Beth had previously written a premium analysis on Elastic back in early 2020 that focused on Elastic’s core products. Please read that analysis here if you haven’t yet.
In this article, I will instead discuss why we are now bullish on Elastic and why we think its stock will do well going forward. This analysis focuses on Elastic’s feud with Amazon AWS, its transition from open-source to open-core licensing and the uncertainty that currently surrounds the stock. Importantly, we believe that this uncertainty could provide an opportunity given the stock’s valuation. We conclude our discussion with an overview of Elastic’s recent results and the company’s financial future.
Why we like Elastic:
Elastic recently reported an acceleration in both sales and user growth. We believe that Elastic is well positioned to continue to report strong growth going forward. Elastic’s rapidly expanding total addressable market (TAM, pictured below) supports our belief that there is plenty of runway ahead for Elastic.
Elastic’s Total Addressable Market (TAM)
Elastic is a search company. As data consumption grows exponentially, search will become increasingly more critical for organizations. Being able to quickly scale and search structured and unstructured data is what Elastic is built for. Search is also necessary for both preventing and detecting security threats. CEO Shay Banon summarized Elastic’s position during the Q1 Earnings Call when he said that “as data volumes grow, the best and most natural way to explore data is by searching it… We see usage of Elastic just as a general search platform that is very useful to do many, many different things”. In short, growth in data consumption will benefit Elastic’s topline going forward. This is also true for companies like MongoDB and Snowflake as well, yet Elastic has a much more attractive valuation.
Volume of Data consumed worldwide 2010 to 2025
Furthermore, having a founder CEO in a complex space such as enterprise search can be a game changer since success is driven by product. Since no one will understand the product more than the founder, a founder-CEO can provide an edge for a company since product is often paramount, especially in tech.
Despite these traits, Elastic trades at a discount to its peers (discussed below), which we believe is due to the uncertainty surrounding Elastic’s transition to open core and the feud with Amazon’s AWS. We believe that these concerns may subside, and that Elastic will emerge from this uncertainty a stronger company. We discuss these concerns in greater detail next.
From open-source to open-core and the feud with Amazon AWS
Elastic has its roots in open source, which facilitated the rapid adoption of its software and has been a cheap and efficient form of distribution. Elastic makes money by offering certain features of its software available through paid subscriptions. Clearly, Elastic has been able to capitalize on its open-source distribution model, as it reported $608 million in sales in FY2021.
While being open source provides many benefits, the caveat is that its free, and that anyone can make changes to the code and redistribute (sell) it. In 2015, AWS started reselling Elasticsearch as “Amazon Elasticsearch”, which Elastic has contended is an obvious trademark violation. CEO Banon has explained that “this trademark issue [with AWS] drives confusion with users thinking Amazon Elasticsearch Service is actually a service provided jointly with Elastic, with our blessing and collaboration. This is just not true”. Essentially, Amazon has been implying a partnership with Elastic and has effectively taken some of Elastic’s revenue for the last 6+ years.
AWS went even further and in 2019, AWS announced that it will maintain an Open Distro of Elasticsearch, which was similar to a fork of Elastic’s code. ESTC stock sold off 5% that day. Elastic’s founder-CEO responded to the AWS news by highlighting how Elastic has been “forked, redistributed and rebundled so many times I lost count. It is a sign of success and the reach our products have. From various vendors, to large Chinese entities, to now, Amazon. There was always a "reason", at times masked with fake altruism or benevolence. None of these have lasted. They were built to serve their own needs, drive confusion, and splinter the community”. Elastic has so far been able to counter AWS’s fork, evident in its rapid user growth (discussed below). The stock is also up 87% since AWS announced the Open Distro of Elasticsearch.
The feud with AWS and Elastic escalated further in early 2021. On January 14th, Elastic announced a licensing change to its Elasticsearch and Kibana products. The change was aimed at preventing cloud providers (i.e., AWS) from selling its free software without contributing back to the open-source project. On January 21st, AWS responded to Elastic’s license change by announcing that “AWS will step up to create and maintain a ALv2-licensed fork of open source Elasticsearch and Kibana”. AWS has since forked the last ALv2 version of Elasticsearch and Kibana and has called it OpenSearch.
As shown below, the AWS announcement on 01/21/21 marked the top in ESTC’s stock. This feud with Amazon AWS has resulted in uncertainty, as the market is concerned that Elastic will not be able to overcome the AWS threat. We note that since January 2021, Elastic’s financials have improved, yet the stock is still below its ATH. We believe that we are presented an opportunity to buy a high performing company at a discounted price due to this temporary uncertainty caused by the AWS fork. We explain why we believe that Elastic will be able to overcome the AWS threat in more detail next.
