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Investing in the IT space can be done many different ways. For the most part, I think investors in this space ought to be looking for managements who take intelligent risks and who seek to maximize growth at least as much as they do short-term EPS. While everyone is trying to find the next Fastly (FSLY)-well until this week perhaps, or the next Twilio (TWLO), much of any thoughtful portfolio construction is going to be all about entering a well-known name such as Atlassian (NASDAQ:TEAM) at a fairly decent price. Much of my stock selection for my Ticker Target model portfolio is highly subjective, and relates to my perceptions of management choices with regards to growth vs. profit maximization. The news from Atlassian’s latest earnings release isn’t that the company announced a beat. The news is that the company is doubling down on its technology investments during the current period of economic contraction and is willing to accelerate technology commitments to foster growth as the economic impacts of the pandemic abate. I find that the leadership team at Atlassian meets my criteria broadly speaking, with a willingness to take on risks despite the pandemic and to make sizable commitments to growth even at the cost of short-term earnings. I am also encouraged that the team at Atlassian had reported the same kind of incremental business progress that most other software companies have seen with the impacts of the economy on the company’s business tapering off progressively. I was surprised to see that one writer on SA seemingly ignored management commentary about the impact of the pandemic and how it had waned.
Here are the specifics of what Atlassian is seeing in the market: “I note on the COVID driven impacts that we saw the greatest impact in April, less of an impact in May, and then again less in June, and so as you take a step back and think about the macro economic impact and free, you know, we believe that both of these drivers will ebb over time in terms of their headwinds to customer growth.”
I do recommend buying Atlassian shares or adding to a position. I have been an Atlassian shareholder for some time now, and while I have traded around a position, I expect to maintain a holding in the shares for years to come. Today’s software pullback, engendered by some realization that the economy does produce a headwind for most enterprise software companies presents a further opportunity. While notionally, the use of Jira, the main offering of Atlassian can be used as part of a remote work solution, this company, with more than 170k customers sells to businesses of all sizes, who have experienced all kinds of impacts from the virus and the contracting economy. Atlassian had a decent beat last quarter, and provided in-line guidance for the next quarter. It showed no evidence of hitting any wall-it did show evidence that even software companies are likely to see some impact from a severe economic contraction-just far less than other kinds of businesses.
I wouldn’t necessarily recommend buying Atlassian shares because the set-up with regards to another beat in terms of reported quarterly growth is a good one. Obviously, as the passage above strongly suggests, the economic impacts brought on by the virus are progressively lightening, and yet the company has forecast minimal sequential growth in the September quarter and is not providing full year guidance. Last year the company saw sequential growth of 8.6% in the September quarter, and then achieved 12.3% growth in the December quarter. To me that indicates that the odds are pretty strong that the revenue forecast of $430-$445 million for this current quarter will be surpassed. In years past, Atlassian has raised prices for some of its products that impacted the December quarter to a certain extent. As the company has shifted more of its revenue to the cloud, with typical one year terms, that kind of strategy isn’t as feasible. This year, management articulated during the conference call that its plan is not to raise prices materially given the less than stable economic conditions of many of its customers and it advised analysts to eliminate that tailwind from current models. I believe my model, which is based on 25% full year revenue growth through June of 2021, and not much sequential improvement in percentage revenue growth until the end of the fiscal year is consistent with that sentiment.
At this point, as mentioned Atlassian is not providing full year guidance. Atlassian is a company whose products have been acquired by SMB’s and enterprises across all geos and across all verticals. In particular, Atlassian has traditionally sold Jira to a large number of development teams in smaller enterprises. The company has seen some churn in that base since the start of the economic slowdown; management doesn’t feel that it has the requisite visibility to determine just how the interplay of churn, the impact of monetizing the free tier of users, and the discounted cloud migration offers will play out over the course of the coming year to provide annual guidance. That really is not something that should greatly upset longer-term investors.
Since the start of the pandemic, Atlassian has been viewed to some extent or the other as a work-from-home company deriving some benefits from the turmoil that has been the result of the reaction of enterprises to the scourge of the pandemic. Atlassian shares have risen 45% year to date, although they have been flat the last 90 days. By comparison, the IGV has risen by 33% YTD and has risen 20% in the last 3 months. So, whatever premium Atlassian has enjoyed because of some perceived tailwinds from reactions to the virus has been worn away significantly in the last 3 months
There is no real evidence that other than the advent of the economic contraction that Atlassian is seeing any long-term reduction in its growth rate. It has seen some users pause projects and seat additions, and other users churn-not, perhaps to a degree similar to that articulated by Alteryx (AYX) Thursday afternoon, but demand headwinds are blowing across most segments of the IT space with the exception of cyber-security. I will discuss some of the company’s growth drivers later in this article, but the company’s mainstream Jira product including its various flavors continues to be adopted as part of modern technology workflows. Indeed, it is my belief, that the additions this company has made to its product line have dramatically expanded its TAM, and that its highly efficient viral go to market motion continues to work well and should work well for the foreseeable future.
