Description

Summary

Backblaze is a cloud data storage business that went public at the end of 2021 to invest in their B2 Cloud Storage product, which is essentially a low-cost competitor to Amazon S3. As a recent tech IPO with declining margins, it’s not surprising that the stock has gone straight down over the last 12 months. The company is now trading at a very low valuation (1-2x sales) which to me suggests that the market is overlooking the LT potential earnings power of the business.

The company was founded by 5 co-founders who all still work at the company and collectively own ~15M out of ~32M total shares and they control 68% of the voting power. Prior to the IPO in 2021, the company was bootstrapped for most of its existence having only raised less than $3 million of outside capital since its inception in 2007. The need to be profitable early on has led the company to be very cost conscious and capital efficient. Interestingly, all the co-founders effectively made minimum wage for the first 3 years.

While private, the company has been able to deliver respectable ~30% growth with 20-30% FCF margins which I think represents the mature margin structure that this company can deliver if the owners decide to run it for cash generation. Today the company is investing its IPO proceeds in the go-to-market + R&D for its higher growth offering called B2 Cloud Storage (~45% growth) and as a result the profitability profile has retracted to negative ~20% FCF margins in 2022. 

The company has sold off considerably since the November 2021 IPO along with every other tech IPO that came public late last year. Today the business trades at an enterprise value of $135 million against NTM revenues of roughly $100 million. At their mature margin profile (~25%) this would indicate an EV/FCF of 5.4x or an ex-cash FCF yield of 19%. A high-teens normalized FCF yield and the prospect to grow revenues in the 20%+ range for the next several years can set up for a very attractive investment return. If BLZE can grow revenues to ~$200 million in CY26 (low-20s growth CAGR), get back to ~10% FCF margins, and trade for 20x FCF (reasonable for the growth & go-forward margin expansion beyond 10%) then the stock could be worth $13/share by YE25 (130% upside / low 30s IRR). At a 10x FCF multiple on the same numbers the stock would be worth over $7/share (vs. $5.50/share today).

Business Overview

Backblaze is a cloud-based data storage company which allows businesses and consumers to store, access, and protect their data on Backblaze’s cloud infrastructure. The company has developed proprietary software to manage and operate its global infrastructure of roughly 200,000 hard drives and over 1 TB per second of network bandwidth sitting across 5 data centers. Their software layer provides data compression, caching, access, load-balancing, failover prevention, deletion, and encryption for over 500 billion files while also managing the automation, monitoring, and security of their physical infrastructure.

The company has two core offerings which both sit on top of the same cloud infrastructure and address two very different data storage use cases. The company’s first product was Backblaze Computer Backup which is a cloud back-up service for desktops and laptops. This product helps both consumers and businesses protect their data from crashed hard drives and from ransomware encryption attacks. Backblaze charges a flat rate of $70/year per computer for unlimited data backup. This is a more mature offering which generates $50 million of run-rate revenues and grows low-teens. The growth here is split roughly evenly between expansions from existing customers and net new logos. Computer Backup customer count grows mid-to-high single digits, and the net revenue retention rate is 108% (gross retention is 90%). The company raised prices on Computer Backup in late 2021 which has acted as a tailwind as it rolls into these numbers (1-2 year annual deals that update to new pricing upon renewals). They have not seen any material increase in churn following these price increases, so I suppose that fact supports the idea that there is still some room for prices to move higher in this segment. Computer Backup is the more stable cash cow business for them that supports the growth investments being made in their second offering.

