Following their Q1 earnings report on May 3rd, Confluent stock jumped by 16%. Since then, CFLT has continued appreciating, recently passing their previous high for 2023. While the report itself was pretty good (but not outstanding), the market appears to be anticipating more growth to come. Perceived AI tailwinds are likely at play. In order to capitalize on the potential advantages from advanced insights and new proprietary AI models, enterprises need access to all their data in one place. It should be filtered, consistent and recent. As the leading independent provider of data streaming, and soon stream processing capabilities, Confluent is well positioned to address this demand.

Fortunately, Confluent doesn’t have to convince most enterprises of the value of real-time data streaming. Over 75% of the Fortune 500 already use Apache Kafka at some level to accomplish this. Confluent’s task is to demonstrate that their data streaming platform, which offers many enhanced capabilities over self-managed open source Kafka, is worth the incremental cost. While this may have been a more difficult sell in the corporate data center, Confluent Cloud provides enterprises with a managed solution on their hyperscaler of choice, eliminating the need to maintain a large team of operations engineers with Kafka expertise.

Additionally, stream processing tools allow data engineers to filter, transform and aggregate data in flight, front-loading processing before it arrives at its destination. The most popular open source solution for stream processing is Apache Flink. With their acquisition of Immerok in January, Confluent is now integrating a managed Flink stream processing toolset into their core Cloud platform. Management expects that revenue from stream processing could eventually match that of core data streaming, effectively doubling their TAM.

While their Q1 results continued to reflect the pressure of elongated deal cycles and enhanced scrutiny, Confluent managed to deliver subscription revenue growth over 40% y/y. For the remainder of 2023, they maintained revenue targets at conservative levels. Profitability measures dipped in Q1 due to a couple of one-time charges, but are tracking towards break-even operating margin in Q4. That will represent another 2000 bps of annual improvement. Long term, the Confluent management team sees FCF margin reaching 25%.

Revenue growth is primarily being driven by expansion of Confluent’s largest customers, with continued increases in $1M+ commitments and even anecdotal references to $5M-$10M of annual spend. Confluent’s NRR rate remains above 130% overall, with NRR for just Cloud well above that. Confluent needs to keep the new customer pipeline flowing, as focus has shifted to Kafka migrations and workload expansions within existing customers. Confluent’s revenue target for this year represents about 1% of their calculated $100B addressable market, leaving plenty of room for future expansion.

Following disappointing results from the hyperscalers, Confluent was one of the first independent software infrastructure providers to report Q4 earnings on January 30th. Further complicating the picture, they preceded that report with an announcement of an 8% staff reduction on January 26th. That filing included top-level Q4 results. This flurry of news overshadowed two key points from the reports that subsequently became clear.

First, Confluent largely maintained their revenue growth target for full year 2023 that had been previously set in Q3. Initially, the market seemed to be anticipating the standard q/q raise. However, subsequent earnings reports from other software infrastructure providers made it clear that just maintaining guidance represented a positive signal, as several companies made fairly significant downward revisions to their full year revenue target from either what analysts had modeled or the company’s own guidance from the prior quarter. Among peers, Confluent was one of few companies that kept the target about the same.

Second, the driver of the layoff was a desire to pull in profitability targets by a year. Because force reductions can be organizationally disruptive and sometimes a signal of worsening demand, the layoff was initially interpreted negatively. The full Q4 report provided sufficient evidence that demand was softening, but not falling off a cliff, as new customer activity was strong.

The upside to the staff reduction is a significant decrease in expenses. Confluent’s revised operating margin target for end of year 2023 is now Non-GAAP break-even. If achieved, Confluent will have improved their operating margin by 2000 bps (20%) for two years in a row. They have telegraphed that FCF margins will follow a similar path.

These two factors, along with other positive signals in the report and earnings call, make Confluent’s results look more favorable relative to peers. When compared to subsequent reports from most other software providers, Confluent is forecasting less revenue growth deceleration and a marked improvement in operating margin.

This momentum may well provide investors with a favorable set-up going into 2024. Looking to next year, we could have a situation in which Confluent is growing at 30%+ revenue with positive operating margin. The stock appears fairly valued now, implying that further price appreciation could increase proportionally to revenue growth.