In a year of successful IPOs, the U.S. stock market just had one of its IPOs of the entire year. Search company Elastic (NYSE:ESTC) saw its stock nearly double in value from its IPO price on Friday. As CNBC reported, Elastic finished at $70 per share, representing a 94.4 percent rise even though the S&P 500 tech index fell by 1.7 percent. Elastic had raised its initial share price from $26 to $36 in anticipation of high demand and now the company has a valuation of nearly $5 billion.
Elastic is a fantastic company which investors should realize has incredible potential, but $70 a share is incredibly expensive. The company will likely see its share value drop within a few months as many IPOs do, and so investors should hold off on investing for now. But remember that there is a reason for why investors were so excited for this IPO.
A New Kind of Search
Elastic calls itself “a search company” in its S-1 report, but that does not make it the same thing as Google or Yahoo. Instead, the company manages proprietary search engines for companies and websites like Uber or Tinder. In addition to search, Elastic’s main product known as Elastic Stack helps business compile search data and run analytics, is open source, but offers a paid subscription. As of July 31, 2018, Elastic has over 5,500 paid customers across 80 countries.
There are two important things to note about Elastic’s approach. The first is that as Dharmesh Thakkar with Forbes notes, Elastic is the latest open-source company to achieve major success by going public, following in the footsteps of Hortonworks (HDP) and MuleSoft. Investors have wondered whether open-source software could succeed as a larger company could theoretically copy the software and improve on it, but that has not happened so far.
The reason that does not happen is the second important thing. In theory, Uber or Home Depot could copy Elastic’s software and tailor it for their specific needs. But that is not their specialties, and creating their own search engine out of scratch would disrupt their business. Elastic makes their software free and then offers a paid subscription once their customers become used to depending on its search and analytical capabilities. It is a business model which promises loyal and dependable customers.
Admittedly, those customers may not be so loyal or dependable if Amazon or Google develop an Elastic clone, and that is a potential long-term risk for this company. But at this point, practically any tech IPO runs some risk in terms of being overwhelmed by those tech giants and there is no indication that Elastic has a uniquely high amount of risk.
The challenge for open-source software companies, as well as practically any tech company going public, is to figure out how they can make money with their software before growth slows down. In this regard, Elastic is in excellent shape.
Elastic’s total revenue in the 2018 fiscal year was almost $160 million, representing an 81% increase compared to 2017. This is higher revenue growth than MuleSoft or Twilio (NYSE:TWLO) had when they went public, and Elastic’s high growth is one of the biggest reasons to be excited about this company. Net losses increased in that same time frame from $51 million to $52 million and losses of $52 million compared to revenue of $160 million are perfectly acceptable.
Elastic’s incredible revenue growth, acceptable losses, and massive potential for growth as companies grow more interested in search means that this is a company with bright hopes ahead. But as noted above, that does not make it $70 per share bright. There is no denying that a valuation of nearly $5 billion is expensive for a company making less than $200 million in revenue.
If we assume that Elastic’s growth rate drops to 65%, its revenue for the 2019 fiscal year should be about $263.9 million. Assuming constant valuation that gives a PS ratio of 18.94 and an EV/FTM of 17.4. Both values are not excessively higher compared to other open-source companies, but it remains a high value. Furthermore, we often see tech IPOs which storm out of the gate, only to fall in value after the hype fades and especially once we get closer to the end of the lock out period.
Wait and See
There may be some concerns about Amazon, but there is minimal reason to worry about Elastic’s long-term potential as the search engine and data analysts for businesses across the globe. The only concern for investors should be how long to wait or whether to jump on the bandwagon as soon as possible.
Given Elastic’s high valuation, it should be better to wait until the company’s share price falls into the 50s rather than moving now. Elastic’s price will inevitably fall within a few weeks to months. That will be the type for smart value investors to take advantage and get a great stock.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.