Elastic’s Ambitious Growth Plan

I haven’t written about Elastic since late 2020. I held a position in 2020, but shifted my allocation to Datadog in 2021. At that point, it was becoming clear that Datadog was emerging as a leader in the observability space. While I still maintain a large portfolio allocation to Datadog, Elastic may provide a favorable return over the next two years, if they can execute on their aggressive growth plan and FY2025 financial targets.

At their Analyst Day in September, the leadership team set an ambitious growth target for $2B in revenue by FY2025. As we are halfway through Elastic’s FY2023, this represents roughly a 2x increase in revenue within 2.5 years. When the leadership team presented the model for this target, they projected a revenue CAGR of 36% to reach it. That would be an acceleration from the current growth rate in the low 30% range.

Additionally, this target comes with profitability improvements, anticipating a couple percentage points of growth each year for adjusted operating and FCF margins, over their roughly break-even state at the time. As ESTC stock appears reasonably valued with a P/S ratio just below 5, these targets might allow for a positive return over the next 2-3 years.

Of course, the macro environment and softer IT spend could hamstring these plans. Elastic’s most recent quarterly report for Q2 FY2023 issued a month after the Analyst Day made these targets appear more challenging. Yet, the leadership team didn’t reset them. Given their exceptionally high net expansion rates for large customers and particularly among new Elastic Cloud users, they might just get close.

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By way of background, the Elastic story involves more than observability. Broadly, it represents a play on “search”, which really encompasses the ability to ingest, process and report on large volumes of data. While Elastic brands themselves as a search company, the Elastic toolset can be applied to a wide range of problems. To make the platform actionable for customers, Elastic focuses on three solution categories:

• Enterprise Search. The ability to search for content either on a web site or within a corporate application. This primarily applies to text-based searches, both in free form fields and pre-set search facets.
• Observability. Observability primarily hinges on the ingestion of data streams and logs from various hardware and software instances to monitor the health of an enterprise’s infrastructure and applications. Elastic provides out of the box solutions for processing metrics (Infrastructure), traces (APM) and log analysis (Logs). These address “the three pillars of observability”.
• Security. Delivers threat prevention, detection and response with security solutions for SIEM, SOAR, XDR and endpoint.

The search platform is built on the open source Elastic (ELK) Stack. This includes three components – Elasticsearch (core search engine), Logstash (data ingestion pipeline) and Kibana (data visualization). While there is an open source project at the core of the Elastic product, they have built many proprietary features around it to add value for enterprises (open core model). These address functions like security, machine learning and high availability.

In order to access the full package of capabilities, an enterprise would need to purchase a software license from Elastic. For those customers that run their own data centers, they can buy a Self-Managed subscription. However, like other open source software companies, Elastic offers a cloud-hosted deployment of the Elastic Stack called Elastic Cloud. Customers can subscribe to the Elastic Cloud service, billed on a monthly basis. There are four levels of the Elastic Cloud subscription, with increasing amounts of core engine capabilities, application specific features and support.

The portion of revenue contributed by Elastic Cloud has been growing rapidly and now makes up 39% of revenue. This is up from 26% two years ago. While Elastic prefers that most customers adopt the Elastic Cloud service, having a Self-Managed license option allows them to still monetize customers who are not currently migrating to the cloud. This still represents a fair percentage of customers. Fortunately, the Elastic team uses the same code base for both implementations, so it’s not double work to maintain the two.

For customers, Elastic Cloud offers several benefits. The largest is that they do not need to install and manage the Elastic servers. They benefit from the knowledge and support of the team that wrote the software. Additionally, upgrades to newer versions of the software are easier to apply. Elastic Cloud is available on all three of the major hyperscalers.

As a platform, the value proposition for enterprise customers boils down to the versatility and customization available. For versatility, engineering organizations can apply Elastic to solve multiple problems with the same platform. This can reduce costs and system overhead. If a single toolset can provide search functionality on the customer’s web site, observability for its applications and security log analysis, the customer can consolidate three vendor solutions into one. For customization, because the product is open source, customers can extend the core capabilities to meet their unique use case. If a customer wants to apply the concept of observability to a non-standard use case, like fraud detection or cellular network reliability, they can easily customize the capabilities of the Elastic search functionality to that context. This would be much more difficult with a fully proprietary system like Datadog or Splunk.

