Should You Put Confluent on Your Investing Watch List?

This company focuses on data streams, allowing businesses to connect, analyze, and integrate data in real time. In this episode of Industry Focus: Tech, host Dylan Lewis is joined by Motley Fool contributor Brian Feroldi. They break down why Confluent checks a lot of the boxes in The Motley Fool's investing approach and why the company is going to have to educate the market.

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Confluent started trading after this podcast was recorded.

This video was recorded on June 18, 2021.

Dylan Lewis: It's Friday, June 18th and we're getting together to talk Confluent (CFLT 2.39%). I'm the host, Dylan Lewis, and I'm joined by Fool.com's Co-Chief checkup Commander of Core Cloud Computing Companies, Brian Feroldi. Brian, how are you doing?

Brian Feroldi: Well done, Dylan. Well done. Yet another time where you nailed my title. I need to get my grade off.

Lewis: What do you think of that little pun there? Getting together to talk Confluent.

Feroldi: Dylan, I'm very proud of you for coming up with that all by yourself.

Lewis: I need that validation. I appreciate it so much. Yes, we're talking about another cloud computing company, another business that's going to I think checked a lot of the Brian Feroldi boxes if I'm being honest and we have this one courtesy of one of our listeners Brian.

Feroldi: That's wonderful. Yeah, this is a company that I hadn't heard of before until the S-1 came out. The company we're talking about is Confluent, ticker symbol CFLT. Yet again, whenever these S-1s come out in these tech companies, if it's SaaS-based, I'm always going to take a look and as I was reading through it, I was like, there's a lot I like here.

Lewis: There's a lots of like, shout out to our listeners fan for giving us the heads up on this one, one of the joys of what we get to do is basically have ideas thrown at us by listeners, by members of The Fool, and just get to kick them around and talk about them. Hopefully you guys enjoy listening to it as much as we enjoy doing it because it's one of my favorite things, it's a highlight of my week. Let's get into it, Brian. What are the deeds here?

Feroldi: What we know so far is that the proposed ticker symbol is CFLT. As of right now, they're going to plan on selling 23 million shares at about $33 each. That number could, of course, change. If that pricing holds, they'll be raising about $700 million and they'll come public at about a $7.6 billion valuation. Now, as both of us are reading through this S-1, this is a complicated story to understand so I think it's actually pretty helpful to start with the founding story because that can really set the stage. This company was founded in 2014 by a group of entrepreneurs that were working together at LinkedIn. These three co-founders were in charge of rebuilding LinkedIn's data infrastructure from the ground up to be not only based in the cloud, but you really handled the entire site which was going through hyper-growth at the time. Now, what they found was there were plenty of options existing for storing data, data storage systems have existed forever, databases. But they had a huge problem with allowing that data to talk to each other and unifying it together and making it analyzable. They searched around for an off-the-shelf solution that they could buy for years and they really didn't come up with anything, so they decided to build their own.

Lewis: Yeah, I want to pull specifically from the perspectives here and this is I believe Jay Craft is in the founders letter. What struck us at the time was although there were hundreds of different technologies for storing data, our most acute need was not a problem of storage, what we needed to do was unite all the different applications and data stores that made up a global social network into one coherent system. One that could react and respond continuously and in real-time to everything that occurred across a complex fabric of interconnected software systems. This need seemed like it would be common enough, so we assume that there surely would be some product or technology that addressed it and that we must be ignorant of it but there wasn't, and he goes on to say, "Though this problem was really at the heart of creating a unified digital business, it hadn't received even a fraction of the commercial or intellectual investment that data storage and databases had. When we realized this, we started to build.'' We talk about it often but Brian, a founder identifying a problem, is often a very compelling investment thesis.

Feroldi: It really is. Off the top of my head, I can think of Jeff Lawson at Twilio, he started a company based on a problem that he had, Tobias Lutke at Shopify, he had a problem, he built it. The co-founders of Wix, they were trying to make a website and they built it. All of those have been really successful companies. That's a founding story that I can really get behind. Now, what's interesting about the way that they built this from the ground up is they call this system that they built internally, Kafka, and they ended up making it open source and they donated it to the Apache Software Foundation where it's gone out and really developed a huge number of developers and a community around this product that has really become global. There's tens of thousands of developers that are working on the open source version of Kafka. When they had this software, they realized that there were going to be a whole bunch of companies that needed help not only deploying this software, they didn't necessarily have the skills and that's where the founding of Confluent really came from.

Lewis: Yeah, and just to clarify, we are over the Internet, we're not in the same room. I believe it's Kafka like the writer. Just in case, sometimes the Ts and the Ks can blend together, it's a little hard to hear, but I believe it's Kafka.

Feroldi: You are correct.

Lewis: I don't know if they drew any specific inspiration from the author there but, yeah, it's an interesting and maybe less traditional founding story than we're used to. Typically you don't hear about people creating something that they think is game-changing and then making it open source and that's precisely what this company did. But I think that with this business, you start to piece things together. We talked a little bit about how it's a hard one to wrap your head around. I think it's a well-named company and also when you start working through precisely what they do and the problem that they're trying to solve, you realize fairly quickly that there are so many applications for this type of solution.

Feroldi: They really are. If you think about where computing is heading in the future, the amount of data that's being created today is unprecedented but it's just going to continue to grow over time. If you're a believer that 5G is going to take off, that AI and machine learning are going to become mega trends, e-commerce, augmented reality, virtual reality, machine learning, the amount of data that's going to be created up there is set to explode. The way that we currently use data isn't really set up to handle that volume. Confluent really helps enterprises and companies to take advantage of what's going to happen in data.

Lewis: Yeah. I think walking through just a couple of examples that they provide on use cases help us for illustrating it because, Brian, data has basically been the buzzword of the last decade, 15 years. It seems like everyone has some angle on organizing data and making sense of data, interpreting data, and really being able to just walk through how companies are using their solution, makes it a little bit easier.

Feroldi: For sure. They have dozens of use cases they have right on their website if you want to read about them, but for example they have partnerships with financial services companies. Financial services companies use Confluent to secure transactions in any currency and to manage real-time payments and also help with fraud detection. They have examples on there from our retailers that use Confluent software to make sure all their systems talk to each other to make sure that inventory management and supply chain automation is all done in real-time. May have examples of Domino's Pizza, for example, handling the complete customer experience. Taking it in order, handling the supply chain, and getting it out to customers in time. All of those things need real-time data access, and Confluent helps them do it.

Lewis: My understanding, having watched a good chunk of videos on YouTube about the business, is that they take a slightly different approach to the way that they are looking at data and the structure of data. Instead of assigning a lot of the relationship to an object or an item, they are tending to look a little bit more in a stream of events with how they're using data and have a primitive understanding of this. From getting this wrong, excuse me, our listeners. But basically, that allows for a much more versatile, interactive, and continuous way for developers and other folks that are trying to access that data to do so and also make sense of it across other applications.

Feroldi: Their tag line is "To set data in motion." The way they're saying that data has been stored for decades is it goes into a database and then it just sits there, and it's only useful when a query is set out to actually retrieve that data. Rather than data just sitting there with Confluent, they set data in motion so that it's always being interacted with in real-time from a huge number of input sources. That's really the key here.

Lewis: I wonder if our listeners [...] had any idea that this is a subscription business and that it would pretty much immediately be something that you are interested in, Brian. No surprises here for the space that we're talking about, the industry we're in and just the fact that it's a Cloud-based business, it's going to look pretty familiar to a lot of folks.

Feroldi: It is basically a Software-as-a-Service company at its core that sells its products primarily through subscription. There's something called the Confluent platform that can be used by companies or enterprises on-premise in their private Cloud or in a public Cloud. They also have a product offering called Confluent Cloud, which is their SaaS-based offering. Basically, they can meet a company wherever it wants to be and use software on Cloud, on private Cloud, or on-premise. In addition, they also derive about 10% of their revenue from services business, that's a professional services and education segment. That is about 10% of revenue. While it is revenue, it's not really revenue that investors should care about because it's very low margin.

Lewis: But as we talk about often when it comes to the services revenue, it's necessary. It's a core part of what they do and also really just making sure that their customers are using a product. They're satisfied with the product and that it's really meeting their needs.

Feroldi: It's a way of getting your foot-in-the-door with our customers. That's really important. Speaking of customers, again, this technology is a little bit hard to wrap their head around. If you're looking for third-party validation, this company already has it. Keep in mind that this company is only seven years old, but they've already grabbed 136 of the Fortune 500, including Citigroup, Expedia, Humana, Lowe's, UC San Diego, and in 2019, Google [Alphabet] actually named Confluent their 2019 Google Cloud Tech Partner of the Year. All told, as of March 31st of 2021, they have more than 2,500 customers on the platform. That figure was up 142% over the prior year. Clearly, they're doing something right.

Lewis: Brian, when we talk about stuff in the Cloud and in the software space, one of my immediate things is, what's the scope of this? How many industries is this applied to? How helpful is this going to be? Because it helps you get a better sense of what total addressable market might be, what optionality might look like for a business. Just running through that list, I want to emphasize that for a second. Citigroup, so you have financials, Domino's Pizza, you have consumer goods, Expedia, online travel, Humana, that's a healthcare business, Lowe's, and other consumer goods businesses. UC San Diego, that's academia, that's higher education. There are already so many different industries represented by their customer base.

Feroldi: That's correct. Name a company that needs data and software to run their business. That could potentially be a Confluent customer. Pretty much every company on Earth relies on software to run their business. Same goes for the government. Yes, if this business doesn't work out, it's not because the opportunity isn't there.

Lewis: So far, based on what we're seeing in terms of the financials, it's working out pretty well. This is an early stage. We talked about that proposed market cap before being below $10 billion. This is an early relatively high-growth business. The financials indicate that. [laughs] That's basically what we're seeing here.

Feroldi: In 2020, this company reported total revenue of $236 million. That was up 58% over the prior year. If you drill down a little bit, they have over 2,500 customers, but they have some really big customers already. Already 561 customers are going to spend $100,000 or more on this platform over the next year. That figure was up 50% and 60 customers are going to spend one million on this platform over the next year, that figure was up 82%. If you look at the dollar-based net revenue retention rate, which is a figure that we absolutely love. In the most recent quarter, it was 117%. That shows that they're getting their foot-in-the-door and then sticking around. They're doing a great job of growing that top line.

Lewis: Yeah, and they're bringing in a lot of customers. One thing that I think is interesting is the 2,500+ customers for 2020, that was 140% growth. They're seeing really interesting adoption. My hunch is this is one of those businesses where once you get in the door, you are going to expand within that business. Use cases are going to emerge. More and more people are going to want to get their hands on it and make use of it. In that sense, what we might see on the top line could follow what ultimately is customer acquisition.

Feroldi: That's one of the things that this company calls out as a long-term competitive advantage. Once a customer adopts this software, they typically use it for one particular use case in their company. Once Confluent gets in there, the power of the platform really starts to grow as other applications and other uses come on. It's almost like the company gets internal network effects at a local company. Once it gets its foot-in-the-door, it can grow in the company. Now, there aren't network effects in the sense that it goes, that the more companies that use this, the more customers there are, the more powerful this becomes. But the company does seem to, once it gets its foot-in-the-door, it's really hard to get off this platform.

Lewis: While it doesn't check the traditional network effects box for you, it does check a network effects box and I know it checks several other boxes for you, Brian.

Feroldi: That's true. But let's get into the gross margin here because that's always a key thing to look at. The non-GAAP gross margin in the last quarter was 71%. That's a pretty good figure. What's even more impressive about that is if you tease the gross margin apart a little bit, the subscription-based revenue, which is 90% of revenue, that gross margin is 78%. The service revenue bounces up and down, in last quarter that was about 10%. Because this company has a service component to it, you can't necessarily just look at gross margin and compare it to other software companies that don't. This company has very high margin software sales. Now, the top line looks pretty good. However, they are spending aggressively to build out their R&D platform and their sales team. Because of that, this company is losing lots of money. The net loss over the last year was $230 million. That's almost the same as the top line. Now, that's on a gap basis and that includes stock-based compensation. If you look at free cash flow, free cash flow was about negative $87 million last year, and it looks like it's been on pace for this year. The company is nowhere close yet to making money.

Lewis: But you look at those financials, you figure with a certain amount of scale, they could turn on that profitability switch down the road. Not surprising for a company at this size and with these growth rates to be losing money. We talked about it all the time. If you know that you're early on in expanding into your market, you want to get as many customers on board as you can. You're willing to market and spend aggressively to get those customers. The key is just holding on to those customers.

Feroldi: They're doing a great job at that. It does show you given the scale that they're already at. Again, almost 240 million in trailing 12-month sales. That's a decent size number that they're still spending that aggressively, that they are losing that much money. Now, the good news is their balance sheet was in pretty good shape prior to coming public. As of March 31st,280 million in cash. They did have about half a billion in convertible preferred stock, but they did give us an idea about what their balance sheet would look like if they came public at the valuation that they've proposed. They're basically going to have $950 million in cash and no long-term debt. If that comes to pass, they will have plenty of liquidity to continue to fund themselves for many, many years.

Lewis: That's an awfully strong position to be in. I do want to emphasize, we're just throughout that top line number in a year that ended just under $240 million in revenue for 2020. They are going to be, as you'd expect, trading at a pretty rich valuation if that $7 billion-ish market cap lines up.

Feroldi: That will be about 28 times sales. Given the growth rate and the stickiness of the platform, that's not too surprising. Now importantly, that's the pricing of the IPO. You and I as investors if you wanted to buy, there's no way of telling what valuations is this going to get, once you and I could get our hands on it, but let's just say it's going to be rich.

Lewis: I was going to say, Brian, 28 almost sounds palatable. We're used to seeing things in the 35 and 40 range, which on day one, day two, it would not shock me to see a trade-up in that space. It's just where the market is. I mentioned before the founders' note and citing some specific language from Jay Kreps. This is a founder-led business, Jay Kreps is the CEO and one of the co-founders. He is not the only Co-founder still in the mix.

Feroldi: Yeah, all three Co-founders are actually still involved with the company. Two of them are on the board, but Jay Kreps is really the person of interest that we need to focus on as the Co-founder and CEO. The initial checks that I do on this guy really come back positive. On Glassdoor, he gets stellar reviews from employees, 98% approval rating among his employees, and 93% of employees would recommend the company to a friend. Ownership is actually pretty decent too, given the stage of the game here. Jay Kreps himself still owns about 12% of the company, and if you look at all insiders, all insiders will still own about a third of the company. Lots of skin in the game.

Lewis: Yeah, I think that's precisely what you want to see for a business that size. Owning more than 10% of the business puts you in a spot where you are really running the show, and financially, the success of the business is going to dictate your personal financial success.

Feroldi: Yeah. What's exciting is, while they have almost $240 million in trailing revenue, if you believe this company's numbers, they think that they're TAM, is enormous. If you just add up their current market potential, they basically see their current TAM at over $40 billion. If that number is true, that means that they are sub 1% of their current market penetration rate. Moreover, all of their markets that they are in are growing at a 20%-plus clip. If those are directionally accurate, this company has a long way to go.

Lewis: Yeah. You'd love to see that. That's plenty of greenfield ahead of them. We've talked about how the technical sophistication of this business is a little bit beyond us. The land and expand model seems very apt here, and it also, to me, seems like this business is probably a platform shift for how a lot of companies are handling data, working with data. It's hard for me to fully appreciate how dramatic that is and how mission-critical something like this becomes, but the more I read about it, the more I am convinced that they're probably onto something pretty dramatic, and if they can be the ones to bring it to customers, there is a lot of upside there for them.

Feroldi: This company, when I was reading through it, so much reminds me of Twilio. The first time I heard of Twilio business I was like, what do they do? Really like, what do they do? Clearly they do something important because the numbers indicate that they are doing something important, but that just took me a long time before I really grasped what Twilio does. I think it's going to be the same thing with Confluent, where I have a decent grasp of it right now, but as a non-technical, I'm not going to be interacting with the software myself, so I can't really fully understand it. But I got a feeling over time as I watch this company, I'm going to understand it more and more.

Lewis: Yeah, and we mentioned that this all came from an open source project, and I think the risk section for this company is perhaps a little different than it would be for a lot of other software players out there.

Feroldi: Yeah. They do call out that they are competing against some other big cloud companies, all the usual suspects, Google, Microsoft, and Amazon, they basically say that their number one competitors are IT teams that choose to build this product themselves using the open source software that is already out there. Now that's both a good thing, that yes, they're competing against companies doing it themselves, on the flip side, that also means that there is a lot of education to do in the market to get customers on board. That is probably a big reason why this company's losses are so big, because they are investing so much upfront to educate the market on why they could use this product. If they can do that successfully, and the numbers clearly indicate that they can, that gives them a long growth runway.

Lewis: Yeah. Actually Brian, I love the Twilio metaphor that you brought up before, because a lot of the things that Twilio does, companies could decide to do in-house. They could build that out, and it will be hard for them. It might be a little bit expensive for them, and they'd run into some issues making it as clean as what Twilio does, and it doesn't seem that hard as an outsider. It's brutally difficult to make that decision as a customer. What you realize over time is that it leads to really sticky customer relationships, and I think we tend to underestimate the do it yourself nature of software, because you can create something homespun, but you might run into other issues because of that. Working with someone who has already cracked it and has cracked it for a bunch of different businesses, just has such tremendous benefits for a big company.