Elastic’s stock returns since its IPO
Why we believe that Elastic will be able to overcome the AWS threat
It will take time for Elastic’s licensing change to take effect, since only new releases of Elasticsearch software will be impacted. So, we will have to wait a few quarters to know for sure if Elastic is benefitting or not from the licensing change. This uncertainty can be our opportunity.
By taking a step back and observing the situation from a developer’s perspective, we can better gauge the situation. AWS is forking the Elasticsearch software to maintain its use for AWS, not for other uses. If you want to use it for AWS, great. But if you want to use it in a multi-cloud environment, then the software will likely require further modifications. These modifications will accentuate the differences between AWS’s fork and Elastic’s official releases. The two products will likely operate very differently and portability/migration between services will become harder over time. Do you pick AWS’s fork, or Elastic’s core software?
If you operate strictly on AWS, then the AWS fork may be appealing. If you operate in a multi-cloud environment, then the official Elastic releases will likely be a better choice since it was developed for all different cloud environments. Moreover, certain capabilities are absent from the AWS fork, such as machine learning, which is “built into Elasticsearch and readily available to all customers, without dependencies on any specific proprietary external services. [Elastic does] not believe this to be the case with the new forks, which are primarily built for and governed by AWS”. Machine learning is often a key reason why corporations migrate to the cloud, so we should expect users to want this functionality and hence prefer Elasticsearch over OpenSearch.
At the I/O Fund, we believe that multi-cloud environments will dominate going forward, which should drive traffic to neutral and best-of-breed Elasticsearch over AWS supported OpenSearch. Multiple surveys also signal that most companies are already using multi-cloud providers (shown below). Since Elastic collaborates with all major cloud providers, its software will be optimized for multi-cloud environments. The AWS fork of Elasticsearch will likely be biased towards AWS, meaning that AWS operability will be prioritized over other cloud platforms.
We also note that Elasticsearch also observes and monitors a cloud providers performance. We believe that cloud users want an independent party monitoring their cloud environments. For the last six years, AWS has been able to sell its “Amazon Elasticsearch” product by implying a partnership with Elastic using its trademark. This feigned partnership has likely led users to believe that Elasticsearch was developing the software, not Amazon. By changing the licensing agreement, Amazon has been forced to change the name of Amazon Elasticsearch to OpenSearch. This should help resolve the misunderstanding that Amazon Elasticsearch was not independent of AWS. Furthermore, this should also redistribute the revenues that went to Amazon Elasticsearch back to Elastic, benefiting Elastic’s topline.
We believe that Elastic will benefit from the licensing change as users will prefer the agnostic Elasticsearch versions to search and observe their cloud environments. This should also lead to a redistribution of revenue that Amazon has taken by reselling Elasticsearch as its own product, benefitting Elastic’s topline. The prevalence of multi-cloud environments will also favor Elasticsearch over AWS’s fork. In the next section, we go beyond the licensing change and provide a brief overview of Elastic’s growing presence in cybersecurity and what this could mean for the company going forward.
Security and SIEM
On top of the licensing changes, Elastic recently released a new version of its code which included a new product called Limitless Extended Detection and Response (XDR), which builds on Elastic’s security offerings. Elastic XDR can be used to unify security information and event management (SIEM) capabilities across all endpoints onto a single platform. Elastic explained further that XDR allows users to “ingest and retain large volumes of data from diverse sources, store and search data for longer, and augment threat hunting with detections and machine learning”.
A question we need to answer is if Elastic is expanding into the highly competitive security vertical because it is running out of runway in its core search market or if this is a natural progression for the firm. The latter appears to be the case, as searching data is a great way to detect and prevent threats. CEO Banon explained during the Q1 Earnings Call that “as companies go online, their surface areas become bigger and they generate more data that needs to be used to detect” threats that can remain hidden out of view. Searching that data is a natural way to detect threats and prevent future threats.
CEO Banon also clarified how Elastic will be able to compete with the numerous security vendors on the market during the Q1 call. He explained that a user first needs to be able to observe threats in order to detect them, and searching the data is the best way to observe threats. He stated further that Elastic’s search engine has been built to identify, among other things, threats.
During the Q1 call, CEO Banon painted a clear picture of what the XDR product is trying to solve: which is to provide a unified place where “you can store all data possible and threat hunt extremely fast, either manually or through AI and machine learning algorithms, and then extend to the peripherals so you can detect and prevent”. Elastic’s platform is already built to scale and quickly processes large amounts of data, so it’s a natural progression to use it for threat detection and prevention.
Finally, what really sets Elastic’s XDR product apart is its ability to scale. Elastic is built to scale: you can change the timeframe of your data search from 2 weeks to 2 years and still receive results within minutes (some competing products can take days or fail to ever finish a query if the dataset is too large). Elastic’s 10+ year history and large developer community has contributed to its ability to quickly scale and process large amounts of data. As observability and security continue to merge going forward, Elastic’s platform is well positioned to benefit from these converging trends. We also note that Elastic’s financial performance has improved in recent quarters, which we discuss in greater detail next.
