MADISON STRATEGIC SECTOR PREMIUM FUND

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DATTO HOLDING CORP. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (form 10-Q)

05/09/2022 | 04:47pm EDT

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and the related notes and other financial information included elsewhere in this Quarterly Report on Form 10-Q and our 2021 Annual Report on Form 10-K filed with the Securities and Exchange Commission ("SEC") on February 23, 2022. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those expressed or implied by such forward-looking statements. Important factors that could cause or contribute to these differences include, but are not limited to, those identified in this Quarterly Report and in our Form 10-K, particularly those discussed in the sections entitled "Risk Factors" and "Forward-Looking Statements."

                                    Overview

Datto is the leading global provider of security and cloud-based software solutions purpose-built for delivery through the managed service provider, or MSP, channel to small and medium businesses, or SMBs. We enable our more than 19,200 MSP partners to manage and grow their businesses serving the SMB information technology, or SMB IT, market. Our platform combines mission-critical cloud-based software, technologies and security solutions that MSPs sell to SMBs, business management software to help MSPs scale their own businesses, and marketing tools, content, training and industry-leading events that cultivate an empowered and highly engaged MSP partner community.

MSPs represent the future of IT management for SMBs. Digital transformation is driving SMB adoption of modern software and technology, while regulatory and data protection requirements and proliferating security threats are increasing the complexity and risk of IT for SMBs. These trends have created an inflection point in SMB outsourcing to MSPs for IT management. MSPs are equipped with the IT resources and expertise SMBs lack, providing a single source to meet all of an SMB's IT needs. MSPs are trusted to select, procure, implement and manage software and technology stacks that support their SMB customers' business needs. The number of MSPs continues to grow, with approximately 132,000 MSPs providing this critical function to millions of SMBs worldwide.

We are committed to the success of MSPs. It is the foundation of our strategy and culture. We empower our MSP partner channel, creating enormous sales and support leverage for us to efficiently address the large, but fragmented, SMB IT market. Our MSP-centric platform enables our partners to generate recurring revenue through the sale of our solutions to SMBs and to scale and effectively manage their own businesses. Our relationships are directly with our MSP partners. We are the leading pure-play vendor serving the MSP market, and believe our MSP-centric approach is highly differentiating as it aligns our mutual incentives, creates a motivated and engaged sales channel and reinforces our position as an integral component of our MSP partners' businesses.

Our cloud-based offerings include Unified Continuity, Networking, Endpoint Management and Business Management software solutions. Our Unified Continuity offerings ensure the ongoing availability and security of mission-critical IT systems for SMBs in both private and public clouds. Datto's business continuity and disaster recovery, or BCDR, software enables rapid restoration of an SMB's full IT environment. Datto's SaaS Protection is a reliable, automated and secure backup and restoration product for data stored on cloud applications such as Microsoft 365 and Google Workspace. Datto Networking constitutes a suite of MSP-centric networking solutions sold through our MSP partners to easily deliver networking as a managed service. These solutions are simple for MSPs to deploy, configure and manage across their SMB customers through a single portal. Our Endpoint Management software allows MSPs to remotely manage, monitor and secure SMB endpoints. Lastly, Datto's Business Management software provides critical operational tools to MSPs for efficient workflow management and delivery of end-to-end managed services. Our platform also includes a host of business development tools, training and content to help MSPs address the challenges of marketing and selling to SMB customers.

During 2022, we acquired threat detection and response company Infocyte, extending Datto's security capabilities that protect, detect, and respond to cyberthreats found within endpoints and cloud environments. During late 2021 we launched two new cloud-based solutions - Datto Continuity for Microsoft Azure ("DCMA") and SaaS Defense. DCMA is a comprehensive BCDR solution that protects MSPs and their clients' data in the public cloud in the event of malicious ransomware attacks, security breaches, and vendor outages. SaaS Defense is an advanced threat protection and spam-filtering solution that provides MSPs and their SMB customers with patented technology to proactively detect and prevent malicious malware, phishing, and Business Email Compromise ("BEC") attacks that target Microsoft Exchange, OneDrive, SharePoint, and Teams. The product was built on technology obtained in Datto's acquisition of Israel-based cyber threat detection company BitDam in early 2021.

