Elastic N.V. Can Ride The Wave Of Generative AI

The recent purchase by Cisco Systems (CSCO) of my 2023 technology pick, Splunk (SPLK), could open up the door to further M&A analysts said. That adds further support to the case of Elastic N.V. (NYSE:ESTC).

Cisco's Splunk buy is expected to create a wave of M&A

In December 2022, I chose Splunk as my tech pick for 2023. I called it a "rare tech growth opportunity," due to the low appetite for tech at the time. We now know that it was the start of a new tech rally, driven by the adoption of artificial intelligence.

Despite that, Splunk is still up 73.4%, outperforming the S&P at 11.28%. Cisco agreed to buy the software firm for $157 billion in an all-cash deal, representing a $28 billion equity investment.

Analysts now see Cisco's deal potentially opening the floodgates to further software M&A deals. Citi said Elastic N.V. could benefit due to the fact that Splunk is growing slower than Elastic and could create a "competitive dislocation" once the Cisco-Splunk deal closes.

"A tidal wave of software M&A is on the horizon," wrote Wedbush analysts in an investor note.

Big tech holds Elastic in high regard

Elastic is a Dutch-American firm that helps enterprises build powerful search solutions to crunch large amounts of data. The company states that it is trusted by 50% of the Fortune 500. Elastic has also drawn the attention of big tech players, gaining recognition as Google Cloud's Technology partner of the year. The company was also awarded Microsoft's Worldwide and U.S. Partner of the Year, and the Amazon AWS Rising Star Partner of the Year.

The company also achieved recognition from Gartner and Forrester for its security solutions.

Elastic could be an enticing opportunity for a large company to align its services with the big data and security platform. The Elasticsearch Platform integrates machine learning and AI to power observability, search, and security solutions.

The company also announced an AI assistant in September, which aims to assist site reliability engineers (SREs) to monitor operations.

"The impact and value of generative AI dramatically increase when it has access to an enterprise's proprietary data," said Torsten Volk, analyst at Enterprise Management Associates. "It's exciting to see how Elastic's AI Assistant for Observability may help customers achieve a state where generative AI provides role and situation-specific recommendations, problem resolutions, and suggested efficiency enhancements, all based on the customer's own data sources."

AI data needs could power Elastic growth further

The artificial intelligence boom that has followed Microsoft's adoption of Chat GPTA has seen every big tech player seeking to adopt Large Language Models (LLMs) and other AI tools. Generative AI and LLMs use high levels of data and that could add further upside to Elastic's current growth trajectory from its current user base.

In its recent fiscal first quarter 2024 results, Elastic posted $294 million in revenue up 17% year-over-year. GAAP operating loss was $36 million; with GAAP operating margin at -12%. Operating cash flow was $38 million with free cash flow of $49 million.

“We had a strong start to the fiscal year, and delivered better than expected results as customers continued to consolidate vendors and adopt Elastic as their AI-powered data analytics platform of choice for addressing multiple real-time search use cases,” said Ash Kulkarni, CEO,

Management released guidance for revenue of $303 million to $305 million for Q2, for a 15% year-over-year growth.

Heavy R&D spending masks the company's profitability

Despite the negative operating margin, Elastic has a gross margin of 72%. In its latest twelve-month trailing results, the company made $1.12 billion in revenue and spent $300 million on research and development costs. That represents 26% of the company's revenue, leading to an operating income of -$158.5 million. So, Elastic is currently profitable but is spending for the long term.

If we removed the R&D costs then Elastic is currently valued at around 55x earnings with an $8 billion valuation.

The downside risk to the thesis revolves around the current valuation and could be reduced if Elastic sees growth slow. Personally, I would say that the buzz around generative AI tools in the workplace should be a long-term trend and the company can leverage its large blue-chip customer base for additional revenue.

A small float and low institutional ownership are another driver

Compared to Splunk, Elastic has a small float of shares with only 79.6M compared to the 153.5M of its rival. Institutional ownership is also lower at 75% versus 80%.

If Elastic starts to gain traction amongst Wall Street analysts then that float could get swallowed up quickly, driving the share price higher.

Conclusion

If analysts are right that Cisco's acquisition of Splunk will start a wave of software M&A then Elastic is well-positioned. If we forget about current growth, the company has a valuable platform that can crunch large amounts of data and allow customers to create search tools for that data. This can become even more important as companies scramble to build LLMs and adopt new generative AI tools, which are data-intensive. Elastic also incorporates a security solution to detect threats and provide feedback. Being recognized by Microsoft, Google, and Amazon is a good advertisement and the company's large R&D spending could also enhance its product suite. The company is likely valued at a fair price on current trends, but technology giants may be sniffing around for a potential acquisition.