Technology stocks have been hit hard in 2022, and Atlassian (TEAM -2.58%) is no exception. The tech-heavy Nasdaq Composite index has fallen about 13.7% year to date, but Atlassian stock is down about 30% over the same period.
This fall, however, has not been because Atlassian hasn't performed well this year. The company has seen success and is gaining steam in the work management software industry. Atlassian is one of the top dogs in a market estimated to be worth nearly $29 billion a year.
That leadership advantage isn't the only reason that Atlassian is poised to capitalize on this huge opportunity. Here are three reasons why Atlassian has what it takes to continue dominating its market.
1. Atlassian's transition to the cloud is going well
Atlassian has historically operated with products in three categories: the cloud, data centers, and servers. Cloud solutions are pure software-as-a-service solutions hosted by Atlassian, whereas server solutions are on-premises versions of the company's software, with the data center being a hybrid mix. However, the company announced it is getting rid of its server solution in a strategic move to the cloud. Atlassian has been slowly easing customers off the server products, and it recently stopped upgrades to those licenses. In 2024, it will finally end server product support as a whole.
What does this mean for investors? Short term, Atlassian could see muted growth because of this shift. After all, Atlassian is spending money to help these customers make the shift, but customers aren't increasing their spending yet. This has impacted the company's profitability. In its fiscal Q2 2022 -- which ended Dec. 31, 2021 -- Atlassian's gross margin dropped to 83.3% from 84.1% in the year-ago period. Additionally, the company expects gross margin to decline to 82.5% in fiscal Q3. Its free cash flow margin has followed suit, dropping from 36% in fiscal Q2 2021 to 29% in fiscal Q2 2022.
While this shift might have a negative impact in the short term, Atlassian management believes that this shift will result in customers spending more money over time. Server customers pay an annual maintenance fee for their product, whereas cloud customers pay a monthly subscription fee and can easily add more products to enhance their usage of Atlassian. Because of this, Atlassian estimates that a large customer spending $30,000 annually on the platform as a server customer would end up spending roughly $94,500 annually three years from now if they became a cloud customer.
2. Atlassian is a top dog in a competitive space
Many investors have shied away from Atlassian because of competition from heavy hitters like Monday.com and Asana. That said, Atlassian stands out. It operates in three product segments: development operations, IT service management, and team management. Most work management platforms focus on one of these spaces, which gives Atlassian an edge: It can be the one product that an enterprise uses across its entire business rather than having one for marketing teams, another for IT, and a third for developers.
This has resulted in amazing adoption for Atlassian: It has more than 226,500 customers. What is especially impressive is the diversity of these customers. Across its three big products -- Jira Software, Jira Service Management, and Confluence -- its customers are split roughly evenly between technical and nontechnical teams. This reinforces the concept that Atlassian was built for, and can be used by, everyone.
3. Atlassian has a relentless focus on innovation
Another thing that makes Atlassian special is its focus on development. The company spent nearly $655 million on research and development (R&D) expenses in the first two quarters of fiscal 2022 (which ends June 30), more than double what it spent on sales and marketing (S&M). Traditionally, software companies have to spend hand over fist on marketing to gain share. Atlassian, however, has one of the highest R&D budgets and lowest S&M budgets as a percentage of revenue when compared to competitors. This shows the company's unparalleled focus on innovation, which could pay off in the future.
There are downsides to this focus on development, however. Because the company wants to develop the best product, Atlassian has to hire the best developers in the world, who require expensive salaries that are often bolstered by high amounts of stock-based compensation. Atlassian spent almost $220 million on stock-based compensation awards to R&D employees alone in the first six months of fiscal 2022, which not only hurts its profitability but also dilutes shareholders.
What's the investor takeaway here?
While there are downsides, Atlassian looks incredibly strong. Its competitive advantages set it far apart from the competition, and it has durable strengths that could allow it to gain market share in this competitive space. Atlassian's valuation has fallen to 27 times sales -- a high valuation but much lower than it has been in recent history. Because of its still-high valuation, this stock might not be one to go all-in on, but it is certainly deserving of a spot in your portfolio.