items such as the amortization of intangible assets, stock-based compensation expense and related employer-paid payroll taxes, acquisition related adjustments and restructuring charges, as well as the related tax impacts of these items can have a material impact on operating and net income. As a result, these non-GAAP financial measures have limitations and should not be considered in isolation from, or as a substitute for, their most comparable GAAP measures. We compensate for these limitations by using these non-GAAP financial measures as supplements to GAAP financial measures and by reconciling the non-GAAP financial measures to their most comparable GAAP financial measure. Investors are encouraged to review the reconciliations of these non-GAAP financial measures to their most comparable GAAP financial measures below. For a detailed explanation of the adjustments made to comparable GAAP financial measures, the reasons why management uses these measures and the usefulness of these measures, see footnotes (1)-(6) below. 25-------------------------------------------------------------------------------- Table of Contents Non-GAAP Operating Income and Non-GAAP Operating Margin Three Months Ended Nine Months Ended September 30, September 30, (in thousands, except percentages) 2014 2013 2014 2013 GAAP operating income $ 31,711 $ 31,861 $ 71,749 $ 92,487 Amortization of intangible assets (1) 7,981 5,115 23,127 14,088 Stock-based compensation expense and related employer-paid payroll taxes (2) 8,770 5,675 28,171 17,878 Acquisition related adjustments (3) 2,510 402 3,905 1,006 Restructuring charges (4) 25 827 7,506 1,310 Non-GAAP operating income $ 50,997 $ 43,880 $ 134,458 $ 126,769 GAAP operating margin 28.1 % 36.3 % 23.1 % 38.8 % Non-GAAP operating margin 45.2 % 49.9 % 43.3 % 53.2 % Non-GAAP operating income for the three and nine months ended September 30, 2014 increased as compared to the same periods in 2013 primarily due to increases in stock-based compensation expense, amortization of intangible assets and acquisition related costs, partially offset by a decrease in GAAP operating income for the nine months ended September 30, 2014. Stock-based compensation expense and related employer-paid payroll taxes increased primarily due to share-based incentive awards issued to employees for retention and, to a lesser extent, the addition of employees through acquisitions and organic growth. Our acquisition related adjustments increased in the three and nine months ended September 30, 2014 primarily due to increases in deferred compensation expense related to acquisitions. In addition, our restructuring charges increased in the nine months ended September 30, 2014 primarily due to a lease abandonment charge of $6.8 million related to our former corporate headquarters recorded in the second quarter of 2014. See Note 8, Commitments and Contingencies, in the Notes to the Condensed Consolidated Financial Statements in Item 1 of Part I, for additional information regarding the lease abandonment charge. Non-GAAP Net Income and Non-GAAP Diluted Earnings Per Share Three Months Ended Nine Months Ended September 30, September 30, (in thousands, except per share information) 2014 2013 2014 2013 GAAP net income $ 24,121 $ 22,823 $ 55,146 $ 68,619 Amortization of intangible assets (1) 7,981 5,115 23,127 14,088 Stock-based compensation expense and related employer-paid payroll taxes (2) 8,770 5,675 28,171 17,878 Acquisition related adjustments (3) 2,510 402 3,905 1,010 Restructuring charges (4) 25 827 7,506 1,310 Tax benefits associated with above adjustments (5) (4,843 ) (3,183 ) (16,674 ) (9,308 ) Non-GAAP net income $ 38,564 $ 31,659 $ 101,181 $ 93,597 Weighted-average number of shares used in computing diluted earnings per share 76,463 76,466 76,321 76,580 GAAP diluted earnings per share $ 0.32 $ 0.30 $ 0.72 $ 0.90 Non-GAAP diluted earnings per share (6) $ 0.50 $ 0.41 $ 1.33 $ 1.22 Non-GAAP net income for the three and nine months ended September 30, 2014 increased as compared to the same periods in 2013 primarily due to increases in the adjustments noted above in the calculation of non-GAAP operating income and the income tax effects associated with these adjustments, partially offset by a decrease in GAAP net income for the nine months ended September 30, 2014. 26-------------------------------------------------------------------------------- Table of Contents Non-GAAP Footnotes: (1) Amortization of Intangible Assets. We provide non-GAAP information that excludes expenses for the amortization of intangible assets that primarily relate to purchased intangible assets associated with our acquisitions. We believe that eliminating this expense from our non-GAAP measures is useful to investors, because the amortization of intangible assets can be inconsistent in amount and frequency and is significantly impacted by the timing and magnitude of our acquisition transactions, which also vary in frequency from period to period. Accordingly, we analyze the performance of our operations in each period without regard to such expenses. (2) Stock-Based Compensation Expense and Related Employer-Paid Payroll Taxes. We provide non-GAAP information that excludes expenses for stock-based compensation and related employer-paid payroll taxes. We believe the exclusion of these items allows for financial results that are more indicative of our continuing operations. We