ESTC's Business Model

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I’ve owned ESTC in the past, but don’t own it anymore. I keep itching to buy it because the growth rate is good and their developer mindshare is strong, but don’t have the confidence to take a big position.

Why? Because of their complete open source model. As I understand it, even the proprietary features of their offering (formerly called X-pack) are open source.

I’m not a technie, but can someone help me understand how this is a good thing for the business? What is to stop developers from using the code, the free open source stuff and the proprietary open source code in their products without paying ESTC? What is to stop competitors in the future from using the completely open source code base to build a competing offering?

As far as I know, this is the only company with this model. MDB has a free open source version, but it’s premium features aren’t open source. From a business perspective, that model makes much more sense to me.

How is this a good thing for ESTC?

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I’m no techie Stockfan, but a company growing revenue over 60%+ with 10 straight quarters of 130%+ NER and a near tripling of paying customers over the last two years sure seems to fly in the face of “Open source doesn’t work”.

If it didn’t, why do thousands of enterprises pay for the premium features? I guess it must be terrible since those cohorts spend an average 30+% more with Elastic the following year!

I would really need to see evidence that this model does not work before selling… I.E., NER rate dropping big time, revenue growth dropping significantly, etc.

Best,
Matt

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ESTC’s business model is predominantly from recurring subscriptions.

You pay to get access to their SaaS offerings:

https://www.elastic.co/cloud/

Or you pay a certain subscription level to get “closed” features and/or have them support you with you use/deployment of any of their products:

https://www.elastic.co/subscriptions

This gives a pretty good picture of how their revenue model works:

https://medium.com/@alexfclayton/elastic-ipo-s-1-breakdown-1…

About your other questions, it is not apparent/easy to understand but in order to understand why most of their stuff is “open”, it generally has to do with where they came from and their open-source and community-driven culture. The want to build the best products (in their domain) and they want to get to the hands of as many people as possible with as little friction as possible. In addition, they realize that the open-source community has as much to do to contributing to their success so they try to give back as much as they can to keep the spirit going. Because of this, the adoption and popularity of their products is/has been extremely rapid and is a testament to how good their stuff is and their “open” attitude, mentality, and culture. I personally do not believe that they could have gotten to where they are today without the community and their “openness”.

I’ve owned ESTC in the past, but don’t own it anymore. I keep itching to buy it because the growth rate is good and their developer mindshare is strong, but don’t have the confidence to take a big position.

Why? Because of their complete open source model. As I understand it, even the proprietary features of their offering (formerly called X-pack) are open source.

I’m not a technie, but can someone help me understand how this is a good thing for the business? What is to stop developers from using the code, the free open source stuff and the proprietary open source code in their products without paying ESTC? What is to stop competitors in the future from using the completely open source code base to build a competing offering?

As far as I know, this is the only company with this model. MDB has a free open source version, but it’s premium features aren’t open source. From a business perspective, that model makes much more sense to me.

How is this a good thing for ESTC?

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Matt,

Dumb question, but what does NER stand for?

From Saul’s “How I Pick a Company to Invest In”:

“Sixth, I’d demand a dollar-based retention rate over 100%. I look for one over 120%, and I’m impressed by one over 130%.”

Is NER dollar-based retention rate, or is it a different sort of retention?

Thanks,

Don

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I agree with you, the numbers are fantastic. But the pure open source model really strikes me as an odd move from a business perspective. It sure hasn’t impacted revenue growth yet so maybe my skepticism is unwarranted.

Still it does seem that others are skeptical too since ESTC trades at one of the lowest multiples among the 50%+ growers. of course, if the company keeps delivering growth, that skepticism may melt away and the stock can shoot up quickly.

I wouldn’t be surprised if that happened, I just can’t get over the business model enough to get back in right now. but am still following the stock closely and open to hearing why pure open source is a positive (or neutral) for ESTC.

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I meant to do the “Email this Reply to the Author” option on the previous post.

My apologies.

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It certainly seems that the CEO is a strong believer in not corporatizing his company too much and staying true to the spirit of open source. It sounds like a good thing for developers and maybe it will end up being a good thing for investors also.

One thing is for sure, ESTC has a unique business model among the SaaS stocks and it will be interesting to see what path the company/stock take from here.

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Hi Don,

No worries - NER = Net Expansion Rate. It’s essentially the same thing as the dollar based retention rate. (I use them interchangeably)

Shay Banon, the Founder and CEO has an interesting blog which you can google to find. He is definitely passionate about his business and knows this area very well. I get lost in the logging stuff and the like, but I don’t need to be in the industry to follow the numbers. :slight_smile:

Best,
Matt

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Still it does seem that others are skeptical too since ESTC trades at one of the lowest multiples among the 50%+ growers. of course, if the company keeps delivering growth, that skepticism may melt away and the stock can shoot up quickly.

