Elastic N.V. (ESTC) Earnings Call Transcript & Summary

Well, good morning. I'm Rob Owens with Piper Sandler. I manage our security and infrastructure research practice. Really pleased to welcome our next presenting company here on Zoom. I'd like to welcome Elastic. And joining us from the company is their CFO, Janesh Moorjani. Janesh, welcome. Good to see you.

Great to be here, Rob. Thank you for having us.

Absolutely. So your platform has taken its roots in search and built out impressive products in core enterprise search, observability and security. And for those not familiar with Elastic, give us the quick elevator pitch on what the search-based approach to these problems means and what Elastic is used for?

Yes, happy to. So we were founded as a search company, and that's who we are at our core. And when you think about what search is and what search does anytime you've got very large data sets and you want to be able to find the information in those data sets in near real time and then take action on that data, any time you want to have a conversation with your data, that's a great use case for the search-related technology and for Elastic and the Elastic stack. And as we -- we were founded initially in 2012 and from there, we've grown and we had a very large user base that has continued to extend us into many different areas. We started off in areas like enterprise search and from there extended into observability and security, and those are the 3 main solution areas that we focus on today. And then we're limited really only by the ingenuity of our user base in terms of all the creative ways in which they can apply search technology to solve many different kinds of problems. Whether you're a consumer, whether you're a business, if you think about different ways in which search is used in your day-to-day lives, there's many different ways that, that happens even if you fire up an app on your mobile phone and chances are you start interacting with an app, with a search box within it. And search takes many different forms. It can be searching within a histogram. It can be looking at data that exists within the enterprise on an Internet somewhere. It can be geolocation within the 4 corners of the screen. That's a form of search as well. So there's many different ways in which search can get applied in. And we focus on the 3 technology areas that we talked about, the 3 solutions, enterprise search, observability and security.

Great. So how is Elastic differentiated then? I mean this is a very crowded, very noisy space, lots of vendors, lots of acronyms and marketing. So at the end of the day, where do you differentiate and why does Elastic win?

Yes, it's a great question. And as I step back and think about it, the ubiquity of the ways in which search technology can be used, that in itself is one of the core differentiators for us. You talked about a crowded marketplace. You talked about a number of competitors. But as I look at our entire universe across all of these areas, and all the other creative ways in which we use Elastic as well, there isn't a single competitor that extends across all of those areas. So that's 1 benefit that we have of that natural diversification. And the strength of that really comes from the community that we have, that has been incredibly loyal to us and us to them. And we've built on that with a very strong foundation over the years. From a technology perspective, the things I would say that set us apart is this idea that you've got all of these experiences, these curated search experiences, built into a single stack. And so if you think about what that's meant, as you've seen conversions happen in the industry, that market transition has played very nicely in our favor. I'll use observability as an example. I think a lot of people out there are familiar with the fact that observability has a few different elements to it. There's logging, which traditionally was a strength of ours. There's APM. There's monitoring. And increasingly, these just become features that a practitioner or a customer expects. And they expect to have all of those capabilities brought to them in a single unified stack, and that plays very nicely to our advantage because we are purpose-built for that from the ground up. The other piece that comes into that is the element of unified pricing, which again, is a significant differentiator for us. If you think about how -- I'll use the observability example, again, if you think about how all of these technologies were purchased, historically, they all have very different pricing models, some price based on ingest, others price based on number of hosts or even number of users. And if you're a customer and you're trying to apply all of these technologies to solve a problem, to deal with multiple vendors, to deal with multiple pricing models or even if you're dealing with a single vendor to have multiple pricing models from that same vendor can be quite difficult. So I'd say that's another significant advantage for us. And then finally, on the go-to-market side, I started off with the community. And of course, it extends from there as we move further up within the enterprise. We've got this incredibly strong flywheel effect that sets us apart from many others. So we feel pretty good about our market opportunity and how well we're executing against that.

So you'd mentioned some of the consolidation and observability across some of the different functions, right, between APM, logging, infrastructure managements. And you have solutions that play to security, whether we call it next-generation SIEM or the new XDR acronym for extended detection and response. Are customers looking to aggregate across these 2 different functions as we look at observability and as we look at security? Are they still 2 relatively separate categories?

