Data and how businesses manage it have become a hot investing theme, and data processing platform Confluent (CFLT 1.23%) has been in high demand with investors since the stock went public last year. After trading as one of the most expensive stocks on the market, shares have fallen off a bit since the company reported its earnings to close out fiscal 2021.
Investors probably wonder whether the stock is attractive after falling or if there's more pain ahead. Unfortunately, these are the wrong questions because nobody knows what stocks will do in the near term. These are the right questions: Is Confluent executing on its business, and does the potential growth of the company leave room for the stock to increase over time? Here's what you need to know.
Data in motion
The co-founders of Confluent pioneered an idea it calls "data in motion." Businesses increasingly rely on software to operate, creating more essential data. That's why Seagate estimated that the world's data is on pace to multiply in volume tenfold between 2017 and 2025. Data helps companies make better decisions, create better customer experiences, and protect against fraud.
Image source: Getty Images.
A company's data infrastructure often isn't well-suited for a company's needs. It's usually stored in isolated databases or apps and only updated when new data is introduced. What happens when a company needs to understand and analyze data in real-time? Using outdated data only produces outdated results.
Confluent's co-founders developed a free, open-source software platform called Apache Kafka, which streams data events and can analyze them in real-time. It's become a core platform for many businesses, used by an estimated 70% of Fortune 500 companies. Even though Apache Kafka is a free platform, it's a complicated program and creates added costs for a company to spend money and time to hire in-house staff knowledgeable enough to program applications.
Confluent offers to outsource the needed software products and services that companies can buy to help them get the most out of Apache Kafka. Confluent is almost like a brain that communicates with various databases and apps to accomplish whatever an enterprise uses Kafka to do.
For retail companies, that could be managing inventory or analyzing customer sentiment. Healthcare providers could be connecting medical records in real-time to treat patients proactively. Banks could be detecting fraud early before it costs their customers money. Confluent works with many companies, including Walmart, Morgan Stanley, The Home Depot, and more.
Is it worth the hype?
The stock got a lot of positive reception from investors, trading at a price-to-sales (P/S) ratio of more than 50 at one point, making it among the most expensive stocks on the market. The numbers appear to show why the stock's been so hot; revenue growth has accelerated since the company went public to more than 70% in the fourth quarter of 2021 and sported impressive gross profit margins at almost 65%.
CFLT Revenue (Quarterly YoY Growth) data by YCharts.
The company has 3,470 customers that earned $388 million in revenue in 2021, a 64% increase over 2020. The company has a lot of room to grow in an addressable market that management estimates to be worth $50 billion and will grow 22% annually over the next several years.
However, there are some concerns that investors should be aware of. Confluent's business depends on a software infrastructure that's free for anyone to use, which could result in competition. Confluent even refers to the big three cloud companies (Amazon Web Services, Microsoft's Azure, and Alphabet's Google Cloud) as both partners and competitors.
The company also guided 2022 revenue of $546 million, a 41% year-over-year increase, and a notable slowdown from 2021. It likely contributed to the stock's recent decline. Management may simply be setting a low bar, but it's hard to know for sure because it hasn't been on the public markets that long.
How to buy the dip
It can be risky buying a stock sporting a P/S ratio above 50 because it creates a very high bar for the company. If the business stumbles in any way, investors can quickly change their sentiment. That seems to have happened to Confluent stock, which fell more than 20% in the past week.
Today, the stock trades at a P/S ratio of 32, which is a dramatic decline from its high, but I don't think it's anywhere near a bargain. Investors could use a dollar-cost averaging strategy to buy shares if the stock continues sliding lower. There's a lot to like in Confluent, and continued execution over future quarters could generate big returns for investors. However, jumping into stocks with two feet can backfire, so investors should take a measured approach to buy shares.