At a 22 P/S multiple of TTM revenues currently. Higher than TTD, ROKU, NOW, ZEN, WDAY, and about the same as PAYC.

Not cheap, but not as expensive as the MDBs of the world, which is why I have it as a top allocation in my port. TWLO not much higher P/S, but ZS and OKTA are on a P/S level of their own, and ZM/CRWD are on a P/S planet of their own.

Seems pretty obvious now that the stock was indeed pressured down by the 2-pronged lock-up expiration: first 25% of insider shares were allowed to be sold back in March or April (I forget which) and then the remaining 75% of insider-held shares were allowed to be sold after the quiet period ended, 3 days after the last ER, which turned out to be June 10th. Volumes increased, selling increased, and seems to perhaps have bottomed 14 days ago on June 26th.

Since then, ESTC is up 11% over past 14 days.

Their last ER was the end of their Fiscal 2019, so they provided guidance on June 6th for their current Q1 and for their full fiscal 2020. They guided to 49% growth essentially, on the high end. Believe they finished at $271m for fiscal 2019, and called $403m for fiscal 2020. Keep in mind this is guidance, which every other SaaS company on the planet plays the beat-and-raise game, and Elastic should be no different. I am modeling $425m as their 2020 fiscal full year revenue.

At today’s stock price and market cap, that would translate to about a 14.5 P/S multiple.
Do I believe the stock will stay flat for the next 11 months and trade at a 14.5 P/S multiple? Only if entire market/sector collapses too, which I don’t expect.

My issue with valuations has been that it seems harder to find a stock that can earn you a great appreciation without having to rely on their P/S multiple expanding into the stratosphere.

My napkin math says that ESTC can actually go DOWN in P/S to 20, in 11 months when they announce FY 2020 results next June, and the stock price would be up about 37%.

Now if the market is still insane and give 50% y/y growers 25-30 P/S ratios and higher, a year from now, then ESTC could earn me a 70%+ stock price return if it winds up being a 25 P/S ratio in 11 months.

This may not answer your question on open source, but if you sort this board by cmfmuji or ethan, you will get some great ESTC posts from them both.

Here is some open source insight from when ESTC was set to IPO, which is still less than a year ago, btw:
This was written right about time ESTC had IPO last Fall.

https://blog.timescale.com/open-source-demise-of-proprietary…

Pretty cool history, linux, red hat, mdb and estc.

Helps frame why open source is relevant and gaining traction.

"That said, despite the best efforts of the public cloud vendors to lock you into proprietary services, the desire to avoid that cloud lock-in likely will continue to drive users to open-source options. But time will either prove that hypothesis right or wrong.

As one example, the success of Elastic, in spite of AWS offering its own competing Elasticsearch service, is promising and shows signs that managing the transition to the cloud is feasible for an open-source business."

Dreamer

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My issue with valuations has been that it seems harder to find a stock that can earn you a great appreciation without having to rely on their P/S multiple expanding into the stratosphere.

Dreamer, how do you define “great appreciation”?

Any stock that grows sales at 50%+ per year would have about 50% appreciation if P/S stays the same, a bit less due to dilution.

I am pretty happy with 40-50% returns. Any additional return based on multiple expansion is icing on the cake. It is true that companies with huge gains (double or triple in a year) usually have accelerating growth which then also results in multiple expansion.

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Any stock that grows sales at 50%+ per year would have about 50% appreciation if P/S stays the same

Humans are remarkably adaptive. The present is inevitably the new normal.

At start of 2018, ayx twlo mdb ttdand others had much lower p/s ratios than now. Which was “proper”…the valuation multiple then or now? Depends on markets, i guess.

But I wouldnt invest in ZS with the thought it will still have a 35-ish P/S in 2-3 years.

Personally, i am not comfortable granting any stock higher than a 20 p/s 2 years down the road.

SHOP and TEAM provide examples of 30-ish P/S ratios at mkt cap sizes of $30b or so. So it is entirely possible.

I dont like modeling a CAGR of a stock based on the exceptions to the rule.

Dreamer

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I have read this concern many times on the boards. Here is the companies description from their 10-K.

Our origins are rooted in open source, which facilitates rapid adoption of our software and enables efficient distribution of our technology. Developers can download our software directly from our website for use in development and production environments. These downloads include both free and paid products. Open source also fosters our vibrant community of developers who help improve our products and build on top of them. As of April 30, 2019, our community included over 120,000 Meetup members across 215 Meetup groups in 48 countries. Meetup members are individuals who opt into an Elasticsearch Meetup group on meetup.com, an independent third-party website.

