Confluent (CFLT -0.90%) stock came public in late June 2021 when initial public offerings (IPOs) were trending. At that time, it seemed like newly public companies could do no wrong. But as the market sentiment turned, investors sold off these stocks significantly. Confluent stock, for example, is now trading about 37% lower than its first-day closing price.
Confluent as a company helps businesses stream data in real-time to gain insight and drive innovation quickly. It thrives by helping companies optimize an open-source platform, Apache Kafka, which is popular among Fortune 500 companies.
While this business model is one of the company's most critical resources, the bears warning against Confluent also saw it as the company's most prominent risk. Let's look into why the bears are wrong and why you should consider adding Confluent stock to your portfolio now.
Image source: Getty Images.
The bear case: Confluent has an alternative
The company has its roots based in Apache Kafka -- an open-source solution that allows businesses to analyze data in real time. Confluent helps scale Kafka, bringing the benefits of Kafka to the entire enterprise. The founders of Confluent were the original developers of Kafka, which means they have first-hand knowledge of what this add-on Kafka software can do for Apache. However, because it is open-source and free to use, Kafka could be seen as one of Confluent's competitors.
This is what concerns Confluent bears. In an economic downturn, some investors believe that Confluent's customers would drop its services, instead using Kafka themselves to build an in-house solution to stream data in real time.
This theory got largely discredited in Confluent's second quarter. Businesses faced immense pressure from inflation and recession fears in Q2, yet demand for Confluent's services held up quite well. Confluent revenue soared 58% year over year to $139 million, and the number of customers spending over $100,000 annually jumped 39% over the same period.
Additionally, management anticipates demand will remain strong. Revenue for 2022 is expected to reach $569 million, which represents 47% growth year over year. This shows that customers aren't likely to shift to having their in-house tech support develop their own open-source solution using Kafka, despite the budget constraints many businesses currently face. While it might be free, Kafka requires some expertise to use well and Confluent has convinced its customers it can do the work related to scalability, flexibility, and other features better than anyone in-house might and do so more efficiently.
Another bear case on Confluent does have some merit
While the main bear case might not be something to seriously worry about, the company's unprofitability is. Over the trailing 12 months, Confluent's net loss surpassed $440 million. This compares to $488 million in trailing-12-month revenue.
Additionally, Confluent is burning cash at a fast pace. The company's free cash flow burn reached $142.7 million on a trailing-12-month basis, representing a free cash flow margin of -29%.
While this is concerning, Confluent still has a healthy balance sheet to subsidize these losses for the time being. The company has almost $2 billion in cash and securities on the balance sheet. Over the coming years, management projects this problem will ease. Confluent has aspirations of a 25% free cash flow margin and a 20% to 25% operating margin over the long term, with a 10% free cash flow margin and 5% operating margin goal over the medium term.
Where can Confluent go from here?
Management's optimistic outlook on profitability is appealing, so it's a bonus that Confluent has attractive expansion opportunities as well. The company's emerging product, Confluent Cloud, has caught the eyes of many businesses.
Cloud is a fully managed, cloud-native version of its original product, and businesses are keen on adopting it: Cloud revenue soared 139% year over year in Q2 to $47 million. It represented 34% of total revenue in Q2, which is a noticeable jump from the year-ago period, where Cloud revenue only accounted for 22%.
This major success in the cloud could help it fully capitalize on its large total addressable market, which management expects to be worth $91 billion by 2024.
Right now, Confluent looks like it's firing on all cylinders. The company is proving that it supplies mission-critical services to its customers, which is helping it thrive during a tough economic time. While investors should watch profitability closely to ensure it is keeping up with its medium- and long-term targets, this stock looks like a great company to buy now and hold for the long term.
At 13.5 times forward sales, this business isn't trading at a rock-bottom valuation. However, investors might want to pay up for a small piece of this high-quality business, given its growth, rapid adoption, and enormous opportunity.
