ESTC: down-sizing or selling

Investment Analysis Clubs Saul’s Investing Discussions
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What happened this quarter

There has been pretty good discussion here on the ESTC quarter. My summary:

  • the somewhat gradual slowdown in revenue continued
  • there was improvement in the operating losses and more on the way
  • the guidance was horrible, but they’re probably being overcautious

My thoughts and what I’m doing

ESTC’s results were just ok, while Datadog’s and Crowdstrike’s were sparkling. Is that likely to change? Is Elastic just always going to be little brother to these, and to struggle?

ESTC’s valuation is still less than others (although it has doubled since mid-March lows), but I see no reason why ESTC’s PS multiple would expand. If you believe it will, there’s your case for ESTC. But growth has been slowing consistently. If it really slows to 35-40% I think the shares will get hit hard. If it only slows to 45% or so (like we might have expected anyway) then shares will probably plod along.

But here’s my minor epiphany for the day:

CRWD has a PS of 35 and 85% growth
ESTC has a PS of 17 and 53% growth

Let’s say you think both will slow down gradually. So maybe their PS ratios both drop slightly or at least don’t expand. That would mean you still get a CAGR of something like 75%+ from CRWD over the next few quarters, and less than 50% from ESTC!

I said it was minor. Still, I think ESTC has earned itself a smaller position from me. Bottom line: I used to think ESTC’s PS would expand to be at least close to some of our favorite companies. Now I do not.

I sold a large portion of my ESTC, and I will consider whether or not I can find something better to replace it altogether.

Bear

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Agreed, Q4 was strong on the surface: revenue growth slowed a bit from 61% to 57% but SAAS accelerated again to 120% in constant currency. Big beat on EPS and great improvement in op margins from -18% to -10% and raised guide here as well, what I wanted to see. Gross margins were also steady at 76% on a non-GAAP basis. Mgmt expecting +FCF margin by FY2022 and to hit -2% to -4% margin this year. Billings were also strong at 55% YoY and DBR remained >130%.

The big disappointment is guidance: management projected 36% YoY growth for Q1’21 on the high-end and 26% growth for FY21. For the current FY, they beat guidance by 6%, applying that to their current guidance would still only be 34% growth. They also said COVID could be a headwind to billings.

Now there was some positive commentary on the call to suggest they will beat this by a larger margin: customer and billings growth was consistent and they saw new business ramp back up in April after a dip in mid-late March. They also said COVID should be a long-term tailwind but I am not sure why it is a near-term headwind when peers like CRWD and DDOG reported strong quarters and guidance.

Elastic also benefits from increased usage so I find it surprising that management guided so low and talked about “lengthening sales cycles”. Datadog mentioned on their earnings call that this kind of pricing model helped them avoid a steep revenue decline as it was harder for customers to decrease usage as opposed to seats. Customers from the most affected industries only made up 15% of their revenue base too. I do take this guidance more seriously than AYX for example, as ESTC has more visibility into their business, has a low-cost product that is based on usage instead of seats that should be in high demand in the current environment, and has not beat guidance by large margins in the past.

Again, the metrics look great this quarter but such a drastic potential revenue deceleration and still being far away from profitability is not good. I personally think there is more at play here than just COVID and competition could be stealing market share. I stand by my analysis that ESTC has a great platform that is well-positioned for the future and am encouraged by the improving operating losses but I sold most of my position as there is just too much of a discrepancy between guidance and the story they’re telling here. I’m not confident enough to say they’re massively sandbagging. Seeing as my higher confidence names are also down just as much today, I feel more comfortable reinvesting the proceeds there.

Richard

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In 2014 cybersecurity company FEYE grew revenue 164% to $426mln. It guided for revenue growth around 50%. It traded at 22x 2014 sales. Stock down 75% since then.

In fiscal 2020 cybersecurity company CRWD grew revenue 93% to $480mln. It guided for revenue growth around 50%. It trades at 42x 2020 sales.

t

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Just to be transparent, in March I made Elastic my second largest allocation in my high growth bucket (after Sea). I have sold some since then but retain a chunky allocation.

I have a very high level of confidence that in 10 years Elastic is a much larger company than DDOG. They have a huge virtuous cycle that is going to massively accelerate their platform over time and DDOG is just not going to have the product to survive in this market. But that is a very long-term thesis. Will be interesting to see what happens.

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Hey Bear,
Not going to belabor this point, but guess I don’t get the view of ESTC vs say AYX (which you also did downsize, but seemed more upbeat about).

