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Atlassian Part 2: Muddy Waters Even After Pullback
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This is a follow-up to my last post on Atlassian, which covered the company’s early beginnings, flywheel, and the company’s Act 1.
Today the company has three growth vectors: (1) cloud transition, (2) enterprise adoption, and (3) ITSM. All three initiatives are bets to lengthen the runway of the company’s growth. If they can deliver on these initiatives, the company likely has the ability to grow its top line in the mid-20s for the next 5-7 years. However, there are a number of open questions that make the stock challenging to chase even after the post-earnings pullback.
For those that have not been following Atlassian, the company is in the middle of a cloud transition.
As a company founded in 2001, Atlassian started as an on-premise product. Even as the cloud increased in popularity, existing customers of Jira and Confluence were content and preferred to keep their deployments on-premise. At the company’s IPO in 2015, cloud deployments represented only 25% of revenues.
Jira and Confluence are mission-critical products and store a lot of a company’s sensitive data. And for a long time, the founders were agnostic between cloud and on-premise deployments.
But by 2015, it was becoming clear that the cloud was the future. For one, ¾ of Atlassian’s net new customers were coming via cloud deployments. Atlassian, unlike other SaaS around that time, did not push customers onto the cloud, primarily because their cloud platform was not ready for it. Back then, if a customer wanted to use Atlassian’s cloud product, the company would create a private container for that customer in the cloud. This meant that the cloud instance could not be easily scaled up or down and importantly it was very slow. One of the common refrains of Atlassian’s cloud customers from this time is that it was “slow”. Even with all the improvements the company has made in the platform, scar tissue remains with this cohort of users as many will still say Jira is quite slow.
Additionally, Atlassian’s cloud product could only support 2K concurrent users, which made it a non-starter for enterprise customers. These shortcomings for the company’s cloud product left the door open for cloud-native entrants to chip away at the company’s TAM, especially for the non-developer use cases. So in 2016, the company began a multi-year cloud transition and investment. The project was “completed” in 2018 but scaling it to serve the enterprise customers that were still on-premise would take another two years. This type of investment to scale cloud products for enterprise reliability is not uncommon, Workday had undergone a similar investment cycle after acquiring Adaptive Insights.
And over the course of the next four years, the company transitioned its cloud platform onto AWS and built it to be scalable for the enterprise. This involved forking the code and engineering organization in two: cloud and on-premise. As a result, this led to the company’s R&D burden increasing for a period.
As the company’s investments pared down, the R&D burden stabilized around ~34%. During the transition Atlassian, naturally, did not push customers onto the cloud platforms and customers also did not have an incentive to make the transition.
One of the primary motivations for Atlassian to push customers off the server products and onto the cloud platform is that it’s harder to cross-sell customers when they’re on-prem.
‘20 Investor Day: In my experience with the server and data center business for such a long time, cross-sell, you just got to think of the barriers a customer has to go through on a server deployment to add another product. First off, we'll e-mail, we'll market, we'll do ads. We'll do everything we can to surround a customer with potential new products that they could go use. Then someone, preferably with administration access, needs to go to our website, download those products, install them, get an evaluation or a trial, get everyone else that might be interested, get them on the product to go through the trial, go through the purchasing experience and then integrate that with whatever product they had on-prem before. Like the amount of time, energy and complexity of that is -- and how much Atlassian has visibility into those different pieces is very gapped, right?
After the project was completed, Atlassian began pushing customers off the server and data center products with some carrots and sticks…
…announcing the end of life for the server products (stick)
…increasing the prices of the data center and servers products by 15% in ‘21 and ‘23 (stick)
…offering discounts for the cloud product for early adopters (carrot)
…most importantly, only offering new features for the cloud products (carrot)
Customers’ reception to the news has been mixed. On one hand, migrating to the cloud decreases the total cost of ownership and there’s no meaningful business value in maintaining Jira and Confluence instances yourself. Jira and Confluence are mission-critical in the same way that an email server is mission-critical for organizations - you cannot work without them but there are few strategic benefits of maintaining an email server.
On the other hand, customers, especially larger and/or customers in regulated industries like to keep control of their deployments and data1. Most importantly, Confluence and Jira going down can be crippling for an organization. People will not be able to get their work done and there’s the risk of losing critical data. Unfortunately for some customers that did make the transition, the worst nightmare came true when Atlassian’s cloud product had a nine-day outage. This no doubt, slowed the transition of Atlassian’s customers to the cloud.
In spite of that hiccup, Atlassian has transitioned ~60% of its revenue base to cloud deployments. Some customers have chosen (or forced) to treat the data center as a middle step before fully moving to the cloud…
…so ~40% of the revenue base remains on either the server or data center. The pace of migrations to the cloud from the data center is choppy but growing. My estimate is that ~8% and ~14% of the data center business migrated to the cloud in FY 2022 and FY 2023, respectively. I assume that trend continues to be driven by cloud-only products and double-digit price increases.
Benefits of the Cloud Deployments (for Atlassian)
For Atlassian, pushing all the customers to the cloud has a few benefits:
(1) Improved cross-sell. With customers on cloud deployments, Atlassian is able to more programmatically drive upsell and cross-sell of new products. Expansion within the company’s customer base was primarily driven by seat expansion on Confluence and Jira.
’19 Analyst Day: So an average customer should add their second product sometime in their second year and on average, over 6 years, most customers have 3 products or more.
But most of those cohorts were customers that landed with Atlassian’s on-premise product. The company’s cloud customers expand faster.
‘23 MS Conference: So we've really put in a lot of work and that work shows in terms of customer reaction. From a business angle, there is clear evidence that customers in cloud, especially larger customers in cloud, cross-sell faster, expand faster.
