Description

Datto (NYSE:MSP) is an inexpensive expression of an emerging secular theme in small and medium business IT spend, with an attractive economic model in a large and rapidly growing addressable market. We believe consensus numbers are too low in both the near and medium term, and our growth upside should drive a re-rating, resulting in a $40 stock in the next 1.7 years, a 33% IRR, at 7x 2023 sales. Our view is based on four elements:

1. Open-ended secular growth

1. We believe Datto is currently the only actionable public markets expression of the shift from the legacy internal IT group to recurring outsourced IT services providers, or managed service providers (MSPs). This shift represents a long-term opportunity, spurred by an increasingly complex IT stack that requires proactive and specialized expertise beyond the capabilities of most SMBs.

2. Stock is under-followed and under-valued

1. Due to the recency of Datto’s IPO and the stock’s limited trading liquidity, the mixed track record of prior software vendors addressing the SMB space with less attractive business models, and a conflation by sell-side analysts of the cyclical softness following the pandemic with a secular slowdown, we believe Datto has flown under-the-radar and remains broadly misunderstood by the market.

3. Market structure suggests plentiful catalysts ahead

1. The leading MSP platform vendors—Datto, Kaseya, ConnectWise/Continuum and N-able—are each controlled by financial sponsors well-known in the space—Vista, TPG/Sixth Street Partners, Thoma Bravo and Silverlake/Thoma Bravo, respectively. We believe that in order to monetize their investments over time, these sponsors may look to accretive consolidation with other platforms or IPO. This means that (a) we are likely moving from a 4-player platform market to a more concentrated market over time (although there are numerous smaller point solutions in addition to the peers above), bringing greater market share to the remaining players, and/or (b) there will be more public float and greater awareness of the MSP theme as leading vendors begin trading.

4. Solid Rule of 40+ business fundamentals

1. The financial model for MSP software vendors is highly attractive – high-teens/low twenties ARR growth driven by strong net revenue expansion, exceptional salesforce productivity as the MSPs’ salesforce multiplies the vendor’s reach, and steady-state EBITDA margins in the 30-40% range. Deferred revenue growth and stock-based compensation contribute to strong FCF conversion, driving plenty of fuel for organic or inorganic growth.

1. Open-ended secular growth

Datto is a software vendor, offering a platform of tools, “picks and shovels”, to managed service providers. To understand why we believe Datto represents a compelling investment opportunity, it is first important to understand the trends in the customer end-markets.

What is an MSP?

MSPs are outsourced IT and cybersecurity specialist firms that design, implement and administer solutions for small and medium businesses. For example, if a doctor’s office is looking to host a medical records platform, an MSP could be engaged to (1) design an optimal solution using hardware (servers, network, switches, routers, etc.) and software (middleware, operating system, etc.), (2) build and implement the system by sourcing equipment and licenses and deliver the functioning system to the client, and (3) manage the solution on an ongoing basis (24/7 infrastructure monitoring to minimize downtime and maximize performance, patch management, security, network performance management, etc.).

These services allow customers to reduce cost, outsource non-core activities, get access to specialist expertise and insure rapid resolution of IT issues. This represents an important evolution vs. both internal IT teams, which are a cost center for SMBs and often lack the technical sophistication necessary to design and maintain increasingly complex network architectures, and also the legacy break-fix model of outsourced IT, where issues often go undetected until costs are material and the SMB’s core operations are disrupted. It goes without saying that the pandemic has accelerated trends like de-centralization, remote work, transition to hybrid/cloud environments, and the corresponding security vulnerabilities, all of which play to MSPs’ strengths.

MSPs typically price on a recurring multiyear contract basis, with variability around the number of seats or devices managed and the number of service hours desired by the client. This contract structure gives both parties excellent visibility and simplicity—the MSP can forecast his/her business multiple years out and the client has a single, predictable opex line item.

According to Datto’s S-1 (Figure 1), the global MSP TAM is $28bn, growing at a high-teens CAGR as managed services displace legacy IT services category (and as global IT spend continues to outpace GDP):

Figure 1. MSP TAM

Source: Datto Holding Corp. S-1

Datto S-1: “Based on this analysis, our total global market opportunity was estimated to be approximately $28 billion in 2019, growing at an expected CAGR of 17.0% to approximately $52 billion by 2023. Of the $28 billion, $16 billion was attributable to the Americas, $5 billion was attributable to EMEA and $7 billion was attributable to APAC. Our total market opportunity in the Americas was expected to grow at an 18.8% CAGR from 2019 to 2023.”