Quick side note: not sure fair to compare to CRWD as they just now have their security product as GA, but the DDOG comparisons make sense. DDOG just did 87% Q growth (Jan-Mar Q) and projected 56% growth for full year. Does anyone think their growth will drop by 30%

From an investment standpoint, as they are different business models, why would AYX be more appealing?

ESTC did 53% in a Q which included the full month of April.
AYX did 43% in a Q which went thru March (generally considered a month only half impacted by covid).

AYX called for 15% growth or so in coming Q. I think they withdrew full year guide, at least in ER.
ESTC called for 36% growth in coming Q. ESTC put out a too-conservative (imo) full year guide of 25% growth.

Elastic continued to pare their losses on % basis (despite making an acquisition of Endgame), and projected to be profitable in 18 months, stated they had plenty of cash and saw no need to raise funds at this time, and introduced no meaningful cost-cutting (some events went virtual, of course)…they stressed continuing to invest for growth in headcount and R&D, etc…

From a 57% full year growth, to a Q4 that was 53% growth (57% constant currency) with 50% of that Q impacted by covid, seems pretty solid. If there was no covid, then I get pointing to 53% and saying it seems like a gradual slowdown.

The forecast? Yeah…I really hated that. But I guess until they actually produce a sub-40% growth Q, I have to rely on actual results, and I am not sure they have averaged over 50% growth since their IPO in fall 2018.

I admit my patience with them is waning, in terms of the lack of valuation compared to companies that they have better comps than, such as an MDB.

We saw Zscaler bounce up, partly due to pandemic/WFH-buzz, but also they had made a Sales Leader change about 2 Q’s ago. Elastic did this about 1 Q ago. Not necessarily going to be a correlation, but with security now able to be monetized moving forward, a CFO that seems to have the path to profitability mapped out, and a reorganized sales force for a business growing 50% plus for 2 years, it seems like a solid foundation.

If they actually do sub-40% growth next Q, then I definitely will change my tune. Just need to see actual bad ER first.

Dreamer

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From an investment standpoint, as they are different business models, why would AYX be more appealing?

We’re getting pretty off topic, but it’s a fair question. I do have more confidence in AYX. Why?

  1. The product I know people (AYX customers) who use AYX every day, and love it. (I can’t overstate the confidence boost from this.) It’s also a product I could see using myself, and Elastic is very IT-geek heavy (no offense to any IT geeks). ESTC, like DDOG, is kind of a black box to me. I can’t tell one from the other. AYX is a great product, and I can see why.

  2. The competition (As I see it – I could be wrong) The competitive landscape seems muddy for DDOG and ESTC, and I feel like ESTC is on the wrong side of it. Who is the DDOG crushing AYX? I don’t see one. To use another analogy, comparing AYX to ESTC seems like comparing Chipotle (AYX) to Olive Garden (ESTC). Both are successful to an extent in what they do, but one seems to be carving out a leadership position in its segment while the other isn’t clearly winning at anything in its segment.

From a pure numbers perspective, I can see why you would prefer ESTC. I just don’t believe in them as much long term. That’s it. Of course, I could be very wrong.

Bear

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Hastan,
This is the wrong string for this conversation. You need to keep it on the correct string. But I will leave you with this from the conference call. FEYE is nest gen.

Tal Liani

Hi, guys. I wanted to ask you about the competitive displacement. And I want to just to discuss two things. Number one is what was the experience this quarter with displacing Symantec specifically? And second, we also see that you are displacing next-gen players and the question is, why, what are the deficiencies in their products or what kind of added value do you provide that allows you to displace also next-gen players?

George Kurtz

Sure. Well, we can start with the first one. We continue to displace Symantec customers. Again, for a lot of the reasons that we have talked about in the past, people are looking for platforms and they are looking for technologies that actually work and stop breaches. Ransomware has been a huge driver and signature-based AV is really not capable of dealing with sophisticated ransomware, right. So, people are looking to get off that. Not as a matter of security, I mean that’s certainly an element, but as a matter of business resiliency. And in today’s environment, if we think about the healthcare community, the last thing anyone would want would be a ransomware attack in the middle of the pandemic. So, that’s one. Two is on the next-gen players. Again, we spent the time and effort to build the platform out from the ground up, right. It’s the same Salesforce, Workday, ServiceNow, CrowdStrike. We don’t have an on-premise version, because that’s not our model. So, lot of our competitors built on-premise versions. They try to move it to the cloud and call it a cloud offering. Their data is still on each endpoint. The value is being able to aggregate this data at scale, which we figured out with our threat graph. And effectively that creates a data mode plus the module expansion allows customers to add more modules not agents, right. And even our next-gen competitors, they still have three and four different agents because of their acquisitions. So people want something that’s simple, want something that works and want something that’s future proof and ultimately stops the breach.

