Summary
- Elastic revenues barely surpassed analyst estimates in the Q3 quarter, while Q4 guidance foreshadowed further significant slowdown.
- Meanwhile margins surprised to the upside, mostly resulting from headcount reduction of 13% announced in Q2.
- However, the most important takeaway from Q3 earnings has been the surprising increase in new committed business fueling hopes for a brighter future.
Introduction and investment thesis
Elastic ( ESTC ) is a unique company simultaneously present in three different areas of information technology, which are connected through the company’s core technology: search. These areas are enterprise search, where Elastic has its roots, observability, a strong beneficiary of today’s cloud transition, and IT security, an essential part of every business. The main question around the company for a long time has been whether they are able to compete successfully against incumbent companies like Datadog (DDOG) or Dynatrace (DT) in observability, and CrowdStrike (CRWD) or Symantec or others in IT security.
Management has been mentioning on earnings calls and investor days for a long time that Elastic provides a great platform for consolidation, although results of recent financial quarters didn’t provide many reasons to be overly optimistic in that regard. Recently, the main investment case for shares has been mainly their conservative valuation coupled with fundamentals scratching the surface of Rule of 40 levels.
For the first sight, current Q3 earnings didn’t show meaningful change in this trend as revenue growth slowed considerably amid the current macro weakness. On the top of that management provided quite a conservative topline guide for the upcoming Q4 quarter suggesting no quick turnaround on the corner. Meanwhile, on the positive side margins came in better than expected and should continue their way upwards in the foreseeable future.
However, the most important takeaway from Q3 earnings has been the following: Cross-sell opportunities resulting from vendor consolidation that have been voiced for a long-time began possibly to gain traction. Beside management comments the growth in deferred revenues, remaining performance obligations ((RPO)) and customers above annual contract value ((ACV)) of $10,000 and $100,000 all pointed into this direction. If this trend continues it should provide a strong setup for FY24 leading Elastic back to the Rule of 40 elite league of SaaS companies. If that will be the case indeed, current valuation is very compelling for long-term investors to increase their exposure in ESTC stock in my opinion.
Q3 from the top: Forgettable FY23, exciting FY24
Elastic reported revenues of $274.6 million for the FY23 Q3 quarter barely surpassing analyst estimates, which has been the 3 rd such quarter in a row:
Based on past revenue beats management tries to guide for a ~5% topline beat in my opinion. In the light of this, revenue growth in recent quarters has rather surprised to the downside.
Revenue grew 23% yoy in the quarter or more importantly 27% in constant currency ((CC)). This has been a significant deceleration after 34% yoy CC in FYQ2, which is expected to continue based on management guidance of ~18% growth in FY23 Q4:
Created by author based on company filings
According to management sales cycles continued to be elongated compared to historical standards, while the SMB segment remained challenging. On the top of that, customers took advantage of the company’s flexible usage-based pricing model leading to further pressure on topline growth. As management didn’t see any meaningful change in this pattern during the quarter, they built this into their Q4 forecast as well. With this in mind, Elastic acknowledged that their ambitious goal of reaching revenues of $2 billion in FY25 (communicated for the first time to the public last June) is not realistic anymore.
Luckily, the story doesn’t end here. There were several data points in the company’s earnings release that pointed to a brighter future from a topline growth perspective. Remaining performance obligations have been one of these bright spots. Most SaaS companies I used to cover typically reported a slowdown in their yoy RPO growth rate this quarter, which has been similar to the slowdown in their revenue growth rate. Usually, this has been the result of customers becoming more cautious in the current uncertain economic environment postponing deals or only opting for shorter term commitments. In contradiction to this tendency RPO has increased more than 10% sequentially at Elastic in Q3 manifesting in a yoy increase of 16% (18% in cc) after only 8% in the previous quarter:
Created by author based on company filings
What has been more encouraging that based on management comments this hasn’t been the result of one-time items rather the result of strong sales execution in the quarter:
“So this was not about early renewals. It was not about any particular benefit from deals from Q2 that pushed out. We always see some levels of pushouts and pull-ins. Fundamentally, the environment in terms of sales cycles and enterprise customer buying behavior has not changed. I think it was just good old-fashioned execution on the part of our sales team that did really well to adapt to the circumstances that we saw at the end of Q2. So we felt pretty good about that.” – Janesh Moorjani, CFO on Q3 earnings call
Looking at deferred revenues the tendency has been the same. After growing 18% yoy in CC in Q2 they grew 25% yoy on CC in Q3.
Another metric that supports the fact that Elastic made good progress on sales execution in the quarter has been the number of customers with ACV of more than 10,000 and 100,000:
Elastic Q3 earnings presentation Elastic Q3 earnings presentation
In both customer cohorts new additions increased more than in the preceding two quarters signaling strong execution once again.
Considering these encouraging datapoints and the lackluster topline growth figures I see a tale of two stories, which shaped the Q3 quarter. On the one hand customers decreased their usage of the Elastic platform taking advantage of the company’s flexible, usage-based pricing model. Although this is a significant headwind to revenues on the short run, I believe it’s also beneficial for building long-term commitments. On the other hand, these long-term commitments seemed to materialize during the quarter indeed providing encouraging signs for future growth.
