Earnings Call Transcript - TEAM Q1 2023

Operator, Operator

Good afternoon, and thank you for joining Atlassian's Earnings Conference Call for the first quarter of fiscal 2023. As a reminder, this conference call is being recorded and will be available for replay from the Investor Relations section of Atlassian's website following this call. I will now hand the call over to Martin Lam, Atlassian's Head of Investor Relations.

Martin Lam, Head of Investor Relations

Welcome to Atlassian's First Quarter Fiscal Year 2023 Earnings Call. Thank you for joining us today. Joining me on the call today, we have Atlassian's co-founders and co-CEOs, Scott Farquhar and Mike Cannon-Brookes; our Chief Revenue Officer, Cameron Deatsch; and Chief Financial Officer, Joe Binz. Earlier today, we published a shareholder letter and press release with our financial results and commentary for our first quarter of fiscal year 2023. The shareholder letter is available on Atlassian's Work Life blog and the Investor Relations section of our website, where you will also find other earnings-related materials, including the earnings press release and supplemental investor data sheet. As always, our shareholder letter contains management's insight and commentary for the quarter. So during the call today, we'll have brief opening remarks and then focus our time on Q&A. This call will include forward-looking statements. Forward-looking statements involve known and unknown risks, uncertainties and assumptions. If any such risks or uncertainties materialize or if any of the assumptions prove incorrect, our results could differ materially from the results expressed or implied by the forward-looking statements we make. You should not rely upon forward-looking statements as predictions of future events. Forward-looking statements represent our management's beliefs and assumptions only as of the date such statements are made, and we undertake no obligation to update or revise such statements should they change or cease to be current. Further information on these and other factors that could affect our financial results is included in filings we make with the Securities and Exchange Commission from time to time, including the section titled Risk Factors in our most recently filed annual and quarterly reports. During today's call, we will also discuss non-GAAP financial measures. These non-GAAP financial measures are in addition to and are not a substitute for or superior to measures of financial performance prepared in accordance with GAAP. A reconciliation between GAAP and non-GAAP financial measures is available in our shareholder letter, earnings release and investor data sheet on the IR website. Please keep in mind that we'd like to allow as many of you to participate in Q&A as possible. To facilitate that, we'll take one question at a time. Please rejoin the queue if you have another question or a follow-up, and we'll do our best to come back to you later in the session. With that, I'll turn the call over to Scott for opening remarks.

Scott Farquhar, Co-CEO

Thank you for joining us today. We are proud of our execution in Q1 against our long-term initiatives. We announced a new subscription offering in Atlassian Together, launched Atlas into general availability, and held Work Life, our first large-scale customer event focused on a single market. As you've already read in our shareholder letter, Atlassian is not immune to the broader macroeconomic environment, but we remain steadfast in our conviction that we have the right leaders, products, and strategies in place to capitalize on incredible long-term opportunities in front of us. Turbulent markets provide an opportunity to shake up the leaderboards, and we're determined to focus our investments to take share and strengthen our market position in this environment. We'll, of course, balance our continued investments with the overall growth of our business and be responsive to the macroeconomic conditions. We continue to have line of sight to $10 billion in annual revenue and believe we will emerge from this environment in a much stronger market position. I'm incredibly thrilled to pass the CFO baton to Joe Binz, who I want to welcome to his inaugural Atlassian earnings call. He's only been here since early September, but has quickly gotten up to speed and will likely do far better than I did in my short stint as interim CFO. With that, I'll pass the call to the operator for Q&A.

Operator, Operator

Your first question comes from Keith Weiss from Morgan Stanley.

Keith Weiss, Analyst

Excellent. I guess kind of a top-line and a bottom-line question. You guys mentioned in the shareholder letter, and I appreciate you being upfront about the macro impact you're seeing. Free-to-paid conversion slowed down and it sounds like NRR slowed down a little bit. What have you guys been seeing in kind of top-of-funnel trends? Is that feeling as expected? Or did that slow down as well? And then you are sustaining the operating margin guide for the full year, even with the revenues coming down a little bit. Where are the areas you guys are looking to get the increased efficiencies as we think about FY '23?

