Philippine Markets Newsletter

Uniform Accounting shows how a combination of the right business model and pricing strategy led to this firm’s robust ROAs of 15%+

June 4, 2020

Software-as-a-service has become a strategic requirement for long-term success in the tech industry. This subscription model, usually in the form of tiered pricing, helps firms maintain price stickiness.

This SaaS company follows the same model with an added bonus of a “freemium” strategy. Users get to try the product for free with the expectation that they will upgrade to the paid version if they are satisfied.

While this has created strong economic moats for the company in the form of price stickiness and an expanded user base, as-reported metrics don’t seem to portray that. However, TRUE UAFRS-based (Uniform) analysis shows that the firm has had ROAs north of 15% and not the consistently negative returns that as-reported metrics indicate.

Also below, Uniform Accounting Embedded Expectations Analysis and the Uniform Accounting Performance and Valuation Tearsheet for the company.

Philippine Markets Daily:
Thursday Uniform Earnings Tearsheets – Global Focus
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The COVID-19 pandemic has reshaped the way our society operates. Lockdowns in various countries have people adopting work-from-home protocols and physically distancing themselves outside their homes.

Working remotely has become the current default for businesses to continue operations, and so it is important for firms to adjust in a way that would ensure effective communication among team members.

Firms have gone digital to accommodate these changes. Having an online workspace effectively bridges the gap between employees and minimizes issues caused by distance.

There are applications readily available for those purposes. A few weeks ago, we talked about Zoom Communications, a teleconferencing app that offered virtual chat rooms and video calls for employees to conduct online meetings.

Another company, Atlassian Corporation Plc (TEAM), also offers similar services that make it easier to facilitate online collaboration.

Atlassian is a software-as-a-service (SaaS) firm that has seven primary software offerings, with Jira and Confluence driving almost two-thirds of their revenues. These tools, including others such as Trello and Bitbucket, center around planning and managing projects in a shared space.

Their wide array of software offerings, on top of being a SaaS vendor, makes it possible for the firm to build strong economic moats.

Software-as-a-service is a business model where the software is licensed on a subscription basis and is centrally hosted by the licensing firm. The user doesn’t pay for the software itself, just the authorization to use it for a period of time—much like a rental service.

For users, it’s a lot easier and faster because the software is already configured. This reduces the time spent on installation and software deployment compared to traditional enterprise (non-SaaS) software installations.

Besides the ease of use, marketability and distribution of the software is also easier. Because these are internet-based applications, or one that can be downloaded from the host server’s cloud storage, global expansion is a lot more feasible.

One strategy to market the product is through free trials. Recently, Atlassian has made their software free for a period in response to the pandemic restricting physical team collaboration.

This “freemium” strategy is offered with the expectation that a wider base of end-users gets enough firsthand experience to upgrade to the “premium” product—that is, paying to unlock additional features.

Once the user adopts the product and decides to upgrade, pricing becomes a critical component of the user’s experience in terms of what features fit their needs best.

Generally, SaaS models are priced in tiers, with higher and more expensive tiers that are banded with more features and a longer permitted usage period. This works well because users only pay for what they need, as opposed to buying the entire software and paying full price for features they may not use.

Alternatively, the company benefits from an increase in its customer base because individuals, as well as small- and medium-sized enterprises, who cannot afford a full-priced license now have a lower cost hurdle.

Ultimately though, once the end users fully integrate the software within their operations, it becomes more difficult for them to switch to another platform. It’s advantageous insofar as customer retention goes.

High switching costs and the tiered-pricing subscription model allow Atlassian to maintain price stickiness. With this, combined with an expanding user base, investors would expect that their economic moats would translate to stronger returns.

However, it appears that isn’t the case, with as-reported ROAs inflecting from 7% in 2014 to negative returns going forward. Atlassian looks like a low profitability business that just keeps getting worse.

In reality, Atlassian has been generating strong returns, performing significantly better than what as-reported metrics reflect.

The distortion comes from as-reported metrics incorrectly treating R&D as an expense.

In reality, R&D is an investment in the long-term cash flow generation of the company. By recording R&D as an expense, this violates one of the core principles of accounting, which is that expenses should be recognized in the period when the related revenue is incurred.

Since as-reported accounting records R&D on the income statement, as opposed to as an investment on the balance sheet, net income can become materially understated.

As in the case of Atlassian, the company regularly spends up to $500 million dollars annually on R&D to continually improve its software offerings. Without this adjustment, it will look like the firm is having less success with its R&D investments than it really is, leading to poorer valuations.

