Elastic's (NYSE:ESTC) Posts Q3 Sales In Line With Estimates But Stock Drops On Weak Outlook

Search software company Elastic (NYSE:ESTC) reported results in line with analyst expectations in Q3 FY2023 quarter, with revenue up 22.6% year on year to $274.6 million. However, guidance for the next quarter was less impressive, coming in at $277 million at the midpoint, being 2.34% below analyst estimates. Elastic made a GAAP loss of $72.6 million, down on its loss of $56.7 million, in the same quarter last year.

Started by Shay Banon as a search engine for his wife's growing list of recipes at Le Cordon Bleu cooking school in Paris, Elastic (NYSE:ESTC) helps companies integrate search into their products and monitor their cloud infrastructure.

Building your own search engine is hard and even the biggest companies want to focus their energy elsewhere. Elastic offers a set of software products that ingest and store data from any source, in any format, and perform search, machine learning, and analysis.

For example Uber is using Elastic to power the systems that locate nearby riders and drivers, eBay is using it to help users find what they want to buy and Facebook is using it to power search in their help centre. Elastic is one of the companies that have been benefiting from the growth of the overall internet economy and has lately started expanding the use of their data processing technology from enterprise search into cloud-infrastructure monitoring and network security monitoring products.

Elastic’s business model is based on a combination of open source and proprietary software and the company uses the open-source part to power their distribution strategy. It is really easy to start using Elastic and developers can download limited versions of the software straight away for free, without speaking to any salespeople. Over time, if the software proves itself and the need for it expands inside an organization, it is easy to upgrade to a paid license.

Generating insights from system level data is an increasing priority for most businesses, but to do so requires connecting and analyzing piles of data stored and siloed in separate databases. This is the demand driver for cloud based data infrastructure software providers, who can more readily integrate, distribute and process information vs. legacy on-premise software providers.

Elastic competes in a segment that includes companies such as Yext (NYSE:YEXT), Lucidworks, and Splunk (NASDAQ:SPLK).

Sales Growth

As you can see below, Elastic's revenue growth has been very strong over the last two years, growing from quarterly revenue of $157.1 million in Q3 FY2021, to $274.6 million.

This quarter, Elastic's quarterly revenue was once again up a very solid 22.6% year on year. But the growth did slow down compared to last quarter, as the revenue increased by just $10.2 million in Q3, compared to $14.3 million in Q2 2023. We'd like to see revenue increase by a greater amount each quarter, but a one-off fluctuation is usually not concerning.

Guidance for the next quarter indicates Elastic is expecting revenue to grow 15.7% year on year to $277 million, slowing down from the 34.8% year-over-year increase in revenue the company had recorded in the same quarter last year. Ahead of the earnings results the analysts covering the company were estimating sales to grow 20.4% over the next twelve months.

Customer Growth

You can see below that Elastic reported 19,900 customers at the end of the quarter, an increase of 200 on last quarter. That is a little slower customer growth than what we are used to seeing lately, suggesting that the customer acquisition momentum is slowing a little bit.

Product Success

One of the best things about software as a service businesses (and a reason why they trade at such high multiples) is that customers tend to spend more with the company over time.

Elastic's net revenue retention rate, an important measure of how much customers from a year ago were spending at the end of the quarter, was at 120% in Q3. That means even if they didn't win any new customers, Elastic would have grown its revenue 20% year on year. Despite it going down over the last year this is still a good retention rate and a proof that Elastic's customers are satisfied with their software and are getting more value from it over time. That is good to see.

Profitability

What makes the software as a service business so attractive is that once the software is developed, it typically shouldn't cost much to provide it as an ongoing service to customers. Elastic's gross profit margin, an important metric measuring how much money there is left after paying for servers, licenses, technical support and other necessary running expenses was at 72.6% in Q3.

That means that for every $1 in revenue the company had $0.73 left to spend on developing new products, marketing & sales and the general administrative overhead. Significantly up from the last quarter, this is around the average of what we typically see in SaaS businesses. Gross margin has a major impact on a company’s ability to invest in developing new products and sales & marketing, which may ultimately determine the winner in a competitive market, so it is important to track.

Cash Is King

If you have followed StockStory for a while, you know that we put an emphasis on cash flow. Why, you ask? We believe that in the end cash is king, as you can't use accounting profits to pay the bills. Elastic's free cash flow came in at $6.97 million in Q3, up 111% year on year.

Elastic has generated $1.84 million in free cash flow over the last twelve months, 0.18% of revenues. This FCF margin is a result of Elastic asset lite business model, and provides it with at least some cash to invest in the business without depending on capital markets.

Key Takeaways from Elastic's Q3 Results

With a market capitalization of $5.52 billion Elastic is among smaller companies, but its more than $877.7 million in cash and positive free cash flow over the last twelve months put it in a very strong position to invest in growth.

It was nice that Elastic improved their gross margin, even if just slightly. That feature of these results really stood out as a positive. On the other hand, it was unfortunate to see that the revenue guidance for the next quarter missed analysts' expectations and there was a slowdown in customer growth. Overall, this quarter's results were not the best we've seen from Elastic. The company is down 6.25% on the results and currently trades at $54.75 per share.

Is Now The Time?

Elastic may have had a bad quarter, but investors should also consider its valuation and business qualities, when assessing the investment opportunity. Although we have other favorites, we understand the arguments that Elastic is not a bad business. We would expect growth rates to moderate from here, but its revenue growth has been strong, over the last two years. And while its gross margins aren't as good as other tech businesses we look at, the good news is its customers are increasing their spending quite quickly, suggesting that they love the product.

Elastic's price to sales ratio based on the next twelve months is 4.5x, suggesting that the market is expecting more moderate growth, relative to the hottest tech stocks. In the end, beauty is in the eye of the beholder. While Elastic wouldn't be our first pick, if you like the business, the shares are trading at a pretty interesting price point right now.

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