2023-03-27 13:47:35 ET
Summary
- Elastic's poor performance is being driven by soft customer consumption and elevated exposure to smaller organizations.
- Workload optimization is likely to be ongoing for at least several quarters, and the macro environment will need to improve before demand from smaller organizations rebounds.
- Elastic's valuation is relatively low, but this is a reflection of the company's uncertain competitive positioning and weak growth.
Customer consumption optimization and high exposure to smaller organizations have caused Elastic’s ( ESTC ) growth to decelerate substantially over the past 12 months. While the company has a somewhat questionable competitive position in the security and observability markets, its current problems appear to be more macro related than company specific. Elastic's stock is modestly priced, but an improvement in the macro environment will likely be needed before the stock moves higher.
Market
Elastic's management team has pointed towards elongating deal cycles and increased deal scrutiny, suggesting that their target markets remain challenged. Customers are also optimizing their usage, which is pressuring consumption and revenue.
The SMB segment has been particularly weak, which is problematic for Elastic due to its high exposure to this segment. Elastic is not alone here though, peers are observing similar trends, suggesting that Elastic is primarily facing industry wide problems rather than anything company specific.
Elastic
While Elastic is facing a weak macro environment, management has stated that their pipeline remains healthy and that customer commitments have been strong. Customers have been optimizing usage across all segments of Elastic’s customer base though. This is a significant headwind to growth at the moment, and is dragging Elastic’s net retention rate lower. Elastic offers capabilities like searchable snapshots and tiered storage that help customers reduce costs, potentially contributing to this problem. In theory, these types of features could help Elastic to attract new customers. Elastic’s platform also allows customers to consolidate use cases onto the one platform, reducing complexity and potentially lowering costs.
Vendor consolidation and cost reduction are generally considered important elements of Elastic's value proposition, and hence the company's current struggles could be considered disappointing. In the current environment, Elastic would ideally be seeing customers shift to its platform, but this does not appear to be happening.
Machine learning is an important element of Elastic's business, and the company has taken steps to capitalize on recent advances. Elastic’s platform allows customers to integrate their own machine learning models so that they can adopt new algorithms across use cases as required. Customers are also able to load large transformer models into Elastic Search. This allows customers to perform inference with these models without taking data out of Elastic Search.
Elastic’s management has stated that they are seeing good traction within their SIEM and XDR solutions and strong interest in their cloud security capabilities. Security has historically been Elastic's smallest segment though, and hence any outperformance here is likely to be offset by weakness within observability and search. Cybersecurity continues to be one of the stronger SaaS markets, but Elastic's competitive positioning outside of SIEM appears to be weak.
Elastic's cloud business continues to perform reasonably well, although growth has slowed. Competition with the hyperscalers no longer appears to be a concern, derisking the business somewhat. For example, Elastic's cloud marketplace revenue increased 100% YoY in the third quarter. Elastic has also partnered with cloud hyperscalers on 30 events and go-to-market programs.
In response to market weakness, Elastic is selectively investing in enterprise and commercial sales capacity. The company is also refining its SMB customer acquisition strategy and is targeting customers that have a higher propensity to increase spend over time. This seems to be a recognition that customer acquisition will continue to be difficult going forward and hence growth must be driven more by expansion, particularly amongst smaller organizations.
Financial Analysis
Performance across solutions appears to have been fairly similar, with Elastic reporting a similar solution mix in annual contract values versus the prior quarter.
Relative to most software companies, Elastic has outsized exposure to Europe, which makes its recent performance look even worse. Most software companies have been reporting outperformance in Europe, and hence Elastic's revenue growth could have been expected to be relatively strong. Elastic reported that APJ grew the fastest in the third quarter, followed by EMEA and the Americas.
Elastic is currently expecting total revenue growth in FY2024 to be in the mid to high teen range. Elastic has also dropped its 2 billion USD revenue target for FY2025 on the back of ongoing weak growth. Given softer consumption patterns, it is also expected that it will take longer for Elastic Cloud to exceed 50% of total revenue. Cloud remains a growth driver for Elastic though, due to new and expansion use cases, rather than migrations from self-managed.
Elastic's net expansion rate dropped to roughly 120% in the third quarter, driven in part by slower consumption. The net expansion rate is expected to continue declining for at least the next few quarters. Management has also stated that their gross retention rate has not deteriorated, which could be considered supportive of the fact that current issues are not company specific.
Elastic is clearly having difficulties attracting new customers in the current environment, and this problem is pronounced amongst smaller customers. Growth in mid-sized customers hasn't deteriorated significantly in recent quarters. Growth in large customers has declined, but appears to have stabilized somewhat over the past few quarters.
The number of job openings mentioning elasticsearch in the job openings has declined significantly over the past 12 months, which is not surprising given the slowdown in customer acquisition. Job openings appear to have stabilized somewhat is recent weeks though.
Search interest for "Elasticsearch Pricing" remains low, which could indicate low demand or minimal concern regarding Elastic's pricing. In comparison, search interest for "Datadog Pricing" continues to surge, likely driven by cost concerns.
Elastic's gross profit margins have been relatively stable in recent quarters, and its operating profit margins continue to trend upwards. The company is likely still 1-2 years away from GAAP profitability though.
Elastic dramatically reduced hiring towards the end of 2022 and recently reduced headcount by approximately 13% (~400 people). This should contribute to improved margins going forward, but also suggests that weak growth will be ongoing.
Valuation
Elastic's stock is quite modestly priced as a result of weak growth and a lack of profitability. Elastic should continue progressing towards profitability over the next few years, but growth may remain sluggish until macro conditions improve. Given Elastic's weak positioning in the security and observability markets, it would also be reasonable to expect Elastic to continue trading at a discount to best-in-class peers.
For further details see:
Elastic: High Exposure To SMBs