The flip side of that argument is that many enterprises prefer to have a fully featured solution that is already customized for the use case. They don’t intend to make their own modifications, and actually benefit from the design decisions made by the software provider. These proprietary services are closed, but are also fully functional out of the box. Set up and maintenance is trivial, generally fully outsourced to the provider.

As a software engineer, my assumption was that the majority of customers would prefer the ability to customize. This would lead them to the Elastic solution. The reality is that most customers want an out-of-the-box solution, particularly for functions that offer little incremental value for differentiation like observability and security. This preference has favored solutions like Datadog, enjoying higher overall revenue growth for the past two years.

However, Elastic has been rapidly rounding out the capabilities packaged into their solution offerings. For observability, as an example, they have added Synthetic Monitoring, RUM, Mobile and Continuous Profiling to the feature set, in addition to the core capabilities around log analysis, APM and infrastructure monitoring. The security solution has been extended to cover both endpoint and cloud infrastructure, with capabilities for SIEM, workload protection, CSPM, incident response and threat hunting.

These additional capabilities bring Elastic’s product offerings into closer alignment with other vendors in their target categories. They have also led to an expanded TAM. At Elastic’s Analyst Day Event in September 2022, the leadership team estimated their addressable market has nearly doubled from 2018 to 2023.

At the same analyst event, the company set a target to reach $2B in revenue by FY2025, driven by expected momentum from large customer expansion. Given Elastic’s offset fiscal year, FY2025 would represent the calendar period of May 2024 – April 2025. When the target was set in September, Elastic’s estimate for total revenue for FY2023 (ends in April 2023) was for $1.083B. This meant a $2B revenue target two years later would require about a 36% revenue growth CAGR. As Elastic Cloud increases its share of total revenue (target of 50% by end of FY2024), its higher growth rate will pull up the overall revenue growth rate each year. This implies revenue growth acceleration from about 34% now (in constant currency).

On the profitability side, Elastic leadership didn’t set an explicit target for margins by FY2025. They provided the guidance that they will expand operating margin by several percentage points in both FY2024 and FY2025. That would be over their Non-GAAP operating margin target for FY2023 of about 0.5% at the time (now higher). Free cash flow would follow a similar path. At the time of the Analyst event adjusted FCF margin was about 0.7%.

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Against the backdrop of those long term targets, let’s see what Elastic delivered in the most recent quarter.

Q2 FY2023 Earnings Results

Elastic reported their Q2 FY2023 results (quarter end October 2022) on November 30th. Elastic’s reporting schedule is offset from the calendar year. The current fiscal year ends on April 30th, 2023. As part of the Q4 FY2023 earnings call in May 2023, leadership will presumably provide guidance for FY2024. That will be an important indicator to see if Elastic is on track for the $2B revenue target.

For Q2, Elastic reported $264.4M in revenue, representing year/year growth of 28%, or 34% on a constant currency basis. This beat their prior guidance of $260M – $262M, issued with the Q1 report, and the analyst target for $261.6M. In Q1, the growth rate was 30% on a reported basis and 34% in constant currency. Sequential growth from Q1 was 5.7% on an absolute basis, up from 4.5% sequential growth from Q4 to Q1.

Elastic reports the constant currency adjustment because customers pay in local currency outside the U.S. Due to the strong dollar, the value of foreign currency collected is less when converted to U.S. Dollars. Elastic reports what the actual revenue value would have been at the same currency conversion to U.S. Dollars, so that y/y comparisons are more meaningful.

Elastic Cloud revenue was $103.2M, up 50% y/y as reported and 52% on a constant currency basis. This compares to $97.7M in Q1, for 59% y/y growth as reported and 62% on a constant currency basis. Sequential growth in Q2 was 5.6%, about the same as total revenue. In Q1, sequential growth was 11.4%, following Q4’s annual growth of 71%. Elastic Cloud growth decelerated substantially in Q2, with the new sequential growth rate annualized equaling about 24% revenue growth.

Elastic Cloud revenue represented 39% of total revenue in Q2, up from 34% a year ago and linear to Q1’s 39%. This is the first quarter where Elastic Cloud’s share of revenue did not increase q/q. As I discussed above, the larger contribution of Elastic Cloud is expected to drive overall revenue growth acceleration to 36% a year to hit the $2B revenue target by FY2025.

