2 High-Growth Companies to Watch

In this podcast, Motley Fool producer Ricky Mulvey caught up with Motley Fool senior analyst Yasser El-Shimy to talk about some higher-growth companies whose stocks have taken a hit.

They discuss: 

• How investors can approach growth stocks with a venture capital lens.
• Profitability questions for a streaming data company.
• A second look at a space company that went public via SPAC.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on May 06, 2023.

Yasser El-Shimy: You're going to have your ups and downs in the short and medium terms, thanks to interest rates, thanks to fiscal policies, thanks to a lot of different factors, macroeconomic factors, recessions and so on. But guess what? As Peter Lynch once said, we have had historically 13 recessions and we've had 13 recoveries out of those recessions.

Mary Long: I'm Mary Long and that's Motley Fool Senior Analyst, Yasser El-Shimy. If a growth stock gets cut in a half, is it on sale or just less expensive? Ricky Mulvey caught up with Yasser to discuss the macro landscape for high-growth companies, a mission-critical software company now trading at half its IPO price and a rocket maker with galactic ambitions.

Ricky Mulvey: When others get fearful, it's time to do something. I forget the rest of the quote anyway, joining us now to talk about some strong growthy companies in a downcycle is Motley Fool Senior Analyst, Yasser El-Shimy. Thanks for joining us on this journey.

Yasser El-Shimy: Hi Ricky, good to be here.

Ricky Mulvey: When I think about investing in super growthy companies, I almost think of it as a venture capital approach. Would you agree with that?

Yasser El-Shimy: Yes. Our Motley Fool co-founder and Chief Rule Breaker David Gardner has in fact almost coined the term of a VC approach toward public investing. In that approach, you look for young, innovative, relatively small companies with massive runways for future growth, great products invested leadership and ideally a purposeful mission. Ideally, also you want to have your portfolio reflect your best vision for the future. That's even when you see in the VC world where a lot of investors tend to back companies that they feel strongly about. You may want to also do that with your own personal investment portfolio. One thing we have to keep in mind also the VC style of investing is that, VC investors tend to hold their investments over a very long period of time and even tend to upsize their stakes in those companies that show themselves to be resilient and successful. As David Gardner would say, you should add to your winners, water your flowers and trim your weeds.

Ricky Mulvey: I'd also say that the VCs tend to have a couple of big winners that make up for in a lot of cases, a majority of losses. When it comes to my style of investing, I like to have a mix of things. Do you go for this high-growth approach for all of your stocks?

Yasser El-Shimy: No, I don't. You're absolutely, but right by the way, that only a few of the companies that you'd invest in using that VC approach would work out. Most of the companies that you'd invest in may not generate the kind of returns you are hoping for. However, over a very long period of time, those companies, those investments that do workout and those companies that do perform are going to generate hopefully the kind of returns that should more than make up for any losses you have incurred holding those, let's call them weeds for now. But back to your bigger question, which is investing strategy here, I would say that the Rule Breakers style of investing or the high growth style of investing that I follow, does not represent the entirety of my portfolio. I tend to try and invest across many different strategies. As someone who's thinks of investing in terms of decades as opposed to years, I do lean more toward a Rule Breaker self-investing because I know that I have the stomach to hold those companies over very long periods of time and stomach the volatility, but not everybody can do that obviously. It's a really hard thing to do. But even so, even if I can stomach those kinds of churns, those kinds of gyrations and those stocks. I still like to hold the companies that are more stable or established. They own my fair share of what I consider to be balanced growth companies, small, mid-cap, profitable growth, even value sometimes. I don't say that I'm an ideologue when it comes to investing philosophy.

Ricky Mulvey: Being an ideologue and an investor seems to not work out for many of them. Being a growth investor was much easier a couple of years ago. The aphorism don't fight the Fed is carrying out right now as earlier this week, while the Fed signaled that it's going to pause its interest rate hikes. The risk-free rate of return right now is above five percent. Feel free to disagree. But I think this matters for growth investors because not carrying about Fed actions was a lot easier a few years ago. Now, it would seem that growth investors have to pay a lot more attention to it.

Yasser El-Shimy: Yeah. You're definitely right. If you just take a look at Twitter and in bull markets, everybody is a growth investor. In bear markets, everybody wants to park their cash in the bank, just get that interest or even go after dividend-paying stocks. But here are the full, we are fundamental bottoms-up investors will love to look at companies. We think that fundamental company performance is the main determinant of returns over time. You're going to have your ups and downs in the short and medium term, thanks to interest rates, thanks to fiscal policies, thanks to a lot of different factors, macroeconomic factors, recessions and so on. But guess what? As Peter Lynch once said, we've had historically 13 recessions and we've had 13 recoveries out of those recession. If you zoom out and do not get consumed by the headlines of the day, you're likely to do well over time as long as of course, you put all of your energy and focus into selecting companies that you fundamentally believe in that you think can outperform the market and make money over time.

