Elastic NV (NYSE: ESTC) is the most interesting enterprise software company that I have encountered. Its strong and improving financials are obvious. What is hidden is its unique flywheel, which relies on open-source and powers rapid innovation and growth.
Its core competency is in Elasticsearch, an open-source and near-realtime search solution that supports many applications in analytics, monitoring, security, and likely many more in the future.
The keyword is open-source. Elastic’s steadfast commitment to open-source has fostered a large and dedicated community of developers (150,000 and counting). Users provide rapid feedback, remove bugs, and guide feature development. Elastic effectively crowd-sources innovation from its developer community, taking cues on what to expand into and what to acquire. Crowd-sourcing innovation is also faster and more cost-effective than the traditional, “closed” corporate R&D model.
Another benefit of open-source is shorter sales cycles. The large and loyal base of developers enables an effective bottom-up “grassroots” (as opposed to top-down CIO-first) approach to sales and marketing, shortening the infamously long sales cycle in enterprise software. Elastic counts about half of the Fortune 500 and a third of the Fortune 2000 as customers, which supports high recurring subscription revenue (92% FY20 revenue). Elastic is growing rapidly (57% FY20 rev growth yoy, 45-55% rev growth yoy during Covid qtrs), and is still early in its growth journey because of the innumerable innovations that its community would eventually discover in the future.
Critics often question developer loyalty. Why would a developer release self-developed improvements for free? Because the developer must use Elastic software for projects. The developer has to reports bugs and suggest improvements so that projects can be completed. Elastic has shined in strategic execution to achieve developer mind-share when there are many other open-source search and analytics solutions. There are two subtle but visionary nuances worth discussing.
The first is straightforward (but not simple to execute): a relentless focus on developers. Shay Banon, founder and CEO, discussed how Elastic differs from its open-source competitors:
“One common open source business model, is to sell support subscriptions. Sadly, support-only business models trend towards a conflict between what’s best for the user and what’s best for the company. In these situations, the company isn’t motivated to make their products easier to use, more reliable, scalable because that would eat into their support profits.”
This makes sense. Open-source providers are incentivized to make products difficult to use, so developers must pay for support, discouraging developers from improving the software.
“[Elastic] was never, and never will be, willing to bear the tension of not making our software better in order to ensure that the company stays in business. We want to continuously improve and our goal with support is to make your project successful so that you are the expert in your Elastic Stack deployment. We want you to be successful so that you choose the Elastic Stack for your next projects too.”
Elastic encourages developers to improve its software by promising it would do the same. The software would always improve, and would never be held back for commercial reasons. Wouldn’t this reduce support subscriptions? Elastic’s answer is the second nuance to its strategy. It only sells support to the most intensive users (think Fortune-ranked companies). It also sells them access to some features that are high-value to them but used little by the larger community, who mainly uses the free core software.
Elastic’s strategy serves the entire spectrum from the large corporations, from whom it charges and financially profits, right down to the individual developer, from whom it does not charge but gains technically and intellectually. The flywheel starts with Elastic relentlessly improving the software and helping the developer succeed, incentivizing the developer to turn only to Elastic and nothing else. As more developers use Elastic, they improve the core software more effectively than competing software. Increasing developer usage improves the standing of Elastic at large corporations, which pay for support subscriptions to Elastic, who in turn uses the revenue to reinforce the flywheel.
Competitors to Elastic are specialized solution providers (Datadog/Splunk in application monitoring, FireEye/Checkpoint in endpoint security), some of which are built atop Elasticsearch. The key advantage of Elastic is its large and loyal community, enabling the aforementioned flywheel and unbeatable economics. The community is also its key defense against Amazon. Amazon forked code from Elasticsearch to build AWS Elasticsearch (thought Amazon insisted it wasn’t), but was unable to build a community around it (see approximate community size for Elasticsearch and AWS Elasticsearch here), riddling the service with numerous bugs. AWS Elasticsearch should be effective in retaining unsophisticated users in the AWS ecosystem, but is unable to scale quickly without a dedicated developer community that takes years and resources to build. Because AWS Elasticsearch is only of many AWS managed services, Amazon is unlikely to dedicate sufficient resources to mount a challenge to Elastic.
Elastic’s leading competency in search, open-source distribution, unique flywheel, and shorter go-to-market cycles would sustain growth for years. A reasonable bull case can be made for 30-40% topline growth for current applications in the next 5 years, multiplying revenues by 4-5x (forward EV/sales about 5x). 50-60% growth in deferred revenue and $350 million cash provide adequate funding, further supported by expected positive FCF in FY21. Assuming 4.5x growth in revenue in 5 years, steady-state 35% EBITDA margin, and 36x terminal growth multiple (r=9%, g=6% ~ 3x global GDP), the projected EV is about $16 billion, and target price is $185/sh. (32% upside).
The projection excludes the upside optionality of additional applications which Elastic’s community has yet to discover. The community led Elastic to its current applications in monitoring and security, which were built with a three-pronged approach: community development, internal R&D, and M&A (executed brilliantly by current management). It is likely that Elastic would find future revenue growth from additional applications from its community, continue its excellent execution with improving internal funding, and launch new offerings in years to come.