2023-07-06 14:35:42 ET
Summary
- Elastic, an off-the-radar infrastructure software company, is a strong investment option due to its high-margin, recurring revenue and sticky technology base.
- The company's software powers internal search functions within applications, helps ingest data from multiple sources, and offers IT departments a platform to monitor performance and security.
- The company is planning for substantial operating margin expansion in FY24, on top of high-teens revenue growth.
- The company's transition toward a cloud-based consumption business model gives it the ability to grow alongside its customers as use cases expand.
Right now, the markets are in a delicate dance, with investors frequently changing their minds on the direction of interest rate hikes. Tech stocks, obviously the most reactive to interest rate swings, have seen massive intraday fluctuations over the past few weeks. I continue to encourage investors to take a long-term mindset: and for me, that means investing in "growth at a reasonable price" stocks that can perform well in the long run no matter what the short-term swings are.
Elastic ( ESTC ), in my view, is a great stock to pick up in this regard, especially with the renewed interest swirling around AI. On a relative basis, I've appreciated Elastic's ~25% year-to-date gain, though its rebound has paled next to some much sharper upswings in other tech stocks; in addition, Elastic also still remains roughly two-thirds below its pandemic peak values above $160.
Elastic may not be mainstream, but it is highly investable
Though Elastic has historically required a lot of patience to hold - its product and business stories have never really caught fire with the mainstream markets; and as it stands, Elastic is a relatively off-the-radar infrastructure software company that not many investors are familiar with.
Elastic's software, for investors who are unfamiliar with the name, powers the internal search functions within applications. Its technology also helps companies ingest data from multiple sources, and offers IT departments an observability platform to monitor performance and root out potential security gaps.
And though its brand is not as instantly recognizable as other tech companies, it boasts a top-tier customer list that are among the most recognizable names in the world:
Here, in my view, is the full long-term bull case for Elastic:
- 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.
- 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.
- Very sticky technology base. Elastic is in a category of software considered "infrastructure software," which means that it sits at the heart of a company's IT stack. This kind of software is very difficult to rip out (versus a top-end application, like a CRM system, that is relatively easier to stop using and migrate to another solution).
- Strong cloud growth. Elastic's hosted cloud solutions are seeing much stronger (~40% y/y) growth rates relative to the rest of the company, which serves as an additional upside catalyst for investors to be excited about. It also gives Elastic an easy route to market for customers who are on services like Amazon AWS, where Elastic now features very native integrations.
I remain bullish on Elastic and I am holding onto the stock in my portfolio, especially after reviewing the company's latest results. Stay long here and patiently wait for the rebound.
Q4 download
Elastic recently closed out its fiscal FY23 (April quarter), beating Wall Street's expectations when it reported results in early June.
Revenue grew 17% y/y to $279.9 million, beating Wall Street's expectations of $277.5 million (+16% y/y). Cloud revenue grew 28% y/y and decelerated ten points versus 38% y/y growth in Q3, and represented 40% of Elastic's overall revenue. FX continues to be a headwind here: revenue growth in both total revenue and cloud revenue would have been two points stronger on a constant-currency basis.
The one downside is that Elastic's revenue growth decelerated versus 23% y/y growth in Q3, but this was largely expected as the company comps stronger post-pandemic performance in FY22 plus encounters macro-related slowdowns.
Speaking on the Q&A portion of the Q4 earnings call, CEO Janesh Moorjani said that sales momentum largely played out as expected and that customers continued to engage normally with Elastic in spite of macro conditions. He also noted that the company is entering FY24 with strong sales capacity:
So we didn't see anything significantly different customers continue to engage with us. They are looking to bring more workloads on to the Elastic platform. They're looking to both do that to drive TCO savings but also just get greater business value. And at the same time, they are continuing to focus on ways in which they can optimize their consumption in the near term [...]
And finally, as I think about just ongoing sales execution and other things within the business, we feel pretty good about the increased capacity that we've got as we entered fiscal 2024 with the right amount of capacity in our sales team, as we have talked about before, we continue to hire both enterprise and commercial sales reps. And so overall, when I step back and look at the quarter, it played out as we expected it would, turned out to be a pretty good fiscal year overall despite the macro climate, and we feel pretty good about this year coming up."
The company has two core goals for FY24 reflected in its guidance: first, a desire to keep growth rates consistently in the high teens, guiding to 16% y/y growth in a range of $1.236-$1.250 billion, as well as hitting 10% pro forma operating margins - six points better than FY23.
This represents quite a sizable margin expansion for a company that had merely broken even two years ago. The chart below shows how Elastic has gradually capitalized on its high gross margins and built up its profitability over the past few years:
From a profitability standpoint, Q4 showed healthy momentum toward the company's six-point margin accretion goal in FY24. Q4 pro forma operating margins of 8.6% were twelve points better than -3.3% in the year-ago quarter; and as shown in the chart below, full-year FCF of $56.7 million more than quintupled y/y and represented a 5% FCF margin, roughly in line with pro forma operating margin (indicating that FCF can roughly double in FY24 as well).
Valuation and key takeaways
At current share prices near $62, Elastic trades at a market cap of $6.06 billion. After we net off the $915.2 million of cash and $567.5 million of debt on Elastic's most recent balance sheet, the company's resulting enterprise value is $5.71 billion.
Against the midpoint of Elastic's revenue guidance range of $1.236-$1.250 billion (+16% y/y), Elastic trades at 4.6x EV/FY24 revenue - which, for a company that is growing in the high teens, is just starting to scale toward significant profitability, and has a solid AI foundation already built into its tech stack, is quite cheap.
Stay long here for a further rebound.
For further details see:
Elastic: Opportunity Is Vast