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

Welcome, everybody, to the afternoon session of the second day of the Bank of America Technology Conference. Thank you, everybody, for joining. I am super thrilled -- my name is Koji Ikeda, I am one of the software analysts here at Bank of America, and I'm thrilled to have Navam Welihinda, did I get it right?

You got it.

Right? Amazing. From Elastic, CFO -- new CFO. And thanks for joining us. And yes, let's get it kick off here. And so...

Great to be here Koji.

Yes. No, of course. Thank you so much. I think many in the room are familiar with Elastic. And so instead of going deep into what is Elastic and what do you guys do, we'll get into that a little bit later, you guys reported results last week, and so let's go over kind of the puts and takes of the results. What were the key highlights that you want to talk about from the results last week?

Sure thing. I'll do maybe a 20-second -- for those of you who don't know Elastic. So many of you may know this, but we're a search AI platform. What we do is we help take our customers unstructured messy data and get value out of it. And there are multiple use cases you can use Elastic for, but we focus our -- our focus is on 3 specific solutions, which are search, observability and security. So that's what a lot of customers use us for. We have tens of thousands of customers, more than 50% of the Fortune 500 use us. We've been benefiting from a fair amount of consolidation in the observability and security space. And also, we've been seeing a lot of interest and tailwinds from GenAI. And as you said, Koji, we just reported our fourth quarter last week. From my vantage point, it was a very strong quarter. So we delivered 16% year-over-year growth on the top line in revenue, we discussed a new metric that we disclose called subscription revenue less monthly cloud. So when you think about our business, we incentivized our sales team to go sell our solutions, either a self-managed or cloud. That's how we run our business. So we thought it would be important to disclose this new metric that measures how our sales team is doing. So subscription revenue less monthly cloud was a new metric disclosure that we did. That was a fantastic quarter for us as well, 19% year-over-year growth. Then on the bottom line, we continue to deliver margin improvements. Our year, we increased our operating margin by 400 basis points. And we're at our scale now that we have -- we continue to deliver strong free cash flow margin. So 19% free cash flow margins capping the year. So overall, the message on the fourth quarter was we're very pleased with the results of the fourth quarter, as evidenced by strong top, bottom and free cash flow margin numbers that we provided. We also, I being new, had the unenviable position of delivering a full year's guidance straight off the bat. And what we've done -- what we did at the time was talk about our guidance in the context of what we knew and what we didn't know. What we knew is obviously how Q4 was performing and Q1 was performing. Relatively speaking, we had a very benign macro impact specific to U.S. public sector civilian, and that's the only sort of macro impact we saw in Q4. And despite that, we had a strong quarter. When we issued our full year guidance, though, we didn't want to just assume that was going to be stable. And we laid out our assumptions in providing a much more conservative view for the full year, assuming macro gets worse than what we saw. So we didn't see a bad macro, but we don't know, we don't know at this point. So our guidance reflects that macro conservatism. And we think absent macro, there's plenty of ways for us to beat that guidance that we provided. So all in all, a strong quarter, very pleased with outcome.

I do like the subscription x monthly new metric. Not a new metric to me. I've been looking at that one for a while and...

You're ahead of the curve.

Just a look -- just one instance -- just a little bit in this one instance. And it did grow 19% and reacceleration, which I thought was pretty good. But let's get back to the guidance methodology. And so the public sector softness, I mean, it sounds like there's 3 factors kind of the guide. Public sector softness, SMB and then consumption -- assumed consumption headwinds when you're not seeing anything. And so let's walk through those one by one. On the public sector side, why so much conversation around that as that is the factor that -- one of the main factors of kind of informing the guide going forward.

Yes. I think back to what I said, which is what we saw versus what we don't know, right? What we saw in Q4, and this is not just us. It's almost every software company, not almost, every software company that sells to U.S. public sector, in particular, was impacted by the efficiency drive and the activity by DOGE which was in the front end of the calendar year. So March, April time frame, there was a lot of focus in the civilian agencies, in particular, there were spending moratoriums, there were personnel changes in various civilian agencies. Pub sec as a whole is a very wide segment. So you have the DoD, Intelligence Community, SLED parts of the public sector as well. Those were relatively unimpacted, but civilian agencies, in particular, were an area of focus for DOGE. And that's where we saw the spending moratorium sort of drag out deal cycles. And as you can imagine, if you lose a month of purchasing activity, everything gets dragged out, when personnel are in flux, there is a little bit of uncertainty related to what they want to do. So that was the impact we saw in particular in Q4. We -- that continues to date, right? Sure, it's not the same amount of activity in terms of spending moratoriums as it was in Q4. But the personnel changes, that's still continuing on or the impact is still continuing on. So that's factor number one, which is we've factored in what we've seen.

