CFLT - Confluent's Uncertain Path Amid Rich Valuation

2023-09-20 10:56:29 ET

Summary

• Confluent is a data-driven software company specializing in Apache Kafka-based solutions, including their new platform, Kora, offering 10x performance improvements.
• While Confluent's revenue growth rates remain strong at around 30%, concerns arise due to the company's rich valuation, priced at 12x forward sales.
• The significant portion of stock-based compensation in Confluent's expenses raises questions about profitability and keeps me cautious about going bullish on this stock for now.

Investment Thesis

Confluent ( CFLT ) is a data-driven software company. Confluent's platform has been built on top of Apache Kafka, an open-source technology, to increase Apache Kafka's functionalities. And now, Confluent is introducing Kora, a platform that delivers 10x the performance of Kafka.

There's plenty to like about Confluent, a high-growth story that is cutting its way towards non-GAAP breakeven profitability. But at the same time, I find its valuation rich, with a stock that's priced at 12x forward sales. Consequently, I'm sticking to the sidelines here.

Rapid Recap

In my previous analysis titled , Confluent: On the Rise, But Timing is Everything , I said,

I believe that Confluent has what it takes to deliver a positive surprise and upwards revise its 2023 guidance. However, given that in the past few months, its stock has already re-rated substantially higher, I don't see much reason at this point to turn bullish on this stock.

My thesis is clear, I'm not bullish or bearish on this stock. I assert that something further is needed to galvanize this share price to move higher.

The company is making significant progress toward improving its underlying profitability. But at the same time, it's difficult to make the case that the stock is not already richly valued .

Confluent's Near-Term Prospects

Confluent's platform is designed to enhance operational efficiencies through data-driven processes. It empowers users to efficiently handle and analyze large-scale real-time streaming data. Its core advantage lies in facilitating data-driven decision-making for businesses by leveraging their own data.

Confluent is a company that specializes in a platform built upon the foundation of Apache Kafka, an open-source technology, to extend Apache Kafka's functionalities.

In essence, Confluent provides users with the capability to process data streams to uncover valuable insights.

Moving on, the one problem with paying a high premium for a growth stock is that every aspect of it must be sizzling strong. It must be blemish-free.

As you can see in this graphic above, Confluent's customer ARR appears to be decelerating with the passage of each quarter. That's not to say that it can't soon stabilize around the mid-30s% marker, it can. But so far, it appears to be moving steadily in the wrong direction. And when investors are asked to pay a high premium on a growth stock, it can't leave any room for uncertainty.

Next, Confluent's strategy revolves around redefining the landscape of data streaming with a clear focus on innovation and customer-centric solutions. Central to this strategy is the introduction of Kora, a new engine powering Confluent Cloud. Confluent believes that Kora offers a 10x advantage in performance at a remarkable 60% reduction in total cost of ownership ("TCO").

Beyond Kora, Confluent's strategy is built on five fundamental capabilities: streaming, connecting, governing, processing, and sharing data. These capabilities capture the entire lifecycle of streaming data, from acquisition and processing to utilization, management, and sharing across systems.

By strengthening each of these capabilities, Confluent creates a unified platform that drives efficiency, accelerates development, and enhances data governance for its customers. The connectors, stream governance, stream processing, and stream sharing features all play vital roles in this comprehensive strategy.

Here's Confluent's value proposition: they empower businesses to harness the potential of their data. Whether it's through superior performance with Kora, the seamless integration of connectors, robust data governance, real-time stream processing, or inter-organizational data sharing, Confluent declares that it offers the tools and capabilities needed to unlock insights and drive actionable decisions using data.

Accordingly, Confluent's strategy centers on innovation and performance. Kora is an example of this, with its comprehensive set of capabilities and high performance, Confluent enables organizations to thrive in an increasingly digital world where data is the lifeblood of modern business, with the goal of propelling its customers toward superior insights.

Revenue Growth Rates Are Still Strong

I'm inclined to believe that Confluent could stabilize its revenue growth rates at 30%. Here's my thinking, if Q2 2023 saw Confluent's revenues grow by 36% y/y, despite the really high hurdle with the prior year, this implies that there's a high likelihood that Confluent can continue to grow at 30%, as the comparables are now getting significantly easier.

What's more, this line of thinking extends into 2024, as Confluent comes around to the comparables with this year. This means that for all intents and purposes, this growth story remains fully intact. Now, let's get to the blemish on this stock.

Valuation Remains an Overarching Concern

Presently, Confluent is being priced as a high-growth story, which it is. But where it comes up short, is that its underlying profitability, in the best case, will be at breakeven by the time Confluent exists this year.

On the other hand, the obvious consideration that stands out here, is that nearly 50% of Confluent's revenues are made up of stock-based compensation.

And as of its latest quarter, stock-based compensation was up 34% y/y. In other words, there doesn't appear to be much leverage to be found in its cost structure, given that to grow its revenues by 36% y/y, its stock-based compensation was up 34% y/y.

I won't go as far as to declare that this is a particularly bad offender, after all, that's just the cost of investing in these high-growth SaaS businesses. But it's far from priced at a particularly attractive valuation.

The Bottom Line

I'm feeling a sense of uncertainty when it comes to Confluent. On one hand, it's a high-growth company making strides toward profitability. They're introducing Kora, a platform promising a significant performance boost over Kafka.

However, the stock's valuation seems quite rich at 12x forward sales. So, I find myself hesitating.

Altogether, I'm not convinced it's time to go bullish just yet. The company's revenue growth remains strong, and it appears they can maintain a 30% growth rate. However, the lingering concern is profitability, as it may only reach breakeven this year.

Furthermore, stock-based compensation makes up a substantial portion of their expenses, and that's a concern. So, I'm not entirely bearish, but there are enough uncertainties to keep me on the sidelines for now.

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