Elastic N.V. (NYSE:ESTC) Q3 2024 Earnings Call Transcript

Elastic N.V. (NYSE:ESTC) Q3 2024 Earnings Call Transcript February 29, 2024

Elastic N.V. beats earnings expectations. Reported EPS is $0.36, expectations were $0.31.
ESTC isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good afternoon, and welcome to the Elastic Third Quarter Fiscal 2024 Earnings Results Conference Call. All participants’ will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Anthony Luscri, Vice President of Investor Relations. Please go ahead.

Anthony Luscri: Thank you. Good afternoon, and thank you for joining us on today’s conference call to discuss Elastic’s third quarter fiscal 2024 financial results. On the call, we have Ash Kulkarni, Chief Executive Officer; and Janesh Moorjani, Chief Financial Officer and Chief Operating Officer. Following their prepared remarks, we will take questions. Our press release was issued today after the close of market and is posted on our website. Slides, which are supplemental to the call, can also be found on the Elastic Investor Relations website at ir.elastic.co. Our discussion will include forward-looking statements, which may include predictions, estimates or expectations regarding the demand for our products and solutions and our future revenue and other information.

These forward-looking statements are based on factors currently known to us, speak only as of the date of this call and are subject to risk and uncertainties that could cause actual results to differ materially. We disclaim any obligation to update or revise these forward-looking statements unless required by law. Please refer to the risks and uncertainties included in the press release that we issued earlier today included in the slides posted on the Investor Relations website and those more fully described in our filings with the Securities and Exchange Commission. We will also discuss certain non-GAAP financial measures. Disclosures regarding non-GAAP measures, including reconciliations with the most comparable GAAP measures, can be found in the press release and slides.

The webcast replay of this call will be available on our company website under the Investor Relations link. Our fourth quarter fiscal 2024 quiet period begins at the close of business on Tuesday, April 16, 2024. We will be participating in the Morgan Stanley Technology Meeting and Telecom Conference on March 6 and the Wells Fargo, Software Symposium on April 10. With that, I’ll turn it over to Ash.

Ash Kulkarni: Thank you, Anthony. Good day, everyone. And thank you for joining us on today’s call. Elastic delivered another strong quarter. Our results reflect our continued execution, our ability to deliver differentiated product innovations, our maniacal focus on our customers, and our attention to managing the business with discipline. The trends we saw over the first-half of the fiscal year continued to drive momentum in our business in Q3. First, customer interest in generative AI remains strong, and as customers become more educated about what it takes to build generative AI applications, they’re increasingly able to appreciate the advantages of our platform relative to pure play vector database vendors. Second, we saw continued momentum in platform consolidation as customers chose the Elasticsearch platform to displace incumbent solutions for multiple use cases, particularly in log analytics and SIEM.

Lastly, we saw continued stability in cloud consumption patterns as customers increased their consumption against their previous commitments. These trends reinforce our confidence in the business and in our future growth as more companies choose our search analytics platform as a core part of their IT infrastructure stack for log analytics, SIEM, and Gen AI applications. I’ll talk more about these trends and share some customer success examples driving our growth in a few minutes. First, let me start with a review of our financial performance. I’m pleased with our strong momentum and execution that drove our third quarter results. In Q3, revenue grew 19% year-over-year, with Elastic Cloud growing 29% year-over-year, driven by continued customer traction in the cloud, and consolidation onto the Elasticsearch Platform.

We also exceeded our profitability guidance with a non-GAAP operating margin of 13%. Turning to the broad trends we saw this quarter, as I met with customers around the globe, I saw a strong desire to leverage AI to improve business processes and elevate customer experiences. At the same time, companies remain focused on finding ways to reduce costs. In a sense, it’s all about gaining efficiencies without sacrificing innovation. This is where Elastic shines. With the Elasticsearch platform, businesses can unlock the full potential of all their data to gain insights that drive innovation, optimize customer experiences, and inform strategic decisions. In the area of generative AI, customers are starting to advance their capabilities in leveraging retrieval augmented generation or rag patterns for building GenAI applications using existing and emerging language models.

