Elastic N.V. (NYSE:ESTC) Q2 2024 Earnings Call Transcript

Elastic N.V. (NYSE:ESTC) Q2 2024 Earnings Call Transcript November 30, 2023

Elastic N.V. beats earnings expectations. Reported EPS is $0.37, expectations were $0.24.

Operator: Good afternoon, and welcome to the Elastic Second Quarter Fiscal 2024 Earnings Results Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Anthony Luscri, Vice President, 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 second 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 third quarter fiscal 2024 quiet period begins at the close of business on Wednesday, January 17, 2024. On December 7, 2023, we will be participating in the Barclays Global Technology Conference. With that, I’ll turn it over to Ash.

Ashutosh Kulkarni: Thank you, Anthony, and welcome back to Elastic, and thank you all for joining us today. I’m pleased with how we performed in the second quarter and what is still a challenging external environment. We exceeded our expectations across both revenue and non-GAAP operating margin. In Q2, revenue grew 17% year-over-year with Elastic Cloud growing 31% year-over-year, fueled by continued improvement in cloud consumption as well as our success in generative AI. And we exceeded our profitability goal, delivering non-GAAP operating margin of 13%. Elastic’s mission is to enable everyone to find the answers that matter from all data in real time at scale. Search is at the core of all our solutions and everything we do, whether you are searching a website or searching for security threats in your organization.

Search is also a critical part of the infrastructure for AI. We are proud that Elastic is the leading search analytics platform used by tens of thousands of customers and supported by a large community of users. Our thoughtful investment and innovation in AI has continued to drive customer excitement and engagement with Elastic, and this was visible in our business in Q2. During the quarter, we continued to see recurring trends drive momentum in our business. The first of these being generative AI. I met with dozens of customers across all geographies and a recurring theme was a strong desire to use Elasticsearch Relevance Engine, or ESRE, to build generative AI applications. Generative AI is driving a resurgence of interest in search as customers use semantic search, vector search and hybrid search to ground large language models with their private business context and ESRE provides the most comprehensive and enterprise-ready platform for these use cases.

While it will take some time for generative AI spend to become a significant driver of our revenue, we are very excited about the long-term opportunity. As an example, we signed a multiyear marketplace deal with DocuSign, the world leader in eSignature and contract life cycle management solutions. More than 1.4 million customers and more than 1 billion users in over 180 countries use DocuSign solutions to make doing business smarter, easier and more secure. Search is an essential component of DocuSign’s product and our advanced capabilities with semantic and vector search will enable DocuSign to extend its capabilities. We also signed a contract with a leading video sharing platform for Elastic Cloud via the Google Marketplace to provide hybrid search, blending AI, vector search, semantic search and Reciprocal Rank Fusion, or RRF, offering a platform that enables millions of users to create, edit and share videos, the company is using the Elasticsearch Relevance Engine that will ultimately serve as the core vector database for its millions of videos and associated metadata.

The company has created and stored a vector embeddings in Elastic in order to provide watch list recommendations leading to a better search experience. In Q2, we saw a significant increase in the use of ESRE. ESRE includes a built-in vector database, the ability to bring in your own machine learning models and also ELSER, which is our own proprietary machine learning model for semantic search. This quarter, we saw a rapid adoption of ELSER, which we first released with ESRE launch. With ELSER, customers are able to quickly implement semantic search without any model training to power generative AI use cases. With the release of the even more efficient ELSER Model 2 earlier this month, we expect to see this momentum continue. We also saw hundreds of additional customers starting to use ESRE for vector search use cases in Q2, building on our momentum from the first quarter.

We are very pleased with this growth and are also excited by the progress we have been making on the innovation front. In Elastic 8.11, we delivered support for dense vectors with up to 400 dimensions, which is already greater than what embedding models require. We also delivered the first version of our machine learning inference API to improve the overall developer experience when building generative AI applications with Elastic. When search powers AI, customers are able to quickly build generative AI applications while reducing hallucinations at the lowest possible cost. Elastic’s prospects as a key component of the modern IT stack for generative AI remain extremely strong. The second trend we saw in Q2 was customers continuing to consolidate onto the Elastic platform for multiple use cases.