I think it is a mistake of the first water to view Atlassian as a middle aged software vendor with middle aged prospects. The pandemic is a headwind of indecipherable severity which is being dealt with more or less successfully by Atlassian using a variety of sales tactics which will have different impacts over different time scales. But the company is doubling down of growth investments, and those should substantially reaccelerate growth beyond the current consensus estimate of 22% shown by 1st Call as the consensus revenue growth forecast for fiscal 2021.
As mentioned, the company hasn’t provided full year guidance as a function of the uncertainties and lack of visibility caused by the pandemic and the unknowable impact of the economic contraction on its ability to achieve its sales objectives. I think that analysts who have cited the lack of full year guidance as a negative in evaluating the shares are not appropriately evaluating the company’s product set, its cloud transition strategy, and some of its newest and most unique offerings which are in the process of rolling out. This is not a company rolling into senescence; it is a company lead by two incredibly productive and knowledgeable tech entrepreneurs who are driving the business toward new opportunities.
In my own model, I have used 12 month forward revenue estimate of $2.02 billion, which is based on revenue growth of 25% year on year. That is about 5% the current consensus, and but still implies a very modest percentage growth bounce back in the 2nd half of the year.
Atlassian shares have never been cheap-at least in the years since I have followed it. The company’s EV/S ratio, currently about 22X forward sales as I have calculated them, is about 20% above average for the company’s 30% growth cohort. I think the premium is well justified as the company has a unique business model which simply expressed trades off investment in sales and marketing for investment in research and development and provides users with pricing that is low enough to foster a viral use of the company’s offerings. The net of that strategy has been much higher operating margins than most companies of Atlassian’s size and growth rate cohort and its free cash flow margin of about 34% is at the top of the range for any of the company’s I evaluate.
Despite the pullback after the numbers were reported, the shares are up by 45% year to date, having made a new high just before earnings. The shares have fallen 11% since that point-it is a decent opportunity to either initiate or add to positions in this name, and one that I have taken in the high growth portfolio of Ticker Target, the service we offer investors. For growth stock investors, Atlassian is about as good a fit as they are likely to find in the universe of IT infrastructure names. A core holding in my opinion.
The specifics of the Atlassian Quarter
Late last week, Atlassian (TEAM) released the results of its most recent quarter. Not terribly surprisingly, the company substantially beat the prior consensus. The company reported 29% revenue growth reaching $430 million in revenue in the quarter, compared to the prior consensus revenue forecast of $409 million. In addition, the company’s EPS rose 25%, and was 25% above the prior consensus estimate. The results weren’t terribly surprising because Atlassian has beaten estimates/guidance consistently for some years now. It is what they do.
Also what they do is to guide to levels that frequently engender negative reactions. I am not terribly sure why that tactic would surprise analysts or traders-it has been going on for a long time now and it usually affords investors a decent entry point into the shares. Sometimes the guidance is worse than others-and it hasn’t been unknown for the company to provide an upside to guidance. But during the economic contraction of the magnitude through which we are now moving, articulating conservative guidance for Atlassian, and failing to furnish a full year forecast was probably a foregone conclusion.
The company added 3000 net customers last quarter, a substantially smaller add than in most recent quarters. Part of the reason for the low number of net adds was a function of a new free tier for pricing. This tier has substantial limitations in terms of capacity, support and overall functionality, but it is an important tool Atlassian has been using to attract new users during the current economic contraction. I have linked here to the specifics of the offer: Atlassian adds free tiers for Jira and Confluence
The company forecast Q1 revenue growth of 23%, essentially consistent with the pre-earnings release published estimate. The company’s forecast for non-IFRS EPS for the quarter was a couple of cents below the prior consensus at $.26-$.27. Essentially, the forecast is predicated on a spending plan that calls for continuing sequential investment in opex, with flat revenues. I would be surprised if Atlassian did not achieve substantially greater earnings and free cash flow than it has forecast.
Atlassian’s Pivot to the Cloud and its response to the challenges of selling in a constrained economy.