Yes, it's -- I think they are still separate categories. If I think back in time, observability a few years ago was relatively a new term in the industry. And many people, when the term started to get used and started to get more popular, there was this question about how quickly that convergence would happen. And I would submit that it's happened relatively quickly. And a big part of that is because within customer organizations, very often, these functions all sit within the same group or the same area. And so you've got this entire movement that happened in the industry towards DevOps and observability and the coming together of all of the aspects of observability was driven in part by that. So I think you've got this industry momentum that really helped drive convergence from an observability standpoint. We are starting to see the same within the world of security as well. There are clearly several examples where developers and operators could benefit from shifting right towards security, and security operators could benefit significantly and get much better security outcomes by engaging earlier in the DevOps cycle or shifting left as they say. And we're starting to see that and the industry is starting to see movements called DevSecOps, which is really the coming together of DevOps and Security. So we are seeing clear signs of that, and it's supported from a technology perspective as well, as I mentioned, the ability to have all of these outcomes from a single stack. You mentioned XDR as well. We take a very data-centric approach to it because while you observe, why not also protect. So we see that convergence happening even between observability and security. The 1 distinction I would say is that in many customer organizations, security teams tend to be separate and tend to be somewhat, I wouldn't say necessarily siloed, but at least very often reporting up through a different part of the organization or into a different team. And so as a result of that, I think that convergence will -- is happening, but it's -- we haven't seen it happen quite at the pace at which perhaps it might have happened on the observability side. I still see it coming together, though, quite nicely.

And given there are 2 different buying centers, do you have a different channel to address that security market? Are you playing more towards the traditional channels or still coming somewhat bottom up with that developer-centric approach?

Our approach, our go-to-market approach has remained the same. In fact, we found that it's an incredible way to get adoption of the technology and to move further up within the enterprise. And especially if the theme as we see it emerging, and the theme that we're driving is the theme around convergence. And eventually, we see these all coming together in the form of Limitless XDR. You saw that, for example, in 7.14 with the Elastic agent that we launched, which unifies those. So from our perspective, we think that a generalist approach is still the best way to approach this. And so when we think about our sales coverage models, our go-to-market models, our salespeople are still generalists that represent the entire Elastic stack. Even when a customer buys the Elastic stack, they may purchase a certain level of subscription, gold, platinum or enterprise. And within those, you'll get different levels of feature sets across these different solution areas. So we don't even sell separate SKUs across each of these. So from all of those perspectives, it makes sense that we continue to maintain the same go-to-market approach that we have had. Now in the context of selling to these different buying centers and sometimes you've got technical conversations that need to be had or in some areas, we will need certain kinds of muscle, so we have -- we do have certain areas where we'll apply specialist resources, but those tend to be fewer and the main model is still a generalist model.

Great. And then if we could double-click a little bit, Janesh, around cyber security, which has dominated the headlines over the past year. You've had a lot of major breaches. You've had executive orders that have driven awareness and hopefully drive some spend here in the third quarter. Talk about the impact that this increased visibility has had for your security business, in particular.

Yes. I think you've seen that reflected in the numbers we put out, Rob. And generally, when I think about security, it's a vast market. All of these events, whether you talk about the presidential orders or some of the events that we've seen in the form of ransomware attacks and so forth, they've all served to just highlight the degree to which customers and their infrastructures are exposed and customers increasingly are spending time with us to think about how they can protect themselves from that standpoint. I do think conversations, by the way, take time to play out and as a result of some of these changes, it's not like we anticipate a step function change of some sort in the business. But if I look back over the course of the past couple of years, these trends, whether you're talking about recent events or breaches that have happened over the past couple of years because it just seems like every few months, there's another major breach that is announced somewhere, I think we've been the beneficiary in a number of respects around all of those areas. So if I think about our journey in security, we started off actually with customers using us for security-related use cases even before we had security solutions to offer them. That again speaks to the ways in which the stack can be used and the application of the stack in so many different use cases. And as people started to use us increasingly in security use cases, that's when we started to move on to SIEM. And really it was based on interaction with users and customers and seeing how they are using us. And we launched our SIEM product back in 2019. We added endpoint. SIEM allows us to connect to many different data types and many different sources, and that helped us further increase the fidelity of the data that we were seeing used in these security-related use cases. So it allowed us to get to a much broader and much better security outcomes than point solutions that were focused only on either SIEM or endpoint. And that then also helped us continue further down the path. And you see us -- you saw us do that now more recently with the acquisitions of build.security and Cmd, where we can now protect cloud-native workloads at build time and run time. So from a technology perspective, we've clearly moved in that direction, and you've seen that happen even from the standpoint of the business where a few years ago, right around the time we went public, security was still a relatively nascent part of the overall portfolio. And now based on information as best as we can tell, it's at least roughly 20% of the business. So despite the high growth that Elastic has enjoyed over the last several years, security has grown even stronger within that to be able to increase in mix. And the mix number that I mentioned, as I've said before, we don't sell a specific SKU. So it's really based on directional information that our salespeople provide us, which is why I say it's roughly 20%. And just to put that in context, back in fiscal 2018, which was interestingly enough the year that I joined the company, we reported $160 million in revenue. This year, we're going to exceed $800 million based on the guidance that we provided on our earnings call. So you've seen sort of a 5x increase in the business in 4 years. And within -- even within that, security has grown even faster to grow to roughly 20% of the business. So that should give you a sense of the momentum that we're enjoying there.

