If you invested $1,000 in enterprise collaboration software company Atlassian (TEAM -2.20%) five years ago, you'd have about $1,500 today. That's not too shabby. But you'd have closer to $1,800 if you had invested that same money into a S&P 500 index fund.
Atlassian stock is up, which is encouraging. But it's underperforming the S&P 500, which is discouraging. Can investors expect the company to turn a corner and outperform from here? Here are some things to consider.
Cloud growth is paying off for Atlassian
Atlassian has software that helps people work together -- particularly handy for modern distributed workforces. Historically, the company was like most other software companies: It licensed its software to be used by businesses on premises. But more recently it's been pushing its customers toward subscription services on the cloud.
As one would expect, Atlassian's cloud revenue is consequently soaring. The company just reported financial results for its fiscal third quarter of 2024 (the period that ended in March). And in Q3, its cloud revenue was up 31% year over year to $703 million -- its best growth rate for cloud in a year.
There are pros and cons to the approach. The upside is cloud-based revenue provides companies with a higher-margin, more efficient, and more predictable (subscription) income stream. But the downside is it's easier for enterprises to scale back on spending in adverse economic conditions. Atlassian has experienced the downside in recent years, which further emphasizes the importance of its cloud revenue growth in Q3.
Atlassian has also struggled at times with customers using the free version of its cloud-based software and not upgrading to a paid version. And as businesses downsize, they don't need to buy as many seats to Atlassian's platform.
The downsides acknowledged, Atlassian's emphasis on the cloud has clearly been a net positive. As the company's co-CEOs said in their Q3 letter to shareholders, since the company announced its legacy server business was coming to an end less than four years ago, paid seats on Atlassian's cloud have tripled.
Atlassian is already quite large with over 300,000 total customers and over 44,000 customers spending over $100,000 annually. But management still believes growth is in the cards for this business. As the co-CEOs also said, "We now have an even larger opportunity in Cloud than originally believed."
Specifically, Atlassian believes it's playing in a market worth $67 billion compared with its trailing-12-month revenue of only $4.2 billion. Moreover, it believes its existing customer base presents an $18 billion opportunity. That's why management feels strongly that it can generate more than $10 billion in annual revenue within five years.
The valuation
As of this writing, Atlassian stock trades at a price-to-sales (P/S) valuation of about 11. As the chart below shows, that's approaching an all-time low for this company.
TEAM PS Ratio data by YCharts
To be crystal clear: I think that a P/S of 11 is an expensive valuation. However, I need to be fair when it comes to Atlassian stock. It has an attractive gross profit margin above 80% and it generates a large amount of free cash flow -- $555 million in Q3 alone. Those factors normally warrant a higher valuation for a stock.
The point is that Atlassian stock could find some stable footing from a valuation perspective considering it's below normal now and because the market will likely support an expensive multiple due to its attractive financial metrics. Therefore, I wouldn't be surprised if the valuation for Atlassian stock in five years is similar to its valuation today.
If Atlassian's valuation stays where it is, business growth will drive its stock performance. Concerning business growth, I've already noted that management believes it will generate $10 billion in annual revenue within five years -- that's almost 140% more than its revenue now.
Therefore, even if the valuation went down a little bit, Atlassian stock could realistically double over the next five years if its hits its goals. And this company does have a track record of executing on its plans.
There have been times that I've believed the valuation for Atlassian stock was simply too high to be a good investment. There have been other times that I've worried about macroeconomic headwinds. But I do believe that Atlassian stock is finally in a place where returns for investors can improve from its performance over the last five years.
To be clear, I probably won't buy shares of Atlassian personally because I still don't love the valuation -- I don't like valuation risk. But I admit Atlassian stock is in a much better position to outperform the S&P 500 over the next five years than it has been in recent years, which could make it a good addition to portfolios for other investors.
