2023-04-06 11:14:22 ET
Summary
- Elastic's business model is well-positioned to benefit from the massive amounts of data that need to be searched for insights.
- The problem is that its operations appear to be maturing, with its revenue growth rates now dramatically lower than this time last year.
- With slowing growth rates, investors will be increasingly focused on its profitability profile. Yes, its profitability is decidedly improving. But too slowly.
Investment Thesis
Tech is a brutal place to invest. It's always out with the old and in with the new.
Along these lines, despite a compelling narrative around its prospects, Elastic's ( ESTC ) revenue growth rates appear to be maturing.
If this time last year Elastic could still be counted on for its hyper-growth revenue trajectory, its outlook for fiscal 2024 (starting in less than 30 days' time), is substantially less than compelling.
What this means in practice, is that investors will be increasingly looking toward its free cash flows to support its valuation. And those aren't yet strong enough to get investors excited. But they are clearly improving.
While I'm tepidly bullish on Elastic's prospects, for now, I still need to see more progress on its profitability margins.
Elastic's Near-Term Prospects
Data, data, and yet more data. Every single business is generating more data than it can derive insights from. What if there was a way to search company data for insights?
Enter Elastic Stack, a solution that ingests and stores data in any format. This means data that can come in the form of a tweet or spreadsheet, via structured or unstructured data.
Think of structured data as a rigid spreadsheet. While unstructured data means a database that's always "open" where you can add data to cells and remove data at speed.
The industry term for this type of database is non-relational databases. Databases that can be used for storing media content, processing data mining, or performing analytics. Data that is fluid and can be searchable with Elasticsearch and then visualized with Kibana, one of Elastic's main product interfaces.
So far, prospects appear enticing, right? Now, let me highlight one key issue. Elastic's Cloud business model is a usage-based business model. What this means in practice is that with time, as Elastic Cloud starts to make up close to 50% of Elastic's overall revenues, its business model will derive 50% of its revenues from a consumption-based business model.
But what does this mean in practice?
This means that when the economy is strong, consumption-based business models are terrific. The more the customers use your product, the more you charge them for that usage. And that's awesome.
However, when the economy becomes more restrictive, customers often reduce their usage, as their businesses downsize. And that means that customers end up spending less on Elastic than they might have under a more traditional standalone contract. And this is starting to get reflected in Elastic's financials, which we'll next turn to.
Still Growing at a Considerable Rate
The graphic above reminds us of three considerations.
On the one hand, irrespective of its compelling narrative, Elastic's growth rates are slowing. On the other hand, keep in mind that Elastic typically beats analysts' consensus estimates.
In fact, as you can see above, in the past 12 months, Elastic has always beaten analysts' consensus estimates.
On yet another hand, there's no doubt that the size of the revenue beats are shrinking. If in 2021 Elastic was beating consensus estimates by at least mid-single digits, by the time 2022 rolled around, Elastic was barely beating by low single digits.
And that's the main issue here. When investors back a tech company, they demand high-quality, solid, predictable, rapid growth. And Elastic's business model headed into fiscal 2024 doesn't appear to be delivering this.
Next, let's turn our discussion to what I believe is a bullish consideration to the bull case.
Fully Focused on Improving its Profitability Profile
Fiscal Q4 2023, which ends this month, points to approximately 5% non-GAAP operating margins. That's a massive improvement from the negative 3% reported in last year's Q4 period, something close to an 800 basis point improvement.
Meanwhile, keep in mind that Elastic's management's stock-based compensation typically runs around 20% of revenues. And on top of this, SBC is substantially outpacing topline growth, with fiscal Q3 2023 seeing SBC increase by 46% y/y, which is double the rate of revenue growth.
More specifically, it wouldn't surprise me if Elastic's GAAP operating profits were to remain around negative 15% to 18%, meaning that yes, Elastic is improving its profitability, but there's still a lot more heavy lifting to be accomplished until this business starts to report a clean profit.
The Bottom Line
Elastic is a database search engine. The share price has seen its multiple fully compress and its stock has largely been derisked. And while its future prospects are alluring, management doesn't appear to be translating its potential into an attractive profitable growth opportunity.
For further details see:
Elastic: Primed For A Comeback, With A But