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                               Merger Transaction

On April 11, 2022, Datto entered into an Agreement and Plan of Merger (the "Merger Agreement") with Knockout Parent Inc., a Delaware corporation and a wholly owned subsidiary of Kaseya Inc. ("Kaseya"), and certain other parties, providing for the acquisition of the Company by Kaseya, subject to the terms and conditions set forth therein (the "Merger"). Under, and subject to, the terms of the Merger Agreement, Datto stockholders will have the right to receive $35.50 per share in cash, without interest. The Board of Directors of the Company has unanimously approved the Merger Agreement and the transactions contemplated thereby and the necessary stockholder approval has been duly executed and delivered, adopting and approving the Merger Agreement and the transactions contemplated thereby. The obligations of the parties to complete the proposed Merger are subject to customary closing conditions, including, among others, the receipt of applicable regulatory approvals. The proposed Merger is expected to close during the second half of 2022.

                               Our Business Model

Our cloud-based solutions are purpose-built to address the needs of MSPs and to enable the end-to-end delivery of managed services to their SMB customers.

We generate substantially all our revenue from the sale of subscriptions to our cloud-based solutions and recognize revenue ratably over the subscription term. These contracts typically begin with a 1-year or 3-year term and auto-renew on a monthly or annual basis thereafter. For certain offerings, we enable our ongoing subscription services with an up-front sale of equipment or professional services, for which we recognize revenue at the time of delivery and performance. The majority of our partners pay on a monthly basis, regardless of term length, with some opting to make quarterly, annual or multi-year prepayments.

Subscriptions for our BCDR products are priced based on service tier, which is determined by data storage capacity and data retention period. Subscriptions for Datto SaaS Protection and Datto SaaS Defense (together, SaaS Protection+) are priced based on the number of Microsoft 365 or Google Workspace employee accounts at the SMB domains that our MSP partners protect and data retention period. Networking subscriptions are priced based on the volume and type of networking solutions ordered. Endpoint Management subscriptions are priced per endpoint device at the SMB. Business Management subscriptions are priced based on the number of employees at an MSP that are able to utilize our PSA product.

We employ a highly efficient land-and-expand sales strategy facilitated by offering products that are reliable, easy to adopt and that drive recurring revenue growth and margin efficiency for our MSP partners. We sell our solutions to MSPs primarily through our sales team, benefiting from the reach of our MSP partners for our sell-through products, and provide them with self-service options to upgrade service tiers, add additional units and purchase additional solutions. Our MSP partners often significantly increase usage from their initial purchase and expand their usage to other products on our platform. We also provide access to business development tools and content to help MSPs address the challenges of marketing and selling to SMB customers. We grow alongside our MSP partners as they deploy our solutions across their existing SMB customers, add new customers and upgrade service tiers.

As of March 31, 2022, our annual run-rate revenue, or ARR, was $689.3 million, and our revenue for the three months ended March 31, 2022 was $170.8 million, of which approximately 94% was recurring subscription revenue. For the three months ended March 31, 2022, our net income was $7.9 million and our Adjusted EBITDA was $39.5 million.

As of March 31, 2021, our ARR was $572.5 million and our revenue for the three months ended March 31, 2021, was $144.9 million, of which approximately 94% was recurring subscription revenue. For the three months ended March 31, 2021, our net income was $15.3 million and our Adjusted EBITDA was $46.9 million.

Refer to our discussion of ARR in Key Performance Metrics and Adjusted EBITDA in Non-GAAP Financial Measures.

                            Trends and Uncertainties

Impact of COVID-19

While we have not incurred significant disruptions from the COVID-19 pandemic, there remains uncertainty relating to the ultimate impact of the pandemic on our business because of numerous global factors, including but not limited to, the impact on our customers and suppliers, supply chain constraints, labor shortages, inflationary pressure and other factors.

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Table of Contents Specifically, we may experience impacts from customers deferring purchasing and activation decisions, reducing expenses and requesting extended payment terms or relief from payments.

Our condensed consolidated financial statements reflect estimates and assumptions made by management that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Significant estimates and assumptions reflected in our condensed consolidated financial statements include, but are not limited to, establishing allowances for doubtful accounts, assessing the recoverability of prepaid assets, including trade shows and other marketing events impacted by the pandemic, determining useful lives for finite-lived assets, assessing the recoverability of long-lived assets, determining the fair value of assets acquired and liabilities assumed in business combinations, accounting for income taxes and related valuation allowances against deferred tax assets, valuing stock-based awards, recognizing revenue and the estimate for sales returns and upgrades, determining the amortization period for capitalized commissions and assessing the accounting treatment for commitments and contingencies. Management evaluates these estimates and assumptions on an ongoing basis and makes estimates based on historical experience and various other considerations that are believed to be reasonable. Actual results may differ from those estimates, including as a result of the COVID-19 pandemic. We will continue to evaluate the nature and extent of the impact of the pandemic on our business and our consolidated results of operations and financial condition.

