Elastic N.V. (NYSE:ESTC) Q3 2023 Earnings Call Transcript March 2, 2023
Operator: Good day, and welcome to the Elastic Third Quarter Fiscal 2023 Earnings Results Conference Call. Please note that today’s event is being recorded. I would now like to turn the conference over to Nikolay Beliov, Vice President of Investor Relations. Please go ahead, sir.
Nikolay Beliov: Thank you. Good afternoon, and thank you for joining us on today’s conference call to discuss Elastic’s Third Quarter Fiscal 2023 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 accompany this webcast, can be viewed in conjunction with live remarks and can be also downloaded at the conclusion of the webcast on the Elastic Investor Relations website, ir.elastic.co. Our discussion will include forward-looking statements, which may include predictions, estimates, our 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 risks 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 accompanying this webcast 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 for the next 60 days on our company website under the Investor Relations link. Our fourth quarter fiscal 2020 quiet period begins at the close of business on Friday, April 14, 2023. On March 6, 2023, we will be participating in the Morgan Stanley Technology, Media and Telecommunications Conference. With that, I’ll turn it over to Ash.
Ash Kulkarni: Thank you, Nikolay, and thank you all for joining us. I’m pleased with how we performed this quarter in the context of a challenging market environment. We remain completely focused on our customers and our business and continue to be excited about the opportunity ahead of us. Our total revenue in the third quarter grew 27% year-over-year in constant currency, while we manage the business with discipline to deliver stronger-than-expected non-GAAP operating margin of 7.9%. Elastic Cloud comprised 40% of total revenue, up from 36% in the year ago quarter and grew 40% year-over-year in constant currency. We saw strong customer contractual commitments, and customers continued consolidating on our platform. Before I discuss — the key focus areas for our business, I would like to touch on 3 topics: first, the macro environment; second, how we are executing in the current environment.
And third, the platform consolidation opportunity ahead for Elastic. First, consistent with Q2, third quarter deal cycles continue to be elongated with additional levels of approvals, and the SMB segment remained challenging. Also, as we had anticipated, customers continue to optimize their usage. We saw this across customers of all sizes and across industries. We anticipate that consumption optimization will continue in the near term. Despite these challenging times for everyone, we are focused on consistent execution. This leads me to the second topic. The steps we have taken to adjust and optimize our investments across the business, demonstrate our solid execution and give us continued confidence in the long-term market opportunity. We have continued to selectively invest in our enterprise and commercial sales capacity and have seen those portions of the business performed well with a healthy pipeline and strong customer commitments.
On the SMB side, we continue to refine our customer acquisition and expansion motions and remain focused on attracting customers that have a higher propensity for growth. Janesh will touch on this shortly. The balance between growth and margins is a key focus for the company, and we are demonstrating healthy margin expansion as we drive stronger return on investments across our investments. Third, our platform capabilities play to our strengths in this macro environment as customers look to consolidate suppliers without sacrificing innovation. Our land-and-expand strategy is working with both expansions within solutions and across solutions, bolstered by continued innovations in our underlying platform. We win by helping customers deliver better business outcomes, not limiting what data they can bring into Elastic while at the same time, lowering their total cost of ownership.
Elastic is mission-critical for customers, who need unified visibility across their business to keep their systems secure, reliable and performing at scale. Now I’d like to share our progress across our 3 key focus areas: driving durable growth, widening the competitive moat and fueling profitable growth. Starting with durable growth. We believe the consolidation of IT budgets is benefiting the Elastic platform as customers are looking to Elastic to simplify the environment, reduce costs and increase productivity and visibility. Over the past quarter, I met with dozens of customers across our key geographies, and they consistently expressed their desire to do more with Elastic as a central pillar of their IT infrastructure. We also continued to see strong growth in customers adopting Elastic Cloud and expanding across solutions.
Our revenue through the cloud hyperscaler marketplaces doubled year-over-year including multiple transactions over $1 million ACV. As an example, this quarter, we closed an 8-figure deal with a Fortune 100 financial services provider that is using Elastic Cloud on AWS to consolidate its observability and security infrastructure. The company chose Elastic to streamline operational costs and gain greater visibility across its environment while safeguarding sensitive customer data and meeting regulatory compliance requirements. We also closed another 8-figure deal with a top 10 multinational financial services company that is expanding on Elastic to consolidate its observability, security and internal and external search capabilities on our platform.
