Confluent, Inc. (CFLT) Earnings Call Transcript & Summary

Welcome to our next session. Really happy to have Steffan here from Confluent.

I'm kind of doing something kind of slightly nasty to you. I'm like, okay, so since we haven't met, you did the IPO during the pandemic, I just kind of put you on the spot, like from a CFO perspective, like Confluent. Like I'm trying to explain it to investors. I'm kind of getting the basic version. Like over the years, you probably have developed something like -- so Confluent, like how would you explain it to normal people?

First off, thank you for hosting. Really glad to be here. Confluent, we're in the age of data streaming. And I always find it instructive to give folks a little bit of a history lesson because it really explains what Confluent does. So Jay, Jun and Neha, who are our co-founders, were engineers at LinkedIn, and they were trying to basically run their business in real time, connecting applications and databases and data stores. And there was really no off-the-shelf commercial software available. There was nothing in the open source community. So they created a code -- code base named Kafka. And that really helped effectively run like the back end of LinkedIn in real time. And the power that came out of it was so impressive that they -- with the permission of LinkedIn, they donated the Kafka code to the Open Source Foundation. And it's now become the de facto standard for the developer community to do data streaming across the world. Hundreds of thousands of organizations run Kafka. And when you think about the transition from Kafka to Confluent, it's very instructive. Because what happens is when developers get the taste of using Kafka, they see the power of connecting applications in data stores and running streams in real time but they also bump up into a number of issues around scaling, security, complexity, overall total cost of ownership. Because when you run a Kafka and do-it-yourself environment, you are hiring an engineering team, you have infrastructure. The open-source Kafka doesn't have data governance doesn't have security, they're bolting on a bunch of other things. And so with Confluent coming into the picture, both Confluent Platform and Confluent Cloud, we have a cloud-native, complete and everywhere offering that enables the seamless use of data streaming across an organization. And so we can start very kind of small with one use case or it can brought into literally dozens or hundreds of use cases over time within a customer's environment.

It's interesting because we had the LinkedIn CEO on stage here right before you, and he did talk about some of the -- how often the graph gets updated and how many changes they are pushing through there. And you can see like, oh my God, this is kind of proper stuff, proper technology.

Yes, it's something that you can't throw bodies at. It has to be done through software. And the genius that Jay and Jun and Neha brought to the table was creating Kafka, but then taking to the next level around the commercialization of that, bringing the enterprise-grade security, feature functionality, data governance, everything that comes along with the enterprise-grade Confluent solution is a big differentiator.

And then the -- to get the hedge fund question in, like you guys are kind of delivering kind of really solid numbers even with the macro environment. Can you talk a little bit about -- I have -- my suspicious feeling is like what you're offering is mission-critical, it's very complex like to do well. But people know they need that. Everyone who wants to go to real-time needs kind of proper messaging. So you're kind of in a slightly different cycle than the others. Is that kind of me dreaming? Or like how do you think about that?

I think it comes down to the types of operational workloads that are being used in our data streaming platform. They are being run in the data streaming platform. And these are core functionality that companies are using to run their business. And they really -- if you go by any vertical you can pick, so retail, think of real-time inventory management, point of sale, like logistics, customer sentiment analysis. On the financial and banking side of the house, fraud detection, payment verification, private wealth management solutions. Just kind of across the board, these are mission-critical things where you don't just turn workloads on and off. This is something that's persistent in nature. And we sit in part of the new technology stack where we don't have as much exposure to transactional queries or analytics and it's more core operational workloads.

Yes, yes, yes. So that helps, yes, yes. Okay. And then the -- if you look, the one thing I kind of think that is probably kind of helping you quite a lot here as well as the cloud, can you talk a little bit about the -- and you started off like a lot of the open-source companies like we had a generation before you. But they all discovered, well, should I really need to go to the cloud because that kind of gives me -- makes it easier for the customer, protects me against like the big hyperscalers copying and pasting my stuff. Can you talk a little bit about the evolution of like Confluent Cloud?