The company’s second offering called Backblaze B2 Cloud Storage was released in 2015. B2 is a cloud-based object storage service which effectively lets developers gain access to Backblaze’s storage infrastructure on-demand for use cases that go beyond the traditional “computer backup” problem that Backblaze was originally targeting. In simple terms, B2 is the company’s alternative to Amazon S3. While one could use B2 for generic file storage, just like Dropbox, iCloud, or Google Drive, B2 is much more akin to the underlying storage APIs that those services rely on. For example, Dropbox was originally built on top of the Amazon S3 APIs. B2 can be used by developers who are looking to get cheap on-demand cloud storage which can be directly accessed by their applications through a RESTful API. IT teams can also use B2 to store and back up enterprise data via the CLI. B2 could also be used by IT teams to supplement storage needs if on-premise data center storage limits are reached. B2 was designed to be simple and straightforward making it very developer friendly (S3 compatible API, SDKs, CLI, developer docs, blog posts, etc.). Additionally, B2 is interoperable and can be configured to work with critical tech stack partners including media asset mgmt. tools like Frame.io, content mgmt. systems like Wordpress, and content delivery networks like Cloudflare.

When the company started out, they first looked at building their Computer Backup product on top of an underlying storage service like Amazon S3. However, as a result of being bootstrapped early on they did the math and concluded that they couldn’t build a profitable business on top of S3 given the pricing structure. So the team developed their own efficient and scalable data stores, Backblaze Vaults, which are low-cost hardware data storage units which have been optimized with various compression techniques and could be accessed with the company’s own API calls. They used these Vaults to power their Computer Backup offering and then realized that many of their customers often would ask them for direct access to these underlying cloud data stores. So then in 2015, they decided to release an API which would let other organizations interface with the Backblaze Vaults. This was the inception of Backblaze B2 Cloud Storage.

Additionally, because they optimized for cost while developing the Backblaze Vaults, they can offer B2 at very attractive prices relative to Amazon S3. B2 costs $0.005 per GB/month which is roughly 1/5th of the S3 pricing at $0.026 per GB/month. Azure charges $0.021 per GB/month and Google charges $0.023 per GB/month. Cloudflare R2 which claims to be a new leading low-cost offering charges $0.015 per GB/month. Ultimately, this means that if you stored 500 terabytes with B2 you would pay $30K/year vs. paying $150K/year at Amazon S3. Amazon S3 also has considerably high data egress fees which are ~9x the cost of Backblaze B2’s egress fees.

In terms of sizing the opportunity, Backblaze operates in a growth market that is exposed to lots of the same underlying demand trends that the cloud computing and infrastructure-as-a-service markets benefit from. Despite quarterly ebbs and flows, the digital economy continues to grow, there is a corresponding explosion of data, and a growing demand from enterprises and individuals to store that data in a cloud delivered format. IDC gauges the Public Cloud IaaS market at $91 billion by 2025 (~25% CAGR). For some relative scale, I have seen some analyst reports which estimate Amazon’s revenue generated from S3 is ~$10 billion per year.

Today the business has roughly 500,000 paying customers so it has similar customer reach to other low-cost/SMB cloud service vendors like Digital Ocean (thanks Kerrcap for that recent write-up). Of those ~500K customers, roughly 80K are B2 customers but those customers carry an ARPU which is 3x higher than the Computer Backup ARPU. Today B2 generates $36 million of ARR (growing 45%) and represents over 40% of the total ARR. The growth for B2 is also roughly evenly split between expansion and net new with new logo growth in the low-20s / high-teens. B2 carries a respectable 123% net retention rate and enjoys the same 90% gross retention as Computer Backup.

B2 grew ARR by 57% in 2021 and so far in 2022 they’ve grown ARR by 45% year-on-year, so the growth rate is slightly moderating but is overall still very healthy. While these results demonstrate that B2 has seen nice success over the last few years, the company has been under investing in the development of sales and engineering initiatives for B2. After seeing the strong underlying demand for B2 from their customers over the last few years, the team has decided to start investing more heavily in B2 across a few targeted areas with the ambition of driving better top-line results

Investment Phase and Potential Case for Continued Outsized Growth

Backblaze did not begin to invest its IPO proceeds in the business until the start of 2022. The company has taken several steps over the last year to scale their go-to-market approach with the intention of doubling S&M investments year-on-year in 2022. These GTM investments will take time to pay off and the company doesn’t expect to see any material revenue acceleration from these initiatives until 2023. Backblaze has also used some of the proceeds to make engineering investments over the last year which have yielded several interesting new enterprise features which should support NRR into 2023.

