ESTC - Elastic: Steady Investment In Unsteady Times

2023-11-01 12:15:37 ET

Summary

• Elastic, an infrastructure software company, has performed well in a down market, with a 50% increase in stock price this year.
• Revenue growth has held in the high teens alongside strong net retention rates.
• Elastic's suite of tools for enterprise search, security, and APM, along with its recurring revenue model and profitability, contribute to its positive outlook.
• At <5x FY25 revenue, Elastic's valuation is also undemanding, especially for a company with growth tailwinds in generative AI.

Though interest rates have rocked the world of richly valued tech stocks over the past several months, a number of "growth at a reasonable price" plays have performed comparatively well relative to high-flying peers, indicating the capability of value stocks to shine in a down market.

Elastic (ESTC) is one such stock. This infrastructure software company, best known for developing tools that power the internal search function within applications, is up nearly ~50% year-to-date, with a lot of those gains actually coming over the past two months while most peers in the SaaS sector are down.

I last wrote on Elastic in July , when the stock was trading closer to $60 per share. Since then, the stock has risen by nearly ~20%, and it has also released strong Q1 earnings which featured both stable growth rates/high net expansion rates as well as significant y/y jumps in profitability. Owing to those fundamental upsides, plus a valuation that is still only modest at best, I am remaining bullish on this name and think recent outperformance has plenty of room to continue.

As a reminder for investors who are newer to Elastic, here is what I view as the core bull case for the company:

• Elastic has three powerful tools in its suite, powering enterprise search, security, and APM. Search is Elastic's bread and butter, and the company is the best-in-breed leader at infrastructure that allows you to essentially perform a Google-like search within the confines of a certain application. Security is a natural extension of Elastic's data-monitoring ability, with companies using Elastic to protect against fraud and cyber threats. The latter category ((APM)), meanwhile, is the same space that hotshot Datadog (DDOG) is in, and helps companies maintain their tech stack uptime and monitor performance.
• Many use cases, one platform. The basic point is this: Elastic's core platform supports a variety of use cases and one that has been adopted by major corporations. It estimates its global TAM at $78 billion, suggesting only ~1% current penetration. This TAM has grown significantly versus $45 billion at the time of Elastic's IPO in 2018.
• Natural tie-in to generative AI applications. AI is incorporated into each of Elastic's products, enabling developers to build applications that feature AI-powered search functions.
• Purely recurring, high-margin software product. 90%+ of Elastic's revenue comes from subscriptions, meaning the company has very high revenue visibility. It has net revenue expansion rates of ~120%, meaning the majority of its customers upsell dramatically (versus ~110% net expansion rates for most other software companies). On top of that, Elastic's revenue comes in at a high-70s(%) gross margin. The math on this works out like a charm: as more and more Elastic customers renew and expand, Elastic can take advantage of its huge gross margin to scale profitably, given that renewal deals to existing customers cost far less in terms of sales dollars to achieve.
• Profitability. The company has just started to churn out double-digit pro forma operating margins, leveraging its high gross margin profile and cost savings to really start showcasing its profit potential.

The stock's valuation also remains quite modest. At current share prices near $75, Elastic trades at a market cap of $7.35 billion. After we net off the $957.1 million of cash and $567.8 million of debt on Elastic's most recent balance sheet, the company's resulting enterprise value is $6.96 billion.

For the current FY24 (which is the year for Elastic ending in April 2024) the company has guided to $1.242-$1.250 billion in revenue, representing 17% y/y growth.

For the following year, FY25, Wall Street consensus points to $1.47 billion in revenue, or 18% y/y growth (data from Yahoo Finance ). This puts Elastic's valuation multiples at:

• 5.6x EV/FY24 revenue
• 4.7x EV/FY25 revenue

There's still room here for expansion against FY25 multiples, especially as the company is just starting to crank its profitability lever. Stay long here and ride the upward wave.

Q1 download

Elastic will release Q2 books in November, but it's worth going through the company's recent Q1 earnings (July quarter) to demonstrate the fundamental momentum that the company has picked up recently that has juiced up its stock price.

The Q1 earnings summary is shown below:

Revenue grew 17% y/y to $293.8 million, not decelerating from Q4's as-reported growth pace (though constant-currency growth did slow from 19% in Q4 to 17% in Q1), and beating Wall Street's expectations of $284.5 million (+14% y/y) by an impressive three-point margin.

The chart above shows that cloud revenue growth is also still indexing well above the company total, up 24% y/y in Q1 to $121 million and representing 41% of overall revenue.

Ashutosh Kulkarni, Elastic's CEO, noted on the Q1 earnings call that a buildup of activity around AI is helping to foster growth for the company:

Our land and expand strategy continues to serve us well and our long-term opportunity remains robust. In Q1, we saw two distinct trends within our business. The first is around generative AI. Generative AI and its intuitive approach to interact with massive amounts of information and generate new content is driving a resurgence of excitement around enterprise search. Businesses are recognizing the opportunity to create new customer and employee experiences and drive efficiencies in various business processes through the use of AI-powered search.

This is opening up new opportunities for Elastic. To build generative AI applications that work within their environment and with their proprietary data, businesses need the ability to provide accurate context in real-time to large language models or LLM. And to do so in a way that doesn't violate their privacy or security policies. This requires a platform that can allow businesses to use their own or third-party ML models to generate embeddings from their data, irrespective of the type of data."

The company has also done an excellent job combining steady top-line growth with substantial profit expansion. As shown in the chart below, Elastic is expecting to expand pro forma operating margins by up to 650bps this year to a 10-10.5% margin range:

This is driven, in part, by strong net revenue retention rates - at the 113% mark in Q1. Because the company is spending minimal sales resources to drive upgrades in the install base, it's able to draw operating leverage on its higher revenue base. Also helping is the company's decision midway through FY23 to lay off roughly 13% of its workforce .

Key takeaways

With strong growth rates in the midst of a tough macro economy, growth tailwinds stemming from new use cases in generative AI, and substantial margin gains, there's a lot to like about Elastic, especially at a <5x FY25 revenue multiple. Stay long here and keep riding the recent upward momentum.

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