CFLT - Is Confluent Stock Overvalued? Don't Be Fooled

2023-08-24 14:35:03 ET

Summary

• Confluent has a strong revenue growth and is well-positioned to capture the data streaming market.
• The company's gross margin has improved and it is expected to break even at the operating margin level in Q4-2023.
• The US market and the company's ability to attract new customers are potential risk factors to consider.

"Buy" Case Investment Thesis

Confluent ( CFLT ) has performed well in 2023 and stock prices are up significantly by 49%. Due to this, it is trading at 11 times sales, compared to 2.78 times the sector median. Investors might ignore Confluent at current prices as it is overvalued compared to sector multiple. However, in-depth analysis of the addressable market for Confluent is attractive, which is supported by strong projected revenue estimates and break even at operating earnings level by Q4-2024 are worth considering in investment analysis. Furthermore, Confluent is working on changing the business model by focusing more on the cloud segment, resulting in margin expansion. In summary, Confluent can be a good bet provided management achieves its business long term targets.

Confluent's Platform is a full-fledge data streaming platform that enables customers to easily access, store, and manage data as continuous, real-time streams. Today, over 80% of the Fortune 100 are powered by data streaming technology – and the majority of those leverage Confluent.

Stock Catalysts

1. Confluent Operating in the Rapidly Growing Market

I believe the market opportunity is significant, demonstrated by the total addressable market of Confluent which is approximately $60 billion in Q2-2023, in comparison to, last twelve, month revenue for Confluent was $684 million. The TAM is projected to increase by 19% CAGR (2022-2025) to $100 billion by 2025. The increase in TAM is due to a worldwide increase in expenditure on data, software and cloud, and Artificial Intelligence. Confluent full-fledge data streaming platform is capable of connects multiple data integration tools like Applications, Systems and Teams with a shared view of real-time data.

The worldwide increase in enterprise application software and infrastructure software spending by corporates is important for Confluent's growth, as it leads to higher demand for Confluent's cloud and platform for real-time data processing. According to Gartner, the worldwide enterprise application software market will increase to $334 billion in 2023, due to the accelerated move to digitization and the cloud. The market will reach $519 billion in 2027. Also, worldwide infrastructure software spending will increase to $715 billion in 2027 from $441 billion in 2023. The customer expectations for universal, real-time and contextual data requirements increases infrastructure. Here are examples to understand how Confluent is generating revenue:

• A health benefits provider is using Confluent to accelerate claims processing and approval, and internal systems aggregation. Its spending on the platform increased by 10 times between 2018 and 2022.
• Similarly, an online travel provider increased its spending on Confluent by 29 times between 2016 and 2022.

In summary, an increase in consumer demand for real time data streaming will help Confluent to solidify its position in the industry and capture more customers, and increase topline. The main competitors are DocuSign ( DOCU ), Dropbox ( DBX ), Open Text Corporation ( OTEX ) and Manhattan Associates ( MANH ).

2. Strong Topline Growth

In the current economic situation where the technology sector is struggling to increase revenue and in some cases sustaining growth, Confluent has strong revenue growth. It has increased revenue to $585 million in 2022, an increase of 72% CAGR between FY-2018 to FY-2022, due to robust growth from Confluent Platform and Confluent Cloud. During the same period, Confluent Cloud revenue increased by 200% CAGR to $211 million in FY-2022. For FY-2023 , the management projected total revenue at $772 million, an increase of 31% year over year.

The second quarter of 2023 is the ninth consecutive quarter with reported revenue being greater than the guidance provided by management. This shows the significance of the hybrid model of Confluent offering fully managed cloud and self-managed software. The rapid customer growth is a significant stock catalyst which investors should consider in subsequent earnings. In Q2-2023 , the company had 4,830 customers, an increase of 17% year over year. However, more significant is the growth witnessed in customers spending at least $100k per year, which was a 33% increase for 1,144 customers and a 48% increase for customers spending at least $1 million for 147 customers.