Looking forward to Q3 (end of January 2023), Elastic leadership expects total revenue in a range of $272M – $274M, representing 22% y/y growth at the midpoint or 26% growth on a constant currency basis. This missed the analyst target for $277.7M by almost 2%. At the midpoint, this would generate 3.2% of sequential growth. If we assume a similar beat as delivered in the Q2 actual, then Q3 revenue would be about $276M-$277M, for 4.8% sequential growth and about 24% annually. This is where we start to see the optimistic projections from the Analyst Day a few months earlier start to break down.

For the full year, they decreased the revenue target to $1.067B – $1.073B, down from the Q1 range of $1.080B – $1.086B and missing the analyst target for $1.08B. This updated revenue estimate would represent revenue growth of 24% over FY2022 on a reported basis and 28% on a currency adjusted basis. This is down from the full year growth rate of 26% and 30% set in Q1.

Shifting to Profitability, Non-GAAP gross margin in Q2 was 74.5%, which was up sequentially from Q1’s 73.9%, but lower than 76.8% a year ago. As Elastic Cloud becomes a larger portion of overall revenue, gross margins will face pressure. This will be offset by cost efficiencies gained with scale. Elastic delivered Non-GAAP operating income of $4.9M for an operating margin of 2%. This compares to a Non-GAAP operating loss of $4.7M last quarter and $1.4M of income a year ago. This drove a Non-GAAP EPS of $0.00 in Q2, which beat the analyst estimate for ($0.10) nicely. Adjusted FCF was $10.3M for a FCF margin of 3.9%. This is up significantly from -$12.2M a year ago and $1.7M in Q1.

As part of the Q2 report, Elastic announced a workforce reduction of 13%. The intent is to “align our investments with our strategic priorities and position us for long-term success.” They are rebalancing spend across the company and will invest some of the savings into areas that position the company for profitable growth. As an example, they plan to build out their capabilities for SMB customers who prefer a self-serve sales motion. They will also increase coverage in the enterprise segment. For product development, they will emphasize strategic areas like cloud and serverless.

While a RIF is generally a negative business signal, I think Elastic is applying it prudently. They hired aggressively during 2021 and invested across several areas to drive future growth. As the macro environment has created a headwind to their business and made clear the investment areas with the highest ROI, leadership is applying a one-time reduction to trim excess personnel and focus on growth areas.

The net benefit will be more operating leverage. As a result of these changes, management expects higher non-GAAP operating income in the second half of this fiscal year. For FY2024, they now expect a 10% operating margin, which is above what they had previously committed or achieved in the past. Specific to Q3, they are projecting a non-GAAP operating margin of 4.3% to $4.7%, for an EPS of $0.04 to $0.07. Analysts had modeled ($0.03) for Q3. For the full year, they raised the operating margin target to 2.2% to 2.6%, which is up from 0.3% to 0.7% set in Q1. Further, they raised the EPS target to ($0.03) to $0.03 for the full year, up from ($0.31) and ($0.25) in Q1.

Customer metrics reflected some of the slowdown in demand as well. Total subscription customers numbered 19,700 at the end of Q2, compared to 19,300 in Q1 and 17,000 in Q2 FY2022. This yielded just 2.0% sequential growth and 15.9% annual growth. In Q1, Elastic added 700 subscription customers and annual growth was 20.6%. Q2 represented a substantial slowdown in subscription customer additions and was the smallest sequential count in the last two years. On the earnings call, management attributed this to the weakness in the SMB segment. They also reiterated their strategy of focusing on increasing share with large enterprises that have a higher propensity to spend, versus trying to market to a broad swath of company sizes.

Elastic finished Q2 with 1,050 customers with an ACV over $100k. This is up about 40 total or 4% over the 1,010 such customers in Q1 and 830 a year ago for annual growth of 26.5%. In Q1, Elastic added 50 customers of this size, representing a slight sequential slowdown in additions. They reported a larger change in their Net Expansion Rate. This measures the increase in spend of existing customers from the year ago period to present. In Q2, this dropped to 125% from “just under” 130% in Q1. Expansion rates can vary somewhat, based on timing of contract renewals and other factors, but a 5% drop q/q is more than expected. Historically, Elastic had maintained a NER above 130%.

