Datto Holding Corp.

Ladies and gentlemen, thank you for standing by and welcome to the Datto Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1 on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star 0. I would now like to hand the conference over to your speaker today, Ms. Kelsey Turcotte of the Blue Shirt Group. Thank you. Please go ahead.

Thank you, Operator. Good afternoon. Thank you for joining us today to review DATO's third quarter 2020 financial results. With me on the call today are Tim Weller, Chief Executive Officer, John Abbott, Chief Financial Officer, and Matt Kess, SVP of Finance. All three will be available to take questions after our prepared remarks. During this call, we may make statements related to our business that would be considered forward-looking statements under federal securities laws, including projections of future operating results for our fourth quarter and full year ending December 31, 2020. As a result of a number of factors, actual results may differ materially from those projected in such statements. These factors are set forth in the earnings release that we issued today under the section captioned forward-looking statements. And these and other important risk factors are described more fully in our reports filed with the Securities and Exchange Commission. We encourage all investors to read our SEC filings. The following statements reflect our views as of today and should not be relied upon as representing our views as of any subsequent date. In addition, DATO undertakes no obligation to publicly update or revise any forward-looking statements made here. Additionally, non-GAAP financial measures will be discussed on this conference call. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures is available in our third quarter 2020 earnings press release, which can be found at www.datto.com in the investor relations section. Also, please note that a financial supplement and webcast of today's call are available on our website in the investor relations section. With that, I'll turn the call over to our Chief Executive Officer, Tim Weller. Tim?

Thank you, Kelsey, and many thanks to everyone for joining us on the call this afternoon. We're excited to report our initial quarter as a public company. I want to extend special thanks to our managed service provider partners, the MSPs around the world, for your confidence in our Datto team, and for your round-the-clock efforts keeping small and medium businesses, the SMBs, online and connected with technology during this pandemic. I would also like to thank the Datto team for their hard work and support during the IPO process. We are excited about this next step in our company's journey. I'll start this afternoon with a few highlights from the quarter. Then, because it is our first earnings call, I want to take some time to share the Datto story and our operating philosophy. Finally, I'll turn the call over to John Abbott, our CFO, to discuss our financial results and guidance in more detail. We reported a very strong third quarter. driven by expansion from existing partners and by the addition of new MSP partners, which now total more than 17,200 worldwide. Subscription revenue for the quarter reached $123 million, an increase of 17% from prior year Q3 2019, and represented approximately 94% of the $131 million of total revenue in Q3. ARR, an important indicator of future subscription revenue growth, also grew 17% year-over-year to $523 million. Adjusted EBITDA reached $46 million in the quarter, and we generated $44 million in free cash flow, representing the second consecutive quarter of positive free cash flow in the company's recent history. Looking forward, we believe ARR The market opportunity ahead of us remains very attractive, and we intend to continue ramping up our investments in technology innovation and growth while prudently managing our expense structure. Turning to the Datto story, we are the largest pure play IT solutions provider to the MSP community. Our mission is to build the highest quality products, provide best-in-class service, and enable our MSP partners to effectively, efficiently, and profitably serve their small and medium business clients. The Datto brand means MSP, hence our ticker symbol, and we wake up every morning serving this channel every day in our sales and support motions and in creating technology which is purpose-built for MSPs. We call our over 17,000 MSPs partners, not customers, and we promise to never go around an MSP to sell directly to their SMB end users. That pledge has established a bond that we have spent years building brick by brick and makes us more than just another vendor to MSPs. We are their trusted partner. No other company of our scale can deliver on that promise to MSPs, and it creates a major barrier to entry for our competitors. managed services are a large and growing market with more than 125 000 msps worldwide in fact smbs spent about 137 billion dollars with msps in 2019 and that's growing about four times faster than the overall smb it market as msps serve their smb customers they face their own set of challenges So Datto prioritizes products that are reliable, easy to deploy, and centrally managed, all in an effort to save MSPs time and protect and enhance their relationships with their customers. To that end, we offer 24-7 support and provide the MSPs tools, resources, and content they need to grow their business. Our integrated cloud management platform is purpose-built to empower MSPs and serving SMBs. Datto is a creator of core technology and not a reseller. Our technology continuously protects digital assets, both applications and data, and provides secure access, monitoring, and management for those applications and data. We help MSPs minimize business downtime for their SMBs, and we are the last line of defense when firewalls are breached, data is lost, or servers fail. The majority of our cloud-based solutions are those that MSPs sell through to their end-user SMB customers, helping our MSP partners grow their revenue and profit. These mission-critical products include our flagship unified continuity line and our newer networking line. We also help MSPs manage their own businesses efficiently with our business management products that we sell to MSPs. And finally, we provide a full range of free enablement resources to our partners that helps them in marketing to, selling, and supporting their SMB customers. This drives revenue and profit growth for our partners and for Datto. Our MSP-centric business model efficiently unlocks the large but highly fragmented SMB IT market for Datto. We deploy a land and expand go-to-market strategy executed by our sales team. One Datto sales rep can cover dozens of MSP partners who can then reach thousands of SMBs. Each MSP drives revenue growth for themselves and for Datto as they deploy our products and sell them through to their existing SMB customers. and then add new SMB customers, leveraging our sales enablement resources. These customers can then expand usage with us and adopt additional Datto features and new products. In this matter, we grow our share wallet with each MSP partner. Their success is our success. This is an incredibly efficient sales model that provides leverage in the business and can buffer us from both economic and SMB volatility. We did not want to tell our story without mentioning the pandemic. Our MSP partners have proven to be very resilient during this period, given their position as trusted advisors delivering mission-critical solutions to their SMB customers. As MSPs support their customers' transition to remote work, they've been adopting DATOS SaaS protection and remote monitoring management, or RMM for short, solutions at a record pace. We see MSPs effectively adapting, and longer term, we expect SMB digital transformation to be an irreversible tailwind for MSPs, as SMBs embrace more new technologies and do not fully revert back to offline models. Our level of engagement with MSPs has never been higher. We've introduced Datto's first-ever series of virtual MSP technology days, where thousands of MSPs joined us as we cultivated the MSP ecosystem with thought leadership, education, and peer interaction, and previewed cutting-edge technologies geared for this channel. And finally, we were proud to be recognized by CRN as a winner of the 2020 CRN Annual Report Card Awards in the Data Protection and Managed Services Software category. The award voted on by more than 3,000 solution providers in North America underscores our commitment to the MSP community and our willingness to go the extra mile to deliver best-in-class products and program offerings. Since our founding over a decade ago, our sole focus has been to build an MSP-centric culture that keeps these partners at the core of everything we do. Our success at achieving this objective is a direct result of the hard work of our talented team, of which I'm incredibly proud to be a part. This is an exciting time to be at Datto. Looking ahead, we recognize that our IPO is just one step on the journey of our company. And while we are excited to have achieved this milestone, we have much more to do. We look forward to a strong close to the year and to speaking with many of you during the quarter. Now, I will turn the call over to John.