Cameron Deatsch, Chief Revenue Officer

First off, this is Cameron. I'll speak to the top line for this and then hand off to Joe to talk about expenses. So yes, as we mentioned in the previous quarter, actually back in our August earnings, we spoke about how, while we are seeing plenty of people coming in and trying Jira and our free versions of our product, we continue to see that trend today. Many more people are signing up and using our products, but we saw them starting to slow down when it came to converting to paid customers. So that trend definitely came through throughout the quarter, and we see it today where we still have plenty of people coming in. The year-over-year growth of our customers continues to grow, which is great, but just a little bit slower in the converting to actual paying customers. The new piece we saw in the previous quarter was that towards the end of the quarter, we actually saw user expansion in existing accounts. This is largely people going from 100 users in Confluence to 110 users, and that's largely due to companies slowing down hiring, trying to constrain their internal IT budgets and using more of the license they already have. Now we continue to see growth; it's just that user growth wasn't nearly as strong as what we've seen historically. On the other side, while the user growth slowed down, we do continue to see migrations tracking along as planned, our additions working with people from standard to premium and enterprise versions of our products, and strong cross-sell. Jira Service Management specifically continues to be adopted well. So while we are affected by basically hiring rates and how quickly people are adding to their organizations, we've seen no slowdown in those efforts to date. Joe, do you want to handle the expenses competition?

Joe Binz, Chief Financial Officer

Yes. Thanks, Cameron, and thanks, Keith. So there are really two focus areas. First and foremost, we're making reductions in our non-headcount driven discretionary spending. Secondly, we'll moderate the rate of planned headcount growth in the second half of FY '23. I'd say in terms of areas, Keith, there are efficiencies to be found across the board, whether you're talking about gross margins, process efficiencies, or even resource allocation. We're looking to make sure that we're constantly prioritizing investments and moving those resources toward the highest ROI and most impactful things. As Scott mentioned, this is all with an eye towards strengthening our position in the large, high-growth markets we're targeting and enabling us to emerge in a stronger position out of the downturn as we were going in. So hopefully, that gives you a sense, but I would say it's very broad and based on those two primary principles.

Operator, Operator

Your next question comes from Michael Turrin from Wells Fargo Securities.

Michael Turrin, Analyst

Thank you. I believe the situation will be similar to the previous one, but I'll frame my question a bit differently. I have a couple of points to address. First, I want to clarify some of Cameron's earlier comments. It seems reasonable to conclude that the changes in the revenue target for cloud this year are more related to the expansion rate rather than the pace of cloud migrations. Is it accurate to say that the 130% to 140% rate for large customers is driving this impact? The second point is for Joe. I understand you are new to the call, but I'm interested in your perspective on the possibility of increasing margins. What factors would influence that discussion, as opposed to simply maintaining the current investment strategy? Given the company's long-term focus, I think your thoughts on this, especially in light of changing macro conditions, would be valuable.

Cameron Deatsch, Chief Revenue Officer

I want to clarify that we have not experienced any changes in our migration rates. The progress on migrations remains on schedule, similar to the last few quarters, especially with the server end of life approaching in February 2024 and our loyalty discount program set to decrease in June. We have been collaborating closely with our customers over the past couple of years, and we improve in those discussions every day. Our migration efforts still align with our plans, and there has been no impact from the migrations. The slowdown we have observed in the last quarter primarily relates to users adding more and expanding their use of our products.

Joe Binz, Chief Financial Officer

Great. Michael, this is Joe. Thanks for the question. On the NRR question, the expansion rate question. As you know, we don't provide updates on expansion rates on a quarterly basis. Directionally, it remains very healthy and above the 130% we discussed at the Investor Day. I think that's indicative of the fundamental health of our business, particularly around upgrades to premium and enterprise additions, customers adding new products, and churn rates. While we talked about the macro impact on paid seat growth within existing customers, relative to expectations, the absolute growth rates there are still very good on an absolute basis. So that's a big driver behind those healthy expansion rates. And I'll turn it over to Scott to talk a little bit about the margin trade-off discussion.

