Elastic: Impressive Acceleration, But Strength Is Already Priced In

seekingalpha07-06

Elastic has seen a moderate performance in 2024 after rallying in late 2023, as valuation remains a big ceiling for the stock.Elastic currently trades at just shy of 8x current-year revenue, which is ...

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Maria Vonotna/iStock via Getty Images The biggest theme driving the stock market this year continues to be AI, and Elastic (NYSE:ESTC) was an early beneficiary of that trend. The enterprise search and observability company has been touting its multi-year experience with AI, which led to a sharp rally in late 2023. In 2024, Elastic's performance has been more moderate as investors digested the late-2023 rally. Year to date, the stock is up less than 10%, though the company has achieved a robust uptick since reporting strong fiscal Q4 (April quarter) results in late May and issuing an above-consensus guide for FY25. Still, however: observing how Elastic has traded over the past month, I'm expressing caution over the sustainability of its recent rise. Data by YCharts Rich valuation amid uncertain Gen AI benefits Though previously bullish on Elastic throughout most of 2023 as the stock traded at depressed levels, I wrote a neutral and cautious opinion on Elastic earlier this year in March. I'll acknowledge that Q4 results brought a lot of positive factors: including acceleration in revenue growth, and anecdotal commentary on strong renewal activity which should help retention rates in 2025. At the same time, however, challenges remain, including and especially in the SMB segment that Elastic mostly leaves as a self-service business model. Amid this as well, it remains to be seen whether interest in Gen AI (which Elastic has noted was a driver for many of its customers in Q4) will truly provoke a renewed growth spurt beyond what we're already seeing in Elastic's results. Here are the other risks I'm tracking for Elastic:   Lower consumption rates and budget optimization are pressuring Elastic's growth rates. The majority of Elastic's revenue is consumption based, meaning customers are charged for their usage rather than by seat. The current macro environment has many Elastic customers consolidating their platform usage in order to reduce their spend, though the company has noted that this trend has abated somewhat for larger customers.  Steep competition. As more and more customers turn to Elastic for data observability use cases, it must be noted that rival Datadog (DDOG) maintains better growth rates than Elastic despite its larger scale, and that Elastic is hardly the \"best in breed\" vendor in this space.  The biggest risk of all to Elastic, meanwhile, is its steep valuation. At current share prices near $115, Elastic trades at a market cap of $11.66 billion. After we net off the $1.08 billion of cash and $568.6 million of debt on Elastic's most recent balance sheet, the company's resulting enterprise value is $11.15 billion. Meanwhile, for the current fiscal year FY25 that the company just began (Elastic has an April year-end), the company has guided to $1.468-$1.480 billion in revenue, or 16% y/y growth: Elastic outlook (Elastic Q4 earnings deck) This puts Elastic's valuation at 7.6x EV/FY25 revenue. Elastic is pitching itself as a platform and a data lake repository for conducting AI searches and queries, so one of its closest pure-play, small/mid-cap competitors is C3.ai (AI), also a longtime AI vendor that provides a PaaS (platform as a service) product on which to deploy AI applications. We note that C3.ai is expecting to grow at a faster clip than Elastic (it has guided to 19-27% y/y growth this year), and yet Elastic trades slightly more expensively than this peer: Data by YCharts It's not all grave for Elastic, of course. The company has a track record for outperforming its outlook, and the heightened interest in Gen AI use cases that the company cited in Q4 could materialize into higher revenue growth in FY25. I also like the fact that Elastic has a broad product platform, which a security and observability product that pitches the company against the likes of New Relic (NEWR), Datadog, and Splunk (SPLK). That being said, it's difficult for me to expect any further upside in Elastic unless its growth trajectory meaningfully changes from the low 20s/high teens. I'm reiterating my neutral opinion on this stock and remaining on the sidelines. Q4 download We will acknowledge that Q4 results did tilt fundamental trends in Elastic's favor. Take a look at the Q4 earnings summary below: Elastic Q4 results (Elastic Q4 earnings deck) Revenue grew 20% y/y to $335.0 million, ahead of Wall Street's expectations of $329.8 million (+18% y/y) by a two point margin as well as accelerating one point over Q3's 19% y/y growth pace. In fact, as shown in the chart below, this is Elastic's second straight quarter of acceleration after growth dipped to 16% y/y in Q2 of last year, while constant-currency cloud revenue growth has been accelerating for three straight quarters, up 32% y/y in Q4. Elastic growth trends (Elastic Q4 earnings deck) Elastic's ability to grow existing customers into larger deployments as well as sign on new enterprises is also showing well. In Q1, the company added 60 net-new customers that generate more than $100k in ACV, versus only 30-50 per quarter over the past year: Elastic customer adds (Elastic Q4 earnings deck) The company notes that 145 of these >1330 customers generating more than $100k in ACV are already using Gen AI features. Importantly, the company notes that budget moderation among some of its larger clientele has eased somewhat, while early renewals are also prominent: which may pave the way to improved growth rates looking ahead as well. That being said, month-to-month self service revenue from smaller clients continue to face macro headwinds. Per CFO Janesh Moorjani's remarks on the Q4 earnings call:  We continue to see consumption patterns similar to the prior quarter. While we are not seeing the level of focus by our customers on optimization that we experienced some quarters ago, cost consciousness and operational efficiency remain important themes for them, which continues to be a reason why customers are picking Elastic as their preferred platform to consolidate workloads Elastic Cloud revenue based on month-to-month arrangements came in at 14% of total revenue. As we've shared before, Elastic Cloud revenue based on month-to-month arrangements is driven mainly by a self-service motion in the SMB segment, which remains challenged. [...] We also saw a higher volume of early renewals than we typically see in Q4, reflecting continued customer confidence and commitment to our platform. As a reminder, early renewals do not impact the timing of revenue recognition, so there was no revenue benefit from this in the quarter.\"  We note, however, that the company's recent trend of operating margin gains took a pause in the fourth quarter, with pro forma operating margins holding flat at 8.6% y/y - after expanding from a full-year basis to 11.2%, up 690bps y/y. Elastic margins (Elastic Q4 earnings deck) We note that the company is only expecting modest margin expansion in FY25 to 11.7-12.4% margins, implying only 80bps of y/y expansion at the midpoint. Key takeaways  Personally, I don't see too much incentive to remain invested in Elastic at a near-8x revenue multiple, even if it is able to sustain a low-20% growth rate. 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