Thank you, Tim, and good afternoon, everyone. It's exciting to be with you today on our first earnings call as a public company. I know we have investors, analysts, employees, and maybe even some MSP partners on the call. We appreciate all of your support through the IPO process and look forward to this next chapter in our evolution. As I review our third quarter results today, please note that I'll be referring to non-GAAP metrics unless otherwise specified. You can find a reconciliation of non-GAAP measures to GAAP measures in the press release that we issued this afternoon. Given that this is our first call as a public company, I want to start by sharing some perspectives about our business model and financial profile. Then I'll walk through highlights from the third quarter. And finally, I'll close with guidance for the fourth quarter and full year. And, of course, at the end, we'll open up the call for questions. Our financial model features a highly predictable subscription revenue stream, which is growing at scale. We reported more than $500 million in ARR as of the end of the third quarter, while total revenue grew at strong double-digit rates. Our recurring subscription revenue represents over 90% of our total revenue, reflecting the highly predictable and durable nature of our top lines. And the structural operating leverage from our MSP-centric distribution model, in combination with our track record of financial discipline, has driven margin expansion and strong cash flow generation. At the core of our business model is the unique relationship we have with our MSP partners. We take great pride in helping them profitably grow their businesses, which leads to growth in our business, which in turn builds shareholder value for Datto. And we believe we have a significant market opportunity in front of us to continue to drive profitable growth for us and our partners. Our third quarter results reflect the strength of our operating model and focused execution. Recurring subscription revenue grew 17% year over year to $122.8 million and comprised 94% of our total revenue of $130.7 million in the quarter. The balance of revenue is derived from devices and professional services that enable subscriptions. Nothing is sold without a subscription. If we look upstream at our key business drivers, Annual Run Rate Revenue, or ARR, serves as a leading indicator of subscription revenue. Growth in ARR is driven by a combination of adding new MSPs, which start small and grow over time, and the expansion of existing MSPs as they roll out DATO solutions to more of their SMBs, add new SMBs, and adopt new DATO products. ARR at September 30th of this year was $522.8 million, up 17% from $445.5 million one year prior, and importantly, increasing $16 million in the quarter, almost double the increase we saw in Q2, a clear and strong indication of the reacceleration of the business. So far this year, we've added a healthy cohort of new MSPs, partially offset by MSP churn, resulting in continued net growth of MSP partners. We ended the third quarter with over 17,200 MSP partners, up from 16,200 at the end of Q3 last year. Datto has a proven history of steadily expanding margins. third quarter gross profit margin was 73.5 percent up from 66.7 percent in q3 2019 resulting from an increase in the revenue mix of higher margin subscription revenue and from the operating leverage we're realizing in our 24 by 7 support function and in the infrastructure supporting our unified continuity solutions Third quarter operating expenses were $57 million, or 43.6% of revenue, a reduction of 564 basis points year over year. Within OPEX, sales and marketing expenses were $24.2 million, a slight decline from $24.5 million in Q3 last year. Research and development expenses were $14.8 million, a slight increase from $14.4 million in Q3 last year. General and administrative expenses were $15.6 million, a decline from $16.8 million in Q3 last year. And finally, depreciation expense within operating expenses was $2.4 million compared to $2.3 million in Q3 last year. Operating income for the third quarter was $39 million or 29.9% of revenue compared to $20.5 million or 17.4% of revenue in the prior year quarter. Adjusted EBITDA for the quarter, which excludes stock-based compensation, restructuring and transaction expenses was $45.8 million compared to 25.8 million in Q3 last year. In recalibrating our cost structure during COVID, we further expanded our adjusted EBITDA margins to 35.1%, a significant increase from 21.9% in the third quarter last year. However, we believe the adjusted EBITDA margins achieved this quarter are artificially high, reflecting the full quarter impact of certain expense reductions we implemented in Q2 and significantly lower expenses associated with reduced travel, events, marketing, and office costs during COVID. Consistent with our strategy discussed in our IPO, our focus is on growth. And as we continue investing in technology innovation and expanding our global presence to drive revenue growth, and as commercial activity returns to more normal levels, these expenses will increase and adjusted EBITDA margins will move down into the low to mid-20s. Free cash flow in the quarter was positive $43.6 million compared to negative $2.8 million in Q3 last year. and we ended the third quarter with just over $100 million in cash. Subsequent to the end of the quarter, we completed our IPO, where we sold 25.3 million shares of primary stock, which includes the underwriters' full exercise of their overall allotment option. We used the net proceeds of $641.6 million to pay off our outstanding debt of $590.2 million, with the remaining $51.4 million being added to our cash balance. At that time, we also entered into a new $200 million revolving credit facility which is undrawn and which provides us tremendous flexibility to invest and grow the business. Turning to guidance for the fourth quarter and full year 2020, as we begin life as a public company, We want to ensure that we provide clarity and transparency to our shareholders while maintaining our long-term focus on the business to maximize value for our MSP partners, our employees, and our shareholders. The solid profitability and structural operating leverage in our business provides ample capacity for us to continue investing in technology innovation, go-to-market resources, and scaling infrastructure to support and sustain our long-term growth and expand our leadership position in the market. This balance and the ongoing recovery and re-acceleration of the business from the COVID lows of Q2 are reflected in our guidance. For the fourth quarter of 2020, revenue is expected to be in the range of $133 to $135 million. Adjusted EBITDA is expected to be in the range of $38 to $39 million. For the full year 2020, revenue is expected to be in the range of $512.8 to $514.8 million. and adjusted EBITDA is expected to be in the range of $147.7 to $148.7 million. As you're looking ahead to Q4, I want to highlight some disclosure from our IPO prospectus that you'll see in our third quarter 10Q also. The IPO triggered the vesting of certain employee options, which will add approximately $22 million to our stock-based compensation expense in Q4. The remaining value of those options will be expensed radically at a more normal level as they continue vesting over subsequent quarters. In closing, we believe our Q3 results and Q4 guidance reflect the ongoing reacceleration of the business and that we're still in the early stages of that recovery. We're very excited about our future and look forward to reporting on our progress in the quarters to come. With that, we'll open up the call for questions. Operator?

