Atlassian: Lack Of Profitability And Operating Leverage Concerning (NASDAQ:TEAM)

My Thesis

Earnings periods typically offer some juicy opportunities for patient investors. The market being fickle and unpredictable by nature, many investors tend to react quickly when the news is bad, thereby opening windows of opportunity that are normally hard to come by. One such case this week is Australian application platform development company Atlassian Corporation (NASDAQ:TEAM), which dropped more than 15% after Q2 2024 earnings were announced on the first day of this month. At under $218 (as I write this), the stock is down from near its 52-week highs of around $258 pre-earnings. While one might be forgiven for thinking that I’m going to suggest ‘buying the dip, I’m actually recommending quite the opposite, as we’ll see.

Now, a sudden drop in share price after a disappointing quarter is nothing new, but this seems to have happened despite the company posting estimate-beating revenues and earnings for the quarter in question.

The purpose of my thesis here is to try and answer the two-part question, ‘Was this a simple market correction for a richly valued company that guided for a weak H2 2024 in cloud revenues, or is it a broader sign that portends larger concerns and a high amount of risk?

Spoiler Alert: The problem seems to go beyond market corrections, although that is definitely of concern. My analysis here points me to a Sell, unfortunately, and that might be a hard pill to swallow for TEAM longs, but in my opinion, it is what it is.

What Happened in Q2 2024?

This is not a full-blown report on what happened this past quarter, so I’m only going to touch on some key metrics and important nuggets of information that came out in the press release, the earnings call, and the 10-Q filing.

In a nutshell, TEAM beat Street estimates at the top as well as the bottom, coming in with a hot 21% revenue growth figure and reporting a diluted, normalized EPS figure of 73 cents for a 62% growth rate, both compared to the prior period. It was also the company’s first billion-dollar quarter, with reported revenues of $1.06 billion. Other milestones included $1 billion in annualized recurring revenues or ARR for Cloud and a customer count of over 300,000.

So, why the sudden drop in stock price when the news was significantly upbeat?

The one thing that tipped the scales seems to be the FY 2024 cloud revenue estimate “ in the range of 28.5% to 30.5%”, which was considerably lower than the “35% to 40%” estimate from the year-ago period for FY 2023, but actually better than the “25% to 30%” estimate from Q1 2024 at its upper end. Nevertheless, the stock has dropped over 16% after earnings.

To be fair, TEAM had already warned investors in Q1 2024 that “headwinds continue to negatively impact growth in paid seat expansion at existing customers and free-to-paid conversion rates, and that the trends we’ve seen in these areas throughout the last year persist in FY24”, so the Q2 dip was more of an ongoing story of weakness around cloud revenues.

The result, for the stock, is that it dropped after Q1 2024 results were announced in November, but the more precipitous decline after Q2 looks to me like the market was looking for some kind of confirmation of a weaker cloud business in FY 2024 before pulling the trigger on sell calls. The stock quickly recouped its losses in November, even setting higher highs right through the second quarter; well, until the Q2 guidance came in, that is. Still, the stock showed its resilience by quickly finding support and bouncing off $206, but seems to have hit a wall at around $215.

Growth Drivers (The Bull Case)

TEAM bears, don’t celebrate just yet! There’s no sign that this is part of a broader downturn in market sentiment. In other words, this support level partially answers my thesis question, telling me that the market is still quite bullish on the stock. We’ve already seen this resilience after the first quarter results were announced in November, and while the more recent drop was a lot deeper and could signify a weaker market in FY 2024 overall, I think TEAM is somewhat immune to market idiosyncrasies, and that’s validated in part by the low beta that TEAM has exhibited over the past couple of years (graph courtesy Zacks).

It makes sense that TEAM would show signs of stability despite the disappointing guidance. After all, there’s a lot to look forward to in the coming quarters. Let’s look at some of these growth drivers that Altassian management said it’s prioritizing over the coming quarters.

While we are extremely proud of our accomplishments, we remain laser-focused on executing

against our top strategic priorities: cloud migrations, serving enterprise customers, ITSM, and AI.

Scott Farquhar, Atlassian co-CEO and co-founder

Cloud Migrations

Subscription revenues being the bread and butter of TEAM’s business, users’ migration to cloud is one of the key growth drivers. As more businesses move from on-prem distribution to cloud-based solutions, Atlassian’s offerings naturally come to the forefront when it comes to large teams operating from diverse global locations, not to mention the still-strong work-from-home culture that was triggered by the pandemic. A testament to this culture being a major growth driver is the tremendous growth that stocks like TEAM saw in the post-pandemic era.

Beyond WFH considerations, the bigger-picture growth trend spurred by companies gravitating toward cloud solutions can be seen in strong and stable revenue growth over the same period.

That strong growth rate has continued through Q2 2024, with subscription growth outstripping overall revenue growth, coming in at a nice 31%. That was spurred, in part, by the high spenders and spans both organic and inorganic gains. We saw an 18% YoY growth rate for the >$10,000 Cloud ARR cohort, which clearly indicates that the big-money clients aren’t showing any signs of slowing down their cloud migration momentums. The Loom acquisition brought in an additional 326 clients to that cohort, but overall, it’s a minor impact considering the total count of nearly 43k clients in that spending category.

Enterprise, ITSM, and AI – Support Drivers

The reason I’m clubbing the other strategic focal areas is that these initiatives either directly or indirectly drive revenue growth in the core Subscription segment, which makes up 88% of that billion-dollar-plus revenue for the quarter. That’s up from 82% for the prior period, which further validates the assumption that these other focal areas prop up the core revenue stream.