Financials
Elastic reported Q1 FY2022 results on 08/25/21. The results came in strong as sales accelerated 50% YOY to $193 million and beat estimates by $20 million (12%). The beat flowed into guidance, as Elastic raised its topline guide for FY2022 to $811 million at the mid-point, implying a 34% YOY growth rate which was 3% ahead of the Street’s initial estimate. Since the licensing change went into effect in February 2021, Elastic’s sales have accelerated: from 39% YOY growth in the January quarter (Q3 FY21) to 44% YOY growth in Q4 FY21 and then to a 50% YOY growth rate as of the latest quarter. The acceleration in sales implies that Elastic’s licensing change has not dissuaded customers from signing up and/or increasing their usage of Elastic’s platform.
Elastic’s Q1 gross margin improved 131 bps YOY to 74%, which was above the three-year average of 72%. Operating margins declined 174 bps YOY to -16%, as CEO Banon explained on the Q1 Earnings Call that Elastic has front loaded expenses by hiring software engineers to support its growth initiatives. Cashflows on a 12M basis were an inflow of $15 million, an improvement from an outflow of -$7 million in the prior year quarter. Non-GAAP EPS was $0.04, which beat estimates by $0.16.
Customer metrics also showed an acceleration in Elastic’s business. For example, after the licensing change took effect in Q4 FY21, customer count growth accelerated. Specifically, Q1 FY22 (Q4 FY21) customer count grew 32% (33%) YOY to 16,000 (15,000), faster than the 31% YOY growth rate in Q3 FY21. Furthermore, Q1 customers with contract values greater than $100k increased 24% YOY to 780, an acceleration from the 20% and 18% growth rates reported in Q4 and Q3 FY21, respectively. The acceleration in customer growth suggests that the licensing changes have been beneficial.
However, despite reporting an acceleration in sales, a top and bottom-line beat, a raise in guidance and improving customer metrics, Elastic’s stock slightly sold off after the strong Q1 print. We believe this was because billings came in low. However, we do not think this is a concern since growth in cloud sales does not increase billings.
Cloud sales, which are 100% subscription based with no free option, increased 89% YOY to $62 million, an acceleration from the 70% and 79% YOY rates reported in Q4 and Q3 FY21, respectively. Elastic cloud is mostly billed monthly, meaning there is no deferred revenue and hence, no billings associated with the sales. However, as cloud customers grow in usage, their contracts will get larger in which point they will likely convert to annual billing. This will then lead to a rise in deferred revenue and a rebound in calculated billings growth. In short, we believe that billings are temporarily subdued due to the growth in cloud sales, which is a good problem to have.
Viewed holistically, we believe that Elastic is a high performing company reporting strong growth, positive cashflows and improving customer metrics. While there are concerns, such as the AWS threat and subdued billings, we believe that these concerns are just temporary issues. In the next section, we briefly discuss Elastic’s discounted valuation.
Valuation
Elastic trades at an 18x Fwd P/S multiple, well below its peer group median of 32x Fwd P/S (peers: DDOG, CRWD, DT, SPLK, MDB). Elastic’s EV/Sales multiple of 21x was nearly half its peer group’s 40x EV/sales multiple. However, Elastic is growing just as fast as its peer group. As shown in the below charts, ESTC’s most recent growth rate is above the peer median, yet its valuation is nearly half the peer median. We don’t believe that Elastic deserves such a large discount relative to its peers. As discussed, the AWS threat and subdued billings growth are temporary concerns which will ultimately make Elastic stronger. For its strong growth and healthy margins, we expect that Elastic will start to trade closer to the peer median.
Elastic’s Sales Multiple Relative to the Peer Median
Elastics Three-month Growth Rate vs Its Peers
Conclusion :
The I/O Fund believes that Elastic is a high-quality company with strong growth and a relatively cheap valuation. We discussed the uncertainty that surrounds the stock which helps explain the discount in Elastic’s share price. We also explained why we think that the AWS threat and subdued billing concerns are just temporary issues. Looking forward, we expect Elastic to continue to grow its topline as its TAM continues to balloon. We also expect that the firm’s valuation will converge towards its peer group once the licensing uncertainty is fully behind the firm, which may take a few quarters.
Additional Resources:
Overview of Elastic's Q4 2021 Results
Disclosure: Bradley Cipriano and the I/O Fund may own shares in Elastic and have no plans to change their respective positions within the next 72 hours. You can access the I/O Fund’s positions here. The above article expresses the opinions of the author, and the author did not receive compensation from any of the discussed companies.Disclosure: Bradley Cipriano and the I/O Fund may own shares in Elastic and have no plans to change their respective positions within the next 72 hours. You can access the I/O Fund’s positions herehere. The above article expresses the opinions of the author, and the author did not receive compensation from any of the discussed companies.