They continue to grow use cases with us, most recently expanding their use of monitoring and AIOps and advanced capabilities like tiered storage and machine learning. On the go-to-market front, last quarter, Elastic participated in 30 events and go-to-market programs with our cloud hyperscaler partners, including AWS Reinvent, where we met more than 5,000 customers and prospects and held a joint session with our customer, DISH Media. Our level of investment and engagement in this flagship event is a testament to the momentum of our partnership and the growing base of mutual customers that we serve. Finally, I’m excited to share that we have recently welcomed a new Chief Marketing Officer to Elastic. Matthew Donoghue. Matt brings a strong cybersecurity marketing background and extensive experience developing and executing go-to-market plans to support company growth.
His experience in increasing demand and driving sales will help us accelerate our journey as we build a generational company. The long-term opportunity for Elastic is clear, and we are positioning the business to emerge even stronger as we go through these challenging economic times. Now on to our widening competitive moat. Our solutions continue to be bolstered by innovation on the Elastic platform, driven in part by our AI and machine learning capabilities. As industry analysts have reported and our own customer surveys also indicate, investments in ML are fundamental to IT leaders’ ability to deliver on digital business transformation. ML continues to be a major driver for customers adopting our higher subscription tiers. A key part of our approach to machine learning is allowing our customers to integrate their own models in addition to leveraging the models that we offer.
By natively integrating machine learning into the core of Elastic search, we have enabled our customers to adopt new ML-based features across each of our solution areas. Now I will share some details about additional innovation and customer wins across our security, observability and enterprise search solutions. Starting with security. This quarter, we renewed business with a leading multinational telecommunications company, which is using Elastic Security to bolster its cyber defenses with threat detection and response. A longtime Elastic customer, they expanded business with Elastic via the Google Cloud Marketplace with the goal of consolidating and standardizing their security operations across more than 10 countries. We also renewed a 7-figure multiyear deal with a top 250 MSSP using Elastic Cloud on AWS to expand their security use cases across SIEM, XDR and endpoint.
They chose Elastic Security for our simple, consumption-based pricing that enables them to expand their use of elastic as their customer usage grows. We delivered several new capabilities in Q3, including interactive investigation guides, new deception-based ransomware protections and improved protections against data exfiltration through entity analytics. Elastic Security also continues to be recognized by leading industry analyst firms. In our first appearance in the Forrester Wave for Security Analytics, Elastic was named a leader, achieving the highest score for strategy. Elastic was also named a major player in the 2022 IDC Marketscape for SIEM. Now moving on to Elastic Observability. This quarter, we renewed and expanded a 7-figure deal with Deutsche Telekom, a leading integrated telecommunications company.
As an Elastic Observability customer, they use Elastic for multi-cloud monitoring as well as advanced capabilities like machine learning to forecast bandwidth calculations that assist them in planning their networks and then optimizing costs. The company also uses Elastic Security for SIEM, endpoint and EDR to secure its own internal networks. In Q3, we introduced innovations, including a new curated journey that accelerates root cause analysis by aiding in the identification of performance or availability issues caused by application dependencies. Elastic also appeared for the first time in the Forrester wave for AI Ops, being recognized as a strong performer and receiving the highest possible scores in 13 evaluation criteria. Now on to Enterprise Search.
This quarter, we closed a new 7-figure deal in APJ with a major social e-commerce platform in India, which moved from AWS Open Search to Elastic Cloud via the Google marketplace. With Elastic Enterprise Search, they were able to dramatically reduce search latency across an average of 2.8 million transactions per day while optimizing the shopping experience for their users. On the innovation front, we introduced new tools to implement and manage natural language processing across search indices, accelerating both time to value and higher quality search results. I’m also pleased to share that Elastic was recognized as a leader in the 2022 Gartner Magic Quadrant for Insights Engines, positioned furthest to the right for our completeness of vision.
Photo by Jose Vazquez on Unsplash
Moving on to our long-term model and our focus on profitable growth. When we first shared the $2 billion FY ’25 revenue target in June of last year, it reflected the market opportunity in front of us and the growth trajectory of our business at the time. Although we fully expect to be a multibillion-dollar company over time, given the current macro environment we are operating in, we do not expect to achieve the $2 billion revenue mark in FY ’25. Similarly, while we are seeing healthy customer commitments, given the softer consumption patterns in the near term, we expect Elastic Cloud revenue exceeding 50% of total revenue will take longer than we initially anticipated. Having said this, I will reemphasize our conviction in the long-term opportunity in front of us, especially in Elastic Cloud.