Macro-Economic or Industry Trends

As discussed below, we believe continued favorable industry trends will contribute to the growth of our business, including: i) increased adoption by SMBs of digital and cloud-based technologies; ii) increasing complexity in IT, which impacts the ability of SMBs to evaluate, select and implement an optimal IT environment; iii) increased exposure and vulnerability of SMBs to security and regulatory risk, including cyberattacks; iv) lack of SMB sophistication to meet the expanding challenges of IT management; v) the continued trend of remote work, vi) educational organizations and governmental agencies using MSPs to provide IT services, and vii) the meaningful and increasing costs of downtime or data loss. The customer base of our partners continues to expand as a result of these trends and as evidenced by the anticipated 13.4% increase in available market reported by Frost & Sullivan during 2021.

                            Key Performance Metrics

In addition to our financial information presented in accordance with generally accepted accounting principles in the United States, or GAAP, we review a number of operating and financial metrics, including the following key metrics, to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans and make operating and strategic decisions.

MSP Partners

The number of MSP partners represents the number of MSPs with active subscriptions as of the end of the period. We use this number to assess our ability to attract and retain MSP partners and thereby grow our business. As of March 31, 2022, we had approximately 19,200 MSP partners, a net increase of approximately 700 since December 31, 2021. Net changes in the number of our MSP partners are a result of the total new partners added during a period, largely based on our sales and marketing efforts, and the churn or reduction of existing partners during the period, which can be affected by the broader economic environment and factors such as the effects of COVID-19 on our partners' SMB end customers. As a result of our land-and-expand model, our revenue growth is driven principally by additional revenue from existing MSP partners. We view new MSP partner additions as a leading indicator of the health of the business, but the additions do not immediately drive material revenue growth in our reported results of operations.

Annual Run-Rate Revenue

We define annual run-rate revenue, or ARR, as the annualized value of all subscription agreements as of the end of a period. We calculate ARR by multiplying the monthly run-rate revenue for the last month of a period by 12. Monthly run-rate revenue is calculated by aggregating monthly subscription values during the final month of the reporting period from both long-term and month-to-month subscriptions. ARR only includes the annualized value of subscription contracts and excludes any one-time revenue for devices or professional services. ARR mitigates fluctuations resulting from seasonality and contract term. ARR does not have any standardized meaning and is therefore unlikely to be comparable to similarly titled measures presented by other companies. ARR should be viewed independently of revenue and deferred revenue and is not intended to be combined

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Table of Contents with or to replace either of those items. ARR is not a forecast and the active contracts at the date used in calculating ARR may or may not be extended or renewed by our MSP partners.

The table below sets forth our ARR as of March 31, 2022 and 2021:

          As of March 31,
         2022         2021        $ Change      % Change
                     (dollars in millions)
ARR   $  689.3      $ 572.5      $  116.8         20.4  %



                      Components of Results of Operations

Revenue

We generate revenue primarily from fees received for subscriptions to our products and services, and also from the sale of BCDR and Networking devices and professional services associated with our Business Management offerings.

Subscription. We derive revenue primarily from security and cloud-based software solutions sold on a recurring subscription basis. Subscription revenue is recognized ratably over the subscription term as revenue recognition criteria have been met. We generally invoice subscription agreements monthly over the subscription period. Subscription revenue for our Unified Continuity, Networking and Endpoint Management solutions grows as our MSP partners add more end customers and as the end-customers of our MSP partners add new subscription products, upgrade the service tier of their existing subscription products, increase the usage of their subscription products or add more end-user devices managed by their MSP. Revenue from our Business Management solutions increases as we sell subscriptions to new and existing MSP partners who did not have our PSA solution and as our MSP partners with PSA subscriptions add employees who require seat licenses and as MSPs purchase Datto Commerce subscriptions.

Device. Device revenue includes the sale of BCDR and Networking devices which enable us to deliver our BCDR and Networking services to our MSP partners under a recurring subscription model. Revenue from devices in our Unified Continuity solution primarily consists of the sale of our proprietary data storage devices. Revenue from devices in our Networking solution primarily consists of the sale of wireless access points, switches and edge routers. We recognize revenue at the point in time when control of the device has transferred to the MSP or upon activation of the related subscription. Revenue from devices does not contribute significantly to overall revenue related to our Unified Continuity solutions.

