2023-03-06 01:07:26 ET
Summary
- Despite a tough macro environment, Elastic reported better-than-expected 3Q23 earnings with solid growth in gross margin and operating margin and a slight increase in revenue.
- The slowdown in growth is likely due to longer sales cycles and SMB churns, and the company has revised its revenue forecast.
- I recommend holding off on any investments for now and tracking how ESTC stock is performing against its guidance.
Investment thesis
Despite the tough macro environment, I think Elastic ( ESTC ) reported a better than I expected 3Q23, highlighted by solid growth in gross margin and operating margin and a slight increase in revenue. Not surprising in this weak macro environment, longer sales cycles and SMB churns have weighed on growth. As a result, ESTC has revised downward its revenue forecast for 4Q23, and now expects mid to high teens growth for FY24. That said, management has maintained its margin guidance of 10% for FY24, indicating that profitability remains a priority despite the reduced revenue outlook. Management has also reset market expectations by removing the 50% ESTC Cloud mix target by 4Q24 and a $2 billion FY25 target. Overall, while a slowdown in growth is concerning, the more pressing concern is whether or not the implied growth (from guidance) is achievable to support valuation in the short-term (most investors are focused on the short-term I believe). I believe this is something to track over the next few quarters.
In light of the current climate of uncertainty and risk, I expect ESTC shares to be rangebound for the next few months, until the company reports earnings or there is other major news to drive the stock. In spite of the difficult macro environment, I think FY24/25 could be the starting point which ESTC stock narrative shifts to a "profitable growth business", as I expect ESTC to enjoy high incremental margins in beyond FY24, which means higher margins. As such, I recommend holding off any investment until things get more certain.
Earnings results
Despite the more challenging macro environment, ESTC's results for the quarter were better than expected on most metrics. The $275 million in revenue generated was up 23% year-over-year. Increased operating income was a result of the earlier round of layoffs bearing fruit - this resulted in a 7.9% margin. FCF was also positive at $7 million, compared to projections of a $3 million loss.
Growth slowing in the near-term
What we're seeing at ESTC, I think, is very typical of what's happening at many other software companies as rates go up and the recession sets in. Slowing customer spending is a headwind for ESTC as underlying customers optimizes budget spending. Those familiar with the usage-based ESTC model can probably guess how quickly they would be affected if underlying customers stopped paying for ESTC altogether (unlike annual contracts). This is having serious consequences for revenue growth and likely explains why the company issued a revenue guidance for 4Q23 that fell short of expectations. That said, management stressed that contractual commitments are still healthy as customers sought out new uses for the product. Also contributing to growth is ESTC's progress in expanding its hyperscaler partnerships with Cloud this quarter. With the ESTC platform model in mind, I think it won't be long before companies start using this trend to their advantage in consolidating and streamlining their IT infrastructure. However, I have no doubts that ESTC will see slower growth in the short-term declines. The slowdown is likely reflected in management's forecast for FY24 revenue growth in the "mid to high teens," as opposed to the consensus estimate of 20%.
On track to generate FCF?
Instead of trying to break even by FY23 as was originally planned, management now anticipates an adj. FCF margin in the low single digits. Since ESTC business model requires almost no significant capex , it will benefit greatly from any operating leverage (i.e., high incremental margin), which has the potential to significantly affect FCF. Importantly, a positive FCF generation profile would help ESTC's balance sheet profile.
Guidance
In the latest earnings, management removed their previous goals of $2 billion in revenue by FY25 and 50% cloud revenues by FY24. While this has caught me off guard, I see some positive profit potential as they shift their focus to expanding profitable growth. As a result of last quarter's workforce reduction, this quarter's margins were significantly higher than expected, and management is positive about reaching their target of 10% margins in FY24, with room for further growth in FY25. It's encouraging to learn that management plans to keep costs in check and, instead of putting all their eggs in the SMB basket, will try to attract more high-spending enterprise clients.
Conclusion
Despite the tough macro environment, ESTC reported better-than-expected 3Q23 earnings. However, longer sales cycles and SMB churns have weighed on growth, leading to a downward revision of revenue forecasts for 4Q23. While a slowdown in growth is concerning, management has maintained its margin guidance of 10% for FY24, indicating that profitability remains a priority despite the reduced revenue outlook. The removal of previous revenue goals may catch some investors off guard, but I see this as an opportunity for management to shift their focus to expanding profitable growth. Tracking the implied growth from guidance will be important in determining if ESTC's valuation is supported in the short-term. As such, I recommend to hold off any investments for now.
For further details see:
Elastic: To Hold Off Investing For Now Until Better Certainty On Growth