Summary
- Elastic's growth rate has decelerated significantly, due in part to macro headwinds, but also due to limited success outside its core markets.
- Elastic will continue to grow, even if at a more modest pace, and the company should be able to generate reasonable profit margins.
- Elastic is already being valued like a legacy vendor that is slowly bleeding market share to newer competitors.
- The company's situation is far from this dire, and this is likely to be reflected in the stock price in time.
Elastic’s ( ESTC ) stock has had a difficult few years, due in part to interest rates crushing growth stocks, but also from a rapid deceleration in growth. While the stock is clearly undervalued, the long term potential of the company is questionable as Elastic does not have an advantage in the high potential security and observability markets.
Elastic has a large market opportunity due to their broad applicability of their platform, but investors should be skeptical of their ability to capture meaningful share of much of these markets. Observability is becoming a platform which is absorbing adjacent use cases, blurring the boundary with markets like security. Observability is also a crucial capability for many companies, making it less likely that they will settle for second tier solutions. Similarly, Cloud / Endpoint Security is rapidly evolving and in the process converting SIEM from a product into a feature. Search is really Elastic's strength, but it doesn't offer the opportunity that observability and security do.
Figure 1: Elastic's Total Addressable Market (source: Elastic)
Elastic is pursuing a platform strategy, encouraging customers to consolidate a range of use cases on top of their platform. Elastic’s platform enables customers to analyze all their data across logs, application traces, metrics and other related data. While Elastic is far from a leader in observability and security, their pricing potentially creates a compelling value proposition relative to best-in-class peers.
How much appeal a low TCO platform for consolidating use cases has remains to be seen, but so far it appears that Elastic is having relatively limited success expanding beyond its traditional areas of strength.
Elastic tends to land new customers within Enterprise Search, and log analytics for Observability of SIEM for Security, as these are areas of strength. This suggests that despite recent acquisitions and product development, Elastic is still viewed primarily as a log analytics and search company.
Search
Search is an area of strength for Elastic and their strategy is to make complex search functionality accessible and scalable across use cases and segments. For example, Elastic has introduced vector search, which leverages machine learning to capture the meaning of unstructured data (e.g. text and images). Vector search finds similar data using approximate nearing neighbor algorithms and compared to traditional keyword search, yields more relevant results and executes faster.
Elastic observed an 84% increase in deployments actively running a machine learning models in the last quarter, indicating wider adoption of their natural language processing capabilities.
Observability
30% of Elastic’s Observability clusters are now using APM in addition to log analytics and Elastic are seeing competitive wins as customers consolidate tools. Elastic recently added to their synthetic monitoring capabilities and have seen almost 4x growth in synthetic test runs. Elastic also recently launched Universal Profiling, a performance optimization and cost saving capability.
Observability is a competitive market, with a range of vendors like Datadog ( DDOG ), Dynatrace ( DT ) and New Relic ( NEWR ) all finding significant success. Elastic has been a fairly late entrant to this market and is likely to find it difficult to achieve meaningful market penetration. Elastic’s value proposition in this area is more so targeted towards vendor consolidation and cost control than offering a solution that wins on its own merits. Elastic does not give detailed breakdowns of the performance of each of their product lines, but the data they have given suggests that they have a small share of the observability market and are losing share relative to the market leaders.
Table 1: Estimated Observability Revenue (source: Created by author using data from company reports)
Security
Security is one of Elastic’s growth engines, but it is also currently Elastic’s smallest product line. Similar to other leading vendors, Elastic is offering a unified security approach for the modern security operations center. More than 20% of Elastic’s security customers are using newer use cases in XDR and cloud security. Elastic also has over 30 customers using cloud security posture management for Kubernetes, which recently became generally available.
Elastic has also been adding to their SIEM capabilities, introducing threat intelligence management, hybrid sort and host and user entity analytics. SIEM is Elastic’s primary strength in security, but next-gen endpoint vendors have been moving into this area aggressively in recent years, with CrowdStrike ( CRWD ) acquiring Humio and SentinelOne ( S ) acquiring Scalyr. These both eliminate data schema requirements from the ingestion process and index limitations from querying, allowing the ingestion of massive amounts of data in real-time.
Elastic must not only try to add to its security portfolio and gain traction in endpoint and cloud security, but it will likely have to work harder to defend its position in SIEM as the XDR paradigm takes over.
Table 2: Estimated Security Revenue (source: Created by author using data from company reports)
Product Innovation
Elastic continues to add to their capabilities of their platform, supporting new cases within their three primary business pillars. They recently added more optimized support for metrics data in Elastic Search, which will enable customers to more easily consolidate onto Elastic for all of their observability needs.
