Over the past five months, both Confluent (CFLT -0.99%) and DigitalOcean (DOCN -0.66%) have been stellar performers, with share prices rising 68% and 114% respectively. While the "winners keep winning" mentality often does prevail in these situations, the share price appreciation alone is not why these two stocks are at the top of my watchlist.
Rather, I am thoroughly impressed with each company's business performance and growing adoption by its target customers. Confluent is seeing strong growth among enterprises looking for a managed Apache Kafka service, while DigitalOcean is seeing low churn and higher customer spending among a traditionally high-churn customer base.
Here's why Confluent and DigitalOcean are at the top of my watchlist, and why these two stocks should be at the top of yours too.
Image source: Getty Images.
1. Confluent: Enabling real-time data analysis
Confluent is on a mission to "set data in motion" by providing services that enable businesses to analyze and act on data in real-time. With the increasing amount of data being produced today, many companies will immediately move data to cloud storage providers like Amazon's (AMZN -1.04%) AWS, where they will go to analyze the data later.
However, there are some businesses that need to know information as soon as they receive it, like a bank looking for fraud. A bank cannot simply put all of its data immediately into a data warehouse to be processed later, because that data could contain information about a security breach or a hack that the bank needs to act on in real-time.
The bank can use an open-source platform called Apache Kafka to have all its data processed in real-time, but for non-expert developers, this can be incredibly difficult. Confluent was founded by the same founders who created Apache Kafka to help these companies manage their Kafka service, allowing banks to get the real-time insights they need without having to run Kafka themselves.
Apparently, a lot of enterprises have difficulty running their own Kafka service, because Confluent has been wildly successful. Q3 revenue grew 67% to $103 million, and the company had 664 customers spending over $100,000 with Confluent. The company's net retention rate remained strong at 130%, meaning it can expand its customer relationships while also keeping its churn rate low.
The flip side to all of this growth is that Confluent is losing a lot of money. Its Q3 net loss was $95 million -- or 92% of revenue. This has improved from the year-ago quarter where the company's net loss represented 225% of revenue, but this net loss is concerning. The company also has a negative free cash flow of $21 million, which got worse year over year.
Confluent has quickly become the leader in its space because its platform is cloud-native, offers a complete suite of solutions, and operates both in the cloud and on-premise. In addition to that, its founders created Kafka, so who better to run a managed Kafka service than the people who created Kafka? As the leader in a fast-growing industry which is expected to nearly double in just three years, I think that Confluent could see massive expansion over the next five years and beyond.
2. DigitalOcean: A simple cloud solution
Unlike Confluent, DigitalOcean is not the market leader, but rather an up-and-comer focusing on a specific niche of its market. This cloud platform is trying to provide a simple, transparent, and easy-to-use cloud platform for small- and medium-sized businesses (SMBs).
The problem that many small businesses or independent developers have is that they lack the expertise to be able to work on complex cloud platforms like AWS or Microsoft's (MSFT -1.59%) Azure.
Therefore, DigitalOcean has made a platform that runs basic tools like managed Kubernetes and serverless databases but does not gum up its offering by having complex, intricate solutions that many SMBs have no use for.
The company has seen immense adoption from SMBs that have come to love its easy-to-understand solutions. Its Q3 revenue reached $111 million, which grew 37% from the year-ago quarter. The company also grew its average revenue per customer by 28% to $62. DigitalOcean is nearing profitability, having just $1.8 million in Q3 losses compared to $10 million one year ago.
What is most impressive, however, is DigitalOcean's net retention rate, which has steadily improved. In Q3, the company's retention rate was 116%, which grew from 113% in the second quarter and 104% in Q3 2020. This steady growth shows that DigitalOcean has been extremely effective in holding on to a notoriously high-churn customer base while expanding its relationships with them.
DigitalOcean faces incredible competition from cloud giants that have solutions for enterprises along with smaller solutions specifically for SMBs. While DigitalOcean is still seeing rapid success in this niche market, investors should recognize that continued growth is not guaranteed.
The company is, however, valued for fast continued growth. Its valuation is high at 24 times sales. Share prices have sunk recently, though, putting the valuation at a slight discount from just a week ago where it was 30 times sales.
Investor takeaway
These two companies have shown continued growth despite the odds, and both have immense potential for success over the next decade. Confluent has to capitalize on its fast-growing addressable market as the market leader and grow its revenue while decreasing losses. If DigitalOcean can continue expanding its relationships with SMBs and become "the small guy's cloud platform," then it could push the big players out of this niche.
Each company has shown early signs of success with this, which is why they are both very high on my watchlist today.