Tal Liani

Great. And that includes also next-gen players?

George Kurtz

That was specifically directed at next-gen players, yes, got it

Andy

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Hi Dreamer,

ESTC is an annoying stock, especially compared to something like MDB where the numbers are almost identical. MDB passed ESTC in revenue by a quarter, so its now in-sync but a quarter ahead.

eg:


MDB
Revenue   89,388 99,368 109,441 123,523 
yoy growth 78%.  67%.   52%.    44%

ESTC
Revenue 89,710 101,106 113,181 123,623
        58%    59%     60%      53%

Loss from operations is better for ESTC, as is net loss. But, MDB has a EV of $12.670b, while ESTC has one of $6.525b. Almost exactly half. Huh?

MDB earnings (today I think) will be very interesting. For whatever reason, the market does not love ESTC and does love MDB.

cheers
Greg

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Cybersecurity has always been a business that evolves so quickly that no-one ever stays as a leader for any kind of sustained period of time.

Perhaps CRWD is the one exception. But at 40+x sales I don’t really understand what level of upside you expect. Even if they do 10x on revenue and have 30% FCF less SBC margins you are still paying 15x FCF for that scenario many many years (10+) from now.

If they fail and don’t retain market leadership you lose 80% of your money.

Don’t understand how a long-term investor could possibly want to own any cybersecurity company at 40x sales. Because history tells us that the leader in 5 years is always different from the leader today.

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Hastan,

You seem to have observed security companies for a while… and I generally agree with your observations… however, I see one big difference with CRWD… and that is deferred revenue…

CRWD seems to be able to get people to pay a lot of money in advance… and I can imagine how that can work once CRWD helps a potential client pull out of a ransomware attack…

but the point is - have you seen in the past security companies get paid for 12 months or longer in advance? this to me is a big reason why CRWD can sustain that leadership… they charge a lot and get paid in advance… this did not happen with PANW or FEYE or others to my understanding.

would be curious of your view point.

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Folks, I don‘t have technical background but my take for CRWD is that they kind of want to secure EVERYTHING going to/via cloud including mobile, IoT etc. Not only EDP. And I though that this was the main difference vs old and semi-old security companies. So, they‘re kind of logo to go, when u transition to cloud and want to be secure. So, they‘re riding now huge transition to cloud tailwind.

What do u think?

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If it really slows to 35-40% I think the shares will get hit hard.

I am not so sure. I think over the last year ESTC has been plagued by many investor concerns that has been holding down it’s valuation.

First was whether a business model can be built on open source. Now they have 11k+ customers, 610 with 100K+, 50 with 1Million+. Safe to say that doubt has been put to rest.

Second was the whole Amazon Open distro thing. After 1+ year ESTC is still growing and adding new customers.

Lately there was the thought that DDOG will be sole winner. Now many are seeing ESTC has genuine competitive advantages. I list some in the thread below.

https://discussion.fool.com/estc-good-and-bad-34525922.aspx?sort…

Next Q DDOG which did 87% last Q is guiding for 62%. ESTC which did 53% is guiding for 35%. I see both as conservative guides. Let us say ESTC has low billings next Q as they fear and just do 35-40%. What is such a company with break even cash flow worth? Just compare with other SAAS companies. I don’t think it is likely to crash much, maybe even expand the ps multiple a little. It’s price action over the last 2 days in a down market for SAAS could indicate so. Remember they even said their cash position is strong and don’t find a need to raise money. So, this company is not going to disappear in this slowdown. Another investor uncertainty removed. Of course, this stock has disappointed more in the last year.
One final note. In terms of mission critical security is most important, then observability, then enterprise search. ESTC derives a portion of its rev (they say less than a third) from search which maybe on less firm ground. Think Uber, Tinder but then Insta cart is doing good. So, search is not all bad but it seems to be linked to macro more like AYX, and SMAR. ESTC derives more than 1/3rd from logging which comes under observability which is safer.

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I think in general companies have become more used to making advanced cash payments (usually you get a discount for doing so and it helps smooth the cash flow of the vendor - I think understanding FCF differences between this billing model and a more usage based billing model is pretty important).

What’s more important than the billing model is having the right solution to the problems of today. That’s why no-one ever stays on top. Innovation doesn’t come on demand.

