Datto’s Betting On $150B Small Biz Tech Spend

Last fall, Datto went public 13 years after it was founded.

While Datto has a clear strategy, targets a large market, and reported decent growth in the third quarter, the company is 72.2%-owned by a private equity firm whose CEO, Robert Smith, admitted to serious crimes to evade some $2 billion in taxes. A source close to the company said Smith “isn’t involved with Datto.”

Should you invest in Datto? The good news is that Datto is targeting a large market with a clearly focused strategy. Datto’s challenge is that its top-line growth rate has been solid — but well short of the 20% to 30% rate characteristic of companies that enjoy rapid stock price growth.

If you think Datto can accelerate its revenue growth above the 12% rate that it forecast last November, then its stock should rise.

Datto’s 13 Year Journey To An IPO

In 2007, a Rochester Institute of Technology (RIT) graduate, Austin McChord, started Datto, a Norwalk, Conn.-based provider of data and security software. 11 years later, in October 2018, he quit — with Datto valued at over $1 billion, according to Rochester Beacon.

In January 2019, McChord was replaced as CEO by Weller who joined Datto in June 2017 where he served first as CFO, and then as President and COO.

Austin-based private equity firm, Vista Equity Partners, acquired Datto in December 2017. In 2018, Vista merged IT Services Management provider, Autotask, with Datto which created a company with 1,300 employees and 13,000 customers. By last fall, the company had increased its employee base 23% and its customer count had popped 31% to around 17,000, according to CRN.

Datto went public last October at $27 a share and as of February 4, its shares were about 2% lower — going for $25.23 apiece valuing the company at nearly $4.1 billion.

There’s a complication to this IPO. Vista Equity owns a huge share of Datto’s common equity. Thanks to the admission by Smith that he committed “serious crimes” in what federal prosecutors called a $2 billion tax fraud case, according to CRN, there is some uncertainty in my mind about the fate of those shares.

Yet a recent report suggests that Smith has settled the case and Vista will continue on with Smith at the helm. As the Dallas Morning News reported, he settled the charges with the Justice Department in exchange for his admission that “he had committed crimes, [payment of] $139 million and cooperate against a close business associate indicted in the largest tax-evasion case in U.S. history — Texas software mogul, CEO of Reynolds & Reynolds, Robert T. Brockman.”

With Vista’s huge stake in Datto, it’s a so-called controlled corporation — which will mean owners of Vista’s stock will not enjoy the usual shareholder protections. According to Datto’s IPO prospectus Vista will control board elections, the matters that the board reviews, the composition of the compensation committee — which normally consists of independent directors — and who serves as Chairman of Datto’s board.

Another disturbing twist to the story is that Brian Sheth, who had been president of Vista and a board member of Datto for the previous three years, gave up his board seat before the IPO and resigned from Vista last Thanksgiving, according to the Dallas Morning News.

Replacing Sheth as a Datto director was Adrian Dillon, “a former top finance executive for Skype and Agilent Technologies, who joined the Datto board in August 2020 and serves on its Audit Committee,” according to CRN.

It remains to be seen how this Vista sideshow will affect the way Datto is governed.

Datto’s Tepid Financial Results

Datto’s most recent financial results — for the quarter ending September 2020 — were solid. According to Business Wire, Datto’s net revenues increased 11% to $130.7 million and its free cash flow improved significantly from negative $2.8 million to $43.6 million.

Datto was enthusiastic about these results — suggesting that things were improving since the beginning of the pandemic. Weller said, “Our sequential [Annual Recurring Revenue] ARR growth of $16 million is evidence of the reacceleration of our business and the tailwinds from the digital transformation of small and medium businesses (SMBs).”

Datto guided investors to expect 2020 revenue growth in the 12% to 12.2% range. More specifically, in 2019, Datto generated $458.8 million in revenue and last November it forecast 2020 revenue in the range of $512.8 million and $514.8 million.

Datto’s Large Market Opportunity

Datto is aiming at a large market opportunity. As Weller told me in a February 4 interview, “We provide enterprise grade IT services to SMBs and we reach them through Managed Service Providers (MSPs). We work with 17,000 MSPs [— which is 14% of the] 125,000 total. Moreover, SMB technology spending totals $150 billion — [about 13% of] the $1.2 trillion that businesses spend on IT.”

While the MSP market is large, its growth rate is relatively tame. According to PRNewswire, the global MSP market is expected to grow at a 9.6% compound annual rate to nearly $309.4 billion in 2025.

Datto’s Focused Strategy

Datto’s mission is to provide technology to SMBs that requires them to “do as little as possible. They assume that someone smarter than they are about IT has figured out the right systems for them and all they have to do is to turn it on,” Weller said.

Datto prides itself on making its technology a growth for MSPs. “We are creating margin opportunities for MSPs. We are excited when we see an MSP increase from five to 50 employees and boost its monthly billings from $5,000 to $50,000,” he said.

When MSPs consider whether to partner with Datto or its rivals, they evaluate three factors. “We win with MSPs because our technology works — we are the high school nerds; we give the end-users the services that they want; and we provide a turnkey solution — meaning it is easy for end users to operate,” explained Weller.

Datto also floods the zone when an end-user gets in trouble. “If a law firm loses control of its systems and gets a ransom note demanding $100,000 in bitcoin, we support them on the phone. We are there in the moment of truth.”

Datto is aiming to become a multibillion dollar company and it expects to enjoy the advantages of scale. “We operate an exabyte cloud which lowers our costs. At that scale we can hire the best people, and offer quality and security. Our culture emphasizes great technical support and we aim to [preserve and strengthen our relationships with MSPs] as we scale.”

Should you go along for Datto’s ride? Analysts do not sound overly bullish. “Datto has received a consensus rating of Hold. The company’s average rating score is 2.45, and is based on 5 buy ratings, 6 hold ratings, and no sell ratings,” according to MarketBeat.

Although it’s growing faster than the MSP market, if Datto aspires to boost its market value, it should target a much faster-growing market with a competitively superior value proposition.