On the product side, Elastic leadership provided some stats to reinforce their continued expansion into the three primary solution categories of search, observability and security. As I mentioned, their revenue growth strategy and the path to $2B hinge on the ability to increase share of spend with their largest customers. During the Analyst Day presentation in September, management revealed that the Net Expansion Rate for $100k customers is over 135%, which is higher than the rate for all customers, and these large customers contribute 69% of all customer spend. Further, the NER for Elastic Cloud customers is greater than 140%. With a goal to get Cloud to 50% of total revenue by end of FY2024, future revenue growth will be increasingly driven by the higher NER of Cloud.

The net expansion rate is dependent upon Elastic’s ability to cross-sell the platform to existing customers across all three product categories. The more customers who adopt search, observability and security use cases, the more likely that Elastic can maintain their high NER with larger customers and hit the target 36% annual growth needed to reach their $2B FY2025 goal. With a NER over 135% for large customers contributing 69% of revenue and 140% for Elastic Cloud growing to 50% of revenue, they should be able to hit their target revenue growth rate in the mid-30% range. The risk to the growth thesis is if the slowdown experienced in Q2 is a sustained trend, versus a temporary dip. Of course, that is largely dependent on macro effects.

Elastic’s value proposition for large customers revolves around the idea that they can apply Elastic’s solutions to address many use cases with a single consumption-based pricing model. Especially in the observability and security product categories, this model resonates with some customers, versus the pricing structure of competitive offerings that are segmented by type of observability or security workload. On Elastic, customers can address use cases in log analysis, application traces, infrastructure metrics, security analytics, SIEM, endpoint protection and more for the same rate based on the amount of resources provisioned.

Once customers have success with a single use case, they often add more over time by simply sending new data feeds to their Elastic installation. Elastic leadership cited a number of customers across different industries that have expanded into multiple product categories, including Affirm, AutoZone, BMW, Booking, Comcast and SWIFT. They also provided several examples of customer expansions on the Q2 earnings call, where the customer added another category of data analysis like observability or security in the quarter. These were supplemented by product adoption achievements as well.

• Expanded their security business with Uber. Uber is using Elastic for threat hunting and response. Recently, they increased use of Elastic SIEM to cover their entire enterprise defense platform.
• Shared a metric that more than 20% of security customers now consume Elastic’s newer use cases in XDR and cloud security, beyond basic security analytics.
• Over 30 customers are now using their CSPM product for Kubernetes, which recently went GA.
• Launched new capabilities for SIEM, including threat intelligence management, hybrid SOAR and user analytics. Also, released the first Elastic Global Threat Report, which showcases the first-party research conducted by Elastic’s internal security research team.
• Elastic Security was named a visionary in Gartner’s 2022 Magic Quadrant for SIEM.
• One of the world’s leading media and entertainment companies expanded usage with a unique use case. They are applying Elastic Observability to monitor operations at several theme parks and track critical park functions like Wi-Fi, PoS system availability and virtual lines. These provide an example of non-standard application of Elastic to “observe” systems that go outside of the normal web application context.
• APM is gaining traction with Observability customers, with 30% of observability clusters being used for APM in addition to log analysis. They are seeing competitive wins as customers seek to consolidate tools.
• Enterprise Search is expanding as well, with a 7-figure renewal with a multi-national aerospace company and a renewal with a U.S. government agency.

Like other independent software companies, Elastic has been deepening their relationships with the hyperscalers recently. A few years back, this was not the case, as the hyperscalers (particularly AWS) rolled their own versions of popular open source projects. Partially due to licensing changes, but primarily due to customer preferences, the hyperscalers have reversed their competitive positioning with Elastic and now embrace the Elastic sales team in co-selling engagements. Elastic has forged strong partnerships with AWS, Azure and GCP at this point.

The Elastic CEO explained the shift in disposition as the hyperscalers’ realization that they could generate more revenue and profit by encouraging customers to use Elastic Cloud on their infrastructure. The consumption of compute and storage resources by Elastic on their customers’ behalf is more profitable than trying to roll and support a competing product. The Elastic CEO quipped that the hyperscalers like anything that “spins the meter”. As part of the Q2 earnings call, Elastic leadership shared that revenue through the cloud hyperscaler marketplaces again more than doubled year/year.