We had many key wins where we displaced incumbent solutions for observability and security and helped customers save on their overall IT spend while gaining even greater value through our many innovations. For example, we closed a multiyear 8-figure deal with a leading global wealth management company. Having previously used a legacy vendor, the company moved to Elastic Security for SIEM for deeper threat hunting capabilities in order to keep up with data volume growth and threat sophistication. They are confident in our cloud native technology as well as the speed, scalability and flexibility of Elastic as well as our generative AI capabilities. Additionally, a leading risk transfer company in Europe signed a multiyear subscription with us and replaced their legacy security provider.

Elastic stood out as their preferred solution to fortify their organization against security threats and strengthen their security posture. By leveraging Elastic SIEM and tapping into our advanced capabilities such as cross-cluster search, the company can now effectively monitor and protect its large complex environment from a single pane of glass on one unified platform. As customers continue to consolidate onto our platform, we have been investing in capabilities that make it possible for customers to migrate easily from incumbent solutions to Elastic. In 8.11, we launched a powerful new piped query language, Elasticsearch Query Language, or ES|QL. ES|QL is designed to transform enrich and simplify data investigation with concurrent processing.

ES|QL enables data aggregation and analysis across a variety of data sources from a single query making it an incredibly powerful tool for data analysts, site reliability engineers and security operations center analysts alike. The excitement from our customers on this capability in technical preview has been tremendous. We have also been investing in our AI Assistance for observability and security that make it possible for customers to leverage the power of AI to aid the humans involved in the detection, diagnosis and remediation workflows in observability and security. These AI Assistance, which are in our enterprise subscription tier, are allowing us to leverage our leadership in AI even in the areas of observability and security. And this is something that we believe will continue to be a tailwind for us.

The final trend in the quarter was around cloud consumption, where continued improvements helped drive cloud revenue growth. Customers remain focused on costs, but they have generally optimized their Elastic deployments and are now focused on driving new workloads to Elastic. This is an area where we continue to lean in to help our customers get the most out of Elastic. This customer-centric approach drives improved customer satisfaction and engagement and increases consumption over time. This drove our interest in acquiring Opster. Opster develops products for monitoring, managing and troubleshooting Elasticsearch and OpenSearch. They are the creators of AutoOps, a powerful platform that provides deep insight to detect and resolve issues with cluster health, improved search performance and reduce hardware costs.

By joining forces with Opster, we will be able to help our customers get even more out of their Elasticsearch deployments and drive greater customer satisfaction and consumption. As we progress on our journey towards our serverless offerings, the kinds of management and monitoring capabilities that Opster has built will make our platform even more resilient and easier to use, and I’m very excited about this feature. Now on to our many product innovations in Q2. In addition to the ES|QL and generative AI innovations that I’ve already mentioned, the team delivered amazing capabilities across the Elastic platform. We added chat capabilities with the SQL integration to our AI Assistance. This allows customers to use natural language to explain a query and have the AI Assistant provide the ES|QL query syntax, explain what the query does and provide a prompt to run the requested query.

In observability, Universal Profiling became generally available. And we also integrated it with application performance monitoring, or APM. With this new capability, users will be able to quickly correlate application performance issues with underlying system functions without needing to switch context from APM to Universal Profiling. When search powers observability, site reliability engineers have greater visibility across all signal types, reducing the time to resolve system issues. In security, we delivered Cloud Security Posture Management for Google Cloud. And now our customers can use Elastic to secure their workloads on Google Cloud in addition to their workloads on AWS. We also delivered out-of-the-box integrations with Wiz and Palo Alto Prisma Cloud to make it easier to get a view of the entire threat landscape in the Elastic platform.

When search power security SOC analysts have greater visibility into difficult to detect threats, reducing the time to hunt and remediate threats. Finally, in search and generative AI, we delivered integrations with LangChain, LlamaIndex and Amazon Bedrock, further simplifying the developer experience and providing our customers with greater flexibility as they build generative AI applications. Now on to our go-to-market focus and investments. We see a tremendous opportunity ahead of us as our search analytics platform becomes a key part of the modern IT stack for building GenAI applications. We firmly believe that our relationships with the major cloud hyperscalers will be a key factor in our success in the future. And towards that end, we are continuing to invest in these relationships.

