CFLT - Confluent: Decision-Making Software Look Ahead

2023-04-19 16:19:28 ET

Summary

• Confluent, Inc. puts companies' data at the center of their decision process. Confluent takes ''always-on'' data and provides insights to its users.
• Confluent's growth rates are strong, that's not the main issue here.
• The problem for investors is that Confluent, Inc.'s valuation leaves absolutely no margin of error.

Investment Thesis

Confluent, Inc. ( CFLT ) provides a platform for businesses to unlock insights from their siloed data. All companies have data that's held throughout the organization. But how to unlock their data to inform decision-making? That's what Confluent is attempting to deliver.

The problem is that, for now, beyond a very tightly woven, and dare I say compelling , narrative, Confluent's underlying profitability remains a critical issue for why I'm not backing this stock.

The idea that a company's own data is siloed and if unlocked can be extremely valuable isn't new. What Confluent has to ensure is that can successfully capture enough profitable market share to support its valuation.

Why Confluent? Why Now?

Confluent's platform drives data-driven operational efficiencies. Its value proposition stems from enabling businesses to make decisions using their own data.

Undoubtedly, the appeal of its platform to customers is that companies can utilize all their own data layers to derive insights. Customers are able to get ahead of the required action, by understanding what the data is instructing users to do and fully connecting the data a company holds to inform their decision-making process.

Confluent puts the data in the driving seat of companies' operations, by allowing software developers to build their applications to harness data that's ''always-on'' to drive intelligent and efficient backend operations.

Next, let's dig further into some nuances of the investment thesis.

Revenue Growth Rates Likely to Improve in Back Half

The good news here is that Confluent's Q1 2023 is expected to beat 30% CAGR, and since that's the toughest quarter to compare against, that should mean that there's ample room to upwards revise its full-year 2023 revenue guidance.

The bad news is that Confluence has previously guided that its long-term target for its dollar-based net retention rate was greater than 130%. However, Q4 2022 saw this figure dip slightly below this target.

Given that in Q4 2022, the macro environment was still relatively benign for the IT sector, I believe this could be a considerable headwind for Confluent. Nothing overly dramatic, but still something that's important to keep an eye on.

Next, let's get to the core of the reason why I'm not chasing this stock.

Understanding Confluent's Profitability Prospects

The graphic that follows shows Confluent's segment breakdown.

What you see here is that just under 10% of the business comes from its Services segment. And that segment is a money-losing, revenue-leading operation that produces negative 14.5% gross margins.

That's quite a dramatically negative gross margin profile, which has implications for Confluent's cash flow profile.

As you can see above, Confluent's free cash flow margins are squarely around negative 30%. Needless to say that this doesn't even factor in stock-based compensation, which would substantially exacerbate its negative free cash flow profile even further.

The Bottom Line

Confluent's technology provides a platform to take data from the fringes of the business to the center of the decision-making process.

I believe that H2 2023 is being very conservatively guided and Confluent, Inc.'s management has left itself ample room to positively beat revenue expectations and even upwards revise Confluent's full-year outlook. And yet, I simply can't get past how unprofitable the business finds itself.

As I look ahead to 2023 as a whole, in the best case, Confluent will report around $100 million of heavily adjusted non-GAAP losses. Yes, Confluent does have a squeaky-clean balance sheet . And yes, its multiple has already come down significantly compared to the high price of its IPO.

But I struggle to muster up the enthusiasm and conviction to pay more than 9x forward sales for this cash-burning business. For similar multiples, I can get so many better established and highly profitable SaaS businesses. Indeed, why should I part with my hard-earned capital on Confluent, Inc. stock?

The point of investing is not to back the most alluring narratives of the future. The point of investing is to deploy capital today with a high likelihood that the investment will not lead to a capital impairment. I'm not convinced that this is what Confluent, Inc. offers me. All the best, Michael.

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