Estimated cloud expansion rates seem to be trending higher than the overall company’s, at least the cohorts disclosed at the IPOs.
There are a few confounding factors that make the early cohorts seem better than they likely will be longer term: (1) there was discounting on the initial cloud deals to incent customers to switch and (2) early on-premise customers were on legacy pricing tiers that were simply lower.
Yet, even if you conservatively assume that Atlassian can transition the remaining cohorts and get cohorts that are adjusted by 1 year, that implies a meaningful tailwind to support at least low-20 growth for the next 3-5 years.
(2) Reduced R&D Burden. Since Atlassian forked the code base and effectively created two different technology stacks, the R&D burden today is higher than in a world where they were only supporting cloud customers. As the company stops supporting the server customers and transitions Data Center customers to the cloud, the R&D burden especially on the infrastructure side should decrease. Long-term margins should be slightly higher than what consensus implies but the puts/takes of data center instances on R&D is not clear.
(3) Faster deployments and sales cycles. Cloud deployments and sales cycles should be faster. Atlassian has been investing in “enterprise advocates” over the last few years, and the friction in the sales (or trial) process is much lower than with the on-premise products. As customers complete their cloud transitions, the barrier for enterprise advocates to sell ITSM should decrease.
To further drive adoption, the company is exclusively releasing its new products for cloud customers. Over the last few months, Atlassian has announced the following products:
Jira Product Discovery - helps product managers ideate and do product discovery, somewhat analogous to Productboard
Confluence Whiteboards - virtual whiteboards for teams to collaborate on the cloud a la Miro.
Atlassian Intelligence - CoPilot for Jira, Confluence, and the rest of the Atlassian cloud products.
All these products are only available for the cloud customers. By continuing to release new and in the case of AI, trendy, features only on the cloud, Atlassian is forcing the hand of IT and developer teams to move to the cloud. I could make the argument here that the AI product will be a catalyst for re-bundling around Atlassian’s knowledge graph and may accelerate cloud migrations. But I won’t because I’ve made effectively the same argument for Microsoft and the productivity suite. I think that logic broadly applies here.
In addition to driving more cloud migrations, the other focus areas for Atlassian are (1) ITSM with their Jira Service Management product and (2) Enterprise. Both initiatives seem great on paper but the company has not shown that they’ve de-risked these bets.
45k of the company’s ~260k customers (~17% of total) are currently using Jira Service Management (“JSM”). The company’s motivation for pursuing the strategy is simple, there are many customers that currently use Jira’s ticketing platform “service” workflows including IT requests.
We talk to our customers every chance we get, and nearly 40 percent of them have already been using Jira for service desk operations. After hearing their stories, we set out to give them a powerful new solution to help manage requests even faster than ever.
Unfortunately, the quote is from 2013. Atlassian has been at this for ~10 years and would probably still argue that they are in the third or fourth inning of this bet, as exemplified by the product penetration. This has been one of the shortcomings of Atlassian. While the company has diversified a bit from Confluence and Jira, they have not been able to organically create another meaningful growth driver.
One of the reasons JSM is not further along is because of the company’s relatively late transition to AWS and slow cloud products. This is something that Freshworks has historically used as a differentiator.
The strategy is both offensive (vs. ServiceNow) and somewhat defensive (vs. Freshworks et al).
The company’s positioning against the enterprise vendors is that it’s a simpler, easier-to-use, and much cheaper product. ServiceNow’s product is entrenched and built for the Fortune 500 and Atlassian is really targeting the rest of the “Fortune 500,000”. In effect, the company believes there’s a fat middle of the market for which ServiceNow and BMC are too expensive and hard to manage.
Atlassian’s positioning vs. the Freshworks of the world is that it has feature parity, is ½ of the cost, and sits on the same platform that the company’s developers and IT team use for their software products and internal tooling. Freshworks et al are separate platforms. The benefits of Jira are that there’s no learning curve for new users and the knowledge sharing between the developers and IT is more cohesive on the same platform.
The management team has “doubled down” on ITSM in an effort to capture the installed base opportunity. And the messaging and timing might just be right. We’re going into a downturn, Jira has a good product at a fraction of the cost of its competitors. And the company’s peers may be forced to pull back because investors focus on efficiency. This is where Atlassian’s business model may serve as a competitive advantage and allow the company to consolidate the ITSM market.
Traditionally, you would expect the market leader to offer sales incentives such as buyouts to incentivize customers to rip-and-replace but that it’s a bit too anti-Atlassian. It remains to be seen how impactful ITSM and the enterprise push will be on the company’s financials. The results when looking at headline metrics (e.g., incremental ACVs and NDR) would imply the bets are not meaningfully moving the needle.
The lack of conviction on ITSM and the pace of cloud migrations make it hard to lean into Atlassian even after the recent pullback. The company reported earnings and it was fine, broadly in line with consensus and slight miss on street expectations for Q4 guidance. The stock traded down ~10% and is currently at ~$130. The stock is not yet glaringly cheap at ~9.5x NTM revenues and >40x NTM FCF.
The risk/reward at the current price is good on an IRR basis. My base case is that you can see a path for the company to generate ~$7.50 FCF per share in four years. Assuming a three-year hold and a ~30x FCF multiple at exit, you can get to a low 20% IRR. But the multiple assumes the company can demonstrate to the market they sustain mid-20% top-line growth and for that to work, you have to assume that the other bets outside cloud transition payoff.
The downside case is that the company’s cloud migrations get pushed out and ITSM/Enterprise progress does not meaningfully change. In this scenario, the company trades at ~20-25x FCF with <$7 FCF per share, which implies a mid-single-digit IRR.
The skew is such that there isn’t meaningful downside risk but conviction in the base case is not particularly high. In other words, the growth model for the next few years does not seem particularly de-risked so for now I’m on the sidelines.
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