As a reminder, to ask a question, you will need to press star 1 in your telephone. To withdraw your question, press the pound key. And your first question comes from a line of Sanjit Singh from Morgan Stanley. Your line is open.

Hi, thank you for taking the question. Congrats, Tim, and the Dotto team on a successful IPO and your first quarter reporting earnings as a public company. So congrats on all fronts. To maybe begin the conversation, Tim, what's really shining through, and John as well, what's really shining through this year is just the sort of structural profitability of the business, you know, with EBITDA margins coming in well above 35%, which sort of gives us confidence on like the model that you guys are running. And so I guess the key question is around growth. And so Tim, I was wondering if you could sort of connect the dots for us in terms of what you saw during sort of peak COVID compared this quarter's results to last quarter's results. And as we go into 4Q, what are the trends that you're seeing in your business and what are you assuming, what are the assumptions you're making that's underpinning your guidance for Q4? Maybe that's a good place to begin.

Yeah, thanks, Sanjit, and appreciate the questions. You know, I think you've hit on a couple of the trends, and, John, I will hand to you in a minute, too, in terms of, you know, characterizing some of the guidance in the context of this. We have shown, you know, very strong, you know, shift in structural margins. You heard John, you know, guiding a bit lower on EBITDA because we are first and foremost growth-focused, and we talked about that during our roadshow discussion. In Q2, we obviously saw the sort of peak of COVID from our perspective. We'll look back and see April was the low, for example, and we've been building brick by brick from there. I think the best evidence of that this quarter is probably the ARR and the sequential increase in that. you know, each month has been a little better. And I think that's, you know, that's kind of how we see it going as we, you know, get through the winter here, maybe a tough winter for the global, you know, population, but we've got vaccines on the horizon and what have you. So MSPs have adjusted, SMBs have adjusted. And then next year, I think we also, you know, would start to see the effect of some product cycles for us as well. But You know, more business as usual, and I think we just, you know, we think we can re-accelerate each quarter as we go forward. So I don't have anything like, you know, specific point to point to. But I don't know, John, if you have thoughts on sort of the margin side versus guidance. I mean, I'll just leave you with the overarching answer that we intend to reinvest for growth, and that involves technology product as well as global expansion on the go-to-market side.

Yeah, no. Tim, just to add to that, Q3 saw the full quarter impact of certain cost savings initiatives that began in Q2. But as you can see in the guidance in Q4, we're already seeing not just the impact of costs for being a public company, but the impact of our reinvesting in the business to drive the growth. And you can see in that guidance that we're guiding for the margin to start coming down. And I think Tim also pointed to the ARR is a great indicator of the reacceleration of the business. And we think both the Q3 results and the guidance for Q4 support that thesis and underline that trajectory.

That's super helpful, John. Maybe just as one follow-up, Tim, as we think about, you know, fingers crossed on a better spending environment and a more broader economic recovery in calendar 2021. If we just sort of, you know, take that as given, from your guys' perspective under what's under your control, can you sort of characterize sort of the investments and sort of the playbook that you're focusing your team on in terms of, driving this re-acceleration story in 2021 and beyond in terms of on the go-to-market side, on the product side, your top initiatives on both of those fronts?

