Atlassian – Teamwork makes the Dream work (Part 2)

This is a continuation of a previous post where I touched on various aspects of Atlassian’s business model. If you have not read it, click here to read it 🙂

Atlassian’s top Priority – Atlassian Cloud

The Atlassian Cloud is the absolute number one priority for Atlassian at this point of time. It is discussed widely in earnings calls, investor presentation materials, media interviews and etc.. In the words of Mike, Atlassian’s cofounder:

“The most important strategy is just building a kick-ass cloud offering”

“Second most important strategy, as we would say is reducing the fiction that takes for customers to move over to the cloud”

Source: Q4 FY20 earnings call

Back in FY15, Atlassian’s management recognized that they were in the middle of an inevitable shift towards cloud-based enterprise solutions aka SaaS offerings. Any inertia to transit their suite of products from IaaS to SaaS, could render them obsolete in the near future.

Furthermore, being in the cloud not only increases the speed of the innovation they can offer to customers, it also enhances user scalability. A cloud first business fits snuggly into their business model.

Acknowledging this paradigm shift, Atlassian has taken coherent actions with measurable goals, unveiling a 3-stage plan to migrate its products and new offerings into the cloud

The implications for this shift towards a cloud first business are imperative as it changes the revenue economics. In the short run, a subscription model results in revenues that are lower relative to the license + maintenance model.

However, a subscription model not only injects greater certainty due to the nature of recurring revenues, it results in a larger cumulative revenue in the long run. See the picture below.

In the recent letter to shareholders, Atlassian has demonstrated that they are well on track with their cloud journey. Some excerpts below:

“Key milestones include: forking our code-base to improve the cloud performance in fiscal 2017, migrating our infrastructure to AWS and becoming multi-tenant in fiscal 2018, and building several common services to boost development speed and better integrate our cloud products between fiscal 2018 and fiscal 2020”

“As a testament to our cloud development capability, Access, the first product built natively on our platform and launched two years ago, just reached 1 million paid users”

Atlassian’s priority to move into the cloud is a decision based on their guiding policy to focus on the long term and to continuously innovate. However, a migration of such a scale entails significant execution risk that should not be overlooked. Investors should look out for management’s ability to stay on track with the cloud expansion action plan.

Atlassian’s Management

Atlassian is currently led by its cofounders, which is a very reassuring and positive sign given that founders are usually emotionally and monetary vested for the long run. Their company is effectively one of the most important thing to them and they have a burning desire to ensure the continued success of their company.

Cofounders and CoCEOs – Michael Cannon Brookes(left) and Scott Farquhar (right)

Mike and Scott received a base compensation of USD51k and USD55k respectively in year 2020 – perhaps even lower than some of you readers. Both had opted for their base salaries to be reduced to AUD $74,653.28 – the annualized statutory minimum wage in Australia. Both also opted not to participate in the company bonus plan during the fiscal year ended June 30, 2020.

Instead, both are significantly vested, with each owning a 23.91% individual equity stake in the Company. To put things in perspective, Microsoft CEO, Satya Nadella only owns 1.36% of the company.

The only other information regarding compensation policy is that Atlassian paid a total of ~USD 3.5mil to its executive directors in FY20, which turns out to be roughly USD 700k per director, excluding the coCEOs. As Atlassian is a foreign private issuer, it is exempted from the SEC and Nasdaq rules governing proxies where compensation information is usually available. Without further information furnished by the company, it is difficult to evaluate Atlassian’s compensation strategy.

It is important to own companies that have a compensation plan which aligns with shareholder interests. Having a compensation plan that comprises largely of equity remuneration means that the management has skin in the game. If a CEO has a considerable portion of his/her personal wealth vested in the company’s equity, it instils a degree of confidence that the CEO will make the right decisions given that he/she is monetary aligned with shareholders.

Atlassian’s Financials

I will run through key headline numbers quickly as I feel that the information is easily accessible via MacroTrends. To find out more about the resources I use, click here.

FY 2020

Revenue: USD 1,614.20 mil, YoY growth of 33.38%
Customer Base: 174,097
Gross Margins: 83.35% of total revenue
R&D expense: 47.30% of total revenue
S&M expense: 18.57% of total revenue
G&A expense: 16.63% of total revenue
Debt: USD 1,153.80 mil
Cash & Equivalent: USD 2,156.00 mil
FCF: USD 532.30 mil

To be honest, Atlassian’s financial numbers are pretty good. I like that revenues have been growing at roughly 30+% CAGR and gross margins are healthy for a software company. There’s significant R&D spending, low S&M expense, and low CAC which is consistent with what was discussed. Balance sheet is robust with cash & equivalents more than sufficient to cover total debt. FCF has been consistently positive and trending higher, which is a great sign.