For the last several quarters, Atlassian management has been speaking about a product strategy that encompasses building what Mike Cannon-Brookes, co-CEO described as a “kick-ass” cloud offering. Of the company’s 174k customers, 150k use the company’s cloud products. That said, something like 75% of the company’s paid users continue to deploy some Atlassian products behind the firewall. The company has been offering those users specific transition assistance that allow them to migrate to the cloud without losing their investment in on-premise products that have been previously bought and paid for. By now, the company receives 60% of its revenues from subscription, and subscription revenues grew by 43% last quarter. Perpetual license revenues are no longer a major component of Atlassian’s income-they were less than 5% of revenues last quarter and fell 10% year on year and are expected to decline another 50% this coming year.. About 29% of the company’s revenues are coming from maintenance but as users transition to the cloud, maintenance revenues will probably reach an apogee sometime in this coming year.
In all, Atlassian’s transition to the cloud, which includes the aforementioned special offers for cloud migration and a free tier of cloud service as well, is probably shaving 500-800 bps of growth this year, and perhaps some lesser impact into fiscal 2021. But as with most such transitions, the costs being absorbed in the current fiscal year will positively impact revenues in future quarters. While there probably always be users of Jira who want to use it behind the firewall and supply their own infrastructure, I expect that the transition will be essentially complete within the next 12-18 months, and thereafter it will be producing benefits for the company.
At this point, revenues from Atlassian’s cloud offerings account for slightly less than 50% of Atlassian’s total revenue. On the other hand, 95% of Atlassian’s new customers sign up for the cloud versions of Jira, Confluence and other Atlassian offerings. :Last year, migrations from server to cloud increased by 60%. Atlassian management believes that its cloud users get a better experience using cloud solutions and ultimately wind up spending more on the company’s solutions and are less likely to churn and more likely to add seats and modules. So, as they describe it-a win/win. I would be surprised if the transition to cloud did not generate a substantial uplift in average revenues per user over the course of several years and self-evidently, the cloud is a more effective way for the company to distribute upgrades and enhancements to users.
Since Atlassian doesn’t have a significant direct sales force, this transition has to be fostered by product innovation, effective migration tools, partner services and discounts. Given the very long-lived nature of the infrastructure of what Atlassian offers, the economics of a transition to cloud is highly likely to produce extra growth for Atlassian that is really not yet baked into longer-term growth expectations.
Atlassian: Its parade of offerings just gets longer and longer
I think what investors sometimes miss when they consider Atlassian and its valuation is the rather unique business model the company maintains. The business model, which is part of the guiding philosophy of the founders basically since they launched the business after graduating the University of New South Wales, continues to feature an exceptionally high research and development expense ratio, and an exceptionally low sales and marketing expense metric. If I had to encapsulate the philosophy it is something to the effect that if you provide developers the tools to develop efficiently, and to enhance the experience of workgroups-or teams, you don’t need salespeople. Both of the co-CEO’s continue to be adjunct Computer Science professors at their Alma-mater and they have one of the strongest bromances I know of in the IT space. They are actually next door neighbors-although in their case that doesn’t quite mean the same thing it might mean to most readers-they own the two most expensive houses in Australia and I doubt that they borrow sugar across the back fence, although they were respectively the best man at each other’s wedding. When you buy Atlassian shares, part of what you get is a visionary management team with an exceptional track record of great decisions. It is my view that you cannot pay too much for great management-particularly in the IT space. That said, I do wish their staff would chip in and buy Messrs. Cannon-Brooks and Farquhar access to a barber and a new wardrobe. But that is just me-your 74 year old conservative writer.
Last quarter, the company’s research and development spend reached 63% of revenues on a GAAP basis, up 24% year on year. On a non-GAAP basis, the metric was 44%, up from 37% last year. In addition to spending what might only be considered a complete outlier on research and development, Atlassian buys technology-it bought Halp in May, and it announced the acquisition of Mindville in conjunction with this earnings release.
The point is that Atlassian spends a huge amount on product innovation, and that is one of the key reasons why it is not seeing any fundamental decline in percentage growth, and is unlikely to see any decline in that metric anytime soon. When investors look at Atlassian, they most often look at Jira-and so they should. But in addition to Jira, the company offers OpsGenie, a tool that is competitive with PagerDuty (PD), Datadog (DDOG), VictorOps ( owned by Splunk (SPLK), it offers Jira Service Desk, a competitor of NOW, and Trello, a list making/workflow tool. The Atlassian offering is extensive and I am not going to recapitulate all of it, but to an extent, when an investor buys Atlassian shares, they are buying far more IP per dollar” than is the case for many other IT vendors.