I give so much credit to the founding team of Confluent to having the foresight to make a very tough decision as a private company. Call it, 5, 6, 7 years ago, they knew that Confluent Platform, which is the on-prem solution, was growing like crazy. To have the fortitude and vision to spin up a new engineering team in bringing in additional engineering folks to bring out a multi-cloud solution and really rewrite like the whole platform to be cloud-based, was -- it took a lot of fortitude and it took a lot of vision, and it's paid off in spades. For us, having Confluent Cloud is an incredibly important part of our story because that is where most workloads are either going to or being driven from today, but it's also an incredibly important part of the story to understand that Confluent Platform and Confluent Cloud together help provide the central nervous system that we've been talking about. Because when you talk about data streaming and data in motion, you have to be wherever the data resides. That can be on-prem, it can be in cloud, it can be in multi-cloud. So Confluent Cloud, without a doubt, is -- it's one of the most important parts of our business, but it's all in the context of the data streaming platform and that we can service our customers' needs wherever they reside.

Yes. And from you as a CFO, like what's the -- how do you -- I mean, does it give you more or better visibility in terms of if you have cloud, because you can see the customer more, you kind of see usage pattern, et cetera? Like does it create like a different benefit as well compared to the platform where you have like a deal is happening or not? Like you don't know, like with cloud, do you have the visibility?

So for sure, we have additional visibility around consumption patterns. We think that our cloud business over time from a unit economic standpoint and an overall sales and marketing leverage standpoint will be beneficial to the business. And the reason why I say that is people can get started on the Confluent Cloud journey for free. They come to Confluent Cloud, and we've removed the paywall, so they can start using it and then they can swipe their credit card without even talking to a salesperson. Now as a company who adopts Confluent Cloud starts to move along their journey from one project to multiple projects to applications and infrastructure, you can see us moving up the journey around becoming the true central nervous system. And that's when our great sales and marketing organization kicks into gear, talking about enterprise-class, persona-based marketing, making sure that we have the visibility within an organization, that they understand the use cases, what is the art of the possible. And we think that over time, our Confluent Cloud will really help with the leverage story in our business. Our sales and marketing as a percentage of revenue is high today. We're planning for it to come down over time, and Confluent Cloud is one of the catalysts there.

Do you see the benefits -- I mean, like because like your cloud story has evolved quite a bit over the last few years, like the growth rates are really healthy, it's becoming a much bigger part of the total. Do you see the benefits of having that cloud already? And where I'm coming from, it's more from a pipeline generation and sales efficiency perspective. A CEO once described it to me as like you have everyone in the ballroom and they turn the lights off and say like everyone that needs my help, raise your hand, and you don't see anything. And then having the cloud and seeing the consumption patterns of customers, seeing the early trials and what they're doing makes it much more targeted to go and contact these guys. Do you see that already coming through? Or is that a little bit too early?

We're starting to see that come through, specifically with our pay-as-you-go business. And seeing which verticals are trying us more than others. And then also the developers who are using us in a limited capacity, once they've raised their hand to say we want to start using Confluent Cloud, we're able to market more to those folks. And that also provides a very strong signal for future business.

And then where are we on that journey of -- kind of going back to the self-served on-premise customers and saying like, look, here's the cloud, you should really move. Like are we on an active push already? Or is it just kind of -- is this too early in the life cycle?

I think a good distinction is to be made here. For the self-serve Kafka based companies or do-it-yourself companies who are using Kafka, we are very much being proactive in making the business case and the technology case as to why they should move from Kafka.

Yes. Oh, I see what you mean. Yes. I need to be careful with my words. Yes, yes.

Right, to either Confluent Platform or Confluent Cloud, most likely to Confluent Cloud these days. For those companies that had started out with Confluent Platform only and are looking to expand their footprint, we're seeing cloud by and large, be an additive component to the infrastructure because what they -- like the companies have on-prem applications and data stores that they're using Confluent Platform for, but now they're also moving workloads to the Cloud, and they want to have the central nervous system environment where everything is connected together. And that's why cloud has been largely additive. And the cohort of customers that we call hybrid, which are running both Confluent Platform and Confluent Cloud have the highest net retention rates in the company.

