CFLT - Confluent: Q4 2022 Results Reinforce My View On The Stock Upside

Summary

• The market of data-in-motion where CFLT operates is becoming more attractive to IT budgets. CFLT is in its early stages and has a long runway for growth.
• I expect the cloud component to grow to more than 50% of revenue in the near future.
• CFLT 4Q22 results were largely in line with its pre-announcement on 26 January 2023.

Summary

I still recommend purchasing Confluent ( CFLT ). My opinion on CFLT has not changed since I first wrote about it. The 4Q22 numbers back up my claim that the market in which CFLT competes, data-in-motion, is gaining prominence as an investment target for IT departments. I believe CFLT is still in its infancy and there is a great deal of room to expand both within its current customer base and in greenfield opportunities. The growth of the company is being supported by the increasing usage of cloud on the platform, as it makes up more than 35% of the company's total revenue and is responsible for the majority of its new ACV. Over the next few years, I see cloud adoption increasing and Confluent Cloud's share of the market expanding to more than 50%. That said, the shift toward cloud-based revenue generation could cause short-term fluctuations, in my opinion, due to less in-period revenue recognition and the impact of on-demand arrangements on reported ARR and NER. Although it is still unclear how the macro environment affects the uptake of paid offerings, I believe that Confluent is well-positioned to reap the benefits of the high developer approval ratings and pervasive adoption of Apache Kafka in the business world.

Earnings overview

The fourth quarter 2022 results for CFLT were in line with its pre-announcement on January 26th, 2023. Despite the fact that investors are probably still debating the deceleration in RPO growth and the duration of deal scrutiny, it gives me great comfort to know that the company's expansion was underpinned by an increase in Cloud revenue, which accounted for 70% of the net new ACV. Not only did contract duration and win rates remain stable during the quarter, but early indications are that this trend will continue, as deals that were delayed until the fourth quarter have already been finalized. There may be added pressure on Platform revenue (which includes a portion of upfront revenue), but I anticipate that CY23 Free Cash Flow margins will improve similarly to operating margins.

The recent layoffs at CFLT and the improvement in unit economics for its Cloud offering are supporting an expedited profitability timeline. I believe this is essential if the company is to be prepared to keep up its 30% growth rate once the economy begins to show signs of a recovery.

Earnings details

Total revenue for 4Q22 was $169 million, up 41% year over year for CFLT, with growth coming primarily from subscription revenue of $155 million, up 44% year over year. Revenue from subscriptions continues to rise rapidly, led by Confluent Cloud, which now accounts for 41% of total revenue and is expanding at a rate of 102%. Platform sales increased by 17%, with the rise in hybrid cloud use cases being a major factor. I also kept an eye on these other crucial indicators:

1. The number of customers with over $100,000 in ARR increased by 35%, to 991. This represents a sequential gain of 70 customers
2. With 20 new customers adding over $1 million in ARR, this is a significant increase from the 6 added in 3Q22
3. Despite a slowdown in Platform contracts due to a more challenging demand backdrop, the dollar-based Net Retention Rate for cloud and hybrid remained above 130%

One striking aspect of these financials is that management has lowered the high end of top-line guidance for FY23 by $5 million from its 3Q22 projections. This is largely attributable to the continuation of deal extensions and the adoption by businesses of more stringent budget scrutiny practices. Earnings-wise, Cloud continued its upward trend, making up 70% of net new ACV for the fifth consecutive quarter. Because of its scalability and pay-as-you-go nature, I believe Confluent Cloud will continue to be a revenue generator in the future.

The continued proactive management of expenses, the initiatives to increase productivity and efficiency, and the disciplined approach to investments all contributed to CFLT's non-GAAP operating margin coming in at 21.5%, which is better than the 25% and 41.6% expected by consensus. Importantly, CFLT has moved up their target quarter for non-negative adjusted operating margins from 4Q23 to 3Q23.

Reorg

CFLT has announced that CRO Larry Shurtz has resigned; in my opinion, this was a voluntary decision on his part. As far as I'm aware, the President of Field Operations will now oversee the theater sales leaders instead of Larry. Additionally, CFLT stated that it has no plans to hire a replacement chief revenue officer, effectively cutting out a level of management from the sales department (which can be a good thing as it reduces a layer of complexity). Also, by the end of 2023, CFLT hopes to have between 55 and 60 percent of its sales force fully ramped.

RIF done, focus is on high growth now

The 8% RIF announced by CFLT last week was done so as to maintain the company's current high growth glide path and boost efficiency and profitability, the company said. Management has stated that S&M has had the greatest impact in terms of headcount, but that this has been directed primarily at people who are not quota carriers or who are low performers within quota carriers.

Valuation update

I believe the current market price still presents a decent entry point for investors to enjoy very attractive IRR over the long-term.

Key updates to model:

1. Sales: FY22 sales adjusted to reflected reported figures, which slightly impacts exit revenue figure in FY27.

Conclusion

The 4Q22 numbers back up the claim that the data-in-motion market is becoming a more visible investment within IT budgets. Because of its infancy and the size of its potential market, CFLT has a great deal of time to expand; the widespread adoption of cloud computing will undoubtedly contribute to this. More than 35% of current revenues come from the cloud, and I anticipate that share to rise to over 50% in the near future. There may be some short-term uncertainty, but I think CFLT is poised to take advantage of developer enthusiasm, Apache Kafka's popularity, and strong secular growth drivers.

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