2023-06-05 08:03:13 ET
Summary
- Elastic closed its FY23 year with further softening topline growth, which is expected to prevail in the short run.
- However, there have been positive signs that the second half of FY24 could tell the story of a turnaround, which has been also reflected in the guidance of management.
- Besides generally improving business conditions, the company’s newly announced Elasticsearch Relevance Engine could also play an important role in this process.
Introduction and Investment thesis
Elastic ( ESTC ) reported Q4 FY23 results recently, which showed continued topline growth slowdown resulting from cost optimization efforts by customers. For the Q1 FY24 quarter management sees the same tendencies, which requires further patience from investors who were hoping for a quicker turnaround.
However, I believe it's worth to stick with the company's shares as the second half of the year looks quite promising based on steadily increasing committed business on the company's platform. In the top of that, the recently introduced Elasticsearch Relevance Engine could give a significant boost to the company's search business by providing an essential building block for companies in using large language models (LLMs) real-time on their proprietary data.
For those Readers who are interested in a deeper dive into the solutions Elastic offers, I suggest reading my following article: " Elastic: Assessing Whether The Huge Valuation Discoun To Peers Is Justified ".
Revenue outlook: Getting worse before it gets better
Elastic reported revenues of $280 million for its Q4 FY23 quarter beating the average estimate by less than 1%. This has been an increase of 19% yoy in constant currency ((cc)) a further significant (although expected) slowdown from 27% just one quarter ago. Based on management's Q1 FY24 revenue guidance no significant change is expected in this trend soon as they called for a growth rate of 14% yoy in cc.
The main reason behind this growth slowdown is that customers began to focus on controlling their costs by taking advantage of Elastic's usage-based pricing model. By moving company data needed for search and observability to lower-cost object storage customers can decrease their bills at the expense of a decline in performance. This has a negative impact on Elastic Cloud revenues, which saw almost no growth qoq in Q4.
Based on management's comments even the lowest tier of their object storage (frozen tier) is able to run faster than the higher tier object storage of some competitors, so customers are still doing well this way. However, optimization has its boundaries as well, and according to management it hasn't gotten worse recently.
Meanwhile, the number of use cases and data ingested into platform keeps growing, and new customers are joining the company from quarter to quarter as well. So, if these optimization trends run their course growth could reaccelerate pretty soon. One important sign for this has been the development in the company's remaining performance obligations (RPO), where yoy growth increased for the second consecutive quarter:
Created by author based on company fundamentals
RPO reached $1.1 billion in Q4 FY23 growing 18% yoy (17% in cc), while demonstrating an also impressive 11% qoq growth rate (10% in cc) after a similar Q3 print. This shows that the Q1 FY24 revenue growth rate guide of 14% by management could be rather conservative, and topline growth could quickly reaccelerate in the following quarters.
This is in line with management's FY24 guidance laid out in the recent earnings release, which predicts 16% yoy revenue growth for the financial year. This implies a reacceleration of topline growth from the Q1 projection of 14% in the upcoming quarters:
Created by author based on company fundamentals
Besides the increasing backlog, another reason for management to be optimistic is that the Q3 and Q4 quarters will have significantly easier yoy comps, which can be seen at the chart above. These have been those quarters last year where macro-related cost optimization efforts began to take their toll on the company's topline. Surpassing these numbers will be much easier than the strong H1 ones in the same year.
Based on the above I believe investors have a good chance to acquire the company's shares with a good risk/reward ratio, because the bad news of a further growth slowdown already came to light, but at the same time there is a good chance that things will get better soon.
Finally, there could be another important catalyst for shares, which is the recently launched Elasticsearch Relevance Engine (ESRE). This platform provides Elastic customers the necessary search-related capabilities for applying their chosen LLMs that use their own proprietary data, which is updated in real-time.
Vector search is one of the most important of these capabilities, which has been fine-tuned by Elastic in the last one and a half years. It leverages machine learning to capture the meaning of unstructured data simply based on context by using approximate nearest neighbor algorithms. This function is critical for those companies who want to train LLMs on their company-specific data, so this could be an interesting new market for Elastic in the upcoming years. The company held a detailed presentation on the topic in April, which is available on their website. For those who are interested in more technical details I suggest checking it out.
Elastic is also incorporating AI and machine learning into its own processes to improve efficiencies, but I believe ESRE could be the game changer from a fundamental point of view as it generates new business directly from the increased utilization of LLMs.
Further improvement in margins
Besides further declining sales momentum margins remained a bright spot in the Q4 quarter. Non-GAAP operating margin came in at 8.6% surpassing management's 5% guidance by far. This confirms that Elastic switched to a higher gear considering the company's bottom line after several quarters of breakeven figures:
Created by author based on company fundamentals
Due to seasonal factors the Q1 FY24 quarter should see some margin compression, but management is confident that Elastic can reach the 10% threshold for the entire financial year. This assumes further margin improvement in the back half of the year, just like in the case of revenues. Paving the way for this have been improving operating leverage and the conscious cost control efforts by management (e.g.: layoffs + moderated pace of hiring). Based on the Q4 earnings call the improvement in margins could continue into FY25.
Looking at cash flows, management expects slightly higher FCF margin for FY24 than the 10% non-GAAP operating margin. With this, the company could close out FY24 as a Rule of ~30 company (or somewhat better if exceeding typically conservative guidance), which is far from the top players in the space.
Luckily, this comes with a significantly cheaper valuation (for details see the valuation section of my previous article on the company) and with proven improving growth prospects, which make the shares a good investment at current levels in my opinion.
Conclusion
It seems that after several quarters of mixed results Elastic could finally regain its former glory in the second half of the year. Besides generally improving business conditions the new LLM opportunity with ESRE could be also a positive catalyst providing real hope for a prolonged turnaround.
For further details see:
Elastic: On The Verge Of A Turnaround