Yes. Yes, like heavy use, yes. And then shifting gear a little bit, like the -- how do you see the competitive environment for you guys? And I'm telling you where I'm coming from, there's private guys, but then a lot of -- I think they missed the cloud kind of journey so that's kind of falling a little bit behind. But then you had the hyperscalers, and that's what I'm getting a lot from investors, is like, oh, look, AWS have something. So how does that play out in real life actually?

Well, the 3 cloud service providers are great partners of ours, for starters. There is a level of coopetition and it kind of varies by cloud service provider, but let me start with some commonalities across all 3. The first is we have technical integrations with each of the 3 cloud service providers. Each of those 3 cloud service providers enable their sales reps to retire quota when they sell Confluent. They also allow customers to burn down their credits when they use Confluent and we show up on all 3 cloud marketplaces. And this last quarter, we had kind of record revenue and record transactions going through the 3 cloud service providers in Q3. On the competition side of the house, each of those 3 cloud service providers have products in our space, starting with AWS, they have MSK and Kinesis; Google Cloud has Pub/Sub; and Microsoft Azure has EventHubs. When we compete head-on on a technical bake-off, comparing our Confluent Cloud offering versus like the competitive products from the 3 cloud service providers, by and large, we win on a technical basis. And then specifically, when larger companies are looking at diversifying from one cloud service provider to have a multi-cloud environment, that's also where we index very well because we're multi-cloud in nature, we can enable that. So I would characterize those 3 cloud service providers as great partners of ours. There is a level of coopetition, but by and large, our incentives are aligned. They're trying to get as many kind of workloads into their infrastructure as possible and Confluent Cloud and Confluent Platform candidly can help drive tons of workloads to those clouds. And that's why I'd say it's more coopetition than anything else.

Is it a little bit like -- I'm sorry to -- maybe I'm kind of updating myself like that, but is it a little bit like in the older days -- remember, when you competed with IBM, you had like the IBM global services and they wanted to do everything with you as a vendor. And then you had like the IBM software, which was much smaller and over time where you kind of get more money to the organization, you kind of you win. And this feels a little bit like it because like the amount of compute storage that you bring to them is much, much bigger than what they would gain on the software solution. Is that kind of a fair way to kind of...

I think that's directionally right. Yes.

Yes. Okay. Then as we kind of -- as the economy is kind of -- it's changing a little bit, everyone is a little bit nervous. Is there anything in terms of like your exposure to certain industries, et cetera, that kind of gives you pause for more or less nervousness about like in this environment?

Well, when we look at the composition of our verticals and the industries that we serve from very early on, we've had great traction with financial services, with retail, automotive, tech, but not the large digital natives that are out there, and I can get into the reasons why for that in a moment. But I would say our vertical and industry exposure has been more like to those larger type industries. From like a near term, and I get this question a lot from the investors, how much exposure do we have to crypto to fintech. We have actually very little exposure, or it's the start-up BC community, we don't have a ton there. Now the large digital natives that are out there, we have coveted those companies for a long time. These companies have typically a do-it-yourself Kafka implementation that they've completely fine-tuned for their infrastructure. And they have large engineering teams, large infrastructure-related costs. They have security bolt-ons. And it's something where we didn't necessarily have the right product at the time to go after them when they were building this out. Well, today, we actually do have the right product with Confluent Cloud. We can make the total economic argument very compelling. If you look at TCO, ROI and payback, we index incredibly well against do-it-yourself Kafka. And from a timing standpoint, we have -- we don't have the exposure that other companies have to those folks, but there's an opportunity in this more kind of depressive macro environment to really make a run at some of the large digital natives out there that are going through an analysis around do we want to have large dedicated engineering teams running infrastructure-related data streaming when you can have a cloud offering at a lower TCO.

