Atlassian: Outperformance Has Already Been Priced In
Summary
- Atlassian shares fell modestly after reporting Q3 results, despite beating Wall Street's expectations on the top and bottom line.
- Prior to reporting, Atlassian had been trending near 52-week highs on expectations that the company's collaboration tools would see strong sales amid the remote work trend.
- Though Atlassian continued a strong growth trajectory, the company decelerated in Q3 and expects to continue decelerating sharply into Q4.
- Trading at an astronomical low-twenties revenue valuation multiple, Atlassian is unlikely to outperform the broader market.
Atlassian's (NASDAQ:TEAM) business model seems to have been perfectly built for the coronavirus crisis. Its suite of products, including its flagship JIRA software, are oriented around helping teams manage workflows and collaborate remotely, giving the company a boost in a time when many office workers around the globe have had to lean on digital collaboration tools often for the first time. In addition, Atlassian has long leaned more heavily on a "pull-in" sales strategy that didn't heavily employ high-touch sales executives. In a time when the coronavirus has hampered business travel and prevented software salesmen from making calls on their prospects, investors were right to assume that Atlassian's revenue base would be relatively less affected than other technology companies.
Yet after Atlassian reported third-quarter results, we can see that the stock's outperformance since the beginning of the year (+27% year-to-date, slightly edging out against Amazon's (AMZN) gains over the same timeframe) has already priced in some of this strength. And investors who were hoping that Atlassian's historical growth rates in the high 30s could sustain throughout the rest of the calendar year were disappointed when Atlassian forecasted a continuation of deceleration.
Data by YCharts
I admire Atlassian as a company with a market-leading product. Gartner Research, the leading software industry analyst and observer, has long rated Atlassian as one of the leaders in the enterprise planning and collaboration space, and its growth to >170k customers as of the end of Q3 at a ~20% growth rate reflects the sheer popularity of a product that doesn't rely on being pushed by a direct sales force.
But given all the love that investors have shown the stock this year, and the fact that it has vaulted to a >23x forward revenue multiple (versus valuation multiples in the high teens last year, and most other software companies in the 30-40% y/y growth bucket trading at high single-digit or low teens valuation multiples), Atlassian is unlikely to continue outperforming the broader market. Indeed, the fact that Atlassian trades at a richer multiple of forward revenue than the S&P 500 is trading as a multiple of GAAP earnings is a testament to buildup of enthusiasm on this name. Already we've seen stocks like Zoom (ZM) unwind some of its year-to-date gains; with revenues expected to decelerate, Atlassian is unlikely to be any different.
At the same time, Atlassian's rich operating margins (driven, again, by its lack of a sales force that consumes the majority of competing SaaS companies' operating budgets), free cash flows ($140 million in Q3 alone) and strong balance sheet prevent me from being overly bearish on the stock. Keep watching price movements in this name, but don't be tempted to buy any near-term dips.
Deceleration is inevitable; Q4 guidance points to further slowdown
Over the past several quarters, the biggest question surrounding Atlassian was whether the company would be able to continue growing at its high-30s pace, because the company's rich valuation multiple is tied to the promise of excessive growth rates. In bidding up Atlassian shares this year, investors were betting that its popularity as a collaboration tool would rise amid the remote work requirements.
But while Atlassian has continued to grow, we didn't see any breathtaking surge in growth like we did at other companies, like Citrix Systems (CTXS) - which saw growth soar from the low single digits to 20% y/y. Atlassian's total revenues grew 33% y/y to $411.6 million, beating Wall Street's expectations of $396.2 million (+28% y/y), but decelerating four points over last quarter's 37% y/y growth rate.
Figure 1. Atlassian Q3 revenue trends
Source: Atlassian Q3 shareholder letter
All components of Atlassian's revenue fell, including and especially its critical subscription piece. As seen in the breakdown below, subscription revenue growth fell below 50% for the first time, and was also unable to offset perpetual license revenues slipping negative for the first time:
Figure 2. Atlassian revenue growth by category
Source: Atlassian Q3 shareholder letter
Some investors were hoping that the tailwind effects from remote-work would only partially begin in March and benefit Atlassian through its fiscal fourth quarter, as the depths of the coronavirus impact were only truly felt in April. But Atlassian's guidance for Q4, which covers the quarter through June, implies that this isn't the case. See the company's guidance and accompanying commentary below:
Figure 3. Atlassian guidance update
Source: Atlassian Q3 shareholder letter
The key pieces here: Atlassian's revenue range of $400-$415 million (+20-24% y/y), represents growth slipping by as much as thirteen points sequentially. Of course, Atlassian typically sets its own bar fairly low and will likely achieve the higher end of that range, but it's clear that investors were hoping for much more, especially with the supposed lift from remote work demand. Wall Street, in particular, had a consensus Q4 revenue target of $418.4 million, or +25% y/y. And note that while Atlassian expressed its confidence in the fact that it has 85% recurring revenues and draws 90% of its revenue from existing customers rather than from new deals, it cited "early Q4 data" to note that the negative impacts of the coronavirus would outweigh any positives. This is particularly because Atlassian's customer base skews toward smaller companies (particularly, small tech and software startups) that have seen a spew of layoffs since the coronavirus began, and thus a lower need for seats on Atlassian's platform.
The good news: profitability is still holding up
The better side of the coin, in my view, is the fact that Atlassian has been able to maintain a rich fountain of profits even amid softening growth rates. Many of the larger-cap SaaS software companies around Atlassian's size, like Salesforce (CRM) and Workday (WDAY), have long struggled to meet investors' demand for greater operating leverage and profitability, but Atlassian has long been able to maintain rich operating margins.
Q3 was no different. Despite a slight 50bps drop in pro forma gross margins (we note that Atlassian's gross margins in the mid-80s are sky-high, even for the software industry), Atlassian managed to slightly scale down both R&D and sales/marketing expenses as a percentage of revenues to keep pro forma operating margins flat at 18.8%.
Figure 4. Atlassian margin trends
Source: Atlassian Q3 shareholder letter
Atlassian's third-quarter free cash flow also grew 10% y/y to $140.3 million, and the company says that it's on track to deliver up to $475 million in free cash flow for the full year. Alongside a balance sheet that holds $2.07 billion in cash and no debt, Atlassian is one of the most liquid companies in the software sector - amid a time when liquidity concerns have forced investors to stream out of some of the smaller, faster-growing software stocks.
Still, we note that these rich margins and cash flow are already captured in Atlassian's valuation. At current share prices near $155, Atlassian's market cap and enterprise value are $37.94 billion and $35.87 billion, respectively; the latter carries a valuation multiple at ~75x EV/FY20 free cash flow, which is a heady multiple in a down market that has put many other stocks at fire-sale levels.
Key takeaways
The bottom line on Atlassian: investors had pumped up this stock in the hopes that the company would issue guidance pointing to more robust remote work-driven demand lifts, but Atlassian's outlook for continued deceleration in Q4 has quelled those hopes. With no near-term catalysts on the horizon, it's difficult to see Atlassian's valuation multiple expanding materially from its current ~23x forward revenues and ~75x FCF, already pushing the upper bounds of reasonability. Stay on the sidelines here.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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