In general, I would say that my strategy is very different to the average person on this board so you many not want to listen to me - I only allocate into opportunities where I would be happy to hold for 10+ years and I have a lot more bias towards high levels of profitability and places where I can take a very highly differentiated view through thorough fundamental work.

Clearly high growth have performed extraordinarily well over the past 10 years (and I used to have a lot more of my portfolio in midcap software chasing growth when it was trading at more reasonable valuations). I only own two midcap software companies now (ESTC and PLAN) both of whom I believe have a strong opportunity to dominate a category, and I think the market as a whole does not recognise some extremely large competitive advantages in both cases. At the start of the year I owned 3 others (DDOG, COUP, TEAM) - all of which I have sold due to valuation that makes no sense even to a very long term thinker such as myself. I think each of these will be down over the next 5 years. As I mentioned elsewhere on here I also sold AYX in February as I think there is a decent chance we see negative growth rates this year. So far I have been wrong on AYX - it trades slightly above where I sold it despite my thesis essentially coming true. I plan to reacquire this at some stage as I am a long term bull - but I’m pretty sure I’ll get a better entry point in the future. We’ll see. If I’m wrong I’m always happy to pay up.

Just to help you understand how I think - it’s pretty different to the prevailing sentiment here which is to invest in the fastest growing tech companies in the market with limited regard for market durability or valuation and hope that you recognise a deterioration first. For me this is just a variation on the “greater fool” strategy, and when we get a 2000 type bubble-burst which will happen at some stage in software, I tend to think that this will be a disaster. We’ll see. Entirely possible I will be incorrect.

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Disagree, Hastan. Let’s take Datadog as an example, assuming following growth rates in next 5 years:
Y1 - 80%
Y2 - 65%
Y3 - 50%
Y4 - 45%
Y5 - 37%

I am conservative and assume significant deceleration. Applying these rates means that revenue in 5 years will be 8.8 times higher than today.

Current forward P/S is around 35. The P/S in 5 years will drop to 4 at current stock price. A great software company can achieve 30% net profit margin, giving them a virtual PE around 13 in 5 years with growth in the 30%’s.
As you can see, if Datadog continues to deliver even assuming significant growth slowdown, this is easily a 3-4 bagger in 5 years and who knows much more if higher growth continues.

This is not a bubble at current valuations.

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If you think those growth rates are conservative - I have a bridge to sell you. Even totally category dominant companies didn’t grow like that from this level of revenue. DDOG has multiple major competitors, two of which have better products, just more difficult to use for now.

FYI - DDOG trades at 56x 2019 sales. If there is dilution of 5% a year (will probably be higher) it will trade at 7x sales - in 5 years - not 4x sales even under those assumptions.

Could you provide me with a list of 10%+ growth software companies in non-oligopoly markets with 30% net profit margins? Particularly ones that don’t have a legacy customer base?

I can think of Veeva maybe but that’s a category monopolist with a highly advantageous resale agreement with Salesforce. An agreement that Salesforce would never agree to again.

If DDOG achieves 30% net profit margins on a GAAP basis - it will be many many years from now.

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I cannot think of a single independent software company in history that has achieved that level of growth from that level of revenue.

Take ServiceNow for example - did 6x on revenue between 2012 and 2016, starting at $244mln. They grew revenue at 90% in 2012 - faster revenue growth than DDOG in 2019!

This is a category monopolist - the only cloud-native solution in the market - taking share in a very large existing market, still growing rapidly. It’s a totally different situation to DDOG.

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Hastan, my comments on your two posts:

  • Agree with the share dilution, I was on my mobile so kept the calculation simple. Actual EV/S will therefore be a bit higher, unless they will use cash flow in the future to offset the dilution, such as Paycom, Adobe,… have been doing for years.

  • 30% net profit margins: At this moment, not many great software companies have these 30% margins yet because they are simply growing so fast and spending a lot on R&D and S&M. However, take a look at Microsoft, a more mature but still growing software company. NPM exceeds 30% with 14% revenue growth and they have lower margin businesses such as hardware. Adobe has 26% NPM (non-gaap 35%!) with 20% revenue growth, Veeva 28% NPM (31% non-gaap) with 35% (!) revenue growth, Paycom 28% NPM with 20% revenue growth so of course I believe that the greatest software companies will achieve 30% net profit margin when they are in low growth mode (0-5% revenue growth), and as the examples here above show, possibly even a lot more than 30%. I mean, gross margins are 80%, if they no longer focus on growth, they can cut R&D and S&M dramatically so high margins are inherent to this business model.