A look at the recently-filed Form 10 from N-able (another MSP platform vendor, soon to be spun out of SolarWinds) contains some slightly different numbers, but splitting the difference we can arrive at a global market >$20bn and growing ~mid teens (the two companies have different portfolios and target different customers within the MSP space, which could explain the variation in TAM projections):

N-able Form 10: “According to this analysis, the global market opportunity for our solutions was estimated to be approximately $23.3 billion in 2020 and is expected to grow at a compounded annual growth rate of 13.5% to approximately $43.9 billion by 2025. We believe that the size and projected growth of the global market for our solutions represents a significant opportunity for our business.”

Within MSPs, Datto’s penetration today is quite low (Figure 2), so there is plenty of opportunity for new logos:

Figure 2. Datto penetration by region

Source: Citigroup, Datto Holding Corp materials.

Our call-work with market participants indicates that these addressable market projections could prove conservative. The whitespace is so substantial that according to some, the healthy growth observed to date is more a function of the sales & marketing dollars invested by these platforms than the end-market growth—after all, it is difficult to accurately quantify the millions of SMBs, each in their own lifecycle of growth and technology need, that could be converted to become MSP customers in future years. As MSP vendors gain scale and can marshal more sales resources, their ARR growth outlook actually improves. As we have seen in the transition to SaaS, there is a multiplier effect on what companies can spend once predictable, recurring opex is substituted for lumpy capex dollars, and we believe a similar dynamic holds true in the shift from legacy break-fix IT to MSP.

MSPs tend to have anywhere from 1 to 10,000 FTEs, with the majority of addressable dollars in the 1,000-10,000 range. Their unique business model requires both tools to enable them to operate their own business (so-called “sell-to” solutions), and tools that they resell to SMBs to allow them to manage their customer’s IT infrastructure (“sell-through” solutions). 

The primary sell-to software is the PSA (professional services automation) SaaS product, which is the backbone of an MSP’s operations. In Datto’s words, PSAs “provide a fully integrated solution for single pane of glass management of the critical operational workflows and business processes of MSPs, including … ticketing, project management, customer relationship management, invoicing, inventory management and resource management.” For other back-end functions not offered off-the-shelf in the PSA, Datto offers “embedded integrations with over a hundred other MSP tools and technologies for the seamless and efficient delivery of managed services.” Datto’s PSA dates to the acquisition of Autotask in 2017, and is still branded Autotask PSA to customers. We believe Datto is a top two PSA vendor, competing mainly against ConnectWise.

The main sell-through products are BCDR (business continuity and disaster recovery) and RMM (remote monitoring and management). BCDR is Datto’s flagship product and we believe it still accounts for over half of company revenues. The BCDR products allow an MSP to rapidly restore and spin up client servers and PCs in the event of a security breach, catastrophe or accidental deletion, backing up either physical or virtual servers to on-premise servers, remote client datacenters or into Datto’s own private cloud. RMM is a newer area for Datto where they are a challenger. RMM software allows the MSP to manage a client’s endpoints (servers, laptops, mobile phones) to remotely identify and resolve IT issues. RMM is closely tied into an MSP’s PSA, as alerts are integrated into the PSA’s ticketing and other workflows.

The distinction between sell-to and sell-through is important to understand because it underpins the unique sales leverage in Datto’s business model. When an MSP customer of Datto adds a new SMB client, Datto will add new ARR at negligible acquisition cost if the new client adopts BCDR and RMM services from their MSP. However, Datto’s PSA does not benefit from MSP client growth unless the MSP also adds more seats internally to service the new account.

Below we have crudely relabeled a graph (Figure 3) from a sell-side initiation to make the above point easier to visualize. We have ignored the networking business, which is small and which our checks indicate is being de-emphasized relative to the more exciting BCDR, PSA, RMM and security/cloud initiatives—more on those below.

Figure 3. MSP multiplier effect from sell-through products

Source: Evercore ISI, Datto Holding Corp materials.

To summarize, MSPs operate in a large and growing market with a clear value proposition for both clients and the MSPs themselves.