Yeah, I think when you look at go-to-market, we've done a few things. One is good segmentation of the base, and we've learned a lot. Nothing like a crisis to teach you some key lessons. And, you know, large MSPs may want to be engaging with us in a different way than medium or small, and so we continue to refine that under Sanjay's leadership. I think we're definitely starting to accelerate our investment and focus internationally. And I think you'll see us opening some new markets as we go into 2021 now. So those are probably the two biggest pieces. But overall, there's a lot of room in just what I would call sales machine efficiency and picking up 5% here, 5% there, everything from lead conversion to how we run our virtual roadshows. and so on so it's it's been an efficient selling year and we think we've just scratched the surface of what we can do there um on the product side you know the my major caution about looking too far forward is the existing products that's very good and the tams are very large and you know we haven't been that company that feels like we have to launch five new products a year we've got very solid categories we've talked uh you know quite a bit about shifting to cloud and you know, how all of our products are cloud managed, and we want to continue to put big investment there. And then it won't surprise you, you know, that all things sort of SaaS-related for us in our protection suite, as well as RMM, have experienced very good tailwinds in this world of remote work. So, I think it's mostly more of the same and faster. Our reliability has leapt this year, and you can never squeeze out enough nines of reliability when you're in a continuity and data protection security business. And I don't want to muse about too many other ideas, but we've got one or two tricks up our sleeve too.

Understood. Thank you for taking the questions. I appreciate it.

You're welcome. Your next question comes from the line of Brad Sills from Bank of America Securities. Your line is open.

Oh, great. Hey, guys. Thanks for taking my question. I wanted to ask just maybe a follow-up to those comments that you made. Tim, thanks so much for that color. It sounds like when we look at the average IT spend per MSP, if you just take some market data out there, it's about a $28 billion market with about 125,000 MSPs out there, that implies a much higher IT spend than where you guys are penetrated today with about a $30,000 ARR ASP. So my question is, it sounds like you feel like in order to go after that growing wallet share per MSP, it's really just about selling what you already have into the base. Is there a next leg coming? Is there a solution set within the stack that maybe the penetration is lower today and Maybe it's on the business management product side, or are there other categories that you think you'll enter over time that would really be the catalyst for growing share of wallet within the MSPs?

Yeah, it's a great question. The nuance here and the way to think about this is the power of the sell-through side. So I certainly don't want to leave you with the impression that we don't have a very rich product roadmap, but on a given day, if you've got 17,000 MSPs out there and however many sales reps they each have, that's your sales team. And it's a heck of a lot easier for them to go find customers more SMBs in general and add more data technology out in the field than it is for them to absorb yet another product we're throwing at them. So we're deliberate in our pace in terms of how we do that. And I think that's the nuance versus many times enterprise companies where you put product number one in and that's all the revenue you get. And then you put product number two in and If there's an enterprise equivalent, I think back to Salesforce in the day and why they've done so well. They had this beautiful cohort. Every time you add a sales rep, they automatically are going to get another Salesforce seat. And for us, we want every time an MSP adds an SMB, We want to have more of that data sell through going in there. So that's still a primary motion. And truth be told, that was, you know, and maybe to some degree continues to be one of the challenges for MSPs in COVID. In April, May, June timeframe, spending a lot more time stabilizing their base, getting them comfortable with remote work, making sure everybody's safe versus going to find new SMBs. So the vectors of growth are, first and foremost, penetrate the existing MSP's customer base, then help them find new SMBs, and then come back on the top. And so we definitely have cross-sell, and you're right that in a given SMB or MSP or within a given region, we have a lot of upside in penetration. You know, we don't have deep cross-cell penetration across the space yet. And then we use, you know, we use new products to drive that ARR for MSP up from there. So it's more white space than not, if that makes sense, when you look at that matrix.

Sure. Absolutely. No, thanks, Tim, for that. And then, My other question is just really on the net ads. It's 200 MSP net ads this quarter. It looks like you've been tracking to roughly that number the last few quarters. You know, maybe just some commentary on that metric and, you know, does this, is the pandemic, is it weighing on the net ads number? You know, would we expect maybe some of the sales and marketing efforts to resume after the pandemic that could be, that could drive a catalyst here? for maybe some growth in that metric? Where are we just in terms of kind of the headwinds that you're seeing in the business from the pandemic, and when might we get through those?

Hey, Brad, it's John. I'll address that. The 200, the key there is to remember that that's a net add number. And this year actually has been another very strong year in the gross addition of new MSPs. But it's been accompanied by higher churn of MSPs as well. And generally those have been smaller MSPs. And that all makes sense in the context of COVID. So the cohort, if you think about those powerful cohort graphs, The cohort of new MSPs in 2020 is very strong. It's a substantial number of new MSPs. We've just experienced a little more churn this year of certain smaller MSPs under the pressure of COVID. The other thing you can look at is, of course, the ARR for MSP reflects that trend. dynamic as well, and you can see the AR per MSP rose again nicely in the quarter.

Our next question comes from a line of Seked Kalia from Barclays Capital. Your line is open.

Okay, great. Hey, guys, thanks for taking my questions here, and congrats on becoming a public company. Hey, Tim, maybe I'll start with you. Can you talk a little bit about what Datto is doing to help customers drive resiliency for cloud workloads, particularly in Azure? And maybe how growth in that market could impact Datto's business, if at all?