Scott Farquhar, Co-CEO

In terms of – stepping back in terms of thinking about long term, we have been through multiple downturns in the business. We started in '01/'02 in sort of the dot-com crash, we went through '08/'09, and now we're in the third downturn for us. What we've learned is that during those periods of time, if you can invest wisely, you can come out on the other side with an improved position in the market. We think that we can pick up staff where other companies are shedding staff; there are incredible people in the market who may only become available once a decade, and we have an opportunity to pick up those staff now. We also consider the opportunities we identified in our Investor Day earlier this year. We said we have three promising areas to invest behind: migrating our customers to the cloud at the fastest rate possible, building new products through our Point A program, and investing more in ITSM with our JSM platform. Again, we believe these are long-term investments that pay off in the short, medium, and long term. So we're going to continue to invest in these areas. Therefore, we will be thoughtful around our cost envelope in light of the macroeconomic environment.

Operator, Operator

Your next question comes from Fatima Boolani from Citigroup.

Fatima Boolani, Analyst

Cameron, this question is for you. It's a little bit of a counterfactual. So I know you're staying committed to ensuring a significant portion of your cloud growth comes from migration. But conversely, why wouldn't we see a slowdown in migrations to the cloud if the sensitivity that you've seen thus far is more focused on the user expansion area? In other words, why wouldn't an existing customer just use the capacity that they have versus transitioning to a per-user model where they could incur a higher TCO in the short term? Just a couple of thoughts on why that wouldn't impair the migration cadence to the cloud.

Cameron Deatsch, Chief Revenue Officer

Let me clarify why we haven't seen a slowdown in cloud migration rates when customers might otherwise choose to stay on-premises. The main reason is that over the past two years, we've implemented a well-designed set of programs, including loyalty discounts, new migration tools, and increased engagement with our enterprise customers. This has incentivized both our partners and customers to ensure that moving to the cloud is the right choice for them. Many of them have been in various phases of their migration journey over the past two years. Some have moved quickly, while others are still planning and building. They do not see cloud migration as a capacity issue. Instead, they view it as a way to unlock value and improve productivity by utilizing cloud tools. Therefore, they recognize the importance of completing this project to enhance efficiency, even if it isn't linked to increasing headcount.

Operator, Operator

Your next question comes from Arjun Bhatia from William Blair.

Arjun Bhatia, Analyst

I'm curious, just when you think about the macro impact that you're seeing, is there any way to break it down further between the behavior that you're seeing from larger customers that are perhaps more committed versus smaller customers that are earlier in their journey? And then Joe, one for you: when you're thinking about the rest of the year and the guidance that you've provided, can you help us understand what you're incorporating from a macro perspective in the forward numbers?

Scott Farquhar, Co-CEO

I can take that one. Look, I want to restate our philosophy of being an open company. We've told you every quarter we've been public that we're going to be open and clear about what's going on. The two areas where we're seeing impact are free instances and the rate of converting to paid, and secondly, the rate of user expansion growth, which has been consistent for us but is slowing a bit. We believe customers are optimizing their spend. If you're going to add that 11th user, you're more likely today to think, 'I'll stay at 10.' The good news is we haven't seen any decrease in usage or change in churn rates. These are not customers leaving Atlassian; they are optimizing their spend and tuning the number of users they have. We also highlighted where we see great opportunities in front of us and have been clear about our offensive play. Some of these opportunities include strong migrations, especially since using cloud tools is generally a more flexible optimization strategy compared to on-premise. So that gives us ongoing opportunities, particularly in enterprises that we've positioned ourselves strongly for.

Cameron Deatsch, Chief Revenue Officer

This is Cameron. I’ll add a bit more context regarding the growth we see in our enterprise customer base compared to SMB. First, we observe that user growth constraints apply fairly broadly across all cohorts, whether that's across sizes, industries, or geographies. However, we continue to see strength in our enterprise business due to two main factors: First, migrations align well with our enterprise business compared to small and medium-sized businesses due to pricing dynamics. Second, as I mentioned earlier, we see our enterprise customers continuing to standardize on our applications and choose enterprise editions during migrations. Moreover, we partnered with Accenture, which provides significant scale to assist our customers through their transitions. We also recently became recognized as a leader in the Gartner Magic Quadrant for IT service management, which further validates our credibility in expanding into IT operations.