believe that the exclusion of stock-based compensation expense provides for a better comparison of our operating results to prior periods and to our peer companies as the calculations of stock-based compensation vary from period to period and company to company due to different valuation methodologies, subjective assumptions and the variety of award types. Employer-paid payroll taxes on stock-based compensation is dependent on our stock price and the timing of the taxable events related to the equity awards, over which our management has little control, and does not correlate to the core operation of our business. Because of these unique characteristics of stock-based compensation and the related employer-paid payroll taxes, management excludes these expenses when analyzing the organization's business performance. (3) Acquisition Related Adjustments. We exclude certain expense items resulting from acquisitions including the following, when applicable: (i) amortization of purchased intangible assets associated with our acquisitions (see Note 1 for further discussion); (ii) legal, accounting and advisory fees to the extent associated with acquisitions; (iii) changes in fair value of contingent consideration; (iv) costs related to due diligence and integrating the acquired businesses; (v) deferred compensation expense related to acquisitions; and (vi) restructuring costs, including adjustments related to changes in estimates, related to acquisitions. We consider these adjustments, to some extent, to be unpredictable and dependent on a significant number of factors that are outside of our control. Furthermore, acquisitions result in non-continuing operating expenses, which would not otherwise have been incurred by us in the normal course of our organic business operations, with respect to each acquisition. We believe that providing non-GAAP information for acquisition related expense items in addition to the corresponding GAAP information allows the users of our financial statements to better review and understand the historical and current results of our continuing operations, and also facilitates comparisons to our historical results and results of less acquisitive peer companies, both with and without such adjustments. (4) Restructuring Charges. We provide non-GAAP information that excludes restructuring charges such as severance, relocation and benefits and the estimated costs of exiting and terminating facility lease commitments, including accelerated depreciation on leasehold improvements and fixed assets, as they relate to our corporate restructuring and exit activities. These restructuring charges are inconsistent in amount and are significantly impacted by the timing and nature of these events. Therefore, although we may incur these types of expenses in the future, we believe that eliminating these charges for purposes of calculating the non-GAAP financial measures facilitates a more meaningful evaluation of our current operating performance and comparisons to our past operating performance. (5) Income Tax Effect of Non-GAAP Exclusions. We believe providing financial information with and without the income tax effect of excluding items related to our non-GAAP financial measures provide our management and users of the financial statements with better clarity regarding the ongoing performance and future liquidity of our business. (6) Non-GAAP Diluted Earnings Per Share Item. We provide non-GAAP diluted earnings per share. The non-GAAP diluted earnings per share amount was calculated based on our non-GAAP net income and the shares used in the computation of GAAP diluted earnings per share. Liquidity and Capital Resources Cash and cash equivalents and short-term and long-term investments were $214.8 million as of September 30, 2014. Our international subsidiaries held approximately $83.5 million of cash and cash equivalents of which 72.6% was held in Euros as of September 30, 2014. We expect our international cash and cash equivalents to continue to increase as a percentage of our consolidated cash and cash equivalents. We currently intend that the earnings generated by our international operations will be invested indefinitely in those operations and we do not expect to repatriate those earnings to our domestic operations. If we were to try and repatriate these earnings, we would incur a U.S. federal income tax liability that is not currently accrued in our condensed consolidated financial statements. 27-------------------------------------------------------------------------------- Table of Contents Our available cash and cash equivalents are primarily held in bank deposits and money market funds at September 30, 2014. Our short-term and long-term investments, classified as available-for-sale securities, consist of corporate bonds held in investment accounts in the United States. Our emphasis is primarily on safety of principal while secondarily maximizing yield on those funds. The balances held in our demand deposit accounts in the United States may exceed the Federal Deposit Insurance Corporation, or FDIC, insurance limits. While we monitor the balances in our accounts and adjust the balances as appropriate, these balances could be impacted by adverse conditions in the financial markets or by failure of the underlying depository institutions or guarantors. We strive to maintain our cash deposits, money market funds and