At the start of 2021, the company had no outbound sales reps, but they ended the year with 13 and have been adding more throughout 2022. Typically, the sales-assisted deals are 20x larger than the self-service channel and can be more profitable over time with sticky revenues and more expansion opportunity. The outbound team succeeded in landing the company’s first $1 million purchase order in 2Q 2022. Backblaze is also building out a dedicated partner marketing and support team to help drive partner influenced deals and the growing MSP channel.

Backblaze has historically focused on optimizing organic inbound traffic and had no significant paid advertising function. They started to adapt their marketing strategy and over the past year they have completed a brand refresh and rolled out a new “Blaze It” advertising campaign which targets developers and IT admins. In 2Q 2022, they also hired their first Chief Marketing Officer who used to be the CMO at Five9.

Finally, the company has been adding more resource to support developer evangelism for B2 given these customers are an important channel which doubled ARR last year. Leaning into developers (as opposed to IT teams) has been a key focus area throughout 2022 as they scaled up their developer evangelism teams and tech conference presence. Winning over the developer is critical to the success of any infrastructure software business and is something that we’ve seen be quite important at companies like Datadog, Atlassian, Cloudflare, and Twilio. Developers often select core tech stack components of their applications in a self-serve fashion and then as those applications grow these tech vendors become entrenched over time and get to enjoy much of the upside that comes with greater scale. Developers who build applications which rely on B2 for cloud storage tend to grow quickly over time as their applications scale (150% NRR from developer customers). As of 3Q 2022, 9 of their top 20 customers were developers.

For some context on the spending here, in 2020 they were running at >75% GM and paid ~23% for S&M, ~21% for R&D, and ~12% for G&A so the overall EBITDA margins were ~20%. In 2022, the GMs are running at 76%, S&M has risen to 30%, R&D is at 36%, and G&A is at 21%. They have also absorbed a fair amount of public company operating expenses which represent a large part of their growth in G&A costs. This nets out to -10% EBITDA margins on the year which is a loss but not a tremendously high dollar amount (-$8M of EBITDA) relative to the cash balance of $80M. The operating expenses have risen from $30M in 2020 to ~$75M in 2022 and that growth of ~150% hasn’t materialized in the revenues yet. This investment cycle should provide nice support to the overall revenue growth in 2023 and 2024 as these growth initiatives start pay off.

The combination of Computer Backup and B2 supports a company with a highly recurring business model (>99% recurring revs) that is generating $88M of total ARR (24% growth) as of September. Without assuming a re-acceleration of B2 revenues, I think Backblaze should be able to hold low-20s growth over the next few years as B2 becomes are greater part of the business. If B2 starts to decelerate from mid-40s into the 30s and Computer Backup can hold low-teens growth, then B2 will become roughly 60% of the business by 2026. This mix shift towards B2 should help prop up the overall company growth rate to above 20% for the next few years. 

This mix shift dynamic reminds me of what we saw with MongoDB from 2020 to 2022 where their higher growth DBaaS offering became a large piece of the pie and drove the overall revenue growth to accelerate from 38% in the summer of 2020 to 57% in Spring of 2022. Needless to say, there was some remarkable multiple expansion on the back of those results. While MongoDB is a very special company that’s executed extremely well and I don’t want to overfit here, the math still works the same. In this case, if we assume a slow deceleration in the B2 business we can get a long ~5-year period of sustaining low-20s growth on the path to $300M of ARR. There is also potential for the B2 growth to accelerate (like it did last quarter) as the go-to-market investments that Backblaze is making start to pay off, but I don’t have that in my base case. If that plays out in 2023/24 then you could see overall company revenue re-accelerate towards 30% top-line growth.