Joe Binz, Chief Financial Officer

Then Arjun, regarding the assumptions underlying our guidance, we are presuming two fundamental things. First, we are assuming the current macroeconomic environment persists throughout the year, without significant improvement. Secondly, we are also considering the macro impact on the business and the trends observed in Q1 regarding free-to-paid conversion rates and paid seat expansion at existing customers persist throughout the year. This essentially means we expect the status quo to remain for those two factors. We will monitor both the macro and business situations closely, adjusting where appropriate. Given the uncertainty currently, we believe this is an appropriate range based on what we’ve experienced in Q1 and our quarter-to-date performance.

Operator, Operator

Your next question comes from Alex Zukin from Wolfe Research.

Alex Zukin, Analyst

I want to dive into that last answer from both Cameron and others. If we consider the enterprise impact, could you dissect the cloud revenue growth for the year? Are the headwinds from seat adds more in the mid-market, the SMB, or the enterprise? Is it being compensated by incremental module additions at the enterprise? Help us unpack that and give us a sense for when you started to see these issues. Is it in the last two weeks of the quarter? How has that trended in October? From a financial perspective, what is the cloud growth kind of projected to exit this year? I understand we discussed that the 50% growth target was not just for this year's cloud growth but for the coming years as well.

Cameron Deatsch, Chief Revenue Officer

No problem at all. To start with cloud growth, it's important to understand that new customers, any user additions to existing customers, upgrades to premium or enterprise versions, and migrations all contribute to our cloud growth. Specifically, what we observed in Q1 was a slowdown in the rate of net new customers; we still added over 6,000 net new customers, but that figure reduced compared to prior quarters. This was primarily driven by free customers slowing their conversion. We saw user growth begin to decline as existing cloud customers were increasing their user base at a lower rate than previously. On the positive side, migrations and upgrades remained steady. These are primarily driven by organizations adapting to current hiring conditions, leading to a slow-down in user addition rather than any issues with migrations or added upgrades.

Joe Binz, Chief Financial Officer

Thanks, Cameron. To address how we expect to exit Q4, we anticipate cloud revenue growth rates in the range of 40% to 45%.

Operator, Operator

Your next question comes from Gregg Moskowitz from Mizuho Securities.

Gregg Moskowitz, Analyst

I consider Atlassian an unusual software company, in a positive sense, for a couple of reasons: Firstly, your quarters are typically very linear, and secondly, you have great visibility into customer buying and usage patterns. So I'd believe that you had an early warning of the slowdown in paid user growth beginning midway through the quarter. My question is whether there was anything you were able to do to mitigate that slowdown as it unfolded. Investors have been surprised by results like this from Atlassian. So, I’m curious whether you have the ability to make adjustments and navigate the difficult macro better than others.

Scott Farquhar, Co-CEO

It's Scott here. Philosophically, one thing we prioritize is being a long-term company. Many of our peers operate based on how many salespeople they have, structuring their businesses that way. For us, the customer journey is more self-serve. Our pricing is very attractive compared to many competitors. This can make it difficult to have significant impacts on quarterly results, resulting in the linear revenue flow we're accustomed to. Ultimately, we see that customers are not adding seats and users as quickly, reflecting hiring conditions outside of Atlassian. However, we continue to have opportunities—migration options are strong, and our product pipeline remains robust. We believe this is an opportunity for us to capture market share due to our competitive pricing and strong product offerings.

Cameron Deatsch, Chief Revenue Officer

I can also clarify the timing we observed. We noted in August that there was a slowdown in net new customer acquisition, particularly in the conversion of free customers to paid. Typically, we expect growth to resume after July and August—school year, vacations, etc. However, in September, we didn’t see our expected uptick in user growth. That said, we have multiple growth drivers we can leverage, including upgrades, migrations, and new releases, which will help us navigate these dynamics effectively.