While net income is still negative, I’m not too worried about that. I do not place excessive emphasis on the net income number as I feel that current accounting standards understate the net income of software companies.

Software companies expense a significant portion of their intangible investments in R&D and S&M which translate to a depressed net income figure in the income statement.

In my opinion, some of the R&D and S&M expenses should be capitalised instead. The challenge lies in segregating R&D and S&M expenses into maintenance expenses vs value adding investments – a topic that I will certainly revisit in the future!

Software Metrics

Aside from traditional financial ratios, common metrics to measure performance of SaaS companies include Customer Acquisition Costs (CAC), Churn Rate, Lifetime value (LTV), Unit Economics, Dollar Based Net Expansion Rate (DBNER) and Average Revenue Per User (ARPU). I will cover these in detail in a future post.

Industry specific metrics:
CAC: FY 20 – USD 14,024.33, FY 19 – USD 10,522.81
ARPU: FY 20 – USD 9,271.84, FY 19 – USD 7,923.28 (Not representative)
Unit Economics: Not representative
LTV: Not representative
Retention Ratio: 98% for customers who spent above 50k
DBNER: Not available

CAC seems to have nudged up recently from roughly USD 10.5k in 2019 to USD 14k in 2020. This is understandable given that along the adoption curve, early adopters are the easiest to acquire. Subsequently, it becomes increasing expensive to acquire additional customers further out.

However, if CAC continues to increase without proportional increase in revenues, it might be a sign that the adoption curve is flattening out for current use cases. Atlassian management would have to relook its resource allocation in the user growth and product expansion flywheel.

Fueling the flywheel is an intricate matter, a persistent increase in CAC could reflect that the management is getting some part of the equation wrong.

Atlassian also reported that it has more than 174,000 customers using their software today, with 5,892 customers paying in excess of $50,000. Some quick math and you will realize that customers paying in excess of $50,000 make up a mere 3.38% of Atlassian’s total customer base.

This indicates that customer revenue is skewed heavily to the right. In simple terms, a small group of customers account for the lion share of Atlassian’s total revenue. ARPU therefore, overstates what the median customer is actually paying.

The good news is that retention rate for customers paying above $50,000 is at 98% for now. This is a key figure I would watch as any reduction in retention rate has a non-linear impact on overall revenues.

Conclusion

In my opinion, Atlassian is a high-quality company.

It has astutely leveraged on the user growth and wallet share expansion flywheel to grow to where it is today. Their distribution strategy and guiding policies are highly aligned to drive the flywheel momentum.

Mike and Scott have a proven track record, led by example, built a fantastic culture (see glassdoor) and are in it for the long run. They recognize challenges that Atlassian faces going forward and have outlined an actual strategic plan to tackle the challenges instead of setting fluffy goals /objectives.

Nonetheless, it is critical to keep an eye out for any tell-tale signs that the value proposition of Atlassian has changed. These includes:

  1. Inefficient migration of customers to the cloud
  2. Exponentially increasing CAC without proportional increase in revenues
  3. Stagnation of product offerings / new features
  4. Declining retention ratios

Moving to a cloud first business and the resulting increased pace of innovation poses significant execution challenge for Atlassian. This might pressure the management to conduct suboptimal acquisitions to engineer growth in the short term which is a dangerous path to go down.

At it’s current price of $190, it translates to a market cap of ~$48billion, translating to a P/S ratio of 29x. While the argument can be made that covid-19 has supercharged the tailwind that Atlassian has been riding on, I personally feel that it is too expensive to buy into Atlassian at this point of time.

Assuming that Atlassian’s P/S ratio tapers down to 10x in 5 years’ time, investors are pricing in a CAGR of roughly 25%. This might seem potentially achievable if you extrapolate current trends, but the margin of safety is simply too little for me to be comfortable with. For now, I’ll stick to the side lines for Atlassian.


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3 thoughts on “Atlassian – Teamwork makes the Dream work (Part 2)

  1. Interesting read. I do agree that the retention numbers are impressive and shows that they are indeed a high quality company with a quality software products. Will keep them in my watchlist and hopefully we can buy the dip, maybe following the upcoming US election. We shall see…

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