In 2022, the market stopped caring about flat-out speedy growth and started paying more attention to profitability -- a lot more attention. Tech companies in particular that have been growing like weeds but have yet to turn an honest penny of profit got clobbered.
Atlassian (TEAM -3.23%) fell into this category of especially beaten-down stocks. Shares of the work-collaboration and IT service-management company fell a whopping 66% in 2022. And that knocked the Australian company out of the top 20 software technology companies in the world (as measured by market cap).
What will it take for Atlassian stock to begin making a comeback in 2023?
Revenue growth isn't the problem here
Atlassian -- a play on the name Atlas, who in Greek mythology was condemned to hold up the sky -- hasn't been able to support deteriorating investor sentiment as of late. Weighed down by a growing laundry list of issues, the market severely punished the company's shares. Some of these issues are external, others internal.
First, the external factors: Not unlike other software companies, Atlassian experienced slowing paid subscriptions for its software. With the global economy worsening, organizations now spend far more cautiously than they were just a few months ago.
The good news is that for Atlassian, this slowdown equated to 31% year-over-year revenue growth to $807 million in the last reported quarter (the first quarter of fiscal 2023, ended in September 2022). The company expects second-quarter 2023 revenue to be $835 million to $855 million, up just 23% year over year at the midpoint of guidance.
All of this expansion is delivered despite a strong U.S. dollar, which lowers the value of an international sale (Atlassian is now domiciled in the U.S. for tax purposes).
The company clearly has been able to hold its own even as cloud-native peers like Asana and Monday.com cranked up the competition in recent years. Organizations are still migrating their operations to the cloud, a big tailwind for Atlassian while it completes its own migration away from legacy software.
But what about internal factors that are more within Atlassian's control? It's noteworthy that the company continues to execute well as it develops new uses for its software suite, helping it to continue its strong momentum. Growth isn't the problem the market has had with Atlassian, though; profitability is the issue.
Net loss under generally accepted accounting principles (GAAP) was $13.7 million in the last reported quarter. Free cash flow was positive $75.9 million in the first quarter. What caused the discrepancy between these two profitability metrics?
A $43.1 million noncash gain on investments was a positive that actually helped the net loss come in lower than what would have otherwise been reported. But employee stock-based compensation was the primary culprit for losses. Stock-based compensation was $174 million in the first quarter.
How can Atlassian start to turn the tide?
Stock-based compensation isn't a new problem for Atlassian. New stock issued to employees has been going on for many years, as it has been for most other computing-tech companies. The problem, though, is that as stock prices took a hit and market capitalizations fell, the dilution for existing non-employee shareholders increased.
Stock-based compensation totaled $780 million at Atlassian over the last 12 months (or 2.4% of the current market cap). For full-fiscal year 2023, Atlassian management expects a 2% increase in total share count compared to the end of last year.
Besides a sky-high valuation in 2021, the big discrepancy between net loss versus free cash flow just about sums up the market's beef with Atlassian over the last year. Until the company starts reporting positive net income, shares could continue to struggle into 2023, especially since this is still a premium-priced stock. Even on a free-cash-flow basis, shares trade for 39 times trailing-12-month profitability.
What can Atlassian do to turn shareholder confidence around? Improving its GAAP operating margin will help. Despite slowing growth, management said to expect adjusted margins to come in somewhere in a mid-teens percentage for fiscal 2023. That seems to imply the company is beginning to be a bit more cost-conscious.
As for stock-based compensation, these situations aren't fixed quickly. Stock given to employees is usually done under a long-term contract. What Atlassian could do, though, is initiate a stock-repurchase plan using its free cash flow.
Other cloud software companies, like Zoom Video Communications and Palo Alto Networks, have begun to do this to offset the effect of dilution on ordinary shareholders. Atlassian has generated more free cash flow in the last year than it's paid out to employees in the form of stock.
Data by YCharts. TTM = trailing 12 months.
However, Atlassian gave no indication it plans to use its free cash flow in this way. It could certainly happen, though, especially when factoring in the solid balance sheet that has $1.5 billion in cash and short-term investments and $999 million in debt.
Given the present situation, I'd be cautious with Atlassian stock at the start of 2023. The market's sentiment in favor of companies that are growing slower but are already profitable looks poised to continue for now.
