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Confluent: A Reasonably Valued Growth Stock

Are you an entrepreneur? If so, you’re familiar with the notion of an “elevator pitch.” Be able to explain your business venture to someone in the time it takes for an elevator to move 10 floors. Investors should be able to do the same. We’re holding Confluent (CFLT) stock because the growth of AI doesn’t just demand lots of good clean big data, it also requires that data be processed at the speed of business. Confluent’s data streaming platform for enterprises makes this happen.

When we inevitably arrive at a world where everything has a digital twin, then all that data exhaust needs to be processed as it’s being generated. The sooner you can turn data into information and make it actionable, the more efficient everything will become. Today, we’re checking in with a company that provides some exposure to “the metaverse,” a future where everything is replicated in a digital world.

The Year-End Earnings Call

One thing we like about Snowflake (SNOW) is their consumption-based pricing model. If, as they say, big data will grow exponentially, then we’d prefer to have direct exposure to that growth via usage as opposed to linear growth tied to subscription revenues. Confluent’s latest earnings call highlighted three talking points, starting with their “transition to a fully consumption oriented business,” and then moving on to how they’re now “unifying data streaming with Kafka with stream processing via Flink.” In other words, they’re broadening the appeal of their platform by targeting a platform with a million downloads (Flink) being used by marque names like Apple, Capital One, Netflix, Stripe, and Uber.

Confluent describes the popularity of Flink as “the best engineers picking the best technology.” The company expects “material revenue contributions from Flink to happen in fiscal year 2025.” Lastly, they talk about how “the next wave of generative AI applications” is driving demand for streaming data services with OpenAI signing up as a client late last year “to improve their visibility into customer usage patterns.” While generative AI chatbots seem to have data limitations (they often have a training cutoff date), one can assume that eventually they will need to gather insights in real time to truly add maximum value.

Apache Kafka and Flink are the critical links to fuel machine learning and artificial intelligence applications with the most timely and accurate data. 

Shaun Clowes, Chief Product Officer at Confluent

The Importance of Retention

We’ve grown to really like software-as-a-service (SaaS) companies. Regardless of what they do, the same set of metrics are applicable. You don’t need domain expertise to analyze these complex software offerings. They also provide predictable revenue streams that can easily be monitored and valued. Should shares become too depressed, usually a shark will come around and gobble them up. That’s why solutions that can be used across all cloud vendors are desirable, and IBM’s pending acquisition of HashiCorp (HCP) is a good example.

Our last piece on Confluent – An Annual Checkup for Confluent Stock – looked at how their solution competes with the three largest hyperscalers but also supports them as well. The recently published Forrester Wave diagram seen below lists Confluent, Microsoft, and Google as leaders in the data streaming space.

Streaming Data platforms
Credit: Forrester

As more organizations move to multi-cloud they’ll be looking for tools that work across all vendors. The truest measure of Confluent’s resilience in the face of competition and “ye ole macroeconomic headwinds” would be retention, both gross and net. Same as last year, we’re told that gross retention rate is “above 90%” which isn’t reassuring. While Confluent says this is “very strong,” it isn’t. Gross retention rate should always be in the high 90s.

In other words, up to 9.99% of Confluent’s clients didn’t renew their contracts last year. Multiple analysts on the earnings call probed whether clients were “downgrading” from Confluent’s solution to opensource Kafka (the free-to-use platform that Confluent is based on) and management said they monitor these metrics and they’re not a problem, especially in light of their new consumption-based pricing model. With over 100,000 organizations using Kafka including over 80% of the Fortune 100, these could all be future clients that eventually upgrade to the freemium Confluent Platform because of the additional value it offers.

Infographic comparing Confluent and Apache Kafka
Confluent offers a freemium platform that lends itself to large enterprises – Credit: Nanalyze

In other words, you can go at it alone with bare bones Apache Kafka or pay Confluent for support, better performance, and added functionality & security (timely security patches anyone?). You get what you pay for, and plenty of companies are willing to pay experts as opposed to managing a data streaming platform in house. Confluent currently has nearly 5,000 paying customers, so about 5% of all Apache Kafka users or 1.4% of the $60 billion total addressable market (if you believe the company’s estimate).

Once a client adopts Confluent’s platform, they’ll likely extend usage throughout their organization as they realize the value of data streaming. Increasing spend over time is referred to as “net retention rate” or NRR which, for Confluent, is “slightly above 125%” which is about average for a SaaS firm. These days, we see lots of SaaS companies with declining NRRs based on macroeconomic headwinds, so being “average” is actually quite good. We’re told to expect that number to fall to 120% through this year as they transition to a consumption-based pricing model and enter next year back above 125%.

Growth and Guidance

If you’re selling something disruptive, you should be seeing strong revenue growth. Confluent says they’re “confident in delivering 22% total revenue growth for 2024 and eventually returning to our mid-term target growth of 30%.” Perhaps that coincides with the “material revenue contributions from Flink” expected to happen in fiscal year 2025. One hopes the move to consumption-based pricing will eventually lead to more growth than subscriptions alone.

Going forward, Confluent will provide guidance based on subscription revenues which constitute about 95% of total revenues. The other 5% is “Services” which has been declining over time as a percent of the total. As for survivability, Confluent hit positive operating cash flows for the first time this past quarter. That means they’re adding to the $1.9 billion cash stockpile on their balance sheet. Just bear in mind that’s offset by about $1.1 billion in 0% convertible senior notes due 2027 with a strike price around $100 a share. If shares trade above that, the lender may require $1.1 billion worth of stock or 11 million shares. Based on outstanding shares of 311,511,542, the dilutive effects of this transaction would be minimal. Alternatively, Confluent will either need to pay the $1.1 billion back in 2027 or refinance the debt.

Also worth noting is the change in compensation for salespeople that’s now entirely driven by increasing spend with existing customers.

A recent change in Confluent’s go-to-market sales process could be a catalyst for the cloud business. Today, 100% of a sales rep’s cloud compensation is based on incremental consumption and new logo acquisition versus just 10% to 15% previously. 

Credit: Forbes

Slackers don’t like pay-for-performance environments while BSD salespeople love engagements where there’s unlimited upside.

Confluent’s Valuation

We first looked at the appeal of real-time data analytics solutions back in 2021 when Confluent was a $20 billion company. Today, they’re less than half that size with a market cap of $8.8 billion. That translates to a simple valuation ratio (SVR) of 10.5 which is below their historical average of 11.

Line graph showing Confluent's historical simple valuation ratio (SVR)
Credit: Nanalyze

Compare the 22% growth Confluent expects this year to what Snowflake and Palantir are guiding towards – growth of 22% and 19% respectively. You’re paying a lot less for Confluent’s growth that’s being driven by the two key drivers we want exposure to when investing in any of these firms – AI and big data. Snowflake and Palantir have much higher SVRs – 17 and 21 respectively – while Confluent enjoys a lower relative valuation at 10.5 (though still higher than our tech stock catalog average of around 6.5).

Conclusion

AI algorithms are only as good as the big data you feed them. Once they’re capable of making consistently competent decisions without hallucinating, decision-makers will demand these decisions are made faster. Analyzing streaming data will be a foundational feature for “the metaverse,” a future scenario where all equipment, factories, and even companies are replicated as digital twins so they can be fully analyzed by AI algorithms. Confluent continues to show strong performance in the face of macroeconomic headwinds and hopefully, we’ll see a resumption to 30% growth next year as their support for Flink comes online.