We just announced a new two-year global strategic collaboration agreement with Amazon Web Services. This will accelerate the integration of Amazon Bedrock into the Elastic AI Assistant, enabling customers to get richer and more contextualized and relevant results by using their preferred large language model, coupled with the organization’s unique IT environment and proprietary data sets. Also, building on our recent joint success with Google, we are accelerating and extending our joint go-to-market activities and technology integrations with Google Cloud. Our collaboration includes the powerful combination of the Elasticsearch Relevance Engine and Google Cloud’s Vertex AI platform, which empowers developers with a scalable tool set to build privacy-first generative AI applications.

Beyond our investments with cloud hyperscalers, we are also investing in broadening our global reach with 12 Elastic user conferences across major cities in the Americas, EMEA and APJ. Based on the amazing customer reception we have seen to date, we expect over 5,000 in-person attendees and more than 100 customer and partner speakers to participate in ElasticON across these 12 events. Finally, I would like to reiterate our commitment to managing the business with discipline. We delivered a record non-GAAP operating margin of 13% for the quarter, which was better than our expectations, and we remain on track to deliver on our non-GAAP operating margin target for the full fiscal year. Janesh will talk further about this in a moment. To recap, we had an excellent quarter.

I am pleased with how we manage the business with discipline, executed on our strategy, and I’m very excited about the second half of the year. At a time when companies are looking for ways to reduce costs and gain efficiencies without sacrificing innovation, especially around generative AI, Elastics’ search analytics platform is becoming the natural choice for these businesses. We view generative AI as a massive tailwind that will continue to benefit our business in the years to come. In closing, I want to thank our team for their focused execution. And I also want to thank our customers, partners and investors for their continued support and confidence. Now I’ll turn it over to Janesh to go through our financial results in more detail.

Janesh Moorjani: Thanks, Ash. We once again delivered a strong quarter driven by consistent execution despite a complex external environment. We were pleased that we came in above the high end of our guidance for the quarter, both on the top line and the bottom line. We delivered 17% year-over-year growth in total revenue in the second quarter, with Elastic Cloud driving our strong results accelerating to 31% year-over-year growth. We continued our focus on profitability, delivering another record quarter with non-GAAP operating margin of 13%, reflecting improved consumption trends versus Q1 and our strong investment discipline and demonstrating the leverage inherent in our business model as we continue to scale the business.

As Ash mentioned, we continue to see strong customer engagement around generative AI use cases. We are increasingly seeing customers make technical decisions to select Elastic based on our product leadership position. The multiyear investments we have been making in generative AI are beginning to positively impact our go-to-market, especially around search specific use cases and we are positioned to be a long-term leader in this space. While we expect generative AI will present a meaningful revenue opportunity for us in the coming years, we believe it will take some time for the revenue from GenAI to become significant. During the second quarter, we saw continued improvements in cloud consumption patterns as customers increase their consumption against commitments that they had previously made.

With that said, we continue to monitor consumption patterns against the backdrop of an evolving macro and geopolitical environment. While many customers have already gone through optimization of their consumption use cases, we do continue to see cost consciousness and spend management as themes in the market. Let’s get deeper into the results for Q2 and our outlook. Total revenue in the second quarter was $311 million, up 17% year-over-year or 16% year-over-year on a constant currency basis. Subscription revenue in the second quarter totaled $288 million, up 19% year-over-year or 18% year-over-year in constant currency and comprised 93% of total revenue. Within subscriptions, revenue from Elastic Cloud was $135 million, growing 31% year-over-year on an as-reported basis or 30% year-over-year on a constant currency basis, reflecting the stronger consumption trends I just mentioned.

