Buffett: “The best buys have been when the numbers almost tell you not to. Because then you feel so strongly about the product.”
This quote perfectly encapsulates the tug of war between quantitative and qualitative analysis. The numbers are the quantitative side that might tell you what the business did in the past or how it currently operates, however, the qualitative side will provide more information about the future.
I reference this quote because the company I would like to discuss makes little sense on the quantitative side. In other words, the company looks very pricey. However, there are a variety of qualitative factors that made me investigate further.
The company is Atlassian.
Atlassian makes team collaboration software. If you work in a team, Atlassian has a product for you to communicate, track progress and “get things done.” Let’s make this simple, Atlassian makes shovels and pickaxes for the modern day gold rush that is software. Atlassian likes to say that all companies are either software companies or about to be disrupted by software. I like to think about it like this: If the economy were to become, in the near future, 95% about mining for gold, I could probably make a lot of money selling shovels and pickaxes, instead of fighting over each potential mining opportunity. This is where Atlassian fits into the “Software is Eating the World” economy.
Although software is not by any means my speciality (I am not sure I have a speciality), I think it is vital to continually expand your circle of competence. This is one area that I think Buffett-devotees miss. Along these lines, I have tried to understand how Atlassian is different.
The first difference is what I would call “founder’s mentality.” Atlassian was boot-strapped from the two founders initial $10,000 capital contribution and have never raised outside financings (Atlassian did participate in two secondaries in order to provide early employees with liquidity pre-IPO). This focus on profitability from day one creates a different kind of culture that is not present with your typical Silicon Valley unicorn. Is this important, does that make a difference? I am not sure, but it is a data point.
What Sales Team?
The most obvious and glaring difference for Atlassian is the lack of formalized sales efforts. Instead of a sales force, Atlassian allows it customers to easily trial its products and upgrade to a paid version with no direct human contact. This approach provides customers the ability to test out the products and “buy” them instead of being sold in a top down, Chief Information Officer makes the firm-wide decision method as with other large enterprise software products. Once inside a customer’s teams, the products are collaborative in nature and therefore create a network effect within each company, entrenching the products. Here is a good description on the Low Touch / No Touch Business Model from Dan Benger:
Low Touch / No Touch Business Model
How should the sale take place? We already said that in this SaaS world there is no need for long face-to-face sales and support meetings (otherwise known as a “high touch” sales cycle), as almost everything can be done remotely (via a “low touch” interaction). Why not go one step further and have it all on your website and let customers purchase online with no human interaction needed (“no touch”)? That’s a very easy question. You may think you must have sales executives to close the deal. Well, check Atlassian which develops software products geared towards software developers and project managers. Speak with their sales reps. They don’t have any. You want to purchase, go online to their website and simply purchase the software you want online. Atlassian lists all prices, information about products, documentation, support requests, and training materials on its website. The company does not offer discounts or promotions. You usually purchase a small package for a specific team and then expand it.
Iteration and Please Instead of Trap Your Customer
One upshot of this is Atlassian is able to redirect its sales dollars into R&D spend, i.e. making its products better. However, the “making its products better” is not a once a year software upgrade. Another difference with Atlassian is their constant iteration to improve their customer’s experience. In my research, I spoke with multiple customers of Atlassian and one thing they all mentioned was the “feedback” process where the customers submit feedback and within a week or so, the product is upgraded with new features incorporating that feedback. This is a “please instead of trap” your customer business model. The old guard of softwares systems, most notable SAP, are infamous for having horrible customer satisfaction ratings, yet their software is so embedded in every part of a customer’s business that is almost impossible to leave (seriously ask anyone if they like SAP). Atlassian recognizes that it is better to please your customers than trap them.
The low cost of Atlassian products is a function of their low sales cost and their decision to design their software for a total addressable market that is much larger than your typical enterprise software company. If you are only selling to the Fortune 500, you have a limited numbers of customers and need to charge a high price for your product. However, if you 1000x your customer market, you can offer dramatically lower prices (note: their online sales delivery model allows Atlassian to sell to such a broad audience without dramatically increasing their sales spend).
An upshot of the low cost of Atlassian’s product is a significant barrier to entry for its competitors. Atlassian’s products cost so little, a competitor’s product would need to be dramatically better on a feature basis or cost dramatically less to give Atlassian’s customers a reason to switch. Beating Atlassian on a cost basis is almost impossible, so it becomes a feature war and Atlassian is flush with cash and spending significantly to fight this arms race.