Yes.

On the second place, which is the monthly cloud business, is an SMB business, it's self-serve. It's not what our sales team is doing. So individuals who are running experiments or very small customers take their credit card, they buy Elastic on our credit card. That business has been roughly flat last year. And our expectation next year is that's not changing much. It's going to be a roughly flat business for us. Next year as well. So we're not making any incremental positive or negative assumptions just because that's the way the SMB side of our business has been performing. So that's roughly the same next year as well. Then on the third part, which is we -- the part that we don't know is how macro spreads from one part to another. And that's the Q2 through Q4 assumption of, hey, what if there is more exposure than what we have seen, and this is the unpredictable part. I want to lay out to you what I've assumed in Q2 through Q4, which is what we saw in this small segment in civilian, macro kind of goes around the EMEA and APJ business, and that slows down. To be clear, we haven't seen this. It's just if that assumption takes place, that moves the entire forecast range down. And then additionally, if customers were to face budget headwinds because, well, their businesses are slowing down, they're going to do more optimizations as well. And that informs the bottom end of the guidance, right? So that's essentially the 3 assumptions that you laid out. But to the point I was making earlier, that third part, which is the biggest impact to the guidance. We have seen no activity to date until earnings, that's actually happening. This is more of a what-if scenario in Q2 through Q4. So there are multiple paths for us to exceed the guidance that we provided. Being this late in the year, having an April year-end, we wanted to be prudent in how we're looking at the full year and making clear that there are things that we don't know. And this is very unlike other software companies that had January or December year-ends and their guide -- their annual guide did not factor any macro in.

Right, right. I think on the call, you mentioned that March was not so good on the public. That was when you were beginning to see the effects in DOGE and civilian and things somewhat improved in April. Does the guide use March data or April data, combination of the 2?

Yes. I mean, I would focus more on it. It reflects the conservatism of a lower number in U.S. pub sec in general, right? You are right in the fact that the impact was most acutely felt in that -- and this is, again, not us, the moratorium, I think, hit in that March time frame, where almost nothing happened from a purchasing activity. And that impacts the whole quarter, right? So while things move forward, so to be clear, we still had activity in the U.S. public sector, just not the same level we would have anticipated absent DOGE and USPS civilian sort of pressure. The good news for us is we don't have an overreliance on any single customer or any single vertical. So being a balanced business, the other parts of the business, the North America business, the EMEA business and the APJ business performed really well and covered for USPS.

Is pub sec mostly self-managed for you guys? Or is it a mix of both? I mean walk me through what they buy.

Yes, it's a mix of both. But there's a slight skew towards self-managed. So you get both flavors, but there is more self-managed than pub sec...

Got it. And then just kind of following up on SMB, we punched the numbers into our model, it looked like 12% of revenue coming from SMB.

Roughly, yes.

Roughly. That's a downtick from what it was. So SMB performing worse than before. What's happening in SMB right now? And what's the path to recover -- I guess what needs to happen within SMB for that number to improve?

Yes, it's a good question. So I think your numbers probably have some estimations in the prior quarters because we did not disclose that sub revenue less monthly cloud number, right? So from now on, when we do continuous disclosure, you'll be able to get a clean SMB number. But absent those assumptions you've made, the SMB number was actually roughly flat, it wasn't a big decline. It was roughly flat as a business. And I think the dynamics there largely reflect the strength of the SMB segment in general in this environment. So we saw great SMB activity when the interest rates were low, and that business segment was booming. Like we said -- like I said earlier, we aren't necessarily focusing our sales team there. So it's not an area of dollar deployment and focus where we put our sales and marketing dollars to work the most. It's with our sales-led motion, which is a direct sale to our strategic enterprise high-propensity mid-market customers. So that's where the dollars are going, and the mid-market is kind of moving the way the mid-market moves through the self-serve business. So unless there was a natural uptick because the SMB segment itself is recovering and strengthening like it did several years ago during the low interest rate environment, our expectation is that it remains the same as it did.