Yeah, it's a great question. We generally feel like that's going to be an incredible opportunity. I think it's interesting with an enterprise hat on versus an SMB hat on, the world of shift to cloud looks very different. So first of all, Datto services today are all cloud managed, and they have been from inception. So our partners are used to working in the cloud with us. As SMB data and applications starts to shift to the cloud, the obvious step one is the move to O365M365, and that's clearly growing rapidly for Microsoft, and it's growing very rapidly for us in the context of Datto SaaS protection. Next up, and I say next because some MSPs have moved, but not so many, next will be the lift and shift of on-premises Windows servers. We think primarily to Azure, less likely AWS or Google Cloud in the case of SMBs. And when our MSPs are ready to go there with their clients broadly, we will be with them. This is a gradual evolution. There are some meaningful technical challenges that exist for them. This is not an enterprise CIO lifting up the you know, the whole enterprise at once. And then there's cloud pricing challenges. It can be very hard, especially in Azure, for them to sort of process what their bill is going to look like, you know, three, six, nine months on. And so there's a lot of experimentation going on right now, and we're involved in some of that with them. Our long-term vision, of course, remains offering MSPs a seamless hybrid continuity solution, single dashboard, single set of solutions. you know, reports and so on and controls, independent of where their workloads sit. Those server workloads in the SMB world are largely virtual machines today already. And, you know, they're today largely on premises or in MSP data centers. And in the future, they'll be in public cloud. So we think, you know, the next couple of years starts to represent that migration for them. And maybe they're trailing the enterprise further. you know, three, four years or something, the shift to cloud is a massive opportunity. And I would leave it at that. You should expect us to be investing accordingly there. And it's pretty exciting.

got it that's really helpful john maybe for my follow-up for you um you know you touched on this in the in the prior question but can you just talk a little bit about churn rates here in q3 and maybe broad brush how you're thinking about that in q4 and maybe just as a reminder you know can you just touch on how how the churn rate here is different for data since you're selling to the msps rather than selling to the small, medium businesses that those MSPs ultimately service. Sorry, there was a lot there. Does that make sense?

Yeah, no. Thank you, Saket. I think I got it. And start by saying, you know, we obviously don't disclose churn rates. We do and did talk about in our prospectus the growth retention rate, which pre-COVID was 88%. And As you saw, as the growth retention rate went down to 84% at June 30th, we could see the impact of COVID. And then that's also reflected in those MSP net growth numbers that we talked about. But we do feel like, whether it was pre-COVID or during COVID, that the relationship we have with the MSPs does buffer us from the ultimate end customer SMB churn. And if you think about what broadly people would consider a normal SMB churn levels or even elevated SMB churn levels during COVID, we feel like the churn levels that we've experienced are below those because of that relationship with EMSPs. And so Q4, our numbers reflect, I think, a pretty consistent trend. you know, pattern that we've seen during the year. And we're assuming, you know, generally, as we look ahead, as it relates to COVID, that we're sort of steady state in what we're all seeing right now in the world, and not that it gets a lot worse or that it, you know, miraculously gets a lot better.

Your next question comes from a line of Brad Zelnick from Credit Suisse. Your line is open.

Great. Thanks so much, and I echo my congrats on a fantastic milestone for Datto. My question first for Tim. Tim, you sit in a very unique position with a leveraged view into SMB health, and we've seen some more encouraging signs from other software companies, but just curious to hear your thoughts and what you're seeing real-time that maybe you could share, and perhaps what gives you optimism, and conversely, what might be cause for concern?

Yeah, it's a good question. We do see something. I don't have the perfect lens that you might think. Sometimes MSPs are not, you know, sharing, so forthcoming, I guess, with what's going on in their client base, you know, and they're pretty guarded in some ways. But we certainly saw the trends, early verticals, you know, not hard to figure out in April and May, the travel and restaurant, hotel, you know, businesses like that were struggling. MSPs who served them thankfully were very rare for us, but when they did, the impact was immediate. I think then over the summer, what we heard is Q2 was stabilized, get the remote work in. Q2, Q3, the summer was a bit more of a struggle to find new SMBs. I think you're right in your commentary that SMBs have figured out a way to go forward. The stimulus money was helpful. They've remapped their businesses to the new world of remote work. And the biggest thing for MSPs has been now, how do I go get new SMBs? How do I get somebody to take my call, my Zoom, if I can't go door to door, I can't meet them at the club, you know, I can't use my old selling motions. And so I think one by one, MSPs are starting to figure that out. And we've seen that coming back into improved numbers for us. So, you know, MSPs themselves have been fine in general. We talked about, you know, not having to offer that broad of relief. SMBs in general have been fine, but, you know, we want to see now that further penetration of MSPs to capture the SMB digital transformation that's, you know, ongoing. So, you know, I hope that helps a little bit. We certainly haven't had that many partners raising their hand saying, you know, my whole customer base is tipping over. There's a very much better feeling than what you were hearing in March and April at the moment.

that's very helpful i appreciate the color and maybe just for john john operating cash flow was much stronger than we had modeled can you talk us through the puts and takes any any one-timers to call out and how should we think about cash flow into q4 next year yeah a great question it really definitely a peak in in margins here in q3 um in addition to uh

lower expenditures that just because of COVID, whether that was travel, events, T&E, office expenses, a number of items like that. We also saw the full quarter impact of a number of expense savings initiatives that we had implemented in Q2. And you may remember those were very strategically developed where we considered What are the important long-term growth areas of the business? Make sure that we're continuing to invest and spend in those areas. And in other areas, are there ways to dial down the expenditure, redeploy expenditures, or just find more efficiencies in the business in doing the things we do? We definitely recalibrated the expense level to a new place, and we feel good about that, and we feel like we've created a lot of capacity for investment. But as you can see reflected in the Q4 guidance, we're already reinvesting and accelerating that reinvestment because we feel good about the trajectory on the top line, and we feel really good about the opportunity set ahead of us. And so you can expect us to continue to invest to drive that growth. And we feel good about the capacity that we have to do that. On the call, you may have heard I added the remark that over the course of the coming quarters, that as that investment ramps, you'll see expenses go up and margins continue to come down a bit into the low to mid 20% range.