Excellent. And before we got online here in the green room, we were talking about the return to in-person and when that might happen, with both of us speculating. But I'd like to pivot that conversation to a question in and around what's the last 18 months meant for your business as we think about work from home, as we think about a lot of the trends in digital transformation? Maybe some of the puts and takes in terms of either the challenges, it could have provided a bit of a headwind, but also the tailwind that digital transformation and cloud has brought to Elastic.

Yes. When we first entered the pandemic, I'll call it, and we started to see it really show up in the business and in ways customers were thinking about it, if I think back to maybe the March, April time frame of last year, there was all of this uncertainty out there on what impact COVID will have. And our expectation at the time, which we had laid out in one of our earnings calls back then, was that we would see both headwinds and tailwinds. And clearly, while customers were figuring out how to adapt their businesses, they were focused on that. They were a little bit more distracted. There was also this broader talk of general economic downturns and job losses and reductions in spending across the board. So those were some of the natural headwinds. You saw it clearly a little bit more in impacted verticals like hospitality and transportation and so forth. On the other hand, we also had several tailwinds, again, in certain verticals that were the net beneficiaries of COVID. But also just as we went through the pandemic, we realized that customers are using the opportunity to actually accelerate their digital transformation efforts. And if anything, customers doubled down in terms of their spending on areas where our solutions were very well aligned. The underlying demand trends, when there's that much more data that's being generated offline in a remote way, all of that data needs to be searched. It was a great catalyst for enterprise search. Similarly, when you think about interactions that may have been centralized that suddenly got massively decentralized, it created that many more interactions to be logged and to be monitored, and it was a great catalyst for observability as well as for security because there was that much more surface to be protected. And so we saw customer spending increasingly in all of those areas, and we were actually the net beneficiaries of that. So in the early parts of the pandemic, it was sort of a balanced effect. And then certainly, as we proceeded through fiscal '20, through fiscal '21, coming early into this calendar year and certainly, over the last few months, we've actually seen that we've been the net beneficiaries of that because fiscal '21 turned out to be a pretty good year in retrospect with I think the tailwinds more than offsetting those headwinds. And as we enter fiscal '22, it's anyone's guess on when things will improve. We certainly hope it's sooner rather than later. But to your point, things are gradually starting to get better in terms of the broader environment. In the meantime, customer spending continues to be very well aligned with areas where our solutions are.

Excellent. And could you talk a little bit about the licensing change that you went through? There has been questions around what would happen to those that were using AWS as Elastic search product and with some speculation, this could be a tailwind to adoption of open source or your paid product. Can you provide any details around how these dynamics have played out thus far?