investments with multiple financial institutions of reputable credit quality and, therefore, bear minimal credit risk. We actively monitor the third party depository institutions that hold our cash, cash equivalents and investments. To date, we have experienced no loss or lack of access to our invested cash, cash equivalents, and investments; however, we can provide no assurances that access to our funds will not be impacted by future adverse conditions. Summarized cash flow information is as follows: Nine Months Ended September 30, (in thousands) 2014 2013 Net cash provided by operating activities $ 147,844 $ 113,603 Net cash used in investing activities (70,252 ) (110,115 ) Net cash used in financing activities (41,865 ) (2,481 ) Effect of exchange rate changes (6,497 ) 2,122 Net increase in cash and cash equivalents 29,230 3,129 Operating Activities Cash provided by operating activities is comprised of net income, adjustments primarily related to non-cash operating activities and changes in operating assets and liabilities. Adjustments for non-cash expenses were $44.3 million and $23.8 million for the nine months ended September 30, 2014 and 2013, respectively. These adjustments primarily consist of stock-based compensation expense, depreciation and amortization, deferred taxes and excess tax benefits related to employee stock-based awards. Stock-based compensation expense reduced income before income taxes by $27.4 million and $17.1 million in the nine months ended September 30, 2014 and 2013, respectively. The change in cash flows relating to operating activities resulted from changes in operating assets and liabilities and is primarily driven by the sales of our software and maintenance renewals. The significant changes in operating assets and liabilities include the following: • Deferred revenue increased to $155.4 million at September 30, 2014 as compared to $135.2 million at December 31, 2013, resulting in an increase in operating liabilities and reflecting a cash inflow of $22.9 million for the nine months ended September 30, 2014. For the nine months ended September 30, 2013, net cash provided by operating activities increased $22.0 million due to an increase in deferred revenue during the period as compared to the respective prior period. Deferred revenue primarily consists of billings and payments received in advance of revenue recognition from maintenance fees. • Accrued liabilities and other increased to $31.8 million at September 30, 2014 as compared to $17.7 million at December 31, 2013, resulting in an increase in operating liabilities and reflecting a cash inflow of $14.3 million for the nine months ended September 30, 2014. This increase in accrued liabilities and resulting cash inflow was primarily related to the lease abandonment liability recorded in the second quarter of 2014 related to our remaining obligation under the operating lease of our former corporate headquarters. See Note 8, Commitments and Contingencies, in the Notes to the Condensed Consolidated Financial Statements in Item 1 of Part I, for additional information regarding the lease abandonment charge. For the nine months ended September 30, 2013, net cash provided by operating activities decreased $3.6 million due to a decrease in accrued liabilities during the period as compared to the respective prior period. • Changes in our income tax receivable and payable balances are also significant components of our cash flows from operating activities. Net cash provided by operating activities was reduced by income tax payments of $12.8 million and $15.7 million in the nine months ended September 30, 2014 and 2013, respectively. • Other long-term liabilities increased to $22.6 million at September 30, 2014 as compared to $16.8 million at December 31, 2013, resulting in an increase in operating liabilities and reflecting a cash inflow of $6.0 million for the 28-------------------------------------------------------------------------------- Table of Contents nine months ended September 30, 2014. This increase in other long-term liabilities and resulting cash inflow was primarily related to the lease incentive liability recorded for the tenant improvement allowance received related to our new corporate headquarters. See Note 8, Commitments and Contingencies, in the Notes to the Condensed Consolidated Financial Statements in Item 1 of Part I, for additional information regarding our lease for our new corporate headquarters. For the nine months ended September 30, 2013, net cash provided by operating activities increased $0.2 million primarily due to an increase in other long-term liabilities during the period as compared to the respective prior period related to lease abandonment liabilities recorded related to the closing of certain offices. • Accounts receivable increased to $47.7 million at September 30, 2014 as compared to $45.7 million at December 31, 2013 resulting in an increase in operating assets and reflecting a cash outflow of $3.1 million for the nine months ended September 30, 2014. The increase in accounts receivable for the nine months ended September 30, 2013 as compared to December 31, 2012 resulted in a cash outflow of $9.7 million for the nine months ended September 30, 2013. Our accounts receivable balance fluctuates from period to period depending on the timing of our sales, cash collections and changes to our allowance for doubtful