Your next question comes from the line of Walter Pritchard from Citi. Your line is open.

Hi, thanks.

Tim, I'm wondering how you're thinking about the sort of sold-into MSP-type business, the Autotask, and I guess RMM kind of falls in that. What did you see there? How do you expect that as we get a recovery out of COVID that will behave? And I'm just curious if you saw that somewhat suppressed, just given MSPs are a little bit tighter strings.

Yeah, well, it's good instinct. Certainly in Q2, the easiest thing for an MSP to do if they had to adjust their expense line a little bit was to trim some seats in something like a PSA or, for that matter, any other sell-to tools they had. We don't have much on the sell-to side, but we saw seat compression increase. You know, John mentioned not only sea compression, but some churn in, you know, higher than historical levels on the smaller MSPs. And so I think we had that. We saw that better in Q3, as I said, you know, somewhere in my remarks that sequentially improved. you know, the products all did well Q3 over Q2. So that stabilized. RMM is the other piece of that, and they obviously go well together. RMM has been terrific throughout, and that's obviously very consistent with new models of remote work, employees going home, not being able to visit branch offices, et cetera. Just the more remote monitoring you can put in, the better. And that was on top of already good trends for us. And you know, in RMM, we're more of an attacker than a defender. We're not the largest market share. We're the newer kid on the block in a more mature category. And so that's been a very good story. So really, those are the two pieces for us. And so far, so good. We still remain very bullish on the sell-to side of the house.

Got it. And John, on your end, noting that you took the action in Q1 to get your expense base aligned or prepare to have it aligned, and then you've been coming out of this hiring. Could you help us understand maybe month by month during Q3 and sort of how you expect the hiring to proceed during the fourth quarter? Do you expect to be kind of back to the run rate that you'd like to be during Q4? It just would be helpful to understand that progression. Yeah, I think it'll take – it takes a few quarters. You know, we put a hard stop on the hiring machine in Q2, as we all – stopped to figure out which way was up and found ways to evaluate the business and the expense base and recalibrate that. And then once we got comfortable that the business was as resilient as it was, that the MSP base was holding in there and that we were actually continuing to see good growth, we started to start that machine back up and the growth machine and hiring. And, you know, that takes a little while to get the pipeline refilled, and we think that's moving along now. But it takes time. It will take probably a couple quarters to get where we want to be.

Your next question comes from a line of Brent Thill from Jefferies. Your line is open.

Hey, guys. This is Joe on for Brian, and congrats on the first earnings report as a public company. I just wanted to double-click on the international markets. It's only a quarter of your revenue, but it looked like it meaningfully outperformed the U.S. this quarter. Was there anything particular there, any additional traction you're seeing in EMEA or?

Yeah, it's a good question. We have said it's around numbers a quarter. It's, you know, we would expect it to over time grow faster. We're very under penetrated there. And even a different way to think about it is we're, you know, well over 90% in English speaking countries today. So as we start to do better on the continent in Europe, you know, those have been newer markets for us and we're starting to build on them. and, you know, even a fledgling presence now in APAC on the continent. So I don't think it was any broad trend. I think, you know, they just had a good quarter. We teased all the different regions about who was going to win. I think we did see some particularly good strength in Australia this particular quarter, and you know it's always a little hard northern hemisphere southern hemisphere winter is summer and summer is winter so it's a little bit hard to predict but we've got a very loyal and solid partner based down australia new zealand and um you know i'll give them a shout out for uh for for a terrific quarter but you know i think similar patterns and trends in in all of our major markets i wouldn't call it anything as being structural to the markets

Good to hear. And then any big takeaways from your virtual MSP Tech Day? Any surprises or consistent requests from customers?

You know, the biggest surprise for sure is just the volume that we've been getting. I mean, these are four-hour virtual events. We've done two of them, and You know, we're getting numbers that are as big or bigger than we would have expected at a live conference. It's, you know, they're technical. It's fairly tough to sit there end-to-end, but you can obviously measure it. We've got another one coming up soon. And I think the level of engagement, you know, has been, you know, following that has been very high. People fill out a little form. They tell you what they're interested in. Post-engagement, you know, you can engage them either with a sales engineer or or traditional sales, or if it's an existing partner, even a success rep. So we've been pleasantly surprised at how efficient the engagement model is. And we've obviously done a wide variety of virtual roadshows, smaller hits. CISO might jump on, talk about security. You know, you can get a few hundred MSPs onto that on very short notice, and then you get a chance to engage afterwards on the product side. But we keep most of that pretty high level, and it's there. Competitors can dial in. You don't have to be a Datto partner. They're very much informational, educational, but we find a fair amount of lead gen activity on the back end of those. So it's definitely going to be a model we'll stick with even post-COVID.

Your next question comes from the line of Matt Hedberg from RBC Capital Markets. Your line is open.

Oh, great, guys. Thanks for taking my question. I guess, you know, it could be either Tim or John. You know, in the prepared remarks, you talk about the early stage of the recovery, and obviously you saw some sequential new ARR ad. Was there anything unique about that, like, you know, anything catch-up spend or pent-up demand that may have driven in some of that Q3 strength? And I know you don't guide ARR, but historically speaking, we tend to see sequential ARR, new ARR up into Q4. Is there anything you're seeing that would suggest that that may still play out this year?