Operator, Operator

Your next question comes from Brent Thill from Jefferies.

Brent Thill, Analyst

Headcount accelerated to the fastest growth in 11 quarters in light of this slowdown. Can you explain what you'll do in the next 6 to 9 months regarding your investment pace? Additionally, I have a quick follow-up regarding geographic performance; EMEA appeared to experience the biggest decline. Could you comment on what you're seeing in EMEA versus the U.S.?

Scott Farquhar, Co-CEO

I'll address the headcount issue, and Cam can discuss geography. You're right; this quarter's headcount growth is indeed a high watermark for us. Seasonal trends lead to more graduates entering the workforce during this period. We plan to moderate our headcount growth in response to the macroeconomic conditions while focusing on ensuring our new hires engage in productive projects.

Cameron Deatsch, Chief Revenue Officer

From a geographic perspective, we haven't seen a quantitative change in trends except what we’re already discussing. The user expansion slowdown is broad across our customer base globally. Although we've had conversations and concerns regarding macroeconomic uncertainties in Europe and APAC, our migrations, addition upgrades, and cross-sell initiatives continue to perform well quantitatively.

Operator, Operator

Your next question comes from Michael Turits from KeyBanc Capital Markets.

Michael Turits, Analyst

On the topic of the slowdown in both expansions of customers and conversions, can you comment on whether you're observing similar dynamics in the customer development team? In other words, are headcount trends mirroring overall slowdowns in customer spending?

Scott Farquhar, Co-CEO

I appreciate the direction of the question. It’s important to remember that our sales penetrate across our entire customer base, making it tricky to comment on specific departments. Our primary market has historically been developers, but we have not observed any slowdown in migrations or contract cancellations. It's primarily about the trend of headcount growth rather than departmental reductions.

Cameron Deatsch, Chief Revenue Officer

To add to that, while we were more focused on big customers and project expansion, we haven't seen a material correlation to user expansion analytics or share of wallet. This continues to fall more on overall hiring conditions rather than spending levels directly tied to Atlassian.

Operator, Operator

Your next question comes from Steven Koenig from SMBC Nikko.

Steven Koenig, Analyst

Given that the higher velocity sales motions seemed most affected here. Are you seeing any slippage among existing cloud customers regarding the renewal of their plans, particularly between monthly versus annual plans? Will we need to work through 12 months of annual customer renewals with fewer added seats? Could you share your thoughts on the net expansion rates of the two different cloud customer segments?

Cameron Deatsch, Chief Revenue Officer

The good news is that we offer a mix of monthly and annual plans, allowing customers the flexibility to choose from. We see the user expansion challenge we logged previously across both types of plans without any significant differences. However, the monthly plans allow us to monitor aligned user usage much more accurately when compared to the annual plans. In cloud services, we have strong telemetry systems that give us insights into customer usage to prepare proactive customer success initiatives.

Operator, Operator

Your next question comes from Ari Terjanian from Cleveland Research.

Ari Terjanian, Analyst

Can you provide any insights on your exposure to the tech vertical? We've observed layoffs at firms like Amazon, Shopify, and Stripe, who previously hired aggressively during COVID. Have you accounted for any changes from those cohorts moving forward?

Scott Farquhar, Co-CEO

I understand your question about potential tailwinds from COVID that may be waning. However, I think every company today is effectively becoming a tech company, regardless of their industry. This trend leads businesses to use our products, which is solid in its foundations. We don't have any significant exposure solely to technology workers. We serve multiple industries, which keeps us broad and stable in our growth.

Operator, Operator

Your next question comes from Mark from Raymond James.

Unknown Analyst, Analyst

This is Mark on for Adam. I wanted to ask about the loyalty discounting you're implementing to encourage customers to migrate to the cloud. How would you quantify the potential overall uplift to revenue and margins, and when might we start to see that impact?

Cameron Deatsch, Chief Revenue Officer

The loyalty discounts we’ve been discussing are part of our transition plan to support customers through the server end of life. Customers incentivized to make the switch receive discounts that will gradually decrease over a 3-year period. All customers facing these discounts will be transitioning to list prices by July of next year. The timing presently means we are not expecting immediate impacts on our financials, as subscription recognition and renewals correspond to the timing of those changes.