This is leading them to fully explore the total set of functionalities needed to build enterprise class GenAI applications. Advanced features like hybrid search, personalization, and re-ranking with reciprocal rank fusion, document level permissions, security, and much more. All of these capabilities, in addition to our leading vector search functionality, and the fact that we are already the incumbent platform for data for tens of thousands of customers means that we are able to significantly lower the barrier for businesses to build their own generative AI applications. This is our asymmetric advantage, and as Generative AI and RAG are becoming better understood, our edge is becoming more pronounced. In the third quarter, we once again added several hundred customers using the Elasticsearch Relevance Engine or ESRE.

ESRE allows customers to build Generative AI applications quickly without complicated and expensive model training. This is a big reason why customers turn to us for Generative AI. One example of this is our long-time customer Consensus, an AI-powered search engine that aggregates and distills insights from more than 200 million peer-reviewed papers from the semantic scholar database. They use Elasticcloud for advanced artificial intelligence, semantic, and text search. Consensus 2.0 is powered by ELSER. Their users have benefited from increased accuracy and relevance of search results and new GenAI features such as a summarization of the top 10 studies based on integration with OpenAI’s GPT-4 model. In Q3, we also expanded our business with Stack Overflow, the largest and most trusted online community for developers, which replaced its previous vector database with Elastic.

The company chose Elasticcloud for our scalability, differentiated functionality, and integration across the ecosystem. Stack Overflow is leveraging Elastic’s vector and semantic search capabilities to deliver a more human-like generative AI-powered question-and-answer experience to developers via its overflow AI product. We also continue to see customers choose our platform, because they expect to use our ESRE functionality in the future. In other words, they see us as the right choice for the needs today, as well as for the future. As an example, a cloud-based document management company for legal professionals signed a multi-year deal with Elastic this quarter. With over 6 billion searchable documents, the company chose Elastic for our innovations, performance, and ability to power search across their entire platform.

Previously, using a competitor’s offering, they moved to Elastic because of our market leadership and to modernize the search experience to align with their customers’ expectations by leveraging Elastic’s vector search capability to enhance the user experience. Beyond generative AI, we noted that customers are continuing to displace incumbents and consolidate onto the Elastic Platform for observability and security, which is the second trend I talked about earlier. The Elastic observability and security solutions are built on top of our Search Analytics Platform, with Elasticsearch as the foundation. Our platform has the unparalleled ability to quickly ingest all kinds of data to index it at extreme speed and at petabyte scale and make it searchable, and then allow for all kinds of advanced correlations, AI-powered searches and ad hoc analytics.

This gives customers the ability to centralize onto a single platform for all use cases that require this kind of advanced search and analytics. This is a big reason for our success in displacing incumbent solutions especially around log analytics and SIEM or security analytics. Our recent innovations including our AI assistance for observability and security are making it even more compelling for customers to move to our platform. This quarter, we closed several multi-million dollar deals where we displaced incumbent solutions for observability and security. Our value and our innovation is resonating across industries, as we continue helping customers save on their overall IT spend, while helping them gain even greater value from our innovations.

As an example, a top U.S.-based bank chose Elastic as a desired SIM platform to replace their legacy vendor. The drivers behind the selection included platform speed, performance, scale, and Elastic’s rich set of security features. They also chose Elastic for our innovative storage-tearing searchable snapshots capability, which allows the bank to retain important security logs for longer regulatory retention periods at dramatically reduced storage cost. We also expanded business with the U.S. state agency for elastic security. The agency initially started with Elastic for search and then in Q3 chose Elastic to replace their legacy security vendor for SIEM, enabling them to increase support for their security operations center. The scope of Elastic’s ingest capabilities, search speed, platform functionality, stability, and reporting capabilities allows the agency to gain and maintain visibility across their environment and multiple agency branches and correlate alerts across a broad security tool set.

Now, turning to products and innovation, we continue to invest in capabilities that make it possible for customers to migrate easily from incumbent solutions to Elastic. On our last call, I mentioned the launch of our powerful new piped query language, Elasticsearch Query Language or ESQL. Even as we continue to enhance this new capability, we have seen tremendous interest from our customers with approximately a thousand customers trying it out since we launched in November. Our latest release of Elastic 8.12 in January also included several key enhancements, including scalar quantization, which is a vector search optimization technique that delivers performance improvements across several critical metrics. It dramatically improves enterprise-level scalability, allowing customers to store 4 times as many vectors in RAM, while also improving overall indexing speed and reducing query latency by up to 2 times.

