Tag: CFLT

After delivering favorable results in Q1, Confluent continued on largely the same trajectory in Q2. Sequential growth rates even imply stabilization around 30% annually, after almost 2 years of deceleration from Covid highs. This growth is being led by rapid adoption of Confluent Cloud, with the licensed Confluent Platform offering for on-premise deployments demonstrating surprising resiliency as well.

The other factor providing support is a sharp improvement in profitability measures, with Non-GAAP operating margin increasing by 25 points year over year from -34% to -9%. The company expects operating margin to reach break-even by Q4. Free cash flow is following a similar path. Profitability was helped by an 8% headcount reduction in January, which notably doesn’t appear to have impacted growth.

Confluent’s recent revenue outperformance has been driven by customers exceeding their commitments for Cloud service usage. While customers may be limiting the size of future contractual obligations (reflected in RPO), engineering teams are choosing to allocate more spend to Confluent as the quarter proceeds. To me, this signals the value customers are extracting from the Confluent Cloud product, as they willingly spend more than they had budgeted.

This may reflect the larger overall theme that enterprises are scrambling to improve their data processing infrastructure in anticipation of leveraging AI to create new offerings for their customers, employees and partners. While the expected benefits from AI are still unfolding and enterprises are largely in proof of concept mode, it is generally understood that effective AI requires good data.

Quality data as an input for AI and ML processing isn’t new, but the priority has been increased. This translates into more focus on consolidation, filtering, cleansing and categorization of silo’ed data stores. Data recency is also recognized as an advantage, which is creating a greater push towards real-time data distribution. It is this focus on reaching more data and delivering it in near real-time that is served by Confluent.

As other software infrastructure companies are experiencing rapid drops in NRR, Confluent appears to be holding up well. While they don’t share the actual values, management reported that overall NRR is still over 130% and for Cloud it exceeds 140%. These are pretty remarkable numbers in this IT environment for a product that is approaching an $800M annual run rate.

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.

Confluent stock recently bounced off its 52 week low, yet still trades under the closing price from 2022. This is in spite of posting strong results in their Q3 report in early November, which drove an 11% after-hours pop. More broadly, Confluent is part of a basket of companies that provide enterprises with software infrastructure and services to power their digital experiences. Entering 2023, we see pressure on this basket, associated with concerns around the durability of growth. This effect, along with lingering headwinds from the path of interest rates and macro volatility, has ratcheted down expectations for the software infrastructure basket.

As we consider the possibility of these macro headwinds starting to abate in 2023, growth investors have the opportunity to shift into stock picking mode. The goal is to identify companies that have the potential to outperform muted growth projections for 2023, stemming from an expectation for lower IT investment after a surge of cloud spending over the last two years. While some areas of enterprise IT investment will likely moderate, I think other functions could see a re-acceleration of demand as we exit this year.

Harnessing data to drive efficiencies in enterprise operations, supply chain management and curated customer experiences is one that I see as ripe for further investment. While every consumer-facing business has an app at this point (long couched as “digital transformation”), I am looking forward to the next wave of growth where businesses must instrument every corner of their operations and leverage the data collected to improve efficiency, lower cost and drive competitive advantage. Let’s call this data transformation. New capabilities in IoT, real-time streaming, parallel processing and data mining are converging. Advanced AI models are facilitating algorithms that can automate decision making and produce better work products. Labor shortages will reward businesses that can streamline more of their daily operations and lower cost.

Occupying a critical step in this emerging data-enabled business paradigm is Confluent. With the leading platform for data streaming, Confluent is well positioned to capitalize on the shift from uni-directional consumer and business interactions to multi-directional coordination between all participants (humans and devices) in an industry ecosystem. As the majority of data creation shifts from human activity to device activity, data volumes will explode, requiring better systems to distribute it from many producers to many consumers.

In this post, I will examine some of the emerging trends in harnessing a data-driven economy, how Confluent fits into that and the business opportunities available. I will then review how Confluent has executed against this backdrop and whether it represents the best way for investors to capitalize on this second wave of data (not digital) transformation.