Elastic: A Case Of Pattern Recognition – Elastic (NYSE:ESTC…


Investment Thesis

Elastic (ESTC), a recent IPO, popped with a Zscaler-esque (ZS) vibrancy, even in the midst of the latest tech downturn. It’s an interesting company because of its technology, financial prowess, even though the valuation is a bit gaudy. Take a closer look at this name, possibly even consider a starter position.

Technology

At the heart of the company’s technology is search. Not quite like Google (GOOGL), but more like search within databases. For example, it allows Uber to find drivers to connect to riders and Tinder of Match Group (MTCH) to connect droves of romantics.

In addition to search, Elastic has built application performance monitoring and analytics capabilities. Moreover, all of this is open sourced, enabling the extra power of crowdsourcing. Interestingly, the company has tight control over the source code though. Outside developers have to play by Elastic’s rules. But this hasn’t detracted from the allure of the technology. Since, 2013, the free search offering has been downloaded 350 million times.

This fact alone means Elastic has high brand awareness, especially amongst developers. Similar to Twilio’s (TWLO) approach, the company markets to developers first since they are the end customer rather than marketing to the higher-ups and other C-suiters.

Moreover, the company does provide an Elastic Cloud Enterprise for bigger deal-flow. This is like MongoDB’s (MDB) Enterprise Advanced offering. To further the comparison, Elastic also offers a cloud-based distribution like Mongo’s popular Atlas.

As investors, pattern recognition is important and Elastic seems to have similar competitive characteristics to well-performing tech companies we’ve seen over the past couple years.

Even the financials look similar.

Financial Prowess

Elastic’s top-line growth is fantastic, one of the highest on the market. Revenues grew 81% over the past 12 months and 79% for the past quarter. At the same time, operating losses narrowed from -54% of sales to -30%, a good sign. Free cash flow also swung positive in the latest quarter.

To break down the top-line, nearly all of the sales are from subscriptions, which investors prefer to see since they are recurring in nature. However, a little different from other SaaS-based companies, 16% of sales are from license agreements. These licenses have sky-high gross margins, to the tune of 98%. As such, gross margins can be expected to take a slight hit as the revenue mix shifts to the Elastic Cloud distribution. With that said, gross margins are still around 75%, a more than respectable figure.

Lower down the income statement, the company, for the last two years has spent about 35% of revenue on research and development. However, there has been a major improvement in sales and marketing spend. Last fiscal year, S&M accounted for 64% of revenue whereas this year that figure was about 51%. As time goes on, it is likely this figure will slowly decline, leaving the company with a path to profitability. The fact the company is open sourced will be probably be a tailwind to R&D cost efficiencies as well.

In terms of the balance sheet, Elastic had about $51 million in cash pre-IPO, but now, since it raised $252 million, it has about $300 million on the books. This is plenty of dry powder to keep the company going as the burn rate has been about $50 million annually.

The company also maintains that it is selling into a $45 billion market since it offers search, APM, and analytics. Of that $45 billion, $8 billion can be contributed to Elastic’s bread and butter, which is search. This market alone has nearly tripled in the last six years.



Source: Prospectus

Further, the company has done a great job of up-selling customers into other products, the ones that account for the other $37 billion in TAM. The revenue expansion rate was 142% in the last quarter and that figure has been above 130% for the last seven quarters. Customer count has also grown from 2,800 customer to over 5,500 in the last five quarters.

All in all, with the top-line growing at a blistering pace, a strong expansion rate, narrowing losses, a huge TAM, and fast customer growth, investors’ pattern recognition signals should be firing.

But, as a twist on the saying, “With great power, comes great responsibility”, in the tech world, “With great financials, come a high valuation.” This case is no different.

Gaudy Valuation and Risks

The company tendered roughly 61 million share for the public offering. At a recent price of $65 per share, the market cap comes out to about $3.97 billion. Without accounting for the cash proceeds, that means the TTM price/sales ratio is about 25x. However, on a forward basis, the ratio settles down between 15-16, based on 60% projected growth.

To put those ratios in perspective, MongoDB, a top tech performer this year trades for about a 16x TTM price/sales ratio.

But what do you expect? Elastic is powering some of the most important enterprises in the world, and as the amount of data continues to proliferate, I can’t see search becoming less important.

It can be noted that Elastic does have some competition. Another open-sourced business named Solr is the provider of the incumbent technology. Apparently, Elastic is much more modern and flexible though.

Besides the obvious risk of a premium valuation, the competitive dynamics in this space seem blurred. On one hand, as the company has expanded into APM and analytics, it may bump up against the likes of New Relic (NEWR) and Alteryx (AYX). Though, the latter companies have much more robust functionality, it does beg the question of Elastic’s competitive positioning. On top of this, MongoDB has its aggregation pipeline which enables complex data analysis.

As it stands, it is clear that MongoDB and Elastic operate in a complementary fashion rather than against each other. Mongo stores huge amounts of data and Elastic search can be used for quick indexing and searching, hence the name. In the long term, though, it will be interesting to see if either company will encroach on one another.

I do not purport to know all of the intricate tech details of each of these companies. Nor do I believe that these are the fulcrum upon which an investment in Elastic hinges. However, without such clarity on the competitive positioning, the risk is increased slightly.

To End

Even in the midst of a gnarly tech sell-off, Elastic had a successful IPO. Granted, the company probably did undervalue itself for the much sought-after IPO pop. Still, Elastic looks like a promising investment as it checks a lot of the pattern recognition boxes for a software darling.

I have yet to take a nibble but I can recommend taking a starter position in this one. If anyone has more insights on the competitive positioning of the company, please comment below. Let’s get a conversation started.

Author’s Note: Please scroll up and hit the big, orange “Follow” button so you can get these articles before they hit the paywall. Thanks so much for your time, it will never be taken for granted. Have yourself a fantastic day and happy investing! Check out my links in the profile as well if you want even more.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ESTC over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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