Additional enhancements to search concurrency resulted in speed ups across a very broad set of query types, including vector similarity and full text search, as well as a 40% reduction in latency for analytical queries. In Elastic Observability, we brought several capabilities to general availability, including the enhanced Elastic AI assistant for observability, SLO monitoring, and mobile APM support based on open telemetry. In Elastic Security, we continue to enhance our market-leading Elastic AI Assistant for security, introducing real-time alerts with natural language interactions that enhance the way security analysts approach alert triaging. This results in a more efficient, effective security operation that is adept at navigating the complex cybersecurity environment.

In cloud security, we added support for Microsoft Azure, in addition to our existing support for AWS and Google Cloud for cloud security posture management. On the go-to-market front, we drove continued momentum in Q3 through our participation in AWS re:Invent and our ElasticON conference events that allowed us to connect with thousands of customers, prospects, and users worldwide. We have now concluded six of these ElasticON events and will be holding another six in our fiscal Q4. And as a final, but important highlight for the quarter, I was pleased to announce that Mark Dodds joined Elastic as our new Chief Revenue Officer. Mark leads all of Elastic’s customer-facing functions, including global sales, customer success, solutions architecture, professional services, ecosystem and partnerships, and sales operations.

Mark brings extensive go-to-market experience to our executive team as we continue to drive momentum in Generative AI and growth across all segments of our business. I’m excited about everything that Mark will do for us in the coming years, as we push to capture the full opportunity ahead of us as a company. In closing, I’m very pleased with how we perform this quarter. The innovations we are driving into our Search Analytics Platform, the momentum we are gaining around Generative AI, and the traction we are seeing in customers consolidating onto our platform is continuing to increase our confidence in our future. We see a future where our Search Analytics Platform becomes a core part of every IT infrastructure stack for gaining insights from all data, especially in the context of generative AI.

I want to thank the Elastic team for their resolute focus and the entire Elastic community for their unwavering commitment. Now, with that, let me turn the call over to Janesh.

Janesh Moorjani: Thanks, Ash. We are pleased that we delivered a strong quarter driven by our consistent focus on execution. We once again came in above the high-end of our guidance for the quarter, both on the top line and the bottom line. The third quarter largely played out as expected. We delivered 19% year-over-year growth in total revenue in the third quarter, with Elastic Cloud growing 29% year-over-year. We continued our focus on profitability, delivering non-GAAP operating margin of 13%. Our performance in the quarter reflects both our success in the market and continued investment discipline. We executed well to deliver strong growth in both self-managed and Elastic Cloud revenue. As in prior quarters, we saw a number of customers consolidate onto the Elastic Platform to lower their total spend without sacrificing innovation.

We also saw healthy cloud consumption growth as customers continued to consume against their contractual commitments. As Ash mentioned, we continue to see strong customer interest around Generative AI use cases. Customers express a strong desire to use ESRE to build Gen.AI applications, since it provides a comprehensive and enterprise ready platform to ground large language models with their private business context. While it will take some time for Gen.AI spend to become a significant driver of our revenue, we continue to expect that Gen.AI will present a meaningful revenue opportunity for us in the longer term. Let’s get into the results for Q3 and our outlook. Total revenue in the third quarter was $328 million, up 19% year-over-year or 18% year-over-year on a constant currency basis.

Subscription revenue in the third quarter totaled $308 million, up 20% year-over-year or 19% year-over-year in constant currency and comprised 94% of total revenue. Within subscriptions, revenue from Elastic Cloud $143 million, growing 29% year-over-year on an as reported and constant currency basis, reflecting the trends I mentioned previously. Elastic Cloud represented 44% of total revenue in the quarter, up from 40% a year ago. Elastic Cloud revenue derived from month-to-month arrangements contributed 14% of total revenue. Professional services revenue in the third quarter was $20 million, up 7% year-over-year on an as-reported basis and 6% year-over-year on a constant currency basis. As we’ve said before, professional services revenue may fluctuate across quarters based on the timing of service delivery, and we do not expect it to vary significantly in mix over time.

