Atlassian (TEAM) is a company that develops various software products worldwide. The company has strong fundamentals as it generates positive free cash flow and has a competitive advantage. However, we remain neutral on the company due to valuation risks.
Competitive Advantage
There are a couple of ways to quantify a company’s competitive advantage using only its income statement. The first method involves calculating the earnings power value (EPV).
Earnings power value is measured as adjusted EBIT after tax, divided by the weighted average cost of capital, and reproduction value can be measured using total asset value. If earnings power value is higher than reproduction value, then a company is considered to have a competitive advantage.
The calculation is as follows:
EPV = EPV adjusted earnings / WACC
$3.7 billion = $275 million / 0.075
Since Atlassian has a total asset value of $3.4 billion, we can say that it does have a competitive advantage. In other words, assuming no growth for Atlassian, it would require $3.4 billion of assets to generate $3.7 billion in value over time.
The second method is by looking at a company’s gross margins because it represents the premium that consumers are willing to pay over the cost of a product or service. An expanding gross margin indicates that a sustainable competitive advantage is present.
If an existing company has no edge, then new entrants would gradually take away market share, leading to decreasing gross margins as pricing wars ensue to remain competitive.
Taking a look at Atlassian, we can see that gross margins have expanded in the past several years. As a result, its gross margins indicate that a competitive advantage is present in this regard as well.
Profitability
Most investors appear to be obsessed with earnings. This is especially true for institutional investors who tend to overreact to the slightest earnings miss. However, these paper profits have the potential to be very misleading, which is why we prefer to focus on free cash flow.
In the last 12 months, Atlassian has recorded $810 in free cash flow, making it profitable by our definition. This indicates that the company doesn’t have to rely on equity raises to continue funding its growth. More importantly, its free cash flow has been trending up in recent years. To us, this means that the company’s free cash flows are reasonably predictable.
Risks
To measure Atlassian’s risk, we will first check to see if financial leverage is an issue. We do this by comparing its debt-to-free cash flow. Currently, this number stands at 1.1. In addition, when looking at historical trends, we can see that the debt-to-free cash flow ratio has been trending down.
Overall, we don’t believe that debt is currently a material risk for the company because its interest coverage ratio is 6.9 (calculated as free cash flow divided by interest expense).
However, Atlassian has a very high EV/FCF ratio at 125x. This leaves the company vulnerable to rising interest rates, especially if the Federal Reserve is forced to raise them faster than anticipated.
In addition, there are other risks associated with Atlassian. According to Tipranks’ Risk Analysis, the company has disclosed 65 risks in its most recent earnings report. The highest amount of risk came from the Finance & Corporate category.
The total number of risks has increased over time, as shown in the picture below.
Wall Street’s Take
Turning to Wall Street, Atlassian has a Moderate Buy consensus rating, based on 11 Buys, seven Holds, and zero Sells assigned in the past three months. The average Atlassian price target of $472.60 implies 48.5% upside potential.
Final Thoughts
We believe Atlassian is a strong company with an excellent underlying business. Although the company has a competitive advantage, its valuation is a concern for us. As a result, we are neutral on the stock.
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