Finally, the stock is starting to reflect the value of Confluent (NASDAQ:CFLT) business. I first wrote about the business last December when it was priced at $23.01 with an expected upside of 157%. While the stock was rangebound for 1H23, it has finally inflected, rewarding investors that followed my recommendation at 50% upside so far. Recent results have led me to reiterate my previous recommendation to buy CFLT. The data-in-motion market, which CFLT serves, is becoming an increasingly attractive option for allocating IT resources. Despite being in its infancy, CFLT has enormous growth potential, both among its existing clientele and in as-yet-untapped markets. The rising popularity of generative AI lends credence to this growth potential and may even drive the market forward. The majority of CFLT ACV comes from customers using the company’s cloud-based platform. I believe that CFLT’s robust growth momentum will be maintained by the ongoing shift towards cloud adoption. I think CFLT has a good chance of succeeding in the long run thanks to a number of factors, such as its popularity among developers, the widespread adoption of Apache Kafka in business, and the robust secular growth drivers in the industry. Moving forward, I believe the catalyst for the stock to reach my target price is to show a viable path to generating profits, especially FCF (which should reach breakeven in FY24), while continuing to grow at a healthy rate.
Performance momentum is strong
Growth continues to be very strong for CFLT with subscription revenue growing 41% and is now 92% of total revenue. It is crucial to note that key growth indicators continue to point to the continuation of CFLT’s growth momentum. Examples include the 35% increase in RPO seen in 1Q23 and the 44% increase in cRPO (which accelerated from the prior quarter). In my opinion, these are a clear indicator of how the business is likely to perform in the near-term. Adoption of AI is a blessing to the company because the technology accelerates the streaming of data in real time. One possible application of CFLT is to provide real-time information to large language model interfaces, such as chat bots. Aside from the obvious benefits, AI will also make CFLT easier to implement because it will shorten the learning curve for new users of Confluent and Kafka. However, the macroeconomic outlook is still cloudy which I anticipate will lead to erratic consumer spending. Companies are becoming more stringent with their spending policies, which is delaying sales cycles. Despite these obstacles, I am confident that the need for data streaming solutions will only grow in the coming years. Eventually, I think we’ll get back to normalcy after all these macro issues have been resolved. Importantly, management also reaffirmed their FY23 revenue guidance of $760 to $765 million which says a lot about what management is seeing in the pipeline. However, I agree that the stock’s performance could be affected by the short-term volatility in performance, as some investors could be scared off. For instance, management has reduced its CFLT cloud revenue mix guide from over 50% in FY23 to 48-50%, citing lumpiness in the Confluent Platform revenue rather than cloud-related pessimism as the reason for the reduction. The rational investor, I imagine, would chalk this up to the deteriorating macro environment, but some would see it as a sign of weakness and dump their shares.
Weak macro might be net positive for CFLT
Speaking of the macro environment, I think the situation is not as bad as I would have thought. While it is true that the uncertain macro has forced many businesses to scrutinise deals, thereby elongating the sales cycle, the fact is CFLT also benefits from this. Keep in mind that CFLT has Kafka, which gives them access to a user base that can be easily converted into growth drivers without requiring any net new software projects. In addition, I’d like to point out that, according to the company’s management, paying for access to the CFLT Cloud is more cost-effective than making use of Kafka, according to management in the JP Morgan Global TMC conference. In particular, management mentioned that Michelin ran a TCO analysis contrasting Confluent cloud and DIY, and that the former yields 35% greater savings than the latter. This is some fresh information that I found very interesting. In the Piper Sandler 2021 Global Tech Virtual Conference, management revealed that one customer had reverted back to Kafka in an effort to cut costs, which bolstered my belief, previously, that the open-source version is more affordable. With this new information, my belief has change, especially with management highlighting the significant financial benefit of using Confluent Cloud to run a widespread confluent cloud infrastructure. What this tells me is that it is less likely that large customers will revert back to open source as the cost savings don’t make sense and it is not worth the time to rewire/recode everything. In fact, I now believe that this uncertain macro environment might force some customers (that are growing fast) to make a decision to migrate to Confluent Cloud. While such customers might not make the decision to switch today, I believe it is something they are starting to consider and is likely to switch when the macro environment gets better.
As per what I have written in my previous post, CFLT competes with major public cloud providers including Amazon Web Services (AMZN), Google Cloud Platform (GOOGL), and Microsoft Azure (MSFT)in the middleware and data management areas. Confluent’s future prospects could be harmed if the industry becomes more competitive or if rivals are able to successfully reproduce the company’s core capabilities.
The recent performance of CFLT stock is finally reflecting the value of the company’s business, and I continue to reiterate my buy recommendation for CFLT. The data-in-motion market continues to be attractive for IT resource allocation, providing significant growth potential for CFLT. I believe the ongoing shift towards cloud adoption is going to continue driving strong growth momentum. Importantly, CFLT is well-positioned to capitalize on factors like developer mindshare, widespread adoption of Apache Kafka, and secular tailwinds. Despite potential short-term volatility, the long-term demand for data streaming solutions remains promising.