Joe Binz, Chief Financial Officer

Exactly, Cam. Timing will depend on our accounting strategies related to subscription revenues. We don’t expect immediate financial impacts when those pricing changes occur due to ratable revenue recognition. Thus, the shifts will reflect gradually in our reports.

Operator, Operator

Your next question comes from Peter Wade from Bernstein.

Unknown Analyst, Analyst

Earlier, you mentioned net revenue retention and referenced back to enterprise, noting that you spoke of 130% and 140% previously. I wanted to clarify: when you said 130%, does this refer solely to medium and large-sized businesses, or is that across your entire customer base?

Joe Binz, Chief Financial Officer

Yes, Peter. Thanks for the question. That metric applies to the entire customer base that we report on.

Unknown Analyst, Analyst

Regarding smaller customers that you're attempting to transition to paid, are you experiencing any competitive pressures? For instance, there are discussions around alternatives like GitLab. Are you facing actual competition in terms of customers choosing other solutions, or is it more a matter of users being resistant to upgrading?

Cameron Deatsch, Chief Revenue Officer

First and foremost, across the board, whether it's new customer acquisition or existing customers, we see no significant change to our overall competitive position. Our products are well-received, and we have satisfied customers who routinely engage in our offerings. We also continue to observe numerous free users adopting our applications, which reinforces our market position. The cost-effectiveness of our products remains an advantage in a tightening budget climate. Overall, we have found no change in competitive dynamics impacting our free-to-paid conversion rates.

Michael Cannon-Brookes, Co-CEO

This is Mike. I’d like to emphasize that we view this period as a good opportunity to gain market share across several segments. Our investment in R&D ensures we maintain affordability and provide high-value offerings for our clients, which positions us well for venturing further into these market categories.

Operator, Operator

Your next question comes from Fred Havemeyer from Macquarie.

Frederick Havemeyer, Analyst

I wanted to ask about the slowdown you're observing concerning free-to-paid conversion as well as user expansion. Given the context of layoffs and current trends, how do you conceive of the current environment relative to early 2020, when layoffs were intensifying and spending began to slow?

Cameron Deatsch, Chief Revenue Officer

I'll do my best to reflect on that. It is true early in 2020, we altered our business model from trial-based to free, which resulted in enhanced customer activation rates. However, this period was simultaneous with COVID dynamics, which led many businesses to shut down. Even during those early stages, our new customer growth dropped sharply. In contrast, our current trend of net new customer acquisition remains significantly higher than pre-launch figures. We are observing a consistent level of customers actively engaging with our products yearly. Moreover, their success in utilizing our products is paramount—patience can pay off in revenue over time. This parallels our experiences back in early COVID—recognizing customers' usage helps us ensure successful conversion paths.

Frederick Havemeyer, Analyst

I appreciate that explanation, Cameron. Regarding Atlassian Together, it's been marketed as a bundled solution. Is this primarily focused on enterprise offerings, or could these transitions from on-premise clients present additional opportunities as you onboard them?

Michael Cannon-Brookes, Co-CEO

Great question, Fred. Yes, Atlassian Together is indeed an enterprise-focused offering that we unveiled at Work Life, which targets the burgeoning work management market. We have over 150,000 customers in this area, indicating strong demand. We've built our platform to ensure our products collaborate effectively, offering potential value to customers transitioning from on-premise to cloud solutions. While it’s still early to evaluate specific results, initial customer feedback is encouraging, particularly regarding increased efficacy in adopting multiple applications within larger organizations. We will release further updates as we gather more data post-launch.

Operator, Operator

Thank you. That concludes our question-and-answer session. I will now turn the call over to Mike for closing remarks.

Michael Cannon-Brookes, Co-CEO

I want to thank you for your detailed questions and for engaging with our shareholder letter. I'm grateful to our Atlassian employees for yet another successful quarter. Enjoy your weekend, wherever you are in the world, and we will talk to you next quarter!