I can easily imagine that the current uncertain macro environment is an important catalyst for vendor consolidation, for which Elastic offers an outstanding solution. It will be interesting to see how this unfolds in the upcoming quarters.
Perhaps these encouraging signs have been the reason that management decided to give some hints on FY24 guidance already during the Q3 earnings call . They said that they expect revenues to grow in the mid to high teens in FY24 compared to FY23, which means they didn’t imagine further significant slowdown from currently estimated FY23 Q4 levels. Once again, this seems to be a more optimistic view than in the case of some other SaaS companies who provided guidance for their upcoming financial year.
Besides efficient cross-sell initiatives these welcoming news could have been driven by the ongoing success of Elastic Cloud, growing revenues 40% yoy in CC making up 40% of total revenues in the quarter. Another important note from management regarding cloud revenues has been that these are overwhelmingly generated by new and expansion use cases rather than the migration of self-managed workloads to the cloud. So, predominantly it’s not revenue cannibalization but organic growth, which is welcoming news.
Another important driver of future business has been the strong growth of hyperscaler marketplace revenues, which have doubled on a yoy basis, counting multiple transactions over the $1 million ACV threshold.
Taking all these things together the FY24 revenue growth setup for Elastic seems quite encouraging with a good chance of significant reacceleration in my opinion.
Q3 from the bottom: Sudden increase in non-GAAP profitability
While it seems, investors must wait a few quarters to witness a turnaround on the revenue growth front they didn’t have to wait for margins to do the same. After cutting its workforce by 13% in the previous quarter and optimizing some facility-related costs Elastic managed to reach a non-GAAP operating margin of 7.9% in Q3, a significant improvement from 1.9% just a quarter before:
Created by author based on company filings
Beside the already planned effects from the workforce reduction this has been the result of a better-than-expected gross margin, the earlier-than-planned exit of employees and some shift in expenses to the Q4 quarter. It is important to note that in this case non-GAAP operating margin excludes restructuring charges of ~$30 million as well, so investors shouldn’t expect a beneficial effect on non-GAAP operating margin from decreasing restructuring costs in Q4.
Management guided for a ~5% non-GAAP operating margin for Q4, which I believe seems conservative in the light of the Q3 print and the fact that they confirmed their FY24 non-GAAP operating margin guide of 10%.
Finally a quick thought on FCF. Elastic closed the quarter with $878 million cash and cash equivalents on its balance sheet. This is expected to grow further as FCF margin should take approximately the same path as non-GAAP operating margin in the upcoming quarters.
Valuation: Ample room for multiple expansion
To me, it’s an encouraging sign that even after a significant workforce reduction Elastic has managed to drive significant future commitments to its platform over the Q3 quarter. I believe these positive signs are far from being reflected in the current valuation of shares even if we are only speaking about one seemingly promising quarter until now.
Looking at the valuation of shares we can see the good old conservative multiples, which accompanied Elastic during the previous years. I have established a simple valuation framework to illustrate why I believe that shares are still deeply undervalued at current levels.
I have assumed that revenues grow at CAGR of 20% from FY24 to FY27, which is a rather cautious assumption in my opinion as management expects the bottoming of yoy revenue growth in the first half of FY24, which I think could be somewhere in the mid-teens. As a basis for FY24 I have used current analyst estimates to stay on the conservative side. I have assumed an annual dilution of 3% as this threshold hasn’t been surpassed by the company in the previous two years. For non-GAAP operating margin, I used management’s 10% guide for FY24 and assumed that this could increase to 20% for FY27. Based on their guide that in FY25 it could grow several percentage-points from FY24 levels I believe it’s also a realistic assumption. Based on these inputs my valuation framework looks as follows:
Created by author based on company and own estimates
Based on the rather conservative assumptions above, we can see from the table that at current valuation levels Elastic shares would trade at the market average EV/EBIT multiple of 18.7 already with FY26 non-GAAP operating profit. Going forward one more year in the future, shares would trade at a 23% discount compared to the current market average with FY27 non-GAAP operating profit.
I believe this illustrates it well, how conservative the valuation of Elastic shares currently is. Considering the fact that the company provides transformational software for its customers, which will shape the future for a long time I think it’s hard to imagine that shares will trade at a 23% discount compared to the market average in FY27 rather exactly the opposite. Based on this, I believe there is room for at least 50% overperformance for shares compared to the market in general in the upcoming 3-4 years. This could turn out eventually much more, if revenue growth reaccelerates more than the 20% CAGR I have assumed for this calculation.
Conclusion
Al in all, the encouraging trends in future revenue growth, the significant improvement in margins, and the conservative valuation of shares all point into the direction that shares of Elastic are a great long-term investment at current levels in my opinion.
For further details see:
Elastic Q3 Earnings: The Light At The End Of The Tunnel