In January of 2020, we wrote an in-depth analysis on Elastic (ESTC), which you can access here. We recommend that you read this report to get a full understanding of Elastic’s product positioning within the cloud and data security sectors. Recently, it started showing up on our screens from all angles. We will likely begin initiating a position soon, and build in layers until we see a major breakout.
In this quick blog, we present some of the recent changes that ESTC made to their positioning within cloud. We also address some of the concerns regarding their competition with AWS. We believe these changes will be a boon to their future growth, and want you to get a better idea why we are focusing on ESTC from a fundamental perspective.
Fundamental Overview:
Early in 2021, Elastic modified its open-source license so that it is no longer free for use if it is being repackaged and sold as a SaaS product. This was done to address cloud vendors’ repackaging of Elastic’s opensource code and selling it themselves. Elastic clarified that the vast majority of users will not be impacted, rather “the folks who take our products and sell them directly as a service will be impacted, such as the Amazon Elasticsearch Service.”
AWS responded to this news by stating that it will maintain its open-source fork of Elastic search. Specifically, AWS stated “In order to ensure open source versions of both packages remain available and well supported, including in our own offerings, we are announcing today that AWS will step up to create and maintain a ALv2-licensed fork of open source Elasticsearch and Kibana.” ESTC’s stock sold off in January, possibly in-light of the news that tech giant AWS was going to maintain Elastic’s open source code, which would pressure Elastic’s ability to charge for its software going forward.
However, we believe that Elastic will be able to overcome this AWS threat. This is because cloud customers often want an independent third-party monitoring their cloud stack. Elastic should be able to continue to grow even if AWS maintains a fork of its open-source code. Since Elastic is already embedded in many different organizations and has a large and diverse developer community, we believe that AWS’s open-source fork will not replace Elastic’s open-core platform. We also suspect that the market is wising up to this, as the stock price has recovered most of its losses since the January sell-off.
Being open-source has driven the adoption of Elastic, since being free-to-use increases the size of the ‘cake’ (opportunity). Elastic can get a slice of the cake by charging for certain features. However, cloud vendors such as AWS have been reselling Elastic’s open-source software, so Elastic understandably wants some of that revenue. By changing its license structure, Elastic gets a smaller cake but a bigger slice. The market is still unsure if this is a good path to take, and we will soon find out with Elastic’s results in the coming quarters.
Elastic’s Financials and Outlook
Despite the uncertainty, we have comfort in the quality of Elastic’s recent results and the reasonableness of its forward estimates. For example, Elastic reported high quality revenue in the last quarter (Q4 FY2021). Q4 sales increased 44% YOY to $178 million, while deferred revenue increased 45% YOY to $353 million. Deferred revenue represents cash received upfront, which provides balance sheet support for future sales. Deferred revenue was 199% of three-month sales in Q4, a four-year seasonal high. This is a good trend to see as it means there is relatively more demand for Elastic’s products than in prior years, a sign of strength.
We also see that cash collected from customers also increased in FY2021. We measure cash collections from customers by looking at the YOY changes in accounts receivables and deferred revenue and adding the net change to annual sales. In the below chart, you can clearly see that Elastic has been steadily increasing its cash collections. This is a favorable trend, as it shows that Elastic is not extending payment terms and/or requiring less upfront cash to drive sales. This also validates that there is sustained demand for Elastic’s products. By scaling cash collections from customers to 12M sales, the metric increased to 118%, the highest value since Elastic went public. Stated differently, Elastic is receiving more cash from sales than in any period in its history, another sign of strength. This trend also helped Elastic report positive cashflows in FY2021.
Looking forward, Elastic will report AH on 08/25. The Street expects Q1 FY2023 sales to increase 46% YOY to $189 million, an acceleration from the most recent topline growth rate of 44%. We believe that Elastic will be able to meet its estimates since it has amble support from its balance sheet. As mentioned, deferred revenue increased 45% YOY in the most recent quarter, and was 187% of forward three-month sales. In the last four years, Elastic’s Q4 deferred revenue balance has been ~180% of forward sales. Given the relatively higher levels of deferred revenue, we believe that an expectation for accelerating topline growth is reasonable.
Following the Q1 FY2022 print that will be released soon, we will want to see that Elastic is still growing despite the AWS fork. We believe that Elastic will be able to overcome this temporary threat, and that the narrative around the stock may soon change, which could lead to a large move in the stock price.