accounts, which affects our cash flow from operating activities. Our accounts receivable balance represents trade receivables from customers, including resellers and distributors, when we have provided software licenses and/or software maintenance agreements or software subscription agreements and we have not yet received payment. We have historically had insignificant write-offs related to bad debts. The allowance for doubtful accounts was $0.7 million and $0.3 million at September 30, 2014 and 2013, respectively. We use days sales outstanding, or DSO, calculated on a quarterly basis, as a measurement of the quality and status of our receivables. We define DSO as (a) accounts receivable divided by (b) total revenue for the most recent quarter, multiplied by (c) the number of days in the quarter. Our DSO was 38.9 days and 47.7 days at September 30, 2014 and 2013, respectively. Investing Activities Net cash used in investing activities for the nine months ended September 30, 2014 was primarily related to $63.7 million of cash used for the acquisition of Pingdom (refer to Note 2, Acquisitions, in the Notes to the Condensed Consolidated Financial Statements in Item 1 of Part I, for additional details), $16.8 million of cash used to purchase property and equipment, offset by $13.5 million of proceeds from maturities of investments. The purchases of property and equipment primarily relate to leasehold improvements and other additions for our new corporate headquarters. We received $7.1 million in tenant improvement allowances related to the purchase of leasehold improvements during the first three quarters of 2014. For the nine months ended September 30, 2013, net cash used in investing activities was primarily related to $120.9 million of cash used for the acquisition of N-able, $17.3 million of cash used to purchase available-for-sale securities, offset by $38.7 million of proceeds from maturities of investments. We expect our capital expenditures for the remaining three months of 2014 to be approximately $3 to $5 million, primarily related to our expected growth and expansion of our domestic and international office locations. We expect our capital expenditures in the fiscal year 2015 to be approximately $20 to $25 million, primarily related to purchases of leasehold improvements, furniture, equipment and software in our domestic and international office locations to support their continued growth. Financing Activities Net cash used in financing activities for the nine months ended September 30, 2014 was related to the repayment of borrowings under our credit agreement of $40.0 million (refer to Note 5, Credit Agreement, in the Notes to the Condensed Consolidated Financial Statements in Item 1 of Part I, for additional details), repurchases of common stock of $13.2 million, offset by $6.0 million of proceeds from the exercise of employee stock options and the excess tax benefit related to stock-based awards of $5.3 million, which is a reduction in cash payments related to income taxes. On July 29, 2013, we announced that our Board of Directors approved a share repurchase program, authorizing us to purchase up to $50.0 million of our outstanding common stock. Our share repurchase program expired on July 31, 2014. Purchases under our share repurchase program were made in the open market pursuant to a Rule 10b5-1 plan. During the nine months ended September 30, 2014, we repurchased 0.2 million shares of our common stock for an aggregate purchase price of $7.5 million. During the life of the share repurchase program, we repurchased 1.1 million shares of our common stock for an aggregate purchase price of $40.1 million. Shares were retired upon repurchase. In addition, for the nine months ended September 30, 2014, we withheld and retired shares of common stock to satisfy $5.7 million of minimum statutory withholding tax requirements that we pay in cash to the appropriate taxing authorities on behalf of our employees related to the settlement of restricted stock units during the period. These shares are treated as common stock repurchases in our condensed consolidated financial statements as of September 30, 2014. 29-------------------------------------------------------------------------------- Table of Contents Net cash used in financing activities for the nine months ended September 30, 2013 was primarily related to repurchases of common stock of $18.4 million, offset by $8.1 million of proceeds from the exercise of employee stock options and the excess tax benefit related to stock option exercises of $7.7 million, which is a reduction in cash payments related to income taxes. During the nine months ended September 30, 2013, we repurchased 0.4 million shares of our common stock under our share repurchase program for an aggregate purchase price of $13.6 million. In addition, we withheld and retired shares of common stock to satisfy $4.7 million of minimum statutory withholding tax requirements that we pay in cash to the appropriate taxing authorities on behalf of our employees related to the settlement of restricted stock units during the period. These shares are treated as common stock repurchases in our condensed consolidated financial statements as of September 30, 2013. Anticipated Cash Flows We believe that our existing cash and cash equivalents, our cash flows from operating activities and our borrowing capacity under our Credit