In spite of the company's revenue soaring nearly 170% over the last three years, shares of software company Elastic (ESTC 2.31%) have fallen 9% over that same period. The bear market of 2022 has shone the spotlight on financial flaws with Elastic, and stocks like it, that put up strong sales growth but little to no profitability. Such stocks are out of favor right now.
But the company beat expectations during the first quarter of its 2023 fiscal year (the three months ended July 2022). Is this stock a buy after getting clobbered in the last 12 months?
Strong performance, from a certain viewpoint
Elastic's revenue increased 30% year over year to $250 million (or a 34% increase when backing out the effects of a record run-up in the U.S. dollar against foreign currencies). Despite various macroeconomic concerns and exchange rate headwinds, this slightly beat management's outlook that was provided a few months prior.
Adjusted operating losses totaled $4.7 million, or negative 1.9% of revenue, which also beat Elastic's guidance for adjusted operating margin to be as low as negative 3.8%. When backing out interest payments on debt, management expects to be slightly free cash flow positive for fiscal 2023. The company is forecasting a few percentage points' improvement in adjusted operating margins for the next three years as it realizes greater efficiency from use of its software.
But therein lies the rub for Elastic. With the Federal Reserve aggressively hiking interest rates and tightening the money supply to try to cool off the economy and tame inflation, the market is favoring stable and profitable businesses. Elastic has tons of growth potential, but "stable" and "profitable" are hardly the right adjectives to describe this business.
Software for analytics, security, and cloud-computing monitoring is a highly competitive market, and Elastic expects to turn thin margins at best for the next few years while it tries to maximize its potential. Given the industry it participates in, that's not a wrong strategy, but the average investor might not care that much right this moment.
How low can Elastic go?
The good news is that after getting beaten down, Elastic stock is valued far more reasonably than it has been for years. Shares trade for just over eight times enterprise value to trailing-12-month revenue, even cheaper than it was during the market crash in early 2020 when COVID-19 struck.
That doesn't mean this is a cheap growth stock. Elastic has issues, and it's not just about profitability. The company still shells out ample amounts of stock-based compensation to employees: $157 million in the last year, or about 17% of revenue.
It's also making a transition to cloud-based services, a business model with slimmer margins than its traditional software-licensing bread and butter. Nevertheless, with sales continuing to increase at such a brisk pace, not even stock-based compensation has prevented outsize returns for shareholders on a revenue-per-share basis. If Elastic can start consistently turning those dollars into profit, this stock could take off.
However, that scenario doesn't appear likely this year. Elastic could keep getting ignored by the market until it turns a corner on the bottom line, or until the Fed is sufficiently satisfied with its punishment of the economy.
In the meantime, Elastic's management is still executing its plan to double revenue from where it is today over the next three years ($2 billion in revenue is expected by fiscal 2025). I'm happy to patiently wait with my small position in Elastic, but I'm not ready to buy more of this stock just yet.