The initial public offering (IPO) class of 2021 had a rough start to their public lives. Many of the 980 or so IPOs launched in 2021 fell lower than their initial public price over the first few months of trading as a stock. At least one published report said that only 34% of 2021's IPOs are trading above their initial price, resulting in an average 9% decline for all IPOs last year.
Confluent (CFLT -1.70%) falls into the group trading above IPO. Shares of the tech company are up about 73% since coming public in June 2021. And that rise is despite the stock being down about 34% from 52-week highs set in early November.
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Does the sharp rise (and recent price drop) mean that investors have missed the boat on this opportunity? The short answer is no. Confluent is providing a mission-critical service to its customers and seeing rapid growth because of it. Its business is seeing significant growth that is likely to continue, which is why I think it is still smart to buy Confluent stock. Let's explore some of the reasons why.
Setting data in motion
Much of the data that businesses gather ends up going straight to a data warehouse for storage and eventual analysis. With the increasing amount of data being collected, many of these businesses find they can't analyze the data at the time they obtain it, even though they would benefit from having real-time insights it might provide. Whether it's a bank looking for fraud or a logistics center monitoring the weight of shipments, many businesses need to analyze this data immediately for their operations.
Confluent helps them do this by managing an open-source project called Apache Kafka allows businesses to analyze data in real-time and collects the important data before it gets warehoused. The Kafka variation of Apache is incredibly valuable, but it is difficult to scale across an entire business and complex to manage. Confluent takes care of the scaling and complexity that in-house tech support isn't able to efficiently manage. The success of this service has helped Confluent rack up thousands of customers, including big names like Domino's Pizza and Bank of America.
Confluent is the leading managed Apache Kafka service available for two reasons. First, the company's product is cloud-native yet can be used in the cloud, hybrid, or on-premise. Confluent also has over 120 integrations that provide a complete and secure service.
Second, Confluent's founders were also the developers of Kafka, so nobody knows the ins and outs of Apache Kafka more than they do. With a superior product and leadership who has unrivaled knowledge of Kafka, it makes sense that Confluent has emerged as the leader in the space, which is why the company has pulled in over $338 million in revenue in the trailing 12 months.
A large opportunity
Confluent's service is incredibly valuable to its customers. Considering that Kafka is mission-critical for many enterprises, yet it is only being used in a small segment of the business, Confluent has a very successful land and expand strategy. Once it becomes the manager for a subsect of an enterprise and the business sees the benefits, customers want to expand Confluent into other parts of the business.
This strategy has resulted in very impressive growth for Confluent. In the third quarter of 2021, revenue grew 67% year over year, and customers spending over $100,000 increased 48%. Its net retention rate is also strong at 130%, meaning existing customers spent 30% more in Q3 2021 than they did in Q3 2020.
Despite Confluent's strong success, the company has barely scratched the surface of its opportunity. Of the Fortune 100, 80% use Kafka. However, Confluent's service has yet to be as widely adopted as Kafka has been. However, management thinks this will change and that Confluent's addressable market will nearly double from 2021 to 2024 to $91 billion as managed Kafka services increase in demand.
A risky investment
As its market opportunity grows, Confluent wants to be the first service to come to mind, which is why it is currently spending heavily on sales and marketing. Over the first three quarters of 2021, Confluent spent $219 million on these expenses, representing 81% of revenue. The company has also seen decreasing gross margins because of its cloud service. Confluent Cloud grew 245% in Q3, but Cloud has lower margins than its on-premise and hybrid services because it is new and young. This resulted in gross margins decreasing from 69% in the year-ago quarter to 64% in Q3 2021.
Cloud's gross margin is increasing as it scales and is expected to plateau around 70%, so this margin will slowly improve over time. Confluent's net loss is also expected to improve, with the company seeing the fruits of its investments as the market grows. So, while these two factors are considered risks today, they should improve over the next year or two.
At 40 times sales, this company is not cheap, and investors should be prepared for shares potentially to dip lower in the short term. However, this company has a superior product and unrivaled competitive advantages, which have resulted in strong growth and financial success. Signs point to continued growth for the company, and this might be worth paying up for today if you're investing in the company for the next five years.