Elastic is also introducing a new query language, ESQL, which will provide users with a robust query expression language to interrogate data. As Elastic becomes more widely used, there is an increasing need to take data-as-ingested and transform it to derive insights. ESQL enables "rich and expressive queries where search, filter, aggregation, and transformation are performed via a single query expression". ESQL is anticipated to become available on the platform in 2023.
Elastic also plans on introducing a serverless cloud product, which will broaden their addressable market. The serverless product will support short duration workloads and should complement the existing Elastic Cloud service, which is optimized for long running workloads.
Financial Analysis
Elastic is facing the same macro headwinds as most SaaS companies, with deal scrutiny increasing overall and consumption slowing in the SMB segment. Countries where the strengthening USD has created adverse conditions have been a particular area of weakness for Elastic. The Americas grew faster than APAC and EMEA in the most recent quarter, in part due to currency impacts in those regions. Around 40% of the company’s revenue comes from outside the US, leaving Elastic more exposed than many peers. Currency movements were expected to present a 4% YoY headwind to revenue growth in the third quarter, although with the USD easing significantly in recent months, this may not eventuate.
Elastic Cloud continues to drive Elastic’s growth, growing 52% YoY in the most recent quarter and now contributing 39% of total revenue. The self-managed business continues to contribute 52% of total revenue and grew 20% YoY in the most recent quarter. While the cloud is a bright spot for Elastic, growth hasn’t been as strong as companies in a similar situation, like MongoDB ( MDB ) and Confluent ( CFLT ). With cloud growth slowly declining, even in the absence of macro issues, it raises the question of where Elastic’s growth rate will settle once conditions normalize. Based on past data and Elastic’s future opportunities, it would appear the company’s days of 40+% revenue growth are largely behind them.
Figure 3: Elastic Revenue Growth (source: Created by author using data from Elastic)
Elastic continues to grow its customer base, although customer additions have slowed markedly in recent quarters. Larger customers are demonstrating a preference for consolidating multiple use cases on the platform, which is contributing to expansion rates and large customer growth. Despite this, Elastic’s customer base still skews towards smaller users, reflecting their open-source background and focus on product-led growth. Elastic has more than 3,900 customers with ACV greater than 10,000 USD and 1,050 customers with ACV greater than 100,000 USD.
Table 3: Elastic Large Customer Growth (source: Created by author using data from Elastic) Figure 4: Elastic Customers (source: Created by author using data from Elastic)
The number of job openings mentioning elasticsearch in the job requirements declined significantly in 2022, which is somewhat concerning and could suggest Elastic has problems beyond current macro headwinds. Management has stated that they continue to do well in competitive environments and that their win rates remain healthy. There has also been no significant change in gross renewal rates for subscriptions.
Figure 5: Job Openings Mentioning Elasticsearch in the Job Requirements (source: Revealera.com)
Search interest for Elastic pricing has also demonstrated relative weakness over the past year or so. While management continue to believe they are building a generational company, slowing growth in Elastic’s core search vertical and relatively weak competitive positioning in security and observability suggest the company is finding it difficult to capitalize on the opportunity ahead of it.
Figure 6: "Elastic Pricing" Search Interest (source: Created by author using data from Google Trends)
Elastic’s growth prospects may be deteriorating, but the company has reasonably high gross margins and a track record of relatively efficient growth. Rapid cloud growth is likely to continue weighing on gross margins, but this could be offset by greater efficiency and the addition of higher value add use cases in security and observability.
Figure 7: Elastic Gross Profit Margins (source: Created by author using data from Elastic)
Elastic has never had the same large losses as some of its peers, but the company has also demonstrated limited operating leverage. This appears to be the result of investing in R&D to build out security and observability capabilities, as well as investing in sales and marketing to attract larger customers.
Figure 8: Elastic Operating Profit Margins (source: Created by author using data from company reports)
Elastic is now increasing its focus on profitability, recently cutting its workforce by 13% . Elastic plans on utilizing an automated low-touch sales and marketing approach in the SMB segment and using savings from there to increase coverage in the enterprise segment. The company will continue to invest in R&D, with a focus on areas like cloud and serverless. Continued growth along with less investments should see the company begin progressing towards profitability.
Figure 9: Elastic Operating Expenses (source: Created by author using data from Elastic)
Valuation
While Elastic's growth has deteriorated significantly over the past 12 months, the stock has been overly punished for this. This is not really surprising though, as investors have never really bought into the Elastic story the same way they have with many other SaaS companies. Elastic is likely to struggle outside of its core markets, but the company should still continue to grow at a moderate pace. The expectations that are currently baked into the stock price are so low that Elastic should be able to offer reasonable returns from here in my view, even with mediocre business performance.
Figure 10: Elastic Relative Valuation (source: Created by author using data from Seeking Alpha)
For further details see:
Elastic: Undervalued But Cloudy Long Term Outlook