Atlassian doesn’t report its revenue by product type, but the products I have called out are surely components of IT infrastructure software experiencing very high growth rates, even if those growth rates are currently somewhat constrained in the economic environment wrought by the pandemic. In particular, OpsGenie, whose market is part is observability and IT asset management, has a TAM in the billions as does the company’s service desk offering.
Atlassian didn’t disclose the purchase price of either Halp or Mindville although I imagine it was barely more than trivial with Mindville somewhat larger than Halp. Halp is a tool that is said to be able to turn a Slack eco system into a kind of help desk. Mindville offers a product that models and manages assets and which was always built to integrate into Jira. Over time, a significant use case for Mindville is enabling Atlassian to be used for something called ITSM (IT service management). The service management space is quite large-the TAM is supposedly growing at 20%/year, and is supposed to reach $14 billion by 2025. In the study I have linked here: Cloud IT Service Management (ITSM) Market Size, Share 2025 Atlassian is ranked as having the highest strategic development index. The addition of Mindville’s solution, which had already been offered as part of the Atlassian Market Place probably will further cement the strong rating of Atlassian’s product offering.
The company’s business model-some specifics and thoughts about the coming year.
The company has a high, but not unusually high gross margin. Last quarter, the gross margin reached In 85% non-GAAP despite the free offerings and promotional migration pricing that was offered in the quarter. Gross margins actually improved from the 83% level reported the prior year, partially because of mix, and partially because of price increases the company has made over the course of the year.
In order to pay for the material investment the company makes in product development, it has perhaps the lowest sales and the company spent just 16% of revenues on sales and marketing in this latest fiscal year, compared to a ratio of 20% last year. I have to speculate that if this company raised its sales and marketing spend profile it could sell more product in the short term-but it relies on a viral approach to deliver leads-and overall the result of the strategy has been strong growth for years.
Overall, however, the combination of very high research spending, and very low sales and marketing spend has created a business model with a non-IFRS operating margin that was 19% last quarter, compared to 17% in the same quarter the prior year. Atlassian’s business model is certainly different, and it would not work the same way for company’s offering applications as opposed to the collaboration and infrastructure tools offered by Atlassian, I imagine.
The company has had a high-free cash flow margin; it was 33% last year, actually down slightly from 36% the prior year, mainly a function of the change in the company’s net loss on its capped call and exchange derivative transactions. That is more of a timing issue than a function of any change in cash generation; that metric more than doubled in Q4. In the past, Atlassian has not generated much deferred revenue. Many of its deals are monthly in nature, and even larger deals with enterprises have rarely seen lengthy duration and up-front payment terms. That might change over time as the company shifts more volume to the cloud where the largest users might be seeking larger, enterprise licenses. On the other hand, the company has been controlling its use of stock based comp and this will obviously limit the growth of cash flow. The company has had and will likely continue to have just minimal capex requirements.
The company has said that its plans include the hiring of 1000+ of “Atlassians” mainly in the development space. That is a huge number, given the base of about 4500 the company had at the end of the 2020 fiscal year. The company has said that it sees the pandemic as an opportunity to hire a large cohort of highly skilled developer resources. And the company is also continuing, as noted earlier, to continue to buy enterprises. Much of the focus of the company’s development efforts will be in what is called the DevOps space itself with a dozen new features, automations and integrations recently announced that promote the use of Jira as a single source of truth for developers. The company has seen its solutions in planning tools receive highly positive 3rd party evaluations.
The net of these plans is likely to constrain earnings growth, or turn it negative for a quarter or two in fiscal 2021. But ultimately, this kind of investment will result in a stronger level long-term growth and wider product differentiation, leading to more pricing power, and overall stronger margins.
I have covered many of the reasons why I believe this company should be valued at a significant premium compared to many peers. Strong leadership, high margins, major IP differentiation, a record of accretive acquisitions and a culture of innovation are all factors that should be weighed when evaluating Atlassian as an investment. Ticker Target has a portfolio weighting in the shares of more than 8%.
The shares currently have an EV/S of just less than 21X, about 20% above average for the company’s low 30% growth cohort. On the other hand, its free cash flow margin is amongst the highest of any of the companies that I follow, rivaling that of Veeva (VEEV). I think there is plenty of positive alpha in this name and I think anyone interested in a growth portfolio in the IT space should consider this name.
Disclosure: I am/we are long TEAM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.