Hey, Matt, this is John. No, there was, I don't know that I would say there was any real catch-up or pin-up demand. Obviously, in Q2, there was certainly a period of As I said, where everybody, the whole world stood still for a month or so, right, trying to figure out where this was headed. But there was not a particular catch-up or driver of that that we would point to. And I guess, you know, as far as seasonality in ARR, historically, there was a sawtooth pattern to our program. ARR growth, where you would see it climb steadily across the quarters, Q1 to Q4, and then fall slightly in Q1. But this year, we've obviously seen that disrupted by COVID and, you know, seeing some nice acceleration in ARR. And so unclear whether that pattern's going to hold or not in this environment.

Nothing's normal in 2020. Yeah, expect the unexpected. Yeah, but it is true that just every company and every industry, even not tech, has some mental notion of an annual cycle. And so, you know, there is typically some budget dollar left. Everybody's fighting for it in Q4. So, you know, I don't know if we're going to be able to call this year normal, but maybe we return to that kind of a sawtooth. There's nothing we do special to cause that, and we try to grow every quarter.

Got it. And then that's super helpful, Tim. And then maybe, John, just a quick one. Maybe I missed it, but can you help us out with share count for Q4 on a fully diluted basis?

Yeah, it gets a little tricky. If you're looking at doing EPS calculations, a fully diluted count for Q4, we would suggest using 165 million shares. for the quarter and 145 million shares for the full year. If you're looking ahead, you'll see in the 10Q that the basic share count on the cover of the Q, I guess that was as of November 15th, the basic share count is 161 million post-IPO here. And if you include options, that total share count would be closer to 171 million.

Your next question comes from the line of Kirk Matern from Evercore ISI. Your line is open.

Yes, thanks, and I'll add my congrats on the successful IPO. I guess, Tim, when you've been out talking to maybe some of the folks in your sales organization over the last quarter and you've seen some incremental traction versus where we were in 2Q, is it really about sort of just customers reengaging on a net new basis, on an expand basis, meaning yeah if you look back three months ago you know what maybe surprised you more just i was just kind of curious if it was more you know the the existing customers willingness to expand perhaps at a faster cadence than 2q or are you seeing it you know also on on the lands because as john mentioned you had a nice sort of uh net net ad quarter from from a new customer perspective so just wondering i realize it's probably balanced a little bit but just kind of curious if you could add some color on the margin

Yeah, you know, both were good and both were, you know, surely better Q3 versus Q2. Remember the lands for us, what you call land, you know, a new MSP typically doesn't come with much revenue. You might literally get them for one subscription. And so, you know, you're not going to make your quarter or even your year on that first MSP. That said, occasionally we get large deals. We did have a couple good-sized, what I might call a displacement, where you might get 50 subscriptions to come over from a competitor all at once. Those catch your attention, though, because they're less normal. I think... You know, it's hard for us to say new SMB versus existing penetration. I think the MSPs kind of gathered up their feathers, so to speak. Q2 was difficult for the whole world. Q3, OK, I got to grow this business in the new normal. And remember, in Q3, nobody had any visibility on vaccines or, you know, where the world's going, second wave, third wave. So, you know, I better get after it. in a more remote concept, start selling, grow my business. And then I think on our side, we got a lot better organized. And I credit the whole GoToMarket team looking out a few months in pipeline, understanding, okay, what can we do and what can't we do in this model? Which products are actually likely to accelerate? Matt and the marketing team also lining up some of the online virtual marketing. So I think we just got more efficient MSPs got more efficient. I would call it more of a ground game. I don't think I can point to anything that doubled or some unique insight. It was just better execution and as the world's getting more used to doing business in this manner. But a lot of these insights, as I said, will certainly carry on even after people are back to offices and things. So we're more digital every day.

Due to time constraints, we please ask that you limit yourself to one question. Your next question comes from the line of Keith Backman from Bank of Montreal. Your line is open. Keith Backman, your line is open.

Yeah, thank you very much. I guess with the constraint of one question, I wanted to ask a little bit about AR per MSP. And the question is oriented around 2021. I assume that as COVID recedes, or hopefully COVID recedes, your net ads increases. But I just want to hear a little bit about how you see that um you know how you envision that during the course of 2001 and related to that is how you would anticipate the ar growth and where i'm going to the question is you've been growing ar per msp double digits effectively for the last three quarters almost four quarters but as your um msp base i would assume increases a little bit does the ar per msp then go down a little bit because as you said you know, the initial land, so to speak, is fewer dollars associated with that. But if you could just talk about how you anticipate that metric unfolding during the course of next year, that would be great. Thanks.

Sure, Keith. This is John. I think you're pointing to all the right dynamics, and it really is a bit of a mix issue, right? Is the the new msps are coming in they're typically coming in at a very low arr and then a little bit of the question and one thing we saw this year is that was occurring but we also had some msps more msps churning and by and large they were fairly low arr as well which drove you know the the strong increase in the quarter of arr per msp um I don't know that it necessarily, that dynamic necessarily changes next year. I mean, a lot of it depends on, you know, when are we past COVID? When are we back to normal? You know, if that's mid-year next year, you know, maybe by then or sometime before then, we get back to a little bit more normal churn levels. But, you know, we feel good about the trajectory of COVID. of the ARR, and we feel good about the trajectory of the MSPs, and it's all those pieces coming together, right? The MSPs selling to their SMB base, you know, the extent to which they're able to add more SMBs that all go into that mix of ARR per MSP.

Your next question comes from the line of Frederick Havner from Macquarie. Your line is open.