Ricky Mulvey: Let's dive into some of those growthy companies that have been hit, not just Carvana, one of them that you brought to the table is Confluent ticker CFLT. This is one that has been cut in half since its IPO despite a bump on surprising earnings. This is a tricky company to describe, even from watching YouTube videos and tutorials about it. To set the table, what does this company do?

Yasser El-Shimy: You wouldn't be the only one to have difficulty to fully understand what they do. Think of the movie, everything, everywhere, all at once. Before Confluent, companies used to collect data, store it either in data center or on premise or in the cloud, and then analyze it and act on it. Confluent founders. They found that system was inefficient, slow and full of blind spots. They invented Apache Kafka, which is an open-source data streaming platform that lets you move and process data in real time. Now as soon as data is received from the source, it is immediately transmitted across the entire tech stack of the business. Analyzed by all applications and software programs and acted upon again in real time. Now, Confluent as a company, was built to fully maintain, manage, and improve on Apache with what they called Confluent Kafka. Let me give this analogy and maybe this is one that only trained enthusiasts can fully appreciate, but I'll make it anyway. If Apache was a train cart that moved products from point A to point B, Confluent is the whole rail network with autonomously driven trains that takes stuff everywhere all the time. Now, companies, of course, have the option to use the open source Apache Kafka version. But they will, unfortunately, need to maintain or dedicate many members of their IT team to operate and sustain that program. That takes them away from doing the work that they can actually be valuable to the company's core product or value added. The ROI for many companies using Confluent Kafka is significant as it cuts down on these operating expenses by a large margin.

Ricky Mulvey: I know the train analogy, the train network to train cars, data in motion, all pretend that I got it. But what's a real-life example where one might see Confluence technology at our action?

Yasser El-Shimy: Actually, chances are you have used the technology even though you may not have actually realized you are using the Kafka technology. But one good example of that is Instacart, the service like Instacart needs to have real-time visibility and instantaneous analysis of everything that's happening all the time, where the shoppers are at all times, what products are they collecting. What products are missing, and therefore, they need to suggest replacements for and give customers a time estimate for order arrival and so on. That's just one example. Another example is if someone uses your debit card and an unusual location for an unusual purchase or withdrawal, that transaction can immediately be flagged as fraudulent. The bank puts a hold on the card. It notifies you all of this happening instantaneously and across the board. Another example could be a stock exchange where millions of buying-sell orders are constantly flowing through and you need to execute on those in the most efficient and transparent manner possible, and so we will find stock exchange, like Euronext. For example in Europe, deploys the Confluent Kafka technology. I could go on, but Kafka is essentially what enables a lot of this real-time action, and it quickly becomes mission-critical, not just a nice-to-have software.

Ricky Mulvey: When you don't have time to go back and forth from database to action with whatever that action might be in a stock exchange, inventory at a grocery store for Instacart or debit cards when, when someone's using it in an unfamiliar place. I want to talk about the financials a little bit with Confluent because it has high inside ownership, that's good. It's a sticky product that's mission-critical, that's good, but it also loses gobs and gobs of cash. In its latest quarter, it's operating loss of about equal, it's total revenue, and this seems to be a habit of having a massive operating loss. Maybe it's because Confluent gives out a lot of free software. What's it needed to do to be profitable?

Yasser El-Shimy: While you're absolutely right, they have been burning through a lot of cash, but it's important to put things in context. First, I would say that Confluent is still a relatively young company, less than 10 years old. Even within those nine years of existence of they've been not even not fully nine, yep. But even during those years, they've started for the conference program, which is an on-premise offering. They've moved from that to confront Cloud, which is a hybrid or cloud-first offerings that any company can use, and so they're still on the part of introducing the market to what this product is and the full capability of how this product can be used to transform the business and give good returns on investments. Understandably they have prioritized growth over profitability in this young age. Now secondly, the company has shown it to understand that the 0% interest rates are not coming back anytime soon, and the time has come to prioritize self-funding, and so they've guided toward reaching adjusted EBITDA profitability this year and positive free cash-flow next year. All while growing sales by nearly 30% year over year. They've been also rationalizing their workforce, optimizing their sales, focusing on high-return projects. Some other expenses have been going toward going to prospective clients, demonstrating what conflict can do for their business and signing them up. That is still important, but not maybe top of the list anymore, and maybe some of the existing big clients can provide higher profitability for comfort and that's what they're going to prioritize.