Got it, got it. Maybe shifting gears a little bit to CRPO, kind of a pretty nice number there. CRPO growth 17%. As we -- how do we think about that number based on -- balanced against the guide, the exit rate of the growth guide, call it, 10%, 11%, but CRPO just grew 17%?

Sure, yes. So first of all, on the number itself, it's a new metric disclosure, and we issued 2 new metric disclosures this quarter, CRPO being one of them, sub revenue less monthly cloud being the other. And it's my first quarter here, and I think I talked to you as well the first couple of weeks, I got in, and I heard a lot of investors expressed interest to get more understanding of what's happening in the business performance side. And these 2 metrics are an attempt to provide more visibility, right? Sub revenue less monthly cloud because that's what we have control over, and that's what the business is doing. CRPO because it tells you specific to that subscription revenue less monthly cloud number what the runoff is for the next year. So it's an important number. The reason we provided it is to look at it in conjunction with all the other metrics, right? So revenue is the most important metric followed by sub revenue less monthly cloud, and CRPO was there as another thing for you to consider as you digest our performance. I'd caution against using the number mechanically to sort of imply convergence or understand like what the next year's revenue is going to look like simply with that CRPO number, because there are a lot of puts and takes to that number, right? The starting bases are different. It's -- even though it's the C, it's a current number, it is impacted by duration. So if duration moves around, how much RPO that goes into CRPO will change around, and that will impact the number itself. So it's not a great mechanical estimator to forward revenue number. So the way I personally look at it is it's the coverage of how much I have given the guide. So if I'm guiding to x, CRPO covers an x amount of it. And it gives you a relative risk, derisk view of where the guide sits and where the forward revenue sits. So I would think about forward revenue as informed by the revenue guide, and I'd consume CRPO in the context of that revenue number. But net is, I think it's a very important number to look at, and we'll continue to disclose it every quarter.

So we've talked a lot about subscription x monthly new metric for you guys understand the reason why to make that change. And I want to dig into a little bit about the selling motion there, right? You guys sell Elastic as Elastic. And so walk me through what that sale process looks like? I mean, is -- are your salespeople just coming in, how can Elastic help you? Or is there a push to cloud at all or push to self-management? Walk us through that just a little bit.

Yes, that's a great question and also important and why we disclosed that metric. So when you look at our sales team, it's organized by geo segment. So first of all, it's organized by geography, which is the North American geography, the EMEA geography and the APJ geography and USPS is the fourth one, right? So U.S. public sector, in particular, and then the 3 major geographies. And then you break it down into segments. There's the strategic segment, which are the highest propensity to buy customers like the Bank of Americas, which have massive IT spend, lots of automation in the back end. That would be one of those, not Bank of America in particular, but a customer like them maybe in the strategic segment. Then you have the enterprise segment, which are sort of your Fortune 500 type customers, the larger enterprise spend customers, and then you have high propensity mid-market customers who are the larger G2K kind of customers as well, right? Those are covered by our enterprise sales team with various coverage ratios. So our strategic reps have the lowest -- the lowest amount of customers they need to cover, and it gets slightly bigger as you go into the enterprise and high propensity mid-market segment. But it's still a handful of customers that each rep has to manage. And that rep's responsibility is to meet the customers where they are and sell our Elastic platform to the customers for the solution sets that I talked about earlier, either search or observability or security. If the customer has a lot of -- and let's take GenAI, for example, right, GenAI applications are generally built where the data is. So if the customer has a lot of data in their own environment, this could be their only AWS environment or their GCP environment, they would buy a self-managed Elastic license to build their GenAI apps, self-managed. They're not going to move all their data to cloud and then buy a cloud license, right? So depending on how our -- where our customers are, they may go self-managed or cloud. And in order to hit our revenue growth target, we expect both the self-managed and the cloud number to grow. And that's how we incentivize our sales team. They're given a quota and that quota is the aggregate quota for that territory that they cover. And they can make it up either way, cloud or self-managed. Now they have incentives to sell cloud. We think cloud is a great product. So they'll sell cloud if the customer wants to go there, but we expect both of those revenue lines to grow. Which is why it's so important to then take those 2 numbers in aggregate and say, this is where that growth is coming from. It's from both of these revenue lines, self-managed and cloud.

As much as you can say, how much is that incentive to push cloud? Is it a big little...