As a matter of fact, Subscription revenues are essentially eating the lunches of both Maintenance revenues and Other Revenues, the first of which is actually on the decline, dropping from $78.6 million in Q1 to the last-reported figure of $69 million. Still, the revenues from these other segments are what helped the company achieve its first billion-dollar quarter. Moving forward, if Subscription revenues can grow at just 7.3% on a QoQ basis in Q3 2024, that alone will account for a billion dollars or more in revenues. That would be the real achievement, I think, and there are zero signs that this won’t happen.

The Problem with Growth (The Longer-Term Bear Case)

So, growth is tremendous right now, but that’s also a problem. It’s clear that the market punished the stock for the company guiding lower on cloud revenues, and while that’s not an immediate problem, it reveals an important weakness in the business model. To put it another way, this kind of growth has come at a significant cost – that of profitability; or, rather, a lack of it.

The biggest problem I see is the lack of operating leverage. Normally, a SaaS company would see greater fixed operating expenses that give them leverage on higher revenues, but that doesn’t seem to be the case here.

A simple analysis of operating expenses as a percentage of revenues shows us that there’s very little leverage here, if at all. In fact, TEAM needs to keep its R&D spend at around half of revenues, with SG&A taking another big slice of the profitability pie, leaving very little to make it down to the bottom line.

And this is where a lot of investors will disagree with me, and that’s okay. You can certainly justify elevated expenses when your revenue growth is at this level, but what happens when that starts to slow down? At that point, TEAM will need to spend even more of its revenue on sales, research, and development. Some efficiencies can probably be found at the corporate level, but that would probably be at the cost of layoffs and other belt-tightening initiatives.

We saw that happening nearly a year ago in March of 2023, when the company laid off about 5% of its workforce. Of course, I’m not saying that’s going to happen again in the near future, but market participants tend to get finicky when management guides to less than optimal revenue growth rates in upcoming quarters. Granted, we saw that the stock is resilient, staying above that support level of $206 we saw earlier, but the question is, how long can that last in a volatile environment, and in a segment that’s fragmented and where the company itself doesn’t have an economic moat to speak of? JIRA, for example, already has a 25% market share, with some very large players that it needs to remain competitive against.

To exacerbate that problem, the company is now laser-focused on the enterprise segment and the big spenders, which is arguably a more limited cohort than small to mid-sized businesses. Of course, the opportunities are much more attractive from a dollar perspective, with the enterprise software market being more than three times larger than the SMB software market. However, the opportunity in the enterprise segment is smaller in terms of the number of companies requiring such solutions. It’s a classic case of volume benefits in enterprise leading to much of that difference. And the risks are greater because losing one customer could mean losing thousands or tens of thousands of subscriptions. It’s a kind of concentration risk, although not in the traditional sense.

Further compounding the problem is the fact that returns on equity, capital, and assets have been sub-zero for several years, and it doesn’t look like things are going to be better in the near future.

That’s not the sort of business most investors would want their money in, at least in the long term. Sure, if you’re already long TEAM and you’re a growth investor, you’ll naturally cite metrics like strong revenue growth and anything else that justifies holding on to the stock, but take a hard look at the value investment case and you’ll see the hard truth. To be clear, I’m not saying by any measure that this is a bad company to invest in. I don’t know your investment goals, style, or time horizon. All I’m saying is that TEAM doesn’t appear to be a good investment for long-term value investors. In fact, you’d only be in positive return territory if you’d invested at below $209 a share, and if you net out inflation, this is probably not one of your more lucrative holdings.

Risks To This Bearish Thesis

My bull case certainly looks like the perfect argument against my thesis, but it’s not so. I’m not saying the stock won’t appreciate; it very well might, from the sheer momentum being set up by impressive revenue growth arising from those strong growth drivers we discussed earlier.

A string of quarters that show improved returns on the invested capital, assets, and equity would prove me wrong. Alongside that, a few quarters of improving bottom-line growth are what I’d like to see, because it would tell me that the numbers are moving in the right direction and there’s every chance that GAAP profitability will eventually lead to better core returns. I don’t see any signs of either.

Conclusion

I’ll re-reiterate that TEAM is not a poorly run company or one that’s circling the drain. I don’t want anyone to get that impression. However, it’s definitely not an investment I’d recommend to anyone but the most risk-tolerant investors – simply because it’s in a precarious position with respect to ‘spending on growth’ versus achieving profitability at scale. At a price to adjusted earnings multiple of +80x, the reality of that could hit an investor hard. Market corrections will happen at this level, and they can brutally wipe out all your gains due to factors that are out of your control.

The bull side of that argument is that the company has a long growth runway ahead of it, and that it’s a dominant player in its niche. Of course, it could be immediately profitable if operational expenses were curtailed, but that’s what’s driving growth right now so it’ll be like hitting the self-destruct button, and that’s not what you want to see right now if you’re invested in TEAM.

My recommendation, therefore, is to Sell if you’re above water, and that’s only if you got in before 2021 or after the steep drop in November 2022. If not, and you’re willing to continue holding on to a risky investment, you may just be stuck with it until the company turns profitable on a consistent basis and starts showing positive returns on the assets it possesses, the capital it deploys, and the equity that’s reinvested into the business. And that could be a very long time.