Ricky Mulvey: I got to pushbacks for you from the latest call CEO Jay Kreps said, "The Confluent has less than five Kafka engineers on call for tens of thousands of production in Kafka clusters. That gives us a cost structure for operation that we believe is a hunt as 1,000 times better than our customers, end quote. It seems like they're being efficient on labor costs from the call, but I haven't seen that reflected in the company's operating margins. Also, while the company is young, it's already had a huge adoption cycle. More than half of Fortune 500 companies use Confluent software as of 2021, so that's two reasons I should say I remain a little skeptical and hesitant.

Yasser El-Shimy: Let me start with the last part of your question first about the wide adoption of Kafka. Now, it's important to actually make clear that when we say that 75% of Fortune 500 companies use Kafka there, in fact, using Apache Kafka, which is the free version, the free open source version of the software. This in fact gives Confluent an opportunity to sell them on its flagship product and move them into that self-managed or fully automated, I would say, data streaming platform that Confluent offers. They actually estimate their total addressable market at $60 billion. Whereas in fact, their trailing 12-month sales came up just over $600 million, so, a lot of green grass left. Now, going to your first question about their operating expenses, I would say that that's not managing the data streaming platform has not been where Confluence expenses have gone. They've gotten mostly toward building servers, for example, which is part of the value proposition that they are offering to their prospective customers. When you go to a modern enterprise that has potentially hundreds of different servers with dozens of tech staff, IT staff who's literally manning the data streaming platform, the Apache Kafka, the open source version. You're telling them, you don't need to worry about any of this. You don't need the servers, you don't need most of the IT people to dedicate all of their time and energy toward managing this platform. We will do all of this for you from the back end. The value proposition here is very clear to prospective customers that the total cost of ownership here, the return on investment from migrating toward the Confluence product, the fully automated managed product, is going to actually save them a lot of time and a lot of money. That to me is definitely one of the strong points that Confluent has.

Ricky Mulvey: Let's move to a bleeding-edge tech company or more bleeding-edge, which is Rocket Lab USA. This launches satellites and is working on a Neutron rocket. It is a space start-up that went public via SPAC. Unfortunately, that gives me vibes and memories of Virgin Galactic. What does this company do? What's the case for Rocket Lab?

Yasser El-Shimy: Boy, you don't want to be in the same sentence as Virgin Galactic, if you're an aerospace company. I personally, I've never understood the case for space tourism. Who would spend hundreds of thousands of dollars to fly just to the edge of the earth and come back down in a few minutes. But I'm probably not the targeted audience here. Rocket lab is not one of those companies. Yes, it came public via SPAC and that will forever tarnish any company that ever did so after the painful experience of 2021, 2022. But I think there is something here. This is a company that is focused squarely in the commercial government and research space use cases. It has a long and flawless record of successful rocket launches. Has plenty of serious customers including NASA, the US Space Force and many universities and communication companies across the world. Why do I think it's a good investment? Well, the company is fast becoming another top dog with SpaceX in the commercial space industry. Launching rockets, carrying satellites, and returning them successfully is not easy as it sounds. It is literally rocket science. We have had and we have seen so many field launches by so many new entrants and new comers into this space, including the likes of Relativity Space, Firefly, Astro Space, and I could go on even SpaceX. They just had a field launch with their starship couple of weeks ago. Rocket Lab can in fact be proud of its pristine launch record here. Second, I would say that we actually have anticipated global shortage of launch capacity in the coming years.

We may currently have over 100,000 licenses obtained to launch satellites into space, but nowhere near enough capacity to get them there. That is, even if we assume the likes of Blue Origin and United Launch Alliance, will be successful to give their rockets off the ground and back safely. Finally, just looking even at the numbers, I could tell you that the consensus analyst estimates on S&P Cap IQ for sales to quadruple over the next five years and for Rocket Lab to become profitable in two years. I can also tell you that when I build my model, low assumptions in those the analysts have, I find the shares to offer plenty of upside opportunity, and just one thing I keenly look for in rule-breaker type high-growth investments is that I want to find them at a valuation that is reasonable against expected future earnings and less than 10 times 2026 EV EBITDA multiples for such a high-growth and young company, with clear competitive advantages. Sounds good to me as a patient long-term investor. So much has to go right, of course, for these earnings to flow through and for this investment to be successful, and that's why trusting management, product, and business strategy becomes key, but of course, things could go wrong like with many of these companies.

Ricky Mulvey: I'm really knocking on wood after you said flawless launch record. To clear something up EV to EBITDA basically means the enterprise value of the company, how much it's worth compared to the company's earnings before interest and taxes. Startups are great but it seems like size matters in this case. Can Rocket Lab reasonably compete against the aforementioned SpaceX against Boeing, which builds jet engines as well?

