Elastic N.V. (NYSE:ESTC) reported disappointing results in the first quarter of FY2025 and significantly lowered full-year guidance, attributing weakness to sales segmentation changes. It is hard not to feel that the company’s problems extend beyond just this, though, with MongoDB, Inc.’s (MDB) expansion into search and CrowdStrike Holdings, Inc.’s (CRWD) success in SOC particularly points of concern.

In some ways, I feel that Elastic is unfairly maligned. It continues to grow at a steady pace while improving margins and generating reasonable cash flows. Elastic is not a top-tier SaaS company, though, and is poorly positioned relative to many data infrastructure peers. In addition, generative AI hype created impossibly large shoes for the company to fill, making disappointment an inevitable outcome for investors.

I previously suggested that Elastic’s upside was fairly capped unless growth increased substantially. I felt that stronger growth was unlikely though, due to the weak macro environment and the fact that generative AI was not expected to contribute to revenue in the short run. This has proven to be the case, with Elastic’s growth expected to decelerate sharply in FY2025, and the stock now down over 25%.

Elastic now appears more attractively priced, but the stock has long appeared undervalued while still delivering poor returns to investors. The company’s revenue multiple is near all-time lows, but so is growth, and Elastic still isn’t consistently profitable on a GAAP basis. In addition, I think rising competition makes the stock overly risky, even at current prices.

Market Conditions

There is little to suggest that the demand environment has meaningfully changed in recent quarters, for better or worse. Most software companies continue to report fairly stable growth, with a small number achieving a meaningful growth reacceleration. Several companies have also reported weak results recently, although this has generally been due to idiosyncratic issues. Expectations of lower interest may be creating renewed optimism among some organizations, although this must be weighed against macro data, which generally shows an ongoing slowdown in the economy.

While Elastic’s first quarter was poor, the company did not really try to pin this on the demand environment. Elastic had difficulties closing deals in EMEA due to customer budget constraints, though, a situation that was exacerbated by Elastic’s relatively large exposure to Europe. It is not clear how much of this is due to market conditions versus Elastic-specific issues, though.

A large amount of capital continues to be invested in hardware and foundational models, but this hasn’t created many tailwinds elsewhere yet. Early beneficiaries appear to be the cloud hyperscalers and companies offering turnkey enterprise AI solutions. If generative AI lives up to even a fraction of the hype, it will eventually boost growth in areas like data infrastructure, although this could still be years away. Meanwhile, generative AI may be sucking the air out of the room and pressuring IT spend in other areas.

Elastic Business Updates

Elastic continues to position itself as a cost-effective platform for search, observability, and security. The extent to which this messaging is resonating with customers is unclear, though. Given the headwinds many companies have faced over the past few years, and their desire to achieve profitability, Elastic’s platform could reasonably have been expected to see increased demand. This situation must be weighed against Elastic’s relatively large exposure to smaller organizations and EMEA, though, both of which have been areas of weakness recently.

Elastic is seeing some success among larger organizations, which could indicate that its platform consolidation strategy is working. The company has also transitioned from a bottom up to a top-down sales motion over the past few years, prioritizing landing larger organizations and driving expansion within them.

In line with its focus on larger organizations, Elastic undertook a significant reorganization of its sales segmentation in the US in Q1 and this created unexpectedly large headwinds. In particular, the volume of customer commitments closed in Q1 fell short of expectations. Elastic has suggested that it is now seeing encouraging signs of deals progressing through the sales funnel. Despite this, not all the deals that have slipped are expected to close in the second quarter. Difficulty securing new commitments is also expected to continue feeding through into consumption through the remainder of the year.

Elastic has suggested that demand for generative AI continues to increase, with companies beginning to progress from ideation to testing and adoption. Unsurprisingly, this is primarily related to semantic search and RAG use cases. Elastic ended Q1 with over 1,300 customers using Elastic Cloud for generative AI. Around 200 of Elastic’s $100K+ ACV customer cohort are using Elastic for generative AI. This represents around 6% of the total customer base and 14% of the large customer cohort.