Hi, thanks for taking the question. And again, congratulations on the quarter and your recent entrance into the public market. I'd like to dig into your sales and marketing a little bit more here, as you're already operating with kind of a very low sales and marketing intensity compared to a number of software peers. So we picked up on how your MSP partners are discussing your value proposition as both an easy to use and easy to deploy solution, and also advocating for your platform to each other in online communities. You know, you also highlighted that during this recent quarter, you held your second virtual MSP technology day. So I'd like to ask, how do you think that word of mouth and digital cultivation play into your go-to-market strategy? And are there any areas of your go-to-market that you think could durably change once the world is on a trajectory to emerge from the lockdowns?

Thank you. Those are good insights, actually. And, you know, you've hit on the word community there, you know, online and offline. So, you know, MSPs talk. They're an interesting bunch because, you know, these are techies. There's 125,000 plus of them around the world. And they don't view themselves so much as direct competitors. Clearly, if three of you put an RFP into the end user, you might be. But they tend to share best practices online. You know, there's a number of private social forums where MSPs get together publicly, in person. And so one of our best favorite things to do in person is have a lunch with 25 prospects and sprinkle in three existing partners and just let them talk. We're very open, very transparent. We have a full, pretty meaningful business development team that's just out interacting with partners, other vendors, new prospects, just generally being helpful, and it does drive this community and partnership. So we've taken as much as we can of that experience online. As I said, we're very digital now and have been for a while, so we've pushed the limits on that, and we'll continue to play that going forward. But I also think things like our industry-leading DattoCon conference where a few thousand MSPs get together once a year in the U.S., once a year in EMEA. you know, we're all dying to get back there. And, you know, I've had dozens of emails from MSPs asking essentially me to predict COVID, you know, when can we all get back in person in a hotel? And I've told them I'm going to have to be a lagging indicator on that. But you're hitting on something very good, which is keep it easy, keep it easy to deploy, let reference partners, in effect, bring other partners in and cooperate in a community. So, That's how we're going to continue to play it going forward, I think more digitally than ever, but we'll definitely be back in person.

Your next question comes from the line of Greg Moskowitz from Mizuho. Your line is open.

Okay, thank you very much, and thanks, guys, for taking the question. Tim, you mentioned that it has become more challenging for MSPs to find new SMBs, as well as the fact that many of these SMBs are remapping their businesses to a remote work environment. And I realize that we're in uncharted waters here just given the pandemic, but I'm curious how you see this playing out going forward. In other words, is there a tipping point in terms of customer size or something else whereby these newly digitized SMBs reach a level of complexity where you think they'll need to engage in MSP? How do you sort of see that going forward?

Yeah, that's a great question, Greg. And there's a killer research think piece to be written in there somewhere, I'm sure, because it is different for the three-person flower shop than the 100-person law firm. And one thing we discussed and came to grips with with evidence, I think, more than we might have had before. We had a gut before. You know, we're kind of underlining the M and SMB. The MSP is going for the organization that cares about uptime, that cares about technology continuity, that says, you know, we can't run our business for a day without technology, car dealership, insurance company. You know, we're going to lose a lot of money if we're offline. So that's where the MSPs hone in. And as you said, one by one now, as You know, as other businesses start to get more digital, more online, more people ordering with an app, more people doing delivery, all the different things that are e-commerce related, they start to run a much more complex environment. And the cost of being offline for even a few hours gets very measurable. And I think that's where MSPs come in the point of entry. we don't feel like we've heard stories that they can't sell and close SMBs. It's been more of a, is this the most important thing to do today? It's been such a traumatic first four or five months there in COVID that getting back on the horse and going out into the market and trying to sell wasn't always at the top of everybody's list. And we think they've normalized that much more in Q3, and we see a lot of excitement. I've talked to a few MSPs in the last couple months, told me they're having record years, and they're accelerating the number of proposals that are going out. So there are definitely, you know, been some MSPs running right into the eye of the storm and saying change is good. And I think just more MSPs have to adopt that to, you know, to get back to, you know, return to previous levels.

Your next question comes from the line of Jason Adder from William Blair. Your line is open.

Yeah, thank you. Thanks for squeezing me in. I guess, Tim, I wanted to ask about the relative growth rates between unified continuity and business management. I think you talked about some effect from COVID on business management. I assume there was an effect on unified continuity as well. And then maybe as... Related to that, maybe talk about some of the drivers for continuity this year. I mean, I imagine ransomware is a big one.

Yeah, I think if you look at unified continuity versus business management, probably have been the same. I think within business management early on, you know, we said PSA was impacted. We had seat compression and some smaller MSPs. Within unified continuity, particularly those first couple months, on-premises, you know, deployments became difficult for for some people, depending where they were regionally, depending on their ability to, you know, get in there and work on servers, et cetera. I'm sure you've heard some of that, you know, with some of your equipment companies maybe. But, you know, in the main, not one different than the other when we blend it all in. I think, you know, those were offset by strength in RMM and SAS protection. And so, you know, the beauty of the model now is we're serving many different environments. And you know, the engine has definitely gone from single product to multi-product over the last, you know, couple of years. And it's, you know, it's nice to see in this particular thing, you know, this particular time. So I would probably just leave it at that. John, I don't know if you have anything you want to add right at the end here. I know we're up in time.

I think that covered it. We saw good revenue growth across the you know, all products and feel good, as Tim said, about having the whole suite, you know, quarter to quarter, some will do better than others. And so that's great to have that mix.

There are no further questions at this time. Mr. Tim Weller, I turn the call back over to you for some closing remarks.

Great. Well, I'll keep it short and sweet. Thank you all for joining us today. We're thrilled to Report our first quarter as a public company and get the journey started together. Appreciate your interest and look forward to engaging in Q4 and beyond. So have a nice evening and thanks for joining.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating.