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March 1, 2024

My “plan” to enter the weekend patting myself on the back for a week of decent stock performance in our portfolio might be foiled by Elastic (ESTC).

Elastic (ESTC) at Risk of Spoiling Otherwise Terrific Week

My “plan” to enter the weekend patting myself on the back for a week of decent stock performance in our portfolio might be foiled by Elastic (ESTC).

The company reported Q3 fiscal 2024 results yesterday that, while 2% better than expected on revenue and pairing nicely with ahead-of-consensus Q4 fiscal 2024 guidance, also showed that the all-important Cloud revenue line (44% of total revenue) decelerated to 29% growth from 31% growth in the previous quarter (i.e. Q2 2024).

Elastic Cloud is the company’s hosted software and is what virtually all new customers use. The other option is self-hosted software that customers download. That is the “old” way of doing things.

While it may seem a little silly that 2 points of deceleration in Elastic Cloud would drive the stock down 16% after hours (it improved to “just” -13% pre-market this morning), especially since 29% growth slightly surpassed expectations, the reality is the stock ran higher into the event as investors prepared to be wowed.

They weren’t.

Turning back to the quarter, revenue grew by 19.4% to $328 million (beat by $7.2 million) while EPS grew 112% to $0.36 (beat by $0.05).

It was actually self-managed subscriptions that helped the company beat Q3 expectations. Worth noting that, while investors are zeroed in on Cloud, management isn’t 100% pushing it over self-managed. They prefer Cloud, but it’s more important to land customers.

Another positive was that Elasticsearch Relevance Engine (ESRE) pulled in several hundred customers for the third consecutive quarter. This solution allows customers to build generative AI apps quickly and without model training. The small business market remains a bit weak but among larger enterprises the generative AI use cases and attraction of Elastic’s RAG (Retrieval-Augmented Generation) technology, which helps user save money as they build data intense applications, continue to set Elastic apart from the competition.

On Q4 guidance, management said to expect 18% revenue growth (about $329 million) and EPS of $0.18 to $0.20. No guidance for fiscal 2025 was given, yet.

Stepping back, this really was a perfectly good quarter. Yes, growth could have been more spectacular and the stock will likely take a step back as more modest expectations settle in. But there’s no reason to think revenue growth of around 18% this fiscal year (just one quarter left) can’t be matched, or exceeded, in fiscal 2025. Or that EPS growth won’t exceed earnings growth by a few points.

Elastic remains a solid mid-cap pick that should benefit from AI-related tailwinds over the longer term given its strength in search-related generative AI, with observability and security representing other markets with upside.

Assuming no crazy downside action on the day (and early next week) I expect to keep ESTC at hold, but we’ll keep an open mind depending on how shares react. We were up 62% going into the earnings report so should still have a very nice gain, even with some give back. HOLD

Tyler Laundon is chief analyst of the limited-subscription advisory, Cabot Small-Cap Confidential and grand slam advisory Cabot Early Opportunities. He has spent his entire career managing, consulting and analyzing start-up and small-cap companies. His hands-on experience has taught Tyler that the development of a superior business model is the biggest factor in determining a company’s long-term success. Accordingly, his research focuses on assessing the viability of management’s growth strategies, trends in addressable markets and achievement of major developmental milestones.