2. Stock is under-followed and under-valued

Datto IPO’d on October 20, 2020 at $27. In a hot tech IPO market, Datto traded poorly, breaking the IPO price within a month of the offering and recently trading below $23, despite strong reported performance and 2021 guidance above the roadshow estimates for 2021 growth. We can think of several reasons for the weak share price performance, none of them especially compelling:

• 4Q20 was a frenetic time for growth-focused software investors, with numerous higher profile IPOs to focus on and little reason to do the work on an illiquid name focused on an unfamiliar customer base. It may have just gotten pushed down analysts’ “to do” lists, and languished for lack of incremental buyers, especially during the broad-based growth-to-value rotation we saw earlier this year.

• Our view: This is really more of an opportunity for patient investors to ride the wave of increasing buyside awareness.

• In a similar vein, public market investor awareness of the MSP trend is still nascent. Prior to the IPO, there was no listed software vendor that focused on this market. We believe investors have been wary of the SMB end-market exposure, especially during a period of elevated SMB mortality, and moreover in the context of legacy SMB and/or BCDR-focused vendors like Carbonite and Commvault going ex-growth. 

• Our view: The resilience of Datto’s cash flows during 2020 (adjusted EBITDA grew 78%, and FCF grew from -$27mm to +$68mm) demonstrates the strength of the business through the cycle. 

• Datto is closely held, with Vista and founder Austin McChord accounting for 84% of the shares issued. The stock’s value traded has averaged just $19mm/day since the IPO, and recent weeks have been closer to $10mm—not great for a $4bn market cap. So it has been challenging for funds to establish a position in a reasonable timeframe. On a related note, with the lockup expiration just passed, there is some risk of technical overhang from Vista selling down its stake.

• Our view: While near-term technical volatility could pressure shares, it is a longer-term positive for the equity to have an increased public float, which will broaden the potential investor base to larger, high quality holders. 

• The timing of the IPO, during a period in which business results were muted due to the adverse impact of the pandemic on SMB customers, has caused some concerns about the pace and magnitude of a recovery, and has led to forward estimates of the business materially lagging historical growth. For instance, Datto reported 25% ARR growth in 2019, yet consensus assumes just +16% growth in 2021 and +17% growth in 2022. These estimates presumably include the inorganic benefit of the BitDam acquisition, so the organic ARR growth estimates are a couple of ppts worse.

• Our view: we can think of few reasons why the company would suffer such an enduring slowdown in growth, especially since the pandemic actually accelerated trends favorable to MSP adoption. It appears that brokers have simply extrapolated weaker trends from the past year instead of looking at the pre-pandemic performance of the same business.

• Likewise, most broker models we have seen are driving subscription ARR (which drives 90-95% of sales) using MSP customers * ARR per customer. 

• Our view: This belies the true economic composition of ARR growth, which historically is about 85-90% from existing customers (net revenue expansion) and 10-15% from new logos net of churn. Thus, logo growth is rarely a linear predictor of ARR trends, since new customers tend to be smaller MSPs that contribute immaterial ARR for the first couple of years. To see this illustrated, look at Datto cohorts (Figure 4) and N-able cohorts (Figure 5)—that is why Datto added $20mm of new ARR in 4Q20 despite a reduction in MSP partners of 200 in the same period.

Figure 4. Datto cohort analysis

Source: Datto Holding Corp. S-1

Figure 5. N-able cohort analysis

Source: N-able Form 10

• The other main company-specific criticism of Datto is that the company will struggle to transition its flagship BCDR product from appliance-based physical server backup to cloud-based backup.

• Our view: There are a couple of nuances here that deserve some further discussion. First, while Datto’s legacy BCDR product includes a physical appliance that sits at the client, the company has developed popular cloud-based BCDR products that backup SaaS-based workloads (Google G-Suite, Salesforce.com, Office 365), and Datto’s BCDR tools can backup physical or virtual servers to client datacenters, on-premise servers or Datto’s own cloud. The key functionality that has been missing up to this point is a BCDR product that can backup workloads in Azure (much more popular with Datto’s customer base than AWS). Datto is developing a solution for Azure backup which is currently entering beta with select MSPs, so there is a path towards addressing this portfolio gap in the near term, but details on the feature set, price-point, and margin structure are all forthcoming.