Agreement will be sufficient to fund our operations and our commitments for capital expenditures for at least the next 12 months. Our Credit Agreement, which we entered on October 4, 2013 with a syndicated group of lenders, provides for an unsecured $125.0 million five-year revolving credit facility that is comprised of revolving loans and swingline loans and, subject to certain requirements, may be increased up to an additional $75.0 million for a maximum aggregate commitment of $200.0 million. In August 2014, we repaid the $40.0 million of outstanding borrowings under a revolving loan under the Credit Agreement. The facility remains outstanding through October 4, 2018. See Note 5, Credit Agreement, in the Notes to Condensed Consolidated Financial Statements, for additional information regarding our Credit Agreement. Although we are not currently a party to any material definitive agreement regarding potential investments in, or acquisitions of, complementary businesses, applications or technologies, we may enter into these types of arrangements, which could reduce our cash and cash equivalents, require us to seek additional equity or debt financing or repatriate cash generated by our international operations that would cause us to incur a U.S. federal income tax liability. Additional funds from financing arrangements may not be available on terms favorable to us or at all. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our sales and marketing activities, the timing and extent of spending to support product development efforts and expansion into new territories, the timing of any acquisitions to expand our business, the timing of expansions to our office facilities, the timing of introductions of new software products and enhancements to existing software products, and the continuing market acceptance of our software offerings. We expect to continue to pursue acquisitions that will enable us to enter new markets or new segments of our existing markets by bringing new product offerings to market more quickly than we can develop them. In November 2013, we filed an automatic shelf registration statement with the SEC, which enables us to offer and sell from time to time, in one or more offerings, an unspecified amount of common stock, preferred stock, depositary shares, debt securities, warrants, purchase contracts, purchase units or any combination thereof and is intended to give us flexibility to take advantage of financing opportunities as needed or deemed desirable in light of market conditions. Debt securities sold by us may be fully and unconditionally guaranteed on an unsecured basis by SolarWinds Worldwide, LLC, our principal operating subsidiary. The specific terms of any offerings of securities under the automatic shelf registration statement will be provided in one or more supplements to the prospectus to be filed by us in connection with any future offering. Contractual Obligations and Commitments As of September 30, 2014, there have been no material changes in our contractual obligations and commitments that were disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. Critical Accounting Policies and Estimates Our condensed consolidated financial statements are prepared in conformity with United States of America generally accepted accounting principles, or GAAP, and require our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could reasonably use different accounting estimates, and in some instances, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected, perhaps materially. 30-------------------------------------------------------------------------------- Table of Contents In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management's judgment in its application, while in other cases, management's judgment is required in selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. We believe that these accounting policies requiring significant management judgment and estimates are critical to understanding our historical and future performance, as these policies relate to the more significant areas of our financial results. These critical accounting policies are: • Valuation of goodwill, intangibles, long-lived assets and contingent consideration, including accrued earnouts; • Revenue recognition; • Stock-based compensation; • Income taxes; and • Loss contingencies. A full description of our critical accounting policies that involve significant management judgment appears in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 filed with the Securities and Exchange Commission on February 14, 2014 under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies and Estimates." There have been no material changes to our critical accounting policies and estimates since that time. Recent Accounting Pronouncements See Note 1, Summary of Significant Accounting Polices, in the Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q, for a full description of recent accounting pronouncements, which is incorporated herein by reference. Off-Balance Sheet Arrangements During the first three quarters of 2014, we did not have any relationships with unconsolidated organizations or financial partnerships, such as structured finance or special purpose entities, that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. 31-------------------------------------------------------------------------------- Table of Contents |