Feroldi: That's one thing that they point out in their founder's letter. They say that if you are an Amazon, if you're a Google, if you're Microsoft, you have the resources to do this on your own, to build this solution on your own. Keep in mind, the co-founders were working for Linkedin. They were tasked with essentially creating this. If you are a smaller business or tech isn't a core competency for you, why would you go through the hassle of building this thing yourself when you can outsource it and have Confluent handhold you to make sure that everything is working correctly? I think the customer service aspect here shouldn't be overlooked. While this is primarily a self-service project, lots of tech companies will want help with implementing this software, and that's something that Confluent can do.

Lewis: Brian, putting it all together, what are your high-level takeaways on this company, and where does it sit for you in terms of investable ideas?

Feroldi: Well, let's talk about the good first. It's mission driven, I really like the founding story. I like the founders a lot and that they are all still involved. I like the inside ownership, I like the high-growth, I like the business model, the opportunity if believed is enormous. We didn't get into this previously, but already 36% of this company's sales are in international markets. That means that this concept already translates across borders. I believe that the opportunity is huge. On the flip side, it's still hard for me to really grasp what they do and how they are different, so I have to do more work on them. I don't like the fact that they are going to have to educate the market as they go. That's an enormous expense this company is going to take on, and the fact that they are losing so much money. This is many years away from recouping their investments and reaching profitability.

Finally, the market cap that they are coming public at is going to be about $7 billion. For me to buy a company like this, I would have to believe that it has 10-bag or potential. This $70 billion idea, could this be a $70, $80, $100 billion company one day? It is possible. We've seen lots of software companies that have reached that level, but I would have to really buy into that category. For me, this checks a lot of boxes, but I wouldn't be a day one buyer. This would be more of a watch list idea. But how about you, Dylan?

Lewis: You know, Brian, I'm curious, did you pull that $70 billion number, were you leading to that with any intentionality beyond the 10x?

Feroldi: No. Why? Should I have been?

Lewis: It's just funny, because I was looking at Twilio, which is about a $63 billion business. I wasn't sure if you were trying to create a nice consistent parallel throughout the episode, or if that was just a happy accident. But I do think it's illustrative of these ideas that start out seemingly as niche use cases that some businesses really latch onto early, blossoming into a much larger business. There are so many elements of this company that I like. I'm still in the education camp still, need to learn more, need to better understand it. It has the elements to me of this could fundamentally change the way that a lot of businesses structure themselves, and the way that different systems and applications interact with each other. I need a little bit more proof there before I buy that story.

Feroldi: Yeah. Fair enough. That is a happy accident that Twilio was almost a $60 billion company. If you're going to look, Twilio is in theory more of a niche product than this should be, because Twilio just handles communications tools. Communications tools are used by hundreds of thousands of businesses, and Twilio has hundreds of thousands of customers. By contrast, this company only has 2,500 paying customers, but yeah, there you go. If you believe that this is the next Twilio, 10X returns could be possible.

Lewis: Who knows, Brian? Maybe that will work its way into the title, "The next Twilio."

Feroldi: Foreshadowing.

Lewis: Yeah. We didn't film in Motley Fool Live today because The Fool is taking a half-day. We didn't get to ask our members for a title suggestion, so we're left to our own devices. Members, listeners, you will see exactly how creative we are with whatever lines are airing on today's show.

Feroldi: Can't wait to read it, Dylan.

Lewis: Brian, thank you so much as always for joining me.

Feroldi: Thanks for having me.

Lewis: Shout out to our listeners and fans for throwing this one on our radar. Listeners, if you ever want something, if you ever want a company discussed, if you want us to tackle a topic, [email protected], or you can tweet us @MFindustryfocus. Brian, drop your Twitter handle in there.

Feroldi: I am @BrianFeroldi.

Lewis: He is also incredibly responsive on Twitter. Just saying. You're more likely to get a response from Brian than from me, I'm more of a lurker, I'll confess.

Feroldi: I am highly addicted to Twitter. It's true.

Lewis: Of course, if you're looking for more of our stuff, subscribe on iTunes, Spotify, or wherever you get your podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell stocks based solely on what you hear. Thanks to Tim Sparks for all his work behind the glass today, and thank you for listening. Until next time, Fool on.