CFLT - Confluent: Reiterate My Buy Recommendation As CFLT Continues To Deliver Growth

2023-08-18 10:43:26 ET

Summary

• Confluent's revenue in 2Q23 exceeded expectations, driven by strong subscription revenue from Confluent Platform and Confluent Cloud.
• I expect Confluent to sustain growth of at least 30% in the near term, supported by the strength of Confluent Cloud.
• The market is recognizing Confluent's potential, as evidenced by the positive response to its 2Q23 results and the stock's performance.

Summary

Readers may find my previous coverage via this link . My previous rating was a buy, as I believed Confluent (CFLT) would continue to see robust growth momentum, maintained by the ongoing shift towards cloud adoption. As the business continues to show a viable path to generating profits, especially FCF, the stock price should start to move upwards. I am reiterating my buy rating, as I expect CFLT to continue growing at >30% for the foreseeable future, driven by strength in Confluent Cloud. Valuation is also well-supported by the strength in growth and FCF improvements.

Financials/Valuation

CFLT's revenue of $189 million in 2Q23 was well above the $182.4 million that consensus had expected. Subscription Revenue from both Confluent Platform and Confluent Cloud was a major contributor to the revenue growth. In terms of profits, non-GAAP EBIT came in at -$17.3 million, beating consensus estimates of -$29.3 million. At the rate that CFLT is growing revenue and EBIT margin expansion, it should not take the business too longer before it reaches EBIT breakeven. Non-GAAP EBIT margin stepped up from -23.1% in 1Q23 to -9.2% in 2Q23, ~14pts jump. Assume margin expands at half the rate for the coming quarters, CFLT should start generating positive non-GAAP EBIT in 2 quarters time. However, FCF fell short, coming in at -$35.3 million vs. the consensus estimate of -$19.2 million. That said, FCF did improve sequentially from -$82.9 million in 1Q23 and -$36.9 million in 2Q22.

Based on my view of the business, CFLT should have no issues continuing to sustain growth of at least 30% over the near term. This is consistent with my previous model, as the 2Q23 results showed evidence that growth is still strong, especially the strength seen in Confluent Cloud. I have increased my valuation multiple assumption from 7.4x to 10x as CFLT has continued to deliver growth, which the market is clearly appreciating given the share price action and rerating of multiples. This multiple compares well to other high-growth infrastructure peers like MongoDB (MDB), Snowflake (SNOW), Cloudflare (NET), Datadog (DDOG), Zscaler (ZS), CrowdStrike (CRWD), HashiCorp (HCP), and SentinelOne (S). Given the similar high-growth nature profile, I believe CFLT should continue to trade in line with these peers (the median forward revenue multiple for peers is 10x).

Comments

I believe that the 2Q23 results validate my claim that the market in which Confluent competes, data-in-motion, is gaining prominence as an investment target for IT departments. With subscription revenue up 39% and Confluent Cloud up 79%, it's clear that CFLT is still in its infancy, lending credence to my claim that the company has a long runway for growth, both among its current clientele and in greenfield markets. While there is no virtual way to size the exact TAM expansion driven by the proliferation of generative AI, I would assume the impact to be of sizeable magnitude. One example listed during the call was with Recursion, and CFLT handles more than 23 petabytes (which is a lot of data) of real-time data for Recursion in order to improve the prediction of their models. Management also mentioned that they are seeing more customers come to them to ask about AI-oriented use cases. As such, I believe the TAM has significantly expanded for CFLT, further reinforcing my long-term outlook for the business.

Yes, yes, we've definitely started to see that come up a lot more in our customers, kind of more traditional machine learning was there as one of the driving use cases for a long time. And now, this has become a very significant topic of interest for customers, a lot of experiments happening. So yes, I think that's very promising for us ( 2Q23 earnings )

The results as a whole are positive, and the key metrics I'm tracking are progressing in the right direction as well. A growth rate of 79% for Confluent Cloud suggests that the platform's cloud users are driving the majority of the company's expansion and adding significantly to its net new ACV. I anticipate that Confluent Cloud will become the largest component of CFLT revenue as cloud adoption continues its rapid ascent. If the trend continues, Confluent Cloud subscriptions will account for well over 50% of total revenue in a couple of quarters. From that point on, I think the market will be convinced that CFLT's growth strength stems from Cloud adoption. The strong growth and expanded profitability trickled down to an improvement in FCF again, which I continue to view as the key catalyst for the stock to soar further. And I think the market is gradually waking up to CFLT's potential upside, as the stock was up more than 10% after the 2Q23 results.

I believe there is also a chance for CFLT to see growth accelerate in FY24 and FY25 when the economy recovers (hopefully). If we look at the current macro environment, it definitely has some sort of impact on CFLT's ability to convert customers (customers delay such activities to save costs) and up-sell (customers scrutinize budgets, leading to a long sales cycle). While we cannot quantify them, these headwinds do exist, as we have heard from other software companies. I see these headwinds as short-term issues, and once the economy recovers, they should ease. In the long run, I believe CFLT is strategically positioned to benefit from high levels of developer confidence, widespread adoption of Apache Kafka within enterprises, and robust secular growth drivers.

Risk & Conclusion

Amazon Web Services (AMZN), Google Cloud Platform (GOOG) (GOOGL), and Microsoft Azure (MSFT) are just a few of the major public cloud providers that Confluent competes with in the middleware and data management spaces. The future of Confluent could be jeopardized if competition in the industry increases or if competitors learn how to effectively replicate the company's core competencies. Given these are large players with strong balance sheet and deep technical expertise, this will always be a risk.

In conclusion, my buy recommendation for CFLT remains as the company's growth trajectory persists. The strong revenue performance in 2Q23, notably the Confluent Cloud's 79% growth, underscores CFLT's growth potential. The evolving landscape of AI-driven applications and expanding TAM bolsters its long-term prospects. The market is increasingly recognizing CFLT's potential, as shown by the stock's positive response after 2Q23 results. While short-term challenges exist due to the macro environment, CFLT's strategic position it for sustained growth, making it a compelling long-term investment.

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