Yasser El-Shimy: Well, size does matter but not in the way you think. This field has been dominated by very large rockets carrying very large payloads. SpaceX is a top dog here, no question about it. Rocket Lab, however, has carved a niche of launching reusable small rockets because they cost less to launch and are faster to schedule for take-off. The Elektron, which is made by Rocket Lab, has a sticker price of $7.5 million compared to SpaceX's Falcon 9, which will cost you $60 million. That's a big difference. Also, Rocket Lab unlike SpaceX, is a one-stop-shop for most space needs, including satellite building, components, software, operations command center, radios, and solar panels systems, etc. This is why we have seen defense companies like Lockheed Martin placing orders with Rocket Lab for these systems. In defense, the ability to launch quickly is critical, and Rocket Lab can offer that thanks to its three launch paths, including in New Zealand where there are fewer airspace restrictions on launches than here in the US, and because they are working toward refurbishing the rockets and launching them pretty quickly soon after. Finally, Rocket Lab is working on Neutron, which has a larger rocket capable of carrying up to 13,000-kilogram payload into the lower earth orbit, 2,000 kilograms to the moon or 1,500 kilograms to Mars and Venus. It should also be capable of human space flight. But the primary goal of this one is to compete with SpaceX on launching very heavy satellites and mega-constellations of satellites.

Ricky Mulvey: One potential yellow flag about Rocket Lab that our colleague Alex Friedman brought up is that it has some pretty poor reviews on Glassdoor. I think just 50% of the employee base would recommend working there to a friend. Is that a yellow flag for you?

Yasser El-Shimy: Yes and no. It definitely gives me pause. When I look at Glassdoor for ratings, I do obviously want to see higher ratings or more positive ratings for the CEO, for the company culture and so on but it's not the complete picture. Again, if we take a step back, here we have a management team that hails from a fairly impressive group of companies and organizations including General Dynamics, NASA, SpaceX, Broadcom, Aerojet Rocketdyne, among others. We also have very strong ownership by CEO and founder Peter Beck owns around 11.5% of the company. Even more confusingly, when you look at other company review websites, in this case comparably, for example, they have much higher scores. They give a CEO rating of 90 out of 100 and executive ratings 75 out of 100. It's a mixed picture, I would say, when it comes to these websites. You can never really tell how accurate they are, what methodology they are using, and therefore, I just want to follow closely and see what's going on there and if there's anything to that. But ultimately, if you are working in the space industry, if you're in the business of making rockets, you're probably overworked, you're probably working long hours, very high chances of failure, very cutting-edge research projects you're working on. I can imagine the stressful environment.

Ricky Mulvey: A lot of the complaints are about overwork, work-life balance, that kind of thing. I'm not trying to sound cold or dismissive but I don't see how a space company is run without just an absolute maniac in charge. I'm not accusing Peter Beck of being a maniac.

Yasser El-Shimy: I think you're all aware of that badge with honour.

Ricky Mulvey: Fair enough. Let's do a quick check on the numbers before we wrap up. Rocket Lab is unprofitable on an operating business and launching rockets sure sounds expensive. You mentioned that they can reuse some engines, but is that enough of a story for this company to scale into profitability?

Yasser El-Shimy: Just to be clear, they have not started reusing their engines, just yet. They have run test to check whether they can. So far they report that they have been able to get their engines to work after they have landed back on earth. But yes, I think you raise a very important point here which is the profitability or lack there off for this business on an operating basis. Again, like I was saying with Confined earlier, this is a relatively young company, still long path of growth ahead. For this business to generate a lot of operating profits, it's going to have to first launch rockets more frequently, reuse the missiles, including the engines, become a vendor of choice for most space needs, and more importantly, it's going to need for the Neutron rocket to actually work. One of the worst things that could possibly happen for this company and for this as an investment idea is for the Neutron to fail. If that was to happen, that's going to be a serious blow to this company's balance sheet and future prospects. Now, zooming out beyond the operating expenses, we should see CapEx peaking this year as a lot of the spending on new manufacturing facilities, new launch paths, and the Neutron program is undertaken and we get toward the end of that.

Ricky Mulvey: Final question, Yasser, what's it going to take to convince you to ride on a Neutron rocket?

Yasser El-Shimy: I don't think you can pay me enough.

Ricky Mulvey: Yasser El-Shimy, appreciate your insight and for telling us about these companies.

Yasser El-Shimy: Thank you. 

Mary Long: As always, people on the program may have interests in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy stocks based solely on what you hear. I'm Mary Long. Thanks for listening, and we'll see you tomorrow.