ASAN - Atlassian: Growth Stalling And Profitability Under Pressure

2023-07-07 12:43:21 ET

Summary

• Atlassian Corporation stock faces a negative risk-reward profile, leading to a recommended sell rating.
• The company's revenue growth rates are slowing down, particularly in the cloud segment, with weaker profit margins compared to its premise business.
• Customer growth rates have been moderating, especially among small and medium-sized businesses, impacting Atlassian's market performance.
• Atlassian's profitability doesn't support its current valuation, with decreasing non-GAAP operating margins and challenges in achieving operational leverage.

Investment Thesis

Atlassian Corporation ( TEAM ) is priced at 38x forward non-GAAP operating income. Not this year's, but next year's. This is not a multiple that makes much sense, given that Atlassian's growth rates are clearly slowing down.

Then, to further compound matters, Atlassian's fastest growing business line, its cloud segment, holds weaker profit margins than its premise business.

Altogether, I believe that this stock provides a negative risk-reward. So, I'm asserting a sell rating on this stock.

What Does Atlassian Do? Why I'm Bearish?

Atlassian is a collaboration and workflow company. It's a bit similar to Asana, Inc. ( ASAN ) if readers know that business. Both companies provide collaboration tools for project management.

But Atlassian has a much broader use case. For instance, Atlassian has Jira for issue tracking and Confluence for documentation. Whereas, Asana is predominantly focused on project management and team collaboration.

Also, Atlassian's Jira platform can be highly customizable, so it's often used a lot amongst developers and startups.

In fact, I believe that's part of the reason why I believe so many of Atlassian's shareholders are developers. Because they use Atlassian's products and want to invest in the company since they are already familiar with the company's offerings.

Moving on, in my previous analysis I said ,

[...] at the price Atlassian trades for, everything needs to be sparkling clean. And that's not the case here.

Since I made that declaration, Atlassian's share price has actually moved higher.

Consequently, I now make the case that the stock has got ahead of itself, therefore, I'm asserting a sell rating on this stock as we head into its fiscal Q4 2023 earnings in a few weeks' time ( earnings expected July 28).

Revenue Growth Rates Are Moderating

Here's my core argument: Atlassian's revenue growth rates are moderating. This is no longer a company that can be relied on for hyper-growth of 30% CAGR.

Coming out of the pandemic, there was a lot of software adoption across IT departments amongst both big and small players.

However, right now we are entering a period of ''software digestion.'' There's broad vendor consolation across IT departments. But particularly amongst small and medium-sized businesses, or SMBs, which are Atlassian's main segment of the market.

Reinforcing this insight, consider this recent quote from Atlassian's management:

So, we offer free versions of all of our products today.

And so we're seeing a slower rate of conversion from people upgrading from those free products to paid plans . I think it's important to remember, at the top of the funnel, the number of people clicking into trying versions of our products and stepping into those free instances of our products, that continues to grow in a really healthy way on a year-over-year basis, but there is a lower conversion rate of people hesitating to convert into one of the paid plans. (Emphasis added.)

In fact, I'd already made this argument in my previous analysis,

• In Q1 2023 customer growth rates: 15%
• In Q2 2023 customer growth rates: 12%
• In Q3 2023 customer growth rates: 11%.

The only difference now is that Atlassian believes that their customer adoption curve is likely to be continuing to slow down. Rather than playing down this trend, Atlassian believes they need to get ahead of this reality and start to manage investors' expectations.

Profitability Doesn't Support Atlassian's Valuation

All of these insights enclose this critical aspect, that Atlassian's business is not benefiting from operational leverage by having more revenues to work with.

To put this more concretely, fiscal Q3 2024 saw Atlassian's non-GAAP operating margins end at 22%. While its guidance for fiscal Q4 2024 points to about 17%, including the 200-basis points one-off add-back related to employee and lease-related expense savings.

Supporting this statement, consider this quote from Atlassian's management team which follows,

[...] the cloud does have lower gross margin profile than data center [on-premise business] as we have to incur the hosting costs in a cloud world versus data center where customers are incurring that.

Given everything we've discussed, I don't see much room for the stock to rerate higher. To be more specific, let's make the assumption that Atlassian's non-GAAP profitability reaches $1.1 billion in fiscal 2025 (next year).

This would leave the stock priced at 38x next year's non-GAAP operating income. That's fair from an attractive point for a company with slowing revenues.

The Bottom Line

I find Atlassian Corporation stock to be overpriced with a negative risk-reward profile, leading me to assert a sell rating on the stock.

The company's customer growth rates have been moderating, particularly among SMBs, which make up a significant portion of its market.

Additionally, Atlassian's profitability doesn't align with its valuation, with non-GAAP operating margins decreasing and its cloud business impacting gross margins.

Considering these factors, coupled with a high forward non-GAAP operating income multiple, I believe there is limited room for the stock to rerate higher. Therefore, I assert a sell rating on Atlassian Corporation stock as we approach its fiscal Q4 2023 earnings release.

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