Valuation

This is a very thinly traded small cap name which came public at $16/share, traded up to $27/share in November of 2021, and has now traded off 80% to $5.30/share. The founders own nearly half of the company (~15M shares on 32M) so the float is abysmal on top of an already small market cap, so I get why nobody cares about this thing. At about 1x revenue it is incredibly cheap on traditional SaaS metrics and just feels like it has been left for dead. I get that there are concerns about competing with AMZN and that arbitraging the price of data storage doesn’t feel like a great moat, but frankly I think the risk/reward we are presented with here at these levels compensates us for those concerns. S3 is a massive and likely profitable component of AWS and if BLZE can win some small business on the margin as the low-cost player in this market then this can be a nice little business over time. They’ve clearly already struck a nerve with the 80K paying customers of B2 and I don’t see them constrained by the size of the market.

While I understand why the team is investing now after starving the business for years, it ultimately makes sense but doesn’t help investors get any FCF valuation support in their models for 2023/24. I believe that after a 2-3 investment cycle the company will be back to modest profitability by 2025/26. 2022 has not been a market that rewards longer term stories with delayed profitability, but in this case, I am less worried about the LT margin potential for them given their bootstrapped history and proven ability to deliver 20-30% FCF margin in 2019 and 2020. The founders own nearly half of the company and seem to be good operators with a long-duration mindset. If the founders care about their collective ~$78M of equity ownership here, then they either find a way to get this asset to a state of cash generation where the shares re-rate higher or they sell it to a natural acquirer/PE. 

As they get leverage out of their investments, I suspect that they can return to the 20%+ FCF margins that they delivered in the past. I have them doing $229M of revenue in 2027 (with no growth re-accel from recent investments) and think they can generate $30M of FCF on that (13% margins). 20x $30M would get you to an EV of ~$600M (2.6x revs) and they’d have $50-60M of net cash at that point so call it $655M market cap or $18/share (assuming some dilution) at year end 2026. That would be in the ballpark of where it traded in late 2021 and would yield a ~35% IRR from here. 20x NTM FCF also doesn’t feel too aggressive given that DOCN trades at ~30x FCF and 4.5x revenue. Additionally, DBX trades at 3.8x NTM revenues for lower growth but much nicer FCF margins. BLZE would also make a nice acquisition target for someone like DOCN who is trying to build a broader suite of cloud services for SMBs. I think there’s also an upside scenario where growth acceleration materializes, and they end up closer to $270M of revenue in 2027 (26% CAGR) and FCF of ~$40M (15% margin) which would get you to a $24 year-end 2026 target price on the same multiple assumption.

Risks

• Competition with Amazon S3 given that AWS is the 800 pound gorilla in the cloud computing market and has been known to reduce prices to remain competitive  (although in this case AWS would need to cut S3 prices by 80% to be on par with B2 so it seems unlikely that they would let $8 billion of revenue disappear over this)
• Competition with Cloudflare R2 and potential decline in the quality of their Cloudflare partnership which has been a good driver of customer acquisition for Backblaze
• Potential for the LT margin structure to look different than it did in the past given that the business mix will be more slanted towards B2 (this risk is mitigated by the fact that gross margins have gone up slightly while B2 mix has increased)
• Potential for the path back to profitability to take longer than I am currently modeling if management decides to invest more heavily
• Potential for the ROI of current S&M investments to be lower given that they are investing into a tougher macro-economic climate
• Macro-economic pressures which could negatively impact customer spending intentions
• Revenue exposure to SMB customers

Catalyst

• Sustained high growth of the B2 ARR and potential for this growth to inflect higher after the go-to-market investments pay off
• B2 becoming a larger share of the business
• Potential for further price increases
• Improved transparency about the timeline to reach profitability again
• End of the current 10b5-1 plans that the co-founders all adopted to diversify their holdings after going public (ends May 2023)