3. Position to Capitalize on the Large and Growing Shift to the Cloud Platform

The global cloud computing industry was valued at $569 billion in 2022 & is estimated to increase from $677 billion in 2023 to $2,432 billion by 2030, a growth of 20% CAGR between 2023-2030. The major driver for growth is digital transformation, rising internet consumption and big data. Post COVID, companies prefer to have cloud platforms to demonstrate easy availability of data.

Confluent is heavily investing in its own cloud platform, which can be demonstrated from the shift in revenue mix. In FY-2021, 65% of total revenue was contributed by Confluent Platform and 24% by Confluent Cloud. Due to a change in business model and more focus on providing hybrid services to customers, Confluent has a more balanced revenue mix now. In Q2 2023, 49% from Confluent Platform and 44% were from Confluent Cloud. This shows that Confluent management is changing the business model as per the requirements of the customer and will be able to capitalize on the growing demand for clouds.

4. Driving efficient growth

The revenue growth is insignificant if it does not translate to improving operating margin through efficient cost management. The revenue mix shifts with an increase in revenue stream from cloud result in better margins for the company due to high gross margin for Cloud Platform. The gross margin has improved to 75% in Q2-2023 from 69.5% in FY-2021. Moreover, management is expecting 75%+ gross margin in the long term with 80% cloud revenue. The total operating cost including sales and marketing, general administrative ,and R&D has been reduced in Q2-2023 to 85% compared to 112% in FY-2021, as a percentage of total revenue. However, more significant is the management's long term expectation to reduce operating expenses to 53% as a percentage of total revenue.

Robust revenue and management of cost structure are attributed to expansion of operating margins as well. In Q2-2023, Confluent had negative operating margin of 9% compared to negative 41% in FY 2021, as a percentage of total revenue.

It is worth mentioning that management is expecting to break even at operating margin level in Q4-2023. Furthermore, the mid-term target for operating margin is projected at 5%-10% and the long-term target at 25%+.

In summary, changes in customers, revenue mix, cost structure and margins will have a significant impact on the company's bottom line. We have seen the historical trend and the expected trend for the future. In the next earnings, investors have to closely watch the trend of these expenses to determine operational efficiency.

Risk Factors

US recession: Confluent generated 60% of total revenue in Q2-2023 from the US market. Any drastic change in the economic activity of the US market may have a significant impact on the revenue streams of Confluent.

Revenue Mix: The overall strategy of Confluent management is to transform the revenue mix with 80% cloud-based revenue. However, if it fails to achieve further market adoption, it could impact the long-term targets and operational efficiency.

New customer acquisition and managing existing customers: To achieve long-term targets projected by management, its important to attract new customers or expand potential customer and sales pipeline, otherwise operations will be adversely affected.

My Recommendation: Buy Rating

I recommend a Buy rating for Confluent based on the following factors:

1. I believe the market opportunity is significant for Confluent products, demonstrated by the total addressable market of $60 billion in Q2-2023.

2. In the current economic situation where the technology sector is struggling to increase revenue and in some cases sustaining growth, Confluent has strong revenue growth .

3. Confluent is heavily investing in its own cloud platform, which can be demonstrated from the shift in revenue mix to capitalize on the global cloud market which is, project to increase by 20% CAGR between 2023-2030

4. Margin expansion - The mid-term target for operating margin is projected at 5%-10% and the long-term target at 25%+

Final Thought

The key investor takeaway is that Confluent is a solid company with robust historical revenue growth and projected growth. Confluent is poised to outperform due to gross margin expansion, better management of cost structure and break even operating earnings in Q4-2023. However, investors have to watch closely the impact of new customer acquisitions on revenue growth. In addition, the investor would like to have a management comment on the road map for better margins. We will revisit the post-earnings financial of Confluent and run a detailed DCF analysis on Q2-2023 numbers to find the intrinsic value of the stock.

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