Professional services and other. We derive revenue from professional services associated with our Business Management and Endpoint Management offerings. These implementation and consulting services include configuration, database merging and data migration. Our professional services are generally priced on a time and materials basis and invoiced monthly, with revenue recognized as the services are performed, and we frequently discount our services to drive adoption of our Business Management and Endpoint Management offerings.

Cost of revenue

Subscription. Subscription cost of revenue consists of costs directly related to our subscription services, including personnel costs associated with operating our Datto Cloud infrastructure and customer support operations, hosting and data center related costs, third-party software licenses and allocated facilities and overhead costs associated with delivering these services.

Device. Device cost of revenue consists of hardware, manufacturing, personnel, shipping and logistics costs, as well as allocated facilities and overhead costs associated with the purchase, production and delivery of our devices. Our BCDR products rely on a mix of off-the-shelf hardware and custom designed hardware. Our Networking devices generally consist of off-the-shelf hardware, although some of our devices feature a unique industrial design.

Professional services and other. Professional services and other cost of revenue consists primarily of personnel costs and allocated facilities and overhead costs associated with delivering implementation and consulting services. Our professional services implementations aim to ensure higher software utilization and positive customer satisfaction, in order to drive greater upsell opportunity and lower churn over time.

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Table of Contents Depreciation and amortization. Depreciation and amortization cost of revenue consists of depreciation of our Datto Cloud infrastructure and amortization of our acquired technology intangible assets.

Gross profit and gross margin

Gross profit, or revenue less cost of revenue, has been, and will continue to be, affected by various factors, including revenue fluctuations, the mix of revenue, the timing and amount of investments to expand our Datto Cloud infrastructure and launch new solutions, the use of third-party software licenses and stock-based compensation expense.

Operating expenses

Our operating expenses consist of sales and marketing, research and development and general and administrative expenses as well as depreciation, amortization of internally developed software and amortization of acquired intangible assets. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, sales commissions, payroll taxes and stock-based compensation expense. Other significant components of operating expenses include professional fees, third-party software subscription costs, facilities and overhead costs, events and travel, marketing and promotion costs, payment processing fees and bad debt expense.

Sales and marketing

Sales and marketing expenses consist primarily of personnel costs, costs for events and travel, costs of marketing and promotional activities, payment processing fees and allocated facilities and overhead costs. Sales and marketing expenses may fluctuate as a percentage of our revenue from period to period because of the timing and extent of marketing activities, trade shows, and events including DattoCon and MSP Technology Days, as well as the timing of amortization of sales commissions and stock-based compensation expense.

Research and development

Research and development expenses consist primarily of personnel costs, third-party professional fees and allocated facilities and overhead costs. Research and development expense may fluctuate as a percentage of our revenue from period to period because of the timing and extent of our investments in research and development activities, as well as the timing of stock-based compensation expense.

General and administrative

General and administrative expenses consist primarily of personnel costs across the corporate functions of executive, finance, human resources, information technology, internal operations and legal, as well as third-party professional fees, provision for expected credit losses expense, travel expenses and costs for facilities. General and administrative expenses also include costs of operating as a publicly listed company, including increased expenses for insurance, costs to comply with the rules and regulations applicable to companies listed on a national securities exchange, costs related to compliance and reporting obligations pursuant to the rules and regulations of the SEC, expenses related to investor relations, and professional services fees, particularly related to audit services and compliance with the Sarbanes-Oxley Act.

Depreciation and amortization

Depreciation and amortization expenses in operating expenses consist of amortization of tradenames and partner relationship intangibles, depreciation of other property and equipment such as leasehold improvements, furniture and fixtures, and computer equipment, and amortization of internally developed software.


Other (Income) expense

Interest expense

Interest expense consists of commitment fees under our credit facilities and the amortization of debt issuance costs, and to the extent we have outstanding borrowings, interest payments under our credit facilities. Our 2020 Credit Agreement provides a $200.0 million revolving credit facility. As of March 31, 2022, no amounts had been drawn under the 2020 Credit Agreement. See "Liquidity and Capital Resources-Credit Facilities" for additional details.

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Other (income) expense

Other (income) expense primarily consists of the net exchange (gains) or losses on foreign currency transactions, (gains) or losses from our money market funds and (gains) or losses on the disposal of assets.

Provision for income tax Provision for income tax consists primarily of income taxes related to U.S. federal and state income taxes and income taxes in foreign jurisdictions in which we conduct business.

Stock-Based Compensation

The functional role of the holder determines the financial statement line item within which stock-based compensation expense is recorded.

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