That conviction is founded on the strength of our product innovations and continued customer confidence in Elastic as reflected in customer commitments and in all the examples I shared earlier. Now on profitability. As we’ve demonstrated this quarter, we are committed to managing the business with discipline and remain highly confident in our ability to deliver the 10% FY ’24 non-GAAP operating margin target we established last quarter with further expansion in fiscal ’25. Our fundamentals remain strong. We remain committed to continuing our growth strategy while delivering increasing profitability. In closing, I want to thank our employees for their dedication and contribution to our performance. I also want to thank our customers, partners and investors for their continued support and confidence.
With that, I’ll turn it over to Janesh to go through our results in more detail.
Janesh Moorjani: Thanks, Ash. We are pleased that we once again came in above the high end of both our top line and bottom line guidance for the quarter despite the current economic environment. We delivered 27% year-over-year constant currency growth in total revenue, and Elastic Cloud grew 40% year-over-year in constant currency. Let me start with 2 distinct business themes we saw in the quarter. First, we saw strong levels of customer contractual commitments to Elastic. Customers want to do more with Elastic, and our sales team executed well in the quarter to secure these commitments. As provided several examples of marquee customers experiencing the benefits of the Elastic platform and solutions, this is an important indicator for us since it directly translates into future revenue.
The second theme we saw relates to consumption patterns. Customers continue to look for ways to optimize their usage. We saw this across segments of our customer base. Although this is a near-term headwind, our platform naturally helps customers drive efficiencies with capabilities like searchable snapshots and frozen storage. Combined with the benefits of a consumption model, our platform enables customers to consolidate more workloads on Elastic over time. Putting these 2 pieces together, as customers look to reduce costs, they are choosing Elastic as their partner for the long term while also leveraging the capabilities we provide to help them optimize usage in the near term. The growth and commitments that customers made to us during the quarter gives us confidence in the underlying strength of the business and our ability to successfully address the market opportunity over time.
Now let’s get into the Q3 results and our outlook. Total revenue in the third quarter was $275 million, up 23% year-over-year or 27% in constant currency. Subscription revenue in the third quarter totaled $256 million, up 22% year-over-year or 26% in constant currency, comprising 93% of total revenue. Within subscriptions, revenue from Elastic Cloud was $111 million growing 38% year-over-year or 40% in constant currency. Elastic Cloud represented 40% of total revenue in the quarter, up from 36% a year ago. Elastic Cloud revenue based on month-to-month consumption arrangements continue to be 16% of total revenue, similar to the prior quarter and compared to 17% in the year ago quarter. Professional services revenue in the third quarter was $19 million, growing 32% year-over-year or 37% in constant currency.
We saw sequentially lower revenue from professional services given the timing of completion of projects. Although professional services may fluctuate across quarters, we do not expect it to vary significantly in mix over time. To add more context around deal flow and performance by region, we saw balanced deal flow across geographies on a currency-adjusted basis. APJ grew the fastest, followed by EMEA and the Americas. We also saw a healthy balance across the solutions and continue to maintain a similar solution mix in annual contract values versus the prior quarter. Looking at customer metrics. We continued our strategy of focusing on customers with a higher propensity for growth. This strategy was reflected in our results. In the third quarter, we added over 100 customers above $10,000 in annual contract value to end at over 4,000 such customers.
Looking at customers over $100,000 ACV, we added over 60 customers in that category, representing a strong number of sequential additions and bringing us to over 1,110 such customers as of the end of the third quarter. This is indicative of customer commitments that I referenced earlier. The customer count in this over $100,000 ACV category continues to be a strong underpinning of our land and expand motion as we build a multibillion-dollar company over time. Our total customer count also continued to increase, ending at approximately 19,900 total subscription customers. As I mentioned earlier, these metrics indicate the strength of customer commitments to Elastic. Turning to the net expansion rate. Our net expansion rate was approximately 120%, driven in part by slower consumption.
As a reminder, for customers on consumption-based arrangements, our net expansion rate reflects only their actual consumption and not their commitment. Our customer metrics indicate that our core strategy is sound. Customers are making strong commitments to us, and we remain confident in our ability to address the large market opportunity. Our solutions are used in core mission-critical use cases, and we give customers enormous flexibility with the consumption-based business model on cloud. Now turning to profitability for which I’ll discuss non-GAAP measures. Gross margin in the quarter was 75.5% versus 74.5% in the prior quarter with the sequential improvement driven mainly by better subscription gross margins, which increased to 80.1% versus 79.2% in Q2.
