Atlassian, the Aussie software juggernaut that bypassed the ASX to list on the Nasdaq, is now under Morningstar coverage.

In addition to awarding it a narrow moat rating - indicating Morningstar's belief in a distinct competitive advantage - analyst Dan Romanoff predicts strong growth over the next five years.

The “viral adoption” of the company’s software is a key standout cited by Romanoff, which he notes is sold directly on the company’s website, thereby slashing sales and marketing expenses.

“A robust growth outlook is matched by an equally robust valuation, with shares trading at 55 times 2020 free cash flow,” he says.

Atlassian, founded in 2002, is the brainchild of Australians Mike Cannon-Brookes and Scott Farquhar, who met at the University of NSW and launched the business with a $10,000 credit card loan. These days, the company has more than 150,000 customers and a market cap of US$34 billion.

Atlassian provides project planning and management software, collaboration tools, and IT help desk solutions. Its products are used by organisations of all sizes, from small teams at small and midsize businesses to large teams at large enterprises.

Its flagship product is Jira, a collaborative software product that allows users to identify and track problems and their resolution and to distribute tasks among teams.

In 2013, it expanded this with Jira Service Desk, a workflow solution that applies a ticketing logic to IT help desks, human resources and compliance.

Switching costs and network effect

Atlassian's narrow moat rating is predicated on high customer switching costs and its network effect.

As every office worker knows, changing software systems is a pain. Once these services are adopted, they become crucial to the workflow of software developers and help cement the company’s sustainable competitive advantage, says Romanoff. 

Any changeover to new software can cause a drop in productivity, not to mention the potential loss of data that a changeover to a new software system entails, Romanoff explains.

“The more critical the function and the more touch points across an organisation a software vendor has, the higher the switching costs.”

Romanoff also believes the moat trend is positive, with the company’s scale and growth showing strong and continued adoption - supporting a strong network effect. Atlassian has 15 million visitors to its community site annually.

“The company has more than 500 partners indirectly marketing and selling Atlassian products. It also operates the Atlassian marketplace, which is basically an app store featuring thousands of apps developed by more than 25,000 third-party developers.

"This marketplace has generated more than $500 million in cumulative app sales since inception,” Romanoff says.  

He anticipates total revenue growth of 29 per cent in fiscal 2020, decelerating to 22 per cent in fiscal 2024, representing a five-year compound annual growth rate of 25 per cent.

High uncertainty despite $1bn in revenue

The company does however carry a high uncertainty rating. Despite its advantage in switching costs and network effect, it faces tough competition from Microsoft and its planning tool, Azure.

Atlassian also generally trades at high multiples relative to its peers, Romanoff says.

“At high valuation levels, companies can often become momentum stocks, where companies are punished severely if they do not deliver against expectations, which are regularly higher than consensus figures indicate.”

The potential for Jira software to fall out of favour is a further risk, says Romanoff. “And despite generating more than $1 billion in revenue, the company is still not generating positive international financial reporting standards operating margins and is not expected to do so for a couple of years still.”

Atlassian carries a fair value estimate of US$146 and is currently trading at US$141.20.

Bulls say

“Our bull-case fair value estimate is US$219 per share. In this scenario, Atlassian gathers new customers more quickly, enjoys more rapid expansion and upselling of add-on solutions within existing customers, and benefits from the adoption of Service Desk in areas outside of IT. Higher revenue, in turn, falls to the bottom line more efficiently.”

Bears say

“Our bear-case fair value estimate is US$77 per share. In this scenario, Atlassian gathers fewer new customers, achieves less success in upselling and cross selling within existing customers, and does not enjoy the same level of Service Desk adoption.”