Elastic Cloud represented 43% of total revenue in the quarter, up from 39% a year ago. Elastic Cloud revenue derived from month-to-month arrangements contributed 15% of total revenue, the same as in the prior quarter. Professional services revenue in the second quarter was $23 million, down 1% year-over-year on an as-reported basis and down 3% 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 services delivery, and we do not expect it to vary significantly in mix over time. To add more context around overall deal flow, EMEA grew fastest during the quarter, followed by APJ and the Americas. 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 1,220 customers with annual contract values more than $100,000. Looking at customer additions more broadly, we ended the quarter with over 4,230 customers above $10,000 in ACV and approximately 20,700 total subscription customers. Our net expansion rate, which, as you know, is a trailing 12-month lagging indicator was approximately 110% in line with our expectation for the quarter. Now turning to profitability for which I’ll discuss non-GAAP measures. Gross margin in the quarter was 76.8% versus 76.5% 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 our revenue outperformance and our continued focus on managing our expenses as we invest thoughtfully to drive future growth.

Diluted earnings per share in the second quarter was $0.37. Our free cash flow on an adjusted basis was negative $3 million in the quarter or negative 1% adjusted free cash flow margin, in line with the expectations we had previously shared. As we stated on our previous call, there were some cash collection and payment timing movements between the first and second quarter as well as onetime payments of $13 million in Q2 that related to previously completed acquisitions. 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. We continue to maintain a strong balance sheet. We ended the second quarter with cash, cash equivalents and marketable securities of $966 million.

Turning to guidance. While we were very pleased with our outperformance in the first half of fiscal ’24, we continue to be prudent as we plan for the rest of the year. Despite the many moving parts in the broader macro climate, we anticipate that business conditions will remain largely unchanged. We do expect to see growth in both self-managed and cloud subscription revenue. Additionally, though we are seeing customers ramp their consumption, and we’ve been very pleased with that trend, we believe it is appropriate to anticipate that consumption patterns may continue to fluctuate in the near term. In terms of operating expenses, as we execute in the second half of this year, it will be important for us to exit the year with an appropriate level of investment to secure our success for next year.

Therefore, we continue to invest with discipline in the business as we drive increasingly profitable growth on an annual basis. In addition to incremental organic investments in the second half, our model assumes approximately $12 million of seasonally higher expenses in the fourth quarter related to the timing of employee benefit costs and our engineering all-hands event. We have experienced similar seasonality in prior years, and these expenses were anticipated in the guidance that we had initially laid out for the year. With that background for the third quarter of fiscal ’24, we expect total revenue in the range of $319 million to $321 million, representing 17% year-over-year growth at the midpoint or 16% on a constant currency basis. We expect non-GAAP operating margin for the third quarter of fiscal ’24 in the range of 11.5% to 12% and non-GAAP earnings per share in the range of $0.30 to $0.32 using between 103 million and 104 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 $1.247 billion to $1.253 billion, representing 17% year-over-year growth at the midpoint or 16% on a constant currency basis. We expect non-GAAP operating margin for full fiscal ’24 in the range of 10.25% to 10.75% and non-GAAP earnings per share in the range of $1.06 to $1.15 using between 102 million and 104 million diluted weighted average ordinary shares outstanding. Looking beyond this fiscal year, we continue to expect to grow revenue faster than overall expenses in fiscal ’25, further expanding our non-GAAP operating margin. In summary, we are pleased with our strong performance in the first half and are confident in our outlook for the rest of the year.

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

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Q&A Session

Operator: [Operator Instructions] The first question is from Brent Thill with Jefferies. Please go ahead.

Brent Thill: Thanks. Ash, I’m curious if you could just talk about the timing of revenue impact with AI and how you expect that to unfold. And quickly for Janesh, there was a few client questions around NRR lower, new logo growth also slower, but now seeing, you know, good strength in cloud, can you just break that apart and give us a little better view of what you’re seeing? Thanks.

Ashutosh Kulkarni: Thanks for the question, Brent. So, you know, just first of all, very pleased with the overall performance in Q2, and particularly, like I talked about in the prepared remarks, the adoption of ESRE. And as you know, you know, ESRE includes not just our native vector search capability, but so much more beyond that. And we are seeing customers really adopting that incredibly well. And, you know, we also saw in the quarter that customers are making their purchase decisions for all kinds of use cases, looking at the kind of leadership position that we have in generative AI and seeing that the innovations that we are driving there is going to help them in all kinds of use cases. In terms of the monetization, what I’d say is, it’s still early days.