Looking at operating expenses in the third quarter, we continue to manage our expenses and investments in the business well. Our operating margin in the quarter was 7.9%, which was significantly better than expected due to the earlier-than-planned exit of some employees from our restructuring actions, better gross margin and, to a lesser extent, a shift in timing of some expenses to Q4. Diluted earnings per share in the third quarter was $0.17. Free cash flow on an adjusted basis was approximately $19 million in the third quarter. Based on our strong performance, we are increasing our outlook for the year and now expect adjusted free cash flow margin to be in the low single digits for full fiscal ’23 compared to our prior outlook of roughly breakeven.
As a reminder, this is after the outflows related to the restructuring we announced in the second quarter. We continue to maintain a strong balance sheet. We ended the third quarter with cash and cash equivalents of $878 million. We remain comfortable with our cash position from an operating perspective. Turning to guidance. As I mentioned earlier, we exceeded our expectations for the third quarter, and we also saw greater-than-expected strength in customer commitments. Additionally, customers of all sizes continue to optimize consumption. We believe that it is prudent to consider that consumption trends might slow further before they improve again. We are incorporating this possibility into our guidance for Q4 and are modestly lowering our outlook for the full year.
Given the macro spending environment, we are simply being cautious as we monitor near-term trends. Further, as a reminder, our fiscal fourth quarter has only 89 days compared to 92 days in the third quarter, and this presents a headwind of approximately 3% to sequential growth rates. Year-over-year growth rates are not affected by this. We also continue to manage expenses tightly while investing with discipline in the business, including an enterprise and commercial sales capacity. Given our strong performance so far, we are raising our non-GAAP operating margin outlook for the year. The outlook for the fourth quarter reflects approximately $10 million in seasonally higher expenses in the third quarter related to the timing of employee benefit expenses and our Engineering all-hands event.
With that background, for the fourth quarter of fiscal ’23, we expect total revenue in the range of $276 million to $278 million, representing 16% year-over-year growth at the midpoint. On a constant currency basis, we expect total revenue growth of 18% year-over-year at the midpoint. We expect non-GAAP operating margin in the range of 4.8% to 5.2% and non-GAAP earnings per share in the range of $0.08 to $0.10 using between 100 million and 101 million diluted weighted average ordinary shares outstanding. For full fiscal ’23, we now expect total revenue in the range of $1.065 billion to $1.067 billion, representing 24% year-over-year growth at the midpoint. On a constant currency basis, we expect total revenue growth of 28% year-over-year at the midpoint.
We expect non-GAAP operating margin for full fiscal ’23 in the range of 3.3% to 3.4% and non-GAAP earnings per share in the range of $0.11 to $0.14 using between 99 million and 100 million diluted weighted average ordinary shares outstanding. Finally, looking ahead to fiscal 2024. As you know, we provide guidance for the next fiscal year on the Q4 earnings call. We are in the middle of our planning process, and we still have a significant volume of business to close in the fourth quarter. Having said that, we do want to give you a sense of how we are currently seeing next year’s shape up given the statements we have made about our confidence in delivering strong revenue growth on a sustainable basis. First, we remain focused on delivering durable long-term revenue growth as we build a multibillion-dollar revenue business.
We are confident that we are still in the early stages of this growth journey. Yet, we remain prudent in our view of the macroeconomic environment. Accordingly, as of right now, we expect total revenue growth in fiscal ’24 to be in the mid- to high teens. We expect first half year-over-year growth in total revenue to be slightly lower than our expectation for the full year given tougher comparisons against the first half of fiscal ’23. We will continue to closely monitor customer commitments and consumption patterns, and we’ll provide formal guidance on the next earnings call. Second, we expect cloud will remain a revenue growth driver for us. Our growth in cloud is driven predominantly by new and expansion use cases rather than migrations from self-managed.
Third, we will continue to invest in the business with discipline in support of our drive to durable long-term growth. We remain committed to delivering non-GAAP operating margin of 10% next year, and the actions we have already taken are sufficient in that regard. Some of our expenses are seasonally higher in the first quarter, while revenue will ramp over the year. Accordingly, we expect Q1 to be the low point on non-GAAP operating margin. We also expect to have adjusted free cash flow growth in fiscal ’24, consistent with the non-GAAP operating margin increase. Longer term, we continue to expect to deliver several points of non-GAAP operating margin expansion in fiscal ’25 as we grow revenue faster than expenses. In summary, we remain focused on execution and believe that we are well positioned for long-term durable growth and profitability.
And with that, let’s go ahead and take questions. Operator?
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