After adjusting for R&D and other adjustments, the company’s Uniform ROA sits at 23% in 2019, which is materially higher than its as-reported ROA of negative levels.

Atlassian’s earning power is actually more robust than you think

As-reported metrics distort the market’s perception of the firm’s recent profitability. If you were to just look at as-reported ROA, you would think that the company is a much weaker business than real economic metrics highlight.

Atlassian’s Uniform ROA has actually been higher than its as-reported ROA in the past six years. For example, as-reported ROA was -2% in 2019, but its Uniform ROA was actually significantly higher at 23%. When Uniform ROA peaked at 34% in 2014, as-reported ROA was at a meager 7%.

Through Uniform Accounting, we can see that the company’s true ROAs have actually been much higher. Atlassian’s Uniform ROA for the past six years has ranged from 15% to 34%, while as-reported ROA ranged only from -3% to 7% in the same timeframe.

After dropping from 34% in 2014 to 15% in 2016, Uniform ROA bounced back to 27% in 2017. Afterwards, Uniform ROA declined to 23% in 2019.

Atlassian’s Uniform ROA is driven by robust Uniform earnings margins and Uniform asset turns

Atlassian’s profitability has been driven by stability in Uniform earnings margins and trends in Uniform asset turns.

From 2014-2017, Uniform earnings margins increased from 28% to a peak of 33% levels. It then declined to 27% levels in 2019.

Meanwhile, Uniform asset turns fell from a peak of 1.2x in 2014 to 0.5x in 2016. It then increased to 0.8x in 2017 and remained there since.

At current valuations, markets are pricing in expectations for both Uniform earnings margin and Uniform asset turns to reach new peaks.

SUMMARY and Atlassian Corporation Tearsheet

As the Uniform Accounting tearsheet for Atlassian Corporation Plc (TEAM) highlights, the Uniform P/E trades at 101.3x, which is above corporate average valuation levels and its own recent history.

High P/Es require high EPS growth to sustain them. In the case of Atlassian, the company has recently shown a 35% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Atlassian’s Wall Street analyst-driven forecast is a 24% growth in 2020 and a 1% shrinkage in 2021.

Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Atlassian’s $185 stock price. These are often referred to as market embedded expectations.

In order to justify current market expectations, Atlassian would need to have Uniform earnings grow by 45% each year over the next three years. What Wall Street analysts expect for Atlassian’s earnings growth is below what the current stock market valuation requires in 2020 and 2021.

Meanwhile, the company’s earning power is 4x the corporate average. Also, cash flows are 2x higher than its total obligations—including debt maturities, capex maintenance, and dividends. Together, this signals low credit and dividend risk.

To conclude, Atlassian’s Uniform earnings growth is above peer averages in 2020. Also, the company is trading above average peer valuations.

About the Philippine Market Daily
“Thursday Uniform Earnings Tearsheets – Global Focus”

Some of the world’s greatest investors learned from the Father of Value Investing or have learned to follow his investment philosophy very closely. That pioneer of value investing is Professor Benjamin Graham. His followers:

Warren Buffett and Charles Munger of Berkshire Hathaway; Shelby C. Davis of Davis Funds; Marty Whitman of Third Avenue Value Fund; Jean-Marie Eveillard of First Eagle; Mitch Julis of Canyon Capital; just to name a few.

Each of these great investors studied security analysis and valuation, applying this methodology to manage their multi-billion dollar portfolios. They did this without relying on as-reported numbers.

Uniform Adjusted Financial Reporting Standards (UAFRS or Uniform Accounting) is an answer to the many inconsistencies present in GAAP and IFRS, as well as in PFRS.

Under UAFRS, each company’s financial statements are rebuilt under a consistent set of rules, resulting in an apples-to-apples comparison. Resulting UAFRS-based earnings, assets, debts, cash flows from operations, investing, and financing, and other key elements become the basis for more reliable financial statement analysis.

Every Thursday, we focus on one multinational company that’s particularly interesting from a UAFRS vs as-reported standpoint. We highlight one adjustment that illustrates why the as-reported numbers are unreliable.

This way, we gain a better understanding of the factors driving a particular stock’s returns, and whether or not the firm’s true profitability is reflected in its current valuations.

Hope you’ve found this week’s Uniform earnings tearsheet on a multinational company interesting and insightful.

Stay tuned for next week’s multinational company highlight!


Angelica Lim
Research Director
Philippine Markets Daily
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