And…now we move onward to the “bad things.”
The elephant in the room is obviously valuation. The current market valuation is baking in “a lot” of growth. Although Atlassian has grown over 40% the past 3 years, they are projecting a slowdown in that growth rate for full year 2017 (July 2016 is the start of Atlassian’s 2017 fiscal year) at around 31% growth.
Some back of the envelope calculations looking ten years out are as follows:
- Revenue growth rate of 26% per year gets you to around $6B revenue in 2026.
- Operating Cash Flow at 30% margins (currently 28%) puts OCF around $1.8B.
- At 20x operating cash flow, Atlassian would be valued at $36B in 2026.
- Given the current market valuation of $6.5B, this would provide a compound annual growth rate (CAGR) of roughly 18.5%
18.5% CAGR over 10 years is obviously not bad (some would say, great), however, to get to those numbers you have to make some pretty mighty assumptions about the continued growth of the company. The lesson here for me is that I would love to own a company with these sort of growth rates, but I do not want to pay for the future growth.
One point on growth: although Atlassian primarily makes inward facing software programs with an emphasis on collaboration, they are already taking steps to develop and sell outward facing solutions, i.e. JIRA Service Desk. These services would integrate tightly with the inward facing programs and provide cross-selling opportunities and even tighter integration, i.e. stickiness. In other words, it is not too far fetched to see Atlassian growing at high rates for long period. (Interestingly, I found a case study from 2014 with projected 2016/2017 revenue rates that underestimated Atlassian’s actual growth rates, see below for link to case study).
Circle of Competence
Although I have done some scuttlebutt research on this company, talking to a handful of their customers (Utah has a surprising number of software companies), I still do not feel like I understand how good their software is relative to others, or more importantly relative to others that do not yet exist. My research in speaking with Atlassian customers was highly favorable. Low cost, constant iteration and tight integration with other Atlassian products stood out as strong positives. But the message was always that each customer continued to experiment with others products and nothing in team management or internal communication software was permanent.
It is really hard to build a phone. Design, manufacturing, carrier integration are all complicated steps–therefore new entrants are rare. However, software can be bootstrapped in the same way that Atlassian bootstrapped its way to the company it is now. This does not mean all software companies are uninvestable, but that there needs to be a high bar for your comfort level to understand why Atlassian or another potential company will continue to defend their competitive position. Along these lines, I do believe you should pay up for quality. But the higher price you pay, the more comfortable you need to be with the “quality” you are getting with a specific company. I do not have that comfort with Atlassian yet (and I may never get it). However, I do want to emphasize that I think highly of some of the qualitative factors of Atlassian, most notably:
- Focus on product improvement instead of sales force (iterative nature of product)
- Low Cost entry provides strong low-end competitive advantage
- Young Founders with large insider ownership and seemingly no desire to sell or step aside
- Please instead of Trap your customer: Although value investors like to imagine businesses with “captive customers and large pricing power” as great business, I think companies that provide ongoing value to their customers will always beat out those companies milking their “captive customers.”
- A corollary to “Please instead of Trap”–Provide Significant Value to Customer: Atlassian provides significant value to their customers, allowing collaborative efforts within organizations and outsourced partners (one example often repeated during my research was collaboration with offshore software programing).
- (As a side note: this is the reason I think Apple’s “moat” is so strong right now because of the enormous value an iPhone provides to its customers).
Due to these qualitative factors, I am going to continue to follow Atlassian and I am almost positive I will be able to buy it at a cheaper price if I do feel more comfortable with their competitive position.
Here are a few of the background pieces that might help with any research into Atlassian:
- Interview with President, Jay Simons
- Commentary Regarding sales approach
- Numbers analysis of sales approach
- 2016 Annual Report
- Original F-1 (initial offering for foreign issuer)
Housekeeping Item: I am going to be in New York City this week from Wednesday to Saturday if anyone would like to meet in person. Feel free to email me at firstname.lastname@example.org. I know John met a few people in Philadelphia last week at an investment conference.
Matt Brice is the portfolio manager of The Sova Group, LLC, an investment firm that manages separate accounts for clients. Matt can be reached at email@example.com.