2023-06-02 10:45:00 ET
Summary
- Elastic's Q4 results show that the company is still struggling, but growth is expected to accelerate in H2 FY2024.
- Customers are focused on optimizing cloud consumption, but Elastic remains optimistic due to large multi-year customer commitments and platform consolidation.
- Elastic's AI capabilities could support its competitive position, but the near-term impact may be negligible.
Elastic’s ( ESTC ) fourth quarter results show that the business is continuing to struggle in the face of stiff competition and customers who are trying to control costs. Customer additions were stronger in the quarter, though, and there is a growing sense of excitement around the potential impact of AI on Elastic’s business. Growth is expected to accelerate in the second half of FY2024, but customer optimization efforts are likely to be ongoing, which may set investors up for disappointment.
Optimization
Customers remain focused on optimizing cloud consumption, which is pressuring Elastic’s revenue growth. Elastic’s net expansion rate was 117% in the fourth quarter and is expected to decline further in coming quarters. Customers moving data to object storage is reportedly the most common type of optimization that Elastic is currently seeing. Customers have a number of levers to control costs though, like ingesting less data, retaining data for a shorter period of time and querying data less often. This means that if the macro environment continues to deteriorate, customers can likely cut costs further.
Elastic seems reasonably upbeat about the situation though, as customers continue to make large multi-year commitments, and some customers are consolidating more use cases on Elastic’s platform. Customers reportedly believe that the total cost of ownership for Elastic’s platform is dramatically lower than competitive offerings, which should be a tailwind in the current environment.
Cost is clearly front of mind for customers at the moment, but it is not clear to what extent this is actually benefitting Elastic. Search interest would seem to indicate that there has been a surge in organizations concerned with the cost of Datadog’s ( DDOG ) product, but Elastic’s customer acquisitions remain relatively soft.
Figure 1: "Elasticsearch Pricing" and "Datadog Pricing" Search Interest (source: Created by author using data from Google Trends)
Given that consumption growth is likely to remain a headwind in coming periods, Elastic needs to demonstrate solid customer growth. Elastic’s management has stated that the top of their funnel in May looked fairly consistent with prior periods. This could suggest consistent growth going forward, but the number of job openings mentioning Elasticsearch in the job requirements also shows weakness.
Figure 2: Job Openings Mentioning Elasticsearch in the Job Requirements (source: Revealera.com)
ESRE
Elastic recently announced Elasticsearch Relevance Engine, which appears to be creating some buzz around the company. ESRE utilizes built-in vector search and transformer models that have been designed specifically to bring the power of AI to proprietary and enterprise data. Elastic has a strong background in traditional search and has been working on vector search for a while. These capabilities are now being leveraged with generative AI, although the actual importance of this is yet to be determined.
There is an enormous amount of hype around AI at the moment, a lot of which will likely look silly in hindsight, and Elastic has begun leaning into this. A lot of the fourth quarter earnings call was just analysts trying to find bullish AI arguments for the company, and this could set investors up for disappointment if the near term impact is negligible.
AI is an important part of Elastic’s business, and this extends far beyond just generative AI. As a search company, Elastic should benefit from LLMs, but this may take time. Customers will have to build AI powered applications on Elastic’s platform, and these applications will need to gain traction with users before Elastic begins to see a financial benefit.
Other Innovations
Elastic continues to build out its security portfolio, and recently introduced Cloud Security Posture Management for AWS, container workload security and cloud vulnerability management. Cloud security, and security in general, are competitive markets, though, which may limit Elastic’s success.
Elastic has also contributed Elastic Common Schema to OpenTelemetry, and is committing to joint development of a common schema for observability and security logs. OpenTelemetry is the emerging industry standard for telemetry data, encompassing metrics, logs and traces. This could help cement usage of Elasticsearch for telemetry and support Elastic’s competitive position.
Financial Analysis
Elastic’s revenue increased 19% YoY in constant currency in the fourth quarter, with Elastic Cloud growing 30% YoY and representing 40% of total revenue. The Americas grew the fastest, followed by EMEA and APJ. Results were also reportedly healthy across solutions.
Elastic’s revenue growth continues to decelerate, but according to guidance, is close to bottoming. Growth in the second quarter of FY2024 is expected to be 14% at the midpoint and for the full year 16%. An expectation of acceleration in growth in the second half appears to be largely based on easier comparable periods in 2022.
Figure 3: Elastic Revenue Growth and Operating Profitability (source: Created by author using data from Elastic)
Elastic’s customer base continues to skew towards smaller organizations, which is potentially a headwind in the current environment. The number of larger customers is growing, though, which could indicate that more organizations are consolidating on Elastic for multiple use cases.
The number of customer additions appeared to pickup slightly in the fourth quarter, although they remain weak by past standards.
Table 1: Elastic Customers (source: Created by author using data from Elastic)
Figure 4: Elastic Customers (source: Created by author using data from Elastic)
Valuation
Elastic’s stock continues to look inexpensive relative to many SaaS vendors, but this is largely a function of the company’s growth rate. The economics of Elastic’s business are also not as compelling as top tier SaaS companies.
The question is whether Elastic’s current growth is due to a difficult macro environment, or because Elastic is a maturing company that lacks a strong competitive position. If Elastic’s growth accelerates significantly when conditions improve, the stock could do very well. Otherwise, this could be a value trap.
Figure 5: Elastic Relative Valuation (source: Created by author using data from Seeking Alpha)
For further details see:
Elastic: Q4 2023 Earnings Review