Yes, happy to. And just for folks that might not be familiar with this, we initially started to make our licensing changes back in 2018, where we took a number of features that previously used to be distributed under open source, and we started to distribute those under a free proprietary tier, which we call the basic subscription tier. And we still had an open source distribution as well, but most of the innovation over the last 3 years went into that free and open tier that was still governed by a proprietary license, Elastic license. And so if I think about all the elements -- when people usually hear the phrase open source, it usually conjures up a few things for them. One is that it's free. The second is that the code is open and you can inspect it and play with it and interact with it. The third is that you have a very rich interaction model with the developers that wrote the code, very rich interaction model with the community. And the fourth is what's the governing license. People care really about just those first 3 factors because that's where they get all of the benefit and the value. And that's what we did in 2018. We gave our users the benefit of all of those 3 things but it was under a proprietary license. So fast forward to 2021, the start of this calendar year, what we said is we are not going to distribute the pure open source bits anymore. And what that meant for a player like Amazon that traditionally would take what we would publish and go off of that as a service meant that they could not do that anymore. And so they were frozen as of Version 7.10, and we're already significantly further along in terms of where we are from a technology standpoint. But what that also meant that over the last 3 years, a significant portion of the innovation in areas like APM or observability more broadly and security and all of the organic work that we did as well as the acquisitions along the way, for the most part, those capabilities have gone into proprietary tiers for us. And so we felt very good about our competitive differentiation and the size of the competitive moat, both in terms of the current state and how far along we are ahead of others as well as the momentum that we're enjoying with hundreds of engineers within Elastic continuing to build further on the Elastic stack. So that's when we said we'd stop distributing the open source version. We fully expected Amazon would announce a fork of the pure open source version, which they did, and they recently GA-ed that under the name OpenSearch. In terms of what we've seen, we didn't expect this to drive again a single inflection point or a step function change in the business. Because if I think about the existing customer base, our customers were not affected at all by the change because they've already been using our Elastic licensed technology for a long period of time. The vast majority of our users also were not impacted by the change because the default distribution for the free and open version since 2018 has actually been the proprietary version of the Elastic stack, and that continues to be the case. So we stopped the open source distribution. And so given that almost everyone was downloading the proprietary version anyway, that obviously didn't have any impact on the vast majority of the users. We saw a little bit of a noisy minority on Twitter and other areas, but you'd naturally expect there to be some selection bias there. And in terms of what we've seen in the business, as we expected, we've seen great momentum in our cloud business. We think it's in large part because of the investments that we have been making with our partners like Azure and Google and some of the organic investments we've made around our demand gen efforts and customer acquisition efforts and so forth. We've generally been very pleased with how all of that has played out. So we think that cloud continues to be a great engine for growth for the company. It will continue to grow faster than the overall business. But we do expect that the benefits of that licensing change that we made will just play out gradually over time.

Great. And one of the verticals we picked up success for Elastic in the federal vertical. And given it's the federal fourth quarter, our third quarter here, September quarter, we'd love to better understand the value proposition, the penetration and some of the expectations around federal spend, especially given the executive orders and what we've seen play out from a government perspective.

Yes. We've actually been very pleased with our performance in federal, Rob. And congratulations to our team. They've done a remarkable job delivering consistently over the last several quarters. Q1 for us was yet another milestone in a long series of successful quarters from the team. So we're continuing to make investments in the business. We do have some deals tied to the federal year-end, but we also have many projects that are independent of that, that usually have their own program budgets. And as a result of that, we found in the past that Fed business can be lumpy. But that said, the team has executed really well. So they've been successful in building a strong business. If I think about Fed or even just public sector more broadly, we're quite excited there and we continue to build on the strong foundation there.

Great. And we've got a couple of minutes left. I just have 1 more question. Around the model and as you flirted with profitability over the past year, how should investors think about the longer-term model? And how you're going to balance growth and margin?

Yes. I think nothing really has changed in terms of our core philosophy and approach there. When I think about the longer-term model, I think of us as having the economics of an enterprise software company. And I know that can mean different things to different people. But at the end of the day, that's the core underlying business. And in terms of how we get there, you've seen over the past few years that first off, we've actually been quite wise about investments that we've made in the business. When we've seen momentum, when we've seen opportunity, we've invested aggressively to pursue that. But that's not been at investments at all costs. For example, when we were entering the pandemic at the start of our fiscal '21, we deliberately slowed the pace of investment in the business because there was that much uncertainty out there in the environment. And so for us, as we see the opportunity and as we execute, we think that, that gives us the ability to continue to invest even further in the business. And at the end of the day, the unit economics in the business are incredibly powerful. We invest up front in product. We invest in hiring salespeople. We invest in ramping them to productivity. And that's when the economics then start to kick in, in the form of a radical revenue stream. And so as long as those economics continue to play out quite nicely, we will continue to make those investments in the business and do both. We'll demonstrate investment. But as the performance continues to play out nicely. To the extent there's overperformance, we've demonstrated that there is significant operating leverage in the model because that does flow through to the bottom line. And as you said, that's been behind us flirting with profitability, to borrow that expression. So from our perspective, we are continuing to invest in the business, and it's really a question of driving growth at this point in time. The markets in which we play are large. Customers are spending and they are spending aggressively in all of these areas. And compared to some of the larger industry players out there, we're still relatively small in terms of our footprint in terms of number of people, in terms of number of sales reps. So we've got the foundations established and now we're adding much more fuel to the engine.

Wonderful. Well, Janesh, thank you for your time this morning.

Thank you. Thanks, again, for hosting us.

Yes. Cheers.