Atlassian (TEAM 8.39%) is riding the trend of digital transformation, with its team-productivity software driving its stock up more than 60% this year. Given this momentum, some may have been surprised when the company made an announcement that would disrupt a large set of its important customers: It is ending support for its server products that customers have installed in their own data centers.
Let's take a closer look at what's actually happening here and what it might mean for investors.
What's going on?
Customers have three ways they can install Atlassian's software for users. The most popular option is its cloud-based offerings, which 95% of new customers choose because of the easy start-up, automatic upgrades, and scalability. A second option is a server version that allows customers to install the software in their own data centers and control when software upgrades happen. The company will be ending its support for this version in the coming years. Management estimates that 30,000 customers (out of 182,000-plus) and 75% of the user base will be affected.
Image source: Getty Images.
But for customers who aren't quite ready to commit to the cloud, the third option may be appealing. Its data center products are somewhat of a hybrid of the previous options and provide many of the benefits of cloud (scalability, high availability, and disaster recovery) but with the benefit of on-premise control of hardware, data, and the upgrade cycle. Another benefit of this version is that it is "cloud-ready" and can be migrated to third-party clouds such as Microsoft's Azure and/or Amazon Web Services (AWS) easily. The product is priced like a cloud-based subscription with monthly fees and maintenance and support bundled in.
As customers make decisions on how to proceed, the Atlassian team is committed to ensuring its customers are supported and happy.
Taking care of customers
A core value at Atlassian is "Don't #@!% the customer," and that certainly applies here. The company is going out of its way to ensure customers have a smooth transition. It is providing free migration kits along with substantial documentation on how to ensure a successful migration. Any customer on a maintenance plan gets free access to cloud versions of the software to enable testing before they make the big switch. Additionally, customers transitioning with more than 1,000 users will receive discounts over the first three years using the cloud: 55% discount for year one, 40% for year two, and 20% for year three.
Customers will also have plenty of time to switch. Here's the timeline.
- Feb. 2, 2021: New license sales will stop and on-premise prices will increase 15%
- Feb. 2, 2022: Upgrades will end for server licenses
- Feb. 2, 2024: End of support for all server products
With all of this going on, Atlassian's financials will see some changes over the next few years.
Caution: Financial statement road work ahead
Today Atlassian reports its revenue in four different segments shown in the table below.
|
Metric |
Q1 FY2021 revenue |
% of total revenue |
Year-over-year growth |
|---|---|---|---|
|
Subscription |
$278 million |
60% |
38% |
|
Maintenance |
$128 million |
28% |
16% |
|
Perpetual license |
$22 million |
5% |
(11%) |
|
Other |
$32 million |
7% |
15% |
|
Total |
$460 million |
100% |
26% |
Data source: Atlassian's earnings report. Table by author.
Each one of these product segments will be affected by the transition to the cloud. Let's look at what management indicated would happen to each as the transition unfolds.
Subscription revenue: This includes fees generated by its cloud-based and data center products. This will continue to grow at a rapid pace as new customers join the Atlassian fold and existing customers migrate to the cloud or the data center products. The growth of this segment should accelerate as existing server customers start paying monthly subscription fees.
Maintenance revenue: This segment is related to customer support costs for the server products that are being sunset. Management indicated that revenue is expected to remain flat going into next year. This category will eventually go to zero as customers move away from the server products over the next three years.
Perpetual license revenue: This is the licensing costs for its server products and will decline by approximately 50% in the coming year. Starting in February, prices will increase by 15%, but that will only encourage customers to move to the cloud. As legacy customers move to subscription-based pricing, it won't totally offset the loss in perpetual license and maintenance revenue.
Other revenue: This category is related to the fees the company receives from its third-party application marketplace. Management indicated that this category is expected to be flat going into the next year.
Other financial effects: In addition to the above-mentioned revenue changes, the company will also see declines in free cash flow, gross margin, and operating margin. As the company incurs costs related to the transition without higher revenue, margins will be squeezed, and as lump-sum payments for perpetual licenses decrease, cash flow will decline too. These changes may seem concerning for investors, but the company is on solid financial footing and is in a great position to embark on this transition that will enable it to emerge even stronger on the other side.
The bottom line for investors
Atlassian's leadership is simplifying its product lineup to "double down" on its cloud strategy. This move will enable its product development team to be more efficient and provide more value to customers over the long term. The road ahead won't be without some minor bumps and scrapes, but the company is committed to ensuring that customers transition successfully.
Understanding the details behind this transition should make shareholders more comfortable with management's plan and its commitment to the long-term success of the company. As a shareholder, I'm looking forward to watching Atlassian's progress as it goes all-in on the cloud, and I won't be selling this growth stock anytime soon.