No, the majority of the incentive is on what we call [ NNE ], new and expand bookings. So when you think about where the rep makes the most amount of money is when they hit their quota number. Then there are what we call spiffs, right, like things that you get over the top, you sell a multiyear deal. You sell cloud, there's some competition that the sales teams run. These are typical things that enterprise software company does. That would be over the top, you incentivize sales teams to do various things. And cloud is not just one -- not the only thing we run, we run other competitions as well.

Got it, got it. So switching to generative AI. You guys gave a lot of good data points. And you gave some new data points on the last quarter call too on generative AI and I think that's wonderful, right? Good visibility into how your customer base is testing out AI, even moving into production. And so I think there's a -- you can kind of run the numbers based off of, hey, these many customers are trying things out, and these big customers are trying things out. And trying to put 2 and 2 together of when do we see it in the numbers, right? Yes, great data points. When do we see it in the P&L? And I think the -- at the heart of that is, when do you guys expect or are you beginning to see an acceleration of testing and playing with generative AI becoming actual production experiences?

Yes. It's 100% becoming production experiences. So it's not only in test. We've given multiple examples of this. I can talk about 2, for example, 1 internal and -- 1 customer internal and 1 customer external example, Docusign's Navigator, which I think is a product that Docusign has talked about, it's an AI-driven product that you can query all the documents that you have in Docusign and ask things like, hey, tell me everything that has a termination for convenience clause, we'll help you do that. That has Elastic behind the scenes. That is a production GenAI app, right? And it's out in the world right now. Cisco, I believe, has talked about a customer support service ad. So it's a chat app that allows their customer engineers to query their knowledge base on features, bugs, et cetera, in their existing environment to help them service their customers better, using generative AI. That's an internal applications that they've built in production. So that's just 2. There are many other examples of in-production AI applications with our customer base. And with us Elastic internally as well. But I want to put that in context with the aggregate amount of apps that any enterprise has in its portfolio, right? Like Cisco probably has hundreds, if not thousands, of apps. Bank of America has thousands, if not more, apps. How many of those are generative AI? I would argue a handful of dozen maybe, and you may be in the cutting edge of that. But each of these customers are in the very, very early stages of expanding GenAI across their entire application portfolio. So if you think about where the GenAI wave is right now, it's in hardware, it's in the LLM, but the application layer, it's still very, very early in the adoption cycle of the application layer. So while we are seeing all these applications in production, I'd say it's still the tip of the iceberg on how far we need to go in GenAI with G2K and the Fortune 500 and how much of their portfolio is GenAI [ wide ]? So this is a long way of saying there's a long way to go. We are seeing acceleration in our search business. which is an indicator of GenAI tailwinds affecting us.

You are the CFO, and you have the difficult task, I think, of balancing growth versus profitability. You guys have done a great job expanding profit margins. You have told the Street, expect a little bit less -- expect margin expansion, but less than what we've seen in the past. And I think that's fine given the opportunity that you guys are facing, not only with generative AI, but also with security and observability, too. And so how do you balance that algorithm in your mind of what sort of signals or triggers are you looking for that? Maybe it is the time to step on the gas a little bit more. And would there ever be a time period would you take down margins because the opportunity is so great?

Yes. So first of all, there's a tremendous opportunity ahead of us, and we're early in that opportunity. If you look through our non-GAAP income statement over the past 3 quarters, you've noticed that our sales and marketing costs have gone up and R&D costs have gone up. And that's by design. We've invested in the sales and marketing team, investing in capacity. We've invested in the R&D team to invest in product velocity. We do that because we see the opportunity ahead of us. And the business historically -- and so we are investing to win in this year, not for the downside. And that's the reason we have the 16% target [ op inc ], great compared to the 15.3% we had this past year. So this past year, we delivered 400 basis points of operating margin improvement. The expectation is that we invest to the opportunity and maintaining it roughly around 16%. We don't expect to go back, but if the opportunity is ahead of us, we don't expect to drop a ton into the bottom line, the way we did last year as well -- last year. So that's point number one. Two is, we -- our costs are primarily either people or cloud costs. And if you take last Q1 as an example of, hey, we didn't see the opportunity ahead of us and we pulled back spend, the last thing is very good at doing that. So if macro plays out the way it does in our guide, and we see that, look, it's a little slower because of all the contagion that we've assumed, then we would expect to pull down our investments and deliver more [ op inc ]. So we see it as dynamic. We're very good at moderating [ op inc ]. We're very good at delivering free cash flow. We also want to invest in the opportunity, we've set a target of 16%. If we're coming in towards the lower end of the guidance or towards the guidance, we're going to deliver more. If on the other hand, we see a path to beating the guidance, we're going to maintain that 16%.