To add more context around overall deal flow, EMEA grew the fastest during the quarter, followed by the Americas and APJ. We continue to see a healthy balance across the business based on geography, solutions, and verticals, and this diversification reflects the breadth and popularity of our platform. Moving on to customer metrics. We ended the quarter with over 1,270 customers with annual contract values more than $100,000. Looking at customer additions more broadly, we ended the quarter with over 4,290 customers above $10,000 in ACV, and approximately 20,800 total subscription customers. We are pleased with this quarter’s customer additions in the greater than 100K category, which reflects our focus on the highest value customers, who are the primary driver of the business.

Our net expansion rate, which as you know, is a trailing 12-month lagging indicator, was approximately 109% consistent with Q2 and in line with our expectation for the quarter. Now turning to profitability for which I’ll discuss non-GAAP measures. Our non-GAAP results for the third quarter exclude, among other items, a discrete income tax benefit of $207 million from the release of a valuation allowance for GAAP purposes. This did not impact any of our operating results non-GAAP earnings per share, adjusted free cash flow or cash and cash equivalents. Gross margin in the quarter was 77% versus 76.8% in the prior quarter, reflecting a slightly higher subscription mix. Our operating margin in the quarter was 13%, which was better than expected.

The strong operating margin performance was driven by revenue outperformance and our continued focus on managing expenses as we invest with discipline to drive future growth. Diluted earnings per share in the third quarter was $0.36. Our free cash flow on an adjusted basis was $63 million in the quarter or 19% adjusted free cash flow margin. For the full fiscal year, there is no change in our prior outlook, and we continue to expect free cash flow margin on an adjusted basis for fiscal ‘24 to be slightly above the non-GAAP operating margin for fiscal ‘24. Turning to guidance. While we are very pleased with our execution and our outperformance thus far in FY ‘24, our guidance philosophy remains unchanged. We continue to be prudent in the near-term.

Despite the many moving parts in the broader macro climate, we anticipate that business conditions will remain largely unchanged. In addition, we believe it is appropriate to anticipate that consumption patterns may fluctuate in the near-term. With that background, for the fourth quarter of fiscal ‘24, we expect total revenue in the range of $328 million to $330 million, representing 18% year-over-year growth at the midpoint on an as-reported and constant currency basis. We expect non-GAAP operating margin for the fourth quarter of fiscal ‘24 in the range of 7.4% to 7.8% and non-GAAP earnings per share in the range of $0.18 to $0.20 using between 105.5 million and 106.5 million diluted weighted average ordinary shares outstanding. For full fiscal ‘24, we are raising our outlook and now expect total revenue in the range of $1.260 billion to $1.262 billion, representing 18% year-over-year growth at the midpoint or 17% on a constant currency basis.

We expect non-GAAP operating margin for full fiscal ‘24 to be approximately 11% and non-GAAP earnings per share in the range of $1.15 to $1.18 using between 103 million and 104 million diluted weighted average ordinary shares outstanding. Finally, looking ahead to fiscal ‘25, we’re in the middle of our planning process. While it is too early to provide specifics, especially around revenue outlook, I will share our thoughts on how we are approaching next year from an investment perspective. We’ve already demonstrated that our business model has inherent operating leverage, and this year we’ve expanded non-GAAP operating margin even faster than we had initially expected. As we go through our planning process we expect to balance investing for long-term growth against near-term profitability.

Given the significant opportunity we see in Generative AI, we are planning to accelerate investments in fiscal ‘25 to help capture this large and expanding market. We expect these investments to be broad-based across the business and are intended to drive meaningful revenue growth over the longer term. Therefore, we expect to expand non-GAAP operating margin only modestly in fiscal ‘25 relative to our current non-GAAP operating margin guidance for fiscal ‘24. We expect these investments are likely to be more front-end loaded in fiscal ‘25. We will provide more formal guidance around fiscal ‘25 on our Q4 earnings call. In summary, we are pleased with our strong performance so far in fiscal ‘24 and are confident in our outlook for the fourth quarter.

And with that, let’s go ahead and take questions. Operator?

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Q&A Session

Operator: We will now begin the question-and-answer session. [Operator Instructions] And our first question will come from Pinjalim Bora of JPMorgan. Please go ahead.