  • Level of growth: First of all, Datadog has been growing between 77% and 88% for the last 6 (!) quarters. I have a hard time believing that growth will suddenly drop to 50% in the next quarter or two. In fact, growth rate in Q4 2018 was lower than the rate in Q1 2020. So yes, I do believe that the growth estimates I gave are reasonable. Secondly, Datadog has a NER exceeding 130% and billing is volume/usage based, and we all know the volumes will continue to increase significantly over the next years. ServiceNow, although I am not too familiar with their billing, is as far as I know not usage based. ServiceNow is a lot more dependent on new customers to achieve growth, while Datadog should be able to grow significantly within their current customer base for years to come. ServiceNow doesn’t report NER, but it’s likely always been lower than Datadog.

  • You are arguing that DDOG doesn’t have the best product and is not a category dominant company. That’s possible and no one is telling you here to hold this stock for ten years. However based on today’s numbers I would say that they are the dominant player right now in their market and nothing currently suggest that this will change in the foreseeable future. However I just gave DDOG as an example, I think we can all agree that COUP is the dominant player in BSM, Okta in IAM, AYX in data analytics and so on.

  • Comparisons with dot.com bubble are ridiculous. Nasdaq is up 95% over the last 5 years, it was up 515% in the last 5 years prior to the burst of the bubble. Of course, bubbles are possible within a subcategory of companies, however my calculations above show that I believe this is not the case today. If DDOG was trading at a 100 times forward revenue (x3 from here), I would likely agree with your thesis of overvaluation.

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Just to help you understand how I think - it’s pretty different to the prevailing sentiment here which is to invest in the fastest growing tech companies in the market with limited regard for market durability or valuation and hope that you recognise a deterioration first [bolding mine]. For me this is just a variation on the “greater fool” strategy, and when we get a 2000 type bubble-burst which will happen at some stage in software, I tend to think that this will be a disaster. We’ll see. Entirely possible I will be incorrect.

Hastan –

At the risk of sounding biased or maybe even a little defensive, I believe you are drastically oversimplifying how investment decisions are made by most on this board. I say that as someone who also wondered in my early days here whether this was just chasing the highest growth I could find. This might be a more suitable framework:

  1. Identify hyper growth companies with appropriate trends in customer growth, gross margins and potential profitability to suggest a dominant future. Muji’s recent post (https://discussion.fool.com/distilling-knowledge-34529397.aspx) points out several other variables, but I’ll try to keep it simple for now.

  2. Be willing to pay a premium because potentially dominant companies almost always have one assigned to them. That’s not to say valuation NEVER matters, but to paraphrase Tinker, “Cheap is cheap for a reason.”

  3. Be ruthless in holding your companies accountable to the standards in #1. That doesn’t mean there’s disregard for the “market durability” you mention. In fact, there are several stocks here that have been held a considerable amount of time. The difference is maintaining that durability label is contingent on continually meeting the requirements of #1. If those standards aren’t met in any way, immediately double check your thesis and/or compare it to the top of your watch list. If the thesis falters or a watch list name has passed it, DO NOT HESITATE. Simply move on with a focus of consistently maintaining the strongest overall portfolio possible. We don’t care about stock price when making that decision, so the greater fool theory doesn’t really apply. We only care about the business prospects of the companies we own RIGHT NOW.

Clearly there is enough similarity of thought here (group think?) that many hold large amounts of the same names (CRWD, DDOG, ZM, etc). However, the differences in sizing and secondary holdings for most portfolios shows everyone does it a little bit differently.

Again, I can’t stress muji’s post enough so I’ll link it again (https://discussion.fool.com/distilling-knowledge-34529397.aspx). While it’s not the Knowledgebase, it’s an incredible collection detailing the recent thought evolution of this board. I also agree with tamhas it deserves a permanent link on the side panel. Any attempt to distill Saul’s or anyone else’s method to a few simple bullet points almost certainly won’t do it justice, including my effort above. Nuance matters, and there’s probably no less effective way to express nuance than bullet points. Muji’s done us all a tremendous service by putting a lot of that nuance all in one place.

To your point, is there a possibility this all comes crashing down? Sure, nothing in life is guaranteed. That being said, it is hard to argue against spending the time to explore the nuance here when you view some of the returns posted by members of this board. I believe that’s why so many seem interested in coming along for the ride.

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It is critical to be focused on the business metrics and not the stock metrics.

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