Our business model is based on a combination of open source and proprietary software. Many features of our software can be used free of charge. Some are only available through paid subscriptions, which include access to specific proprietary features and also include support. Unlike some open source companies, we do not build a separate enterprise version of an original open source project. Instead, we develop and test one robust codebase, over which we maintain control. We believe that maintaining full control over the source code enables us to develop better products for our users and customers. Our sales and marketing efforts start with developers who have already adopted our software and then evolve to departmental decision-makers and senior executives who have broad purchasing power in their organizations. All of these actions help us build a powerful commercial business model on top of open source.

Our customers often significantly expand their usage of our products over time. Expansion includes increasing the number of developers using our products, increasing the utilization of our products for a particular use case, and applying our products to new use cases. We focus some of our direct sales efforts on encouraging these types of expansion within our customer base.

https://ir.elastic.co/Cache/398528349.pdf

Our Business Model

Our business model refers to how we make our software available, including our open source distribution and go-to-market strategy, and how we charge our customers. We believe our business model creates significant value for our users, our customers, and our company.

Our business model is based on a combination of open source and proprietary software. We market and distribute the Elastic Stack and our solutions using an open source distribution strategy. Developers are able to download our software directly from our website. Many features of our software can be used free of charge. Some are only available through paid subscriptions, which include access to specific proprietary features and also include support. These paid features can be unlocked with a simple license update, without the need to re-deploy the software. The rate at which our customers purchase additional subscriptions and expand the value of existing subscriptions depends on a number of factors, including customers’ level of satisfaction with our products, the nature and size of the deployments, the desire to address additional use cases, and the perceived need for additional proprietary features. The source code of all Elastic Stack features, whether they are open source or proprietary, is visible to the public in the form of “open code.”

Our open source model facilitates rapid and efficient developer adoption, particularly by empowering individual developers to download and use our software without payment, registration, or the friction of a formal sales interaction. Our use of open source licensing fosters a vibrant developer community around our products and solutions, which drives adoption of our products and increased interaction among users. Further, this approach enables community review of our code and products, which allows us to improve the reliability and security of our software. We believe that the number of times our products have been downloaded and the size of our developer community are indicative of the benefits of our open source strategy and the growth in adoption of our products. However, we typically do not have visibility into whether our products are being actively used unless the user opts to interact with us. As a result, we cannot accurately determine how much of our downloaded software is being actively used.

We have designed our strategy to avoid some of the risks associated with an open source model. One such risk relates to control over the direction and roadmap of our products. We maintain full control over the source code of our products and solutions. While community members may suggest changes to our products, only Elastic employees are able to commit changes to the codebase. Further, unlike some open source companies, we do not build a separate enterprise edition of an original open source project. Instead, we develop, maintain, and test a single robust codebase that is shared by our entire developer community.
Some open source companies sell only support for software that they make available at no cost. We believe this can create misaligned incentives in that the support vendor benefits from low software quality. Accordingly, we focus on designing high-quality software products that include proprietary features and are easy to use and reliable. We include support only as part of our subscriptions.

We believe in building products that provide value and appeal to the people who use them, including developers, architects, DevOps personnel, IT professionals, and security analysts. At the same time, a software company should be able to engage and build relationships with departmental or organizational leaders who make large technology purchasing decisions. At Elastic, we do both.

I make no claim as to understanding the software. However some lessons I have learned from this board are:

Follow the $$. If the revenues are increasing significantly, the company is doing something right.

If the customer base is expanding, they have something people want.

Trust in the company, until they have given you reason not too. If the company says this model is a good one, who am I to argue. Heck the founders built the company from nothing to a company valued just under 6 billion dollars. They obviously know understand the business they are in and what they are doing to a degree.

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Without getting into the finances of ESTC, the question of how to make money on open source software has a lot of parts. As a (retired) software developer, the short answer is that free code is not free, it has to be maintained, customized, updated. Any company may find it more economical to pay someone else (ESTC) to do this, rather than try to do it in house.

Leana

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I make no claim as to understanding the software. However some lessons I have learned from this board are:

Follow the $$. If the revenues are increasing significantly, the company is doing something right.

If the customer base is expanding, they have something people want.

Trust in the company, until they have given you reason not too. If the company says this model is a good one, who am I to argue. Heck the founders built the company from nothing to a company valued just under 6 billion dollars. They obviously know understand the business they are in and what they are doing to a degree. – Retirementdough

While its possible to make any investment super complex, it seems I’ve seen a lot of “recognized great investors” indicate that a great investment can be articulated in 30 seconds. And if you can’t boil it down, it probably isn’t so great.

Long story short, I agree with your synopsis, Retirement.

Then, of course, you can get into a long discussion about “is the valuation too high?” And I won’t go there about any company right now. Not interested in a lot of blah-blah-blah. :slight_smile:

Rob
Rule Breaker / Market Pass / Supernova Navigator Home Fool & STMP/MTH Maintenance Coverage Fool
He is no fool who gives what he cannot keep to gain what he cannot lose.

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