• To gain significant traction, the Datto Azure backup product will need to offer a significant functionality improvement for SMBs over the native Microsoft cloud backup product, while also offering MSPs an attractive margin opportunity. Datto management is optimistic that there is a significant market opportunity for this product which is more incremental to the existing BDCR product portfolio than cannibalistic, and our checks have indicated limited risk of Microsoft entering the MSP market more aggressively.

• It is also worth bearing in mind the inherent inertia within Datto’s SMB end-customers—these are not leading edge enterprises looking to continuously upgrade their network architectures, and there is limited appetite to transition away from systems that already deliver the desired level of functionality, so we believe the cloud transition will lag large enterprise by a number of years, giving Datto a substantial window in which to establish its position in Azure backup.

3. Market structure suggests plentiful catalysts ahead

While there are a range of smaller point solutions around the fringes of the MSP-focused software market, we believe the key comps to focus on are the three larger vendors at various stages of building platform offerings that include some combination of BCDR, PSA, RMM and network performance monitoring/management (NPM), as well as add-ons like compliance, documentation, and security software. 

• ConnectWise is the largest of the three, and offers a strong PSA and an RMM solution bolstered when Thoma Bravo merged ConnectWise with Continuum in late 2019. We believe ARR is between $500 and $550mm.

• Kaseya is a smaller vendor specializing in RMM with a significant BCDR offering. The company is owned by Sixth Street Partners and TPG. 

• N-able is owned, for the time being, by publicly-traded SolarWinds (SWI), but will soon spin out. SilverLake and Thoma Bravo own the majority of SWI and N-able shares (39% and 32%, respectively). The main offering is two RMM products that over-index to the long tail of smaller MSPs. 2020 revenues were $303mm, and subscription ARR is likely just ahead of that.

Datto is well positioned among the four, with enough scale and a broad enough portfolio to realize the advantages of a true platform model, while maintaining more exposure to the multiplier effect of the sell-through products (vs. ConnectWise, which is more reliant on the PSA sell-to product).

The elevated sponsor ownership in the space, combined with the clear trend of consolidating multiple MSP solutions into a single platform, suggests a catalyst-rich event path ahead, with further consolidation likely in coming months and years, as well as the potential for increased MSP software public market cap. 

We believe a combination between complementary platforms represents an attractive supplement to the teens organic growth expected from the industry. For example, a merger between Datto and N-able would combine Datto’s leading AutoTask PSA and dominant BCDR offerings with a robust suite of RMM solutions from N-able, boosting net revenue expansion from cross-selling and providing Datto with a new customer file of smaller MSPs to grow with over time, in addition to the obvious advantage of reducing the core competitive set from four to three.

To the extent private equity investors seek to bring their MSP vendors public, the increased public float and investor relations resources of the sector will create a halo effect for Datto, introducing more capital to this theme and reinforcing the favorable industry dynamics addressed above from a chorus of management teams instead of a lone voice.

In Figure 6 below, we estimate that the MSP platform software vendors for which we have data are growing ARR at a low-20s rate (pandemic impacted 2020), with net revenue retention above 115%, gross retention in the high 80% range, high teens total revenue growth, mid 70s gross margins, and adjusted EBITDA margins in the mid-20s (pandemic artificially expanded 2020 margins). This analysis necessitates some assumptions about N-able, for which we have less information, which we highlight in red.

Figure 6. Rough estimate of MSP platform vendor financial algorithm

Source: company filings, our estimates.

5. Solid Rule of 40+ business fundamentals

As Figure 6 above shows, we estimate that ARR industry growth + adjusted EBITDA margins is easily over 40%. In Datto’s case, this metric was 44% in 2019 and fell only 1ppt in 2020, despite the economic impact of the pandemic. Going forward, the business should benefit from:

• Broad-based economic recovery benefitting SMB end customers

• Increased SMB awareness of the need for BCDR following a sharp increase in the number of phishing attacks and major security breaches during 2020

• Increased international presence, where Datto is only lightly represented today

• Additional contribution from new product launches of Azure backup (2021) and the ramp of recent BitDam acquisition (2022), which expands the platform into higher-growth markets

• Operating leverage on R&D (2022 onwards) and G&A (2021 onwards), and increased exceptional salesforce productivity (Datto net new ARR per dollar of S&M has averaged 0.8x since 2018, as Datto leverages the outsourced salesforce of the company’s MSP partners)