It’s going to take some time for customers to ramp the usage of these generative AI workloads. So, it isn’t a significant contribution to revenue at this time, you know, but we are pleased with the contribution to consumption that we’re already seeing in these early phases from these GenAI use cases. Let me turn it to Janesh for the second question.

Janesh Moorjani: Hi, Brent. So, on the net expansion rates and cloud consumption trends, you know, first off, when I just step back and look at Q2 overall, we are very happy with our overall performance. When you look at the numbers on revenue and on cloud growth, there was a lot for us to be pleased about. The net expansion rate, as you know, is a lagging indicator and it’s a trailing 12-month measure. So even as cloud consumption ramps up like we saw here in Q2, it will take some time for that consumption to be fully reflected in the net expansion rate. And that’s why when I think about the business, I usually look at revenue as the best indicator of current performance. And so, I think the net expansion rate can continue to move a few points in either direction in the near term.

But generally, we expect that the trends in consumption over time should alleviate some of the downward pressure that we had experienced in the net expansion rate over the past few quarters. The other piece that you mentioned was on consumption overall. If I just step back and think about some of the consumption trends we saw, pretty healthy patterns across industries and across geographies. It was broad-based. Our sense is that optimization has stabilized. Customers are still cost-conscious, as we mentioned, but generally, they are where I think they want to be on the optimization. So, we see customers ramping their consumption towards their commitment levels, and we are very pleased that we’re able to help them scale their usage and realize the value of our solutions.

So, those are some of the puts and takes, and we’re quite happy with Q2 and looking forward to the rest of the year.

Brent Thill: Thanks. Welcome back, Anthony.

Operator: The next question is from Raimo Lenschow with Barclays. Please go ahead.

Raimo Lenschow: Hi, thanks. And congrats from me as well. Two quick questions, one for Ash and one for Janesh. Ash, if you think about it, you’re obviously the strong player in search, and now with the AI capabilities and ESRE, you kind of, you know, are able to revisit that installed base. Line, what do you see in terms of, like the overall reviving that search kind of client base and kind of reengaging with them a lot more here? And what are you seeing there in pipeline, customer conversations, et cetera? Because that seems to me like a nice big opportunity to just kind of revisit and kind of reengage with clients there. And the second question for Janesh, is like, you talked about the consumption trends. Just on that note, if I look at the implied guidance for Q4, that does look like a, you know, very kind of small additional number coming in there. Is there anything specific on Q4? Is that just conservatism? Thank you.

Ashutosh Kulkarni: Yes, Raimo, thanks for the question. So, you know, I think, like I mentioned even in my prepared remarks, the generative AI is really driving a resurgence of interest in search. And, you know, I’ve been on the road quite a bit meeting with our customers. We recently, in just this past few months, had multiple ElasticON events, first here in San Francisco, then in Frankfurt, then in Amsterdam, literally hundreds of customers, many customer speakers. So, I had the opportunity to meet with many of our clients there. Also at AWS re:Invent earlier this week, I was there in person meeting with our customers and some of our partners. And across the board, what we are hearing, what I’m seeing is a significant interest in generative AI.

And a lot of it is around use cases that, you know, we would traditionally bucket into the category of search. And the thing that we are seeing is, a lot of the interest is around trying to completely change customer experiences, trying to completely change support experiences. And there’s use cases across the board in every vertical. So, that’s something that we feel really, really good about in terms of the long-term position and the long-term view for us, and over the long haul, what it can do in terms of TAM expansion in the overall area of search. You know, the other thing that I’ll say is, right now what I’m seeing is, a lot of the use cases that are being put into production are internal facing. So, you know, customers are building chat experiences or customers are building applications that are viewed by either their internal support engineering teams, or their internal SRE teams, or their internal, you know, employee portals, and so on.