While Elastic has clearly achieved some level of traction with generative AI use cases, it is not yet clear how meaningful this is. Elastic has stated that the growth of its Search business has reaccelerated, though. Even with a fairly modest level of adoption, generative AI could provide a meaningful boost. For example, a leading sales enablement software company recently signed an expanded deal using Elastic for generative AI, which has led to a more than twofold increase in the company’s Elastic consumption over the last six months.

Competition in Search may be fiercer than many expect though, and it is not clear that Elastic has a significant advantage. MongoDB has stated that Delivery Hero is now using Atlas Vector Search. One of the largest gaming companies in the world also recently shifted its content moderation platform from DocDB, Elastic, and Dynamo to Atlas and Atlas Search. Elastic has suggested that it has not seen any changes in the competitive environment, though.

Elastic is launching Elastic Express Migration, a program that packages all the migration services a company needs to move away from legacy SIEM and log analytics vendors. AI is transforming the SIEM landscape, with customers generally shifting towards AI-enabled security analytics platforms that help automate attack discovery, investigation, and remediation. Elastic has stated that it is pleased with its efforts to displace incumbent solutions.

I tend to think that much of this opportunity will be captured by leading security platforms that can offer a comprehensive portfolio of solutions. In particular, I believe that CrowdStrike and SentinelOne, Inc. (S) are well-placed as a result of their indexless solutions, which potentially offer an advantage in security applications. At the end of FY2024, CrowdStrike’s next-gen SIEM had ARR exceeding $150 million USD and was growing at more than a 160% rate.

Financial Analysis

Elastic generated $347 million USD revenue in Q1, an 18% increase YoY, with subscription revenue increasing 20% and Elastic Cloud up 30%. While Elastic modestly beat guidance, investors were likely looking for a continued increase in the company’s growth rate. Of more concern, Elastic provided soft guidance, and it is hard not to feel that this goes beyond just temporary headwinds from a sales reorganization.

Elastic expects $353-355 million USD revenue in Q2, representing a 14% YoY increase at the midpoint. For the full year, Elastic is guiding to $1.436-1.444 billion USD revenue, an increase of 14%. Despite a $3 million USD beat in Q1, full-year guidance was reduced by $34 million USD. Elastic is assuming that the macro environment will remain stable through the remainder of the year, including EMEA, which was an area of weakness in Q1.

Relative softness in the $100k+ ACV customer cohort supports Elastic’s sales commentary. There is an ongoing reacceleration among smaller customers, though. Elastic’s net expansion rate was approximately 112% in Q1, a modest sequential improvement that indicates underlying usage of the platform is strengthening.

The number of job openings mentioning Elastic in the job requirements suggests a soft, albeit stable, demand environment. The recent drop in Elastic job openings is suggestive of demand weakness beyond just a simple sales reorg problem.

Elastic’s Subscription gross margins have been fairly steady in recent quarters, while Services gross margins continue to trend lower. Weak services gross margins could be suggestive of a challenging macro environment, with low-priced Services potentially being used as a customer acquisition tool.

Elastic reported a non-GAAP operating margin of 10.7% in Q1. Elastic’s bottom line generally continues to improve, although disappointing Q1 results pressured margins, and this may continue for several quarters as Elastic continues to invest ahead of future growth.

Conclusion

Elastic N.V.’s seemingly low valuation continues to attract investors, a trap I have fallen into in the past, and its financial performance continues to disappoint. First quarter results were reportedly due to a sales reorganization in the US and difficulty closing deals in EMEA. While Elastic’s full-year guidance is likely conservative, a 14% revenue growth rate is a large blow for investors who were looking for a growth reacceleration.

While generative AI should provide a meaningful boost at some point, this will require time for applications to enter production and for demand to scale. Any boost may also be more modest than many investors expect.

Elastic is to a large extent a security business and will need to see a large amount of search growth to change this. I am not particularly bullish on Elastic’s security business due to the strength of companies like CrowdStrike and the traction they are seeing with their indexless SIEM products. There is also growing evidence that MongoDB’s Search products are gaining traction, which could further undermine Elastic’s competitive positioning.