While we are mindful that, in a subscription model, the above trends will phase into the reported results more gradually, it is interesting to note that consensus is forecasting 2021 subscription ARR, a stock metric as of 12/31/21 that should reflect forward revenue growth, at $628mm, just +15.6% YoY. This is barely better than the pandemic-impacted +14.3% reported in 2020, and significantly worse than pre-pandemic ARR growth of +25.2% in 2019. It seems quite punitive to assume such growth for a business with accelerating secular tailwinds, expanding portfolio and a cyclical recovery to boot. Nor is the Street’s 2022 forecast much better: +17.0% ARR growth, well below historical ARR growth rates. We anticipate upside in both years, which drives a +3.0% revenue beat in 2021 and +6.0% beat in 2022.

In terms of costs, 2021 will be a rebasing of margins, as R&D spend on security and cloud backup steps up, incremental sales team members are added, and the BitDam acquisition is integrated, but beyond 2021, we see no reason why salesforce productivity should not return to prior levels. Even assuming 0.75x net new ARR per dollar of S&M, instead of the 0.8x historical average, Datto will be gaining S&M operating leverage on +20% ARR growth, and EBITDA margins should expand strongly, vs. consensus forecasts of a decline in adjusted EBITDA margins in 2022. A continuance of the same trends in 2023 yields $857mm of revenues and $230mm of adjusted EBITDA, vs. Bloomberg consensus expectations of $801mm of revenues and $186mm of EBITDA (only two estimates). 

Figure 7. Datto financial forecasts

The company’s 2021 guidance, to which consensus is closely adhering (Figure 8), implies a slowdown in revenue growth from +15% in the first quarter to +12% in the final three quarters of the year, despite management’s constructive commentary on end market acceleration in 1Q21, as well as the significantly easier YoY comparisons (+18% in 1Q vs. just +12% in the final three quarters of the year) and whatever inorganic contribution BitDam has in 2H21 (could be minimal, but probably is not zero). This sounds to us like a management team new to the public markets and eager to keep expectations manageably low.

Figure 8. Datto 2021 guidance vs. consensus

Establishing a confident view on valuation poses a challenge for Datto. There are no publicly traded peers with a similar financial profile in the MSP end-market, and sell-side analysts have struggled to agree on relevant comps, searching high (Ceridian at 14x ’22 sales) and low (Commvault at 4x ’22 sales).

Using the popular sell-side technique of regressing software valuations against a composite metric of sales growth and EBIT margins suggests that Datto is undervalued relative to current consensus forecasts of earnings and growth (see Figure 9). The chart below looks at EV/’23 sales for a range of software companies vs. a composite metric of 0.8 * ’22 revenue growth + 0.2 * ’21 EBIT margin. The CapIQ consensus for Datto is shown in red, indicating that the stock trades at a 2.4x discount to implied fair value on ’23 revenues (fair value is 7.3x vs. current 4.9x). If we update the analysis using our own projections for the business instead of consensus, Datto is worth 8.7x vs. current 4.6x, implying a fair multiple nearly double the current one.

Figure 9. Datto EV/revenue guidance vs. sales growth/EBIT margin composite

However, the above analysis has poor explanatory power and neglects obvious business model differences like end market focus, go to market, cyclicality and competitive risks.

A more theoretically correct approach is a discounted cash flow analysis (Figure 10). Assuming long term EBITDA margins approach the mid 40% range (a bit ahead of N-able TTM EBITDA margins, and roughly 1,000 basis points above the high water mark Datto achieved in 3Q20 of 35%), the stock is worth over $40/share, ~70% above the current level (at WACC of 10% and perpetuity growth of 3%). This approach implies 7.8x ’23 revenues, vs. 4.6x our ’23 estimate at current market prices. Simply assuming the stock can hold its current NTM revenue multiple of 6.7x for the next 1.7 years to YE 2022, and adding in the cash balance projected, the stock will be worth $38/sh on our estimates, up nearly 50% from current. However, in the scenario we forecast (in which growth comes in ahead of consensus) we believe a modest rerating to 7x is warranted, implying fair value of $40/sh, which is a 33% IRR discounted back to today.

Figure 10. DCF analysis of Datto

Catalyst

Earnings beats

M&A