Got it. Got it. I got to ask you a question on cloud net new revenue, you added $1.5 million. I mean, there are some puts and takes with the days and adjust all that kind of stuff. But I do think it was a little lower than some were expecting. Walk me through what's happening with cloud net new kind of predictability, visibility there. How do we think about this particular line item going forward?

Yes. So first and foremost, look at the sub revenue less cloud -- less monthly cloud line because that's what we're driving, and that's where you want to see progress. In cloud, in particular, it's driven by consumption and the amount of days in the quarter tells you how much you're going to -- how much ECUs you're going to consume. So the fourth quarter has 89 days this year, whereas every other quarter has 92. So it's roughly a 10% difference between the 2 quarters. And you have to -- what I do is I normally adjust everything to 92 days and say, well, assume magically, we had 3 more days in this quarter. And then look at what performance is. And if you really want to be very specific, take out monthly cloud. And when you do that, you'd see that the quarter was no different than the last quarter. It was about a 24% year-over-year growth rate. On a net new basis, it was a reasonable incremental revenue addition, and it wasn't as bad as the headline number looks like at $1.5 million incremental quarter-over-quarter. So when you do those puts and takes adjustments, it gives you a better picture. And then second, as the cloud revenue number gets bigger, you start to see a little bit of quarter-over-quarter seasonality trends emerge. Now this is what it's at right now that may again change as the number gets bigger. But normally, what we see is in Q1, you have a lower incremental -- adjusted for days incremental add number as people just start their consumption journey of things they've added in Q3 and Q4. Then Q2, Q3, things get a little higher in terms of the incremental dollars added, [indiscernible] ties towards the end of the year as well. There may be some retail tailwinds. There may be a few things that allow us to get to a higher incremental add number. And Q4 ends up being variable compared to Q3. It could be higher, it could be lower depending on how the last 2 years has been roughly variable. So there are some trends emerging here. The quarter didn't look too different given the trends we've seen once, but the main point is you're going to adjust for those extra days and then look at the picture and the bigger point is, look, as a business, we're pushing the sales team to drive bookings and results against both those lines. And while cloud is important, we'll continue to disclose that number really what we're driving as a business is the sub revenue less monthly cloud.

Yes. You guys are kind of coming up on 1 year from the bookings [indiscernible] 1 year ago. And so how do we think about sales productivity today versus a year ago? I know you guys are still hiring, too. And so how are you feeling?

Yes. I mean I think fourth quarter, we saw some very good results in the customer accounts, the $100,000 and the $1 million customer accounts, both were very strong, and that's a testament to the sales team performing as expected. And a lot of the changes we did in Q1, yes, was a little painful to see that take -- took a little time for it to take hold. But 2, 3, 4 were very good, from a performance perspective. So very pleased with the way the sales team is going. This quarter, there's not -- compared to that quarter last year wasn't any -- it wasn't that much change. It wasn't changing like that. The only changes we did was we added a few incremental security heads or security specialist sales folks and increased capacity. So that's not really disrupting the way things were in the -- in the first quarter. So overall, I think the sales team is doing really well, and that played out in the way fourth quarter bookings played out.

Got it. Last question for you, not a numbers question. You've been here 6 months now -- 3 months, 3 months?

Yes, 3 months, yes.

What's the biggest thing that surprised you, kind of coming into it? You did a ton of work coming into Elastic, but now that you're here, what surprised you?

I wouldn't say it was a surprise, but there's a lot of parallels and similarities in terms of where it was before, HashiCorp being an open source company, very similar investors, very similar customers. But also, I'd say, better tailwinds as a business with GenAI behind us and then having a single code base as a platform is incredibly powerful, right? Like even though we have 3 solutions, it's 1 code base. So having that is a very, very good advantage to have. So I was surprised at the R&D strength and the product strength we have embedded in the company, and I'm pretty excited about what those guys can do.

Got it. Navam, we're out of time. Thank you so much. This was great. Thanks for coming.