Collaboration and project management software provider Atlassian (TEAM +5.81%) is in the middle of transitioning its customer base to the cloud. The company's traditional business of selling software licenses for its products, which include issue tracking tool Jira, collaboration tool Confluence, and a handful of others, is being phased out in favor of cloud subscriptions.
The cloud business has been growing swiftly over the past few years, more than offsetting any declines from legacy software license sales. Part of that growth is driven by migrations of existing customers – the company plans for about 10 percentage points of cloud growth to come from migrations. The rest is driven by new customers jumping on the Atlassian bandwagon, as well as existing cloud customers growing their spending.
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Key Data Points
A tough economy slows things down
In the third quarter of Atlassian's fiscal 2022, which ended on March 31 of that year , cloud revenue grew by 60% year over year. In the third quarter of fiscal 2023, results for which Atlassian reported on May 4, the cloud business suffered a meaningful slowdown. Cloud revenue rose by just 34%, and with a portion of that coming from customer migrations, growth in cloud revenue from new customers and existing cloud customers was likely a mid-20s percentage.
Overall, Atlassian reported revenue growth of 24% year over year, down from 30% growth in the prior-year period. The company won nearly 6,600 net new customers during the third quarter, bringing its total customer count to just under 260,000. On a year-over-year basis, the customer count grew by about 11%.
The sluggish growth in the cloud business is partly due to a worsening economic environment. Not only are existing cloud customers slowing down seat expansions, but some customers that have announced layoffs have reduced seat counts. What's more, the free-to-paid conversion pipeline isn't what it used to be as non-paying users opt to stick with the free plan.
For the fourth quarter of fiscal 2023, Atlassian expects cloud growth to slow further. The company sees cloud revenue growing by just 26% to 28% year over year, bogged down by customers reacting to an uncertain economic climate. While Atlassian hasn't yet seen any issues with churn or upsells to pricier subscription plans, the company does expect some headwinds in those areas to emerge.
A pricey stock
Atlassian has some major competitive advantages. For one, Jira has been around for two decades, gaining mindshare and market share along the way. In the world of issue tracking tools, Jira is the de facto industry standard.
Once the economic picture brightens, Atlassian should have little trouble reaccelerating its growth as customers become more willing to expand spending, and as potential customers stop worrying so much about cutting costs.
However, this long-term potential must be weighed against the valuation. Shares of Atlassian tumbled on Friday following the earnings report, dropping around 11% by midday. That rout brought the company's market capitalization down to about $34 billion.
Atlassian the stock has two problems. First, the market cap relative to sales is high for the current market environment. With analysts expecting sales of $3.5 billion in fiscal 2023, the stock trades for nearly 10 times sales. Other formerly high-flying software stocks that rallied during the pandemic have seen their own price-to-sales ratios contract well into the single digits when things started to go wrong.
Second, Atlassian is not even in the ballpark of turning a GAAP profit. Through the first nine months of fiscal 2023, the company posted a net loss of $428 million on $2.6 billion of revenue. Atlassian does produce positive free cash flow, but only because it doles out an excessive amount of stock-based compensation. If you were to back out stock-based comp, free cash flow would have been negative for the first nine months of fiscal 2023.
Should investors buy Atlassian on the post-earnings dip? It depends. If you have a very long-term outlook, are confident in the company's long-term potential, and can sit through a major correction without throwing in the towel, Atlassian stock is about as cheap as it's been in years. Otherwise, it may be best to sit on the sidelines and see if the stock continues to head lower amid a tough economic environment.