Pinjalim Bora: Oh great. Thanks guys for taking the question. Congrats on quarter. I want to dig in a little bit on the Elastic Cloud side. Janesh, this year seems like so far we have seen a little bit of a different seasonality. Q2 was a much higher sequential uptick versus Q1, which is typically the opposite, and then Q3 seems like was a little bit of a down take versus Q2, which is again, typically opposite? Was there anything one-time in Q2 which did not repeat in Q3, or did you see kind of slightly lower consumption rate versus last quarter or maybe seems like the — if I got that correctly 14% monthly seems like the variability was a little bit of a drag. So maybe any color there would be helpful? And how do you kind of think about the sustainability of that growth at 29%, 30% for total cloud?

Janesh Moorjani: Hey, Pinjalim. Yes, let me unpack that for you. So, you know, first off, if I just step back, we were actually very pleased with our overall performance in the quarter, including on cloud coming in at 29% year-over-year growth. Broadly speaking, I’d say it played out as we expected it would. If I think about the pieces in that, first-off, there was nothing unusual or one-time in Q2 that didn’t recur in Q3 to just take that off the table. But if I think about the performance during Q3, as we look at our performance across the segments, we did really well in both commercial and enterprise, which as you know is our sales led motion and then we drive the consumption after we’ve secured the commitments. And then on the SMB side, which is predominantly in the self-serve motion, that piece remained soft, and that’s been soft for a little bit of time now.

So even that played out as we expected it would, but it was basically consistent with where it’s been. And so just given the relative growth in monthly cloud versus the rest of our cloud revenue, that’s what drove monthly cloud to 14% of revenue versus 15% in the prior quarter or 16% in the year ago period. So I’d say broadly speaking, our sales motions are actually working quite well, both in terms of securing the initial commitments and then of course working with those customers to ramp their consumption. If I think about the seasonality and all the different elements you called out, In fact, in a way that’s just reflective of the nature of consumption, which as we’ve said can fluctuate from time-to-time. If I think about consumption patterns across the quarter, though I’d say Q3 was generally stable across the board, as we mentioned earlier.

And so overall, when I look back at all the moving parts, we were actually quite pleased with our cloud performance and we look forward to delivering a strong Q4.

Pinjalim Bora: Understood. Just a one follow-up, a little bit technical question for Ash. How should we think about the future of RAG in the context of the expanding context windows for tokens for LLMs? I’m thinking, does that latter kind of eat into some of the use cases for RAG or is cost going to be basically the primary driver of how people kind of architect these solutions?

Ash Kulkarni: Hey, Pinjalim, thank you for the question. So we believe very strongly and we are seeing this being confirmed by our customers, the customers that I’m speaking with, that our team is working with, that RAG or Retrieval Augmented Generation is a pattern that’s not only going to continue, but it’s a pattern that will — that is looking to establish itself as the predominant pattern going forward. And the primary reason for that is, like you said, there are two factors. One is that cost continues to grow as you send more and more tokens to these context windows. And as people are building real world enterprise applications, that is definitely something that they worry about, and RAG helps them control that price. And second, when you think about how training or even refinement of a model works, at some point you have to stop that training and then put it into production.

But your internal data, your proprietary data that you’re trying to build your responses on is constantly changing. It’s changing by the millisecond. So for you to be able to provide responses that are actually contextual and accurate, you need RAG no matter what. And so those are the reasons why RAG is really becoming the primary way for people to build these enterprise applications. And we feel very good about our position in there.

Pinjalim Bora: Very clear. Thank you very much.

Operator: The next question comes from Brent Thill of Jefferies. Please go ahead.

Ash Kulkarni: Are you there?

Janesh Moorjani: Hey, Brent, are you there?

Anthony Luscri: Operator, let’s move to the next caller.

Operator: Okay, the next question comes from Tyler Radke of Citi. Please go ahead.

Tyler Radke: Yes, thanks for taking the question. Hopefully…

Janesh Moorjani: Hey, Tyler, you’re breaking up. We can’t hear you.

Tyler Radke: Okay, how about now? Is that better?

Janesh Moorjani: Yes, yes it’s better. Go ahead please.