After the Q2 results were reported on November 30th, ESTC stock dropped 6.6% the following day. This was an improvement over the after-hours drop of almost 16%. By mid-December, ESTC broke $60 again and almost hit its pre-earnings price. Since then, it has dipped back into the low $50 range, which is close to its 52-week low around $48.

Like other software infrastructure stocks, ESTC had peaked in November 2021, at a price over $180. Notably, ESTC is trading near its lowest price since going public in October 2018. Its P/S ratio is even more suppressed, about half of the March 2020 low and a quarter of its first year of trading.

Investor Take-aways

If Elastic can reach its $2B revenue target in FY2025 (ends April of 2025, or less than 2.5 years from now), the valuation starts to look compelling. The current market cap for ESTC is $4.93B, with a trailing P/S ratio of about 5.0. If Elastic reaches its FY2025 target, the P/S ratio would drop to about 2.5. At that point, Elastic would be finishing the year with revenue growth in the mid-30% range and positive operating and FCF margin. Given that they expect these margins to expand by a few percent a year, we could conservatively assume 5-10% adjusted operating and FCF margins. Those growth and profitability metrics would warrant a higher valuation multiple than 2.5. If anything, we could consider Elastic fairly valued now, meaning that the stock could double by April 2025.

Of course, this is heavily dependent on the achievement of those targets. During the Q2 earnings call, one of the analysts asked for an update on the FY2025 target. The CEO expressed confidence in the target, but was noncommittal.

And lastly, around the $2 billion target. Look, what I’ll say is our goal hasn’t changed. The fundamental strength of our business remains strong. And we’ve always talked about the fact that we are building a generational company. We’re building a multibillion-dollar company. Two billion was always a milestone in that journey. Clearly, given the business environment that we are dealing with, we expect that that’s going to be difficult and it’s going to be harder. And, you know, we acknowledge that. So, we are not reaffirming, but we are also not changing any of that guidance. We are going to continue pushing forward. Like we said, fundamentally, we are not compromising on growth. We are just being far more focused based on the reality of the macro environment that we are seeing, and we want to make sure that we are putting our investments where we believe we can get the best return.

Elastic Q2 FY2023 Earnings Call

Interestingly, analysts don’t appear to be modeling the $2B revenue projection at this point. They currently have FY2024 revenue estimated at $1.33B for 24.2% growth over the $1.071B target for FY2023 (within range just set for FY2023 in Q2 results). For FY2025, they are modeling $1.644B in revenue, which would represent another 23.6% annual growth. That is obviously a far cry from Elastic’s 36% growth target set at Analyst Day just three months prior. If Elastic can deliver on their targets, or even come close, then the stock would likely appreciate considerably as analysts mark up their estimates.

If we consider the factors at play, Elastic’s target appears achievable. Elastic Cloud is growing faster than total revenue. More importantly, it benefits from a much higher NER, which was revealed to be over 140% during the Analyst Day. This, plus continued growth in new customers of about 16% a year, should support a 36% annual revenue growth CAGR for the next 2 years. With large customers spread across multiple industries, Elastic appears somewhat insulated from some of the category specific weakness cited by other software infrastructure peers.

In addition to the $2B target, Elastic is making substantial improvement on profitability. They delivered positive adjusted operating and FCF margin in Q2 and should reach nearly 5% margin in Q3. Looking to next fiscal year, they have increased the target to 10% Non-GAAP operating margin, with adjusted FCF following a similar trend. This performance was aided by a difficult, but thoughtful, reduction in workforce. If Elastic can exit 2023 with revenue growth near 30% and then accelerate growth somewhat as macro conditions improve, that growth rate, combined with improving profitability should maintain the current 4-5 P/S ratio. It might even justify a re-rating upwards, which would be more inline with historical values.

With a run rate of $2B in revenue and positive FCF margins, ESTC’s market cap could approach $10B over the next 2-3 years, representing a 2x increase from the current level. If Elastic appears to be tracking towards these targets as 2023 progresses and we get a preliminary favorable view for FY2024, I may restart a position in ESTC in my portfolio.

NOTE: This article does not represent investment advice and is solely the author’s opinion for managing his own investment portfolio. Readers are expected to perform their own due diligence before making investment decisions. Please see the Disclaimer for more detail.