Yes, yes.

And so in this kind of weird sort of way, the timing is actually good for us to -- in '23 and beyond, to really go after that segment. As one data point on this, earlier this calendar year, we were able to do a deal with New Relic. They are a top 20 Kafka user in the world. They had architected their whole infrastructure around do-it-yourself Kafka. And the level of complexity and cost became too much. And so they ended up selecting Confluent Cloud, multiyear deal. And we believe that can also be a blueprint for us to engage in great conversations with other folks that have been large do-it-yourself Kafka shops.

And then -- I mean, the one question you will get is like you had New Relic at the Analyst Day, and it was super helpful to understand like their journey. Like where -- is there an element of people watching New Relic and see kind of how happy they are, and then just prove out the scale and the reliability, et cetera, and then kind of that triggers like a whole kind of follow on? And where are we with that New Relic story?

Yes. We engaged New Relic on a 3-year deal. We haven't yet got to the 1-year anniversary of that but things are going very well with New Relic. I do think it will be a blueprint for other digital-native companies down the road. But I'll also say that there are large tech companies that have standardized on us that are also great proof points for us to go after large digital natives. And I really think it's a timing thing as opposed to a prove-it-out from a product standpoint. And the timing thing that I want to just double-click on is it's really about the economic environment that we think is going to persist at least through 2023 where people are going through belt tightening, they're looking at infrastructure-related optimizations and that sort of thing. And I don't know about you, but there are multiple proof points over the years where if you have a credible managed cloud offering, that wins almost all the time versus a do-it-yourself on-prem solution.

Yes, yes, yes. Okay. Yes, makes sense. And then shifting gears a little bit, like -- how do you -- where are you on the maturity around partners and other people like working with you, helping you? You talked about the hyperscalers already and doing stuff there. Is there not also -- is there a question for like the big SIs to help you? Because these are complex projects, and I would assume a lot of handholding would be nice.

Yes, yes. And so on the partner side of the house, for sure, the 3 cloud service providers are really strong partners of ours. Outside of that, we have an ecosystem of partners, a combination of value-added resellers, but also systems integrators. On the systems integrator front, we are in the early stages of what we think can be a very fruitful journey. As you mentioned, these infrastructure-related projects tend to be very complex. There are lots of services that can be wrapped around infrastructure-related projects. And we're getting to a size and scale where the deals that we're doing now can really move the needle for systems integrators, whereas in the past, we've been -- yes, it's just a little bit more on the smaller end of the curve. So that is definitely an initiative that we have for '23 and beyond.

Yes. Okay. Perfect. Yes, makes sense. It would be interesting. The last few minutes, I want to shift gear a little bit. And sorry to put you a little bit on the spot, but we knew each other from Palo Alto and with like a company that was kind of -- good cash flows coming out, et cetera. Now with Confluent just in a different stage of your life cycle, and I must heard you as well to see like, okay, compared to revenue, how much money you're still spending. But on the other hand, like how do you kind of argue that with yourself to say like, okay, this is kind of necessary, but this is the mechanics where I get to kind of a better place?

I'm a big believer in being deterministic and leading within a framework that we've established, and we always have to be nimble along the way. But balancing growth and profitability is incredibly important to us and defending profitability is also important to us. So when we come up with our internal plans and then we talk about our plans to the Street, the defensibility of the profitability is important. So even though we're in loss mode today, we're showing annual operating margin improvements, we're showing annual improvements in free cash flow margin. We're an 8-year-old company. And our position on this is we're playing in a very large market. We are definitely focusing on top line growth, but we have always been focused on profitability and improving profitability. We've laid out the track to get to basically non-GAAP operating margin breakeven in Q4 of '24. And we're showing meaningful operating margin improvement along the way. And free cash flow tracks to non-GAAP operating margin roughly, so we also think about it in the sense that we are fully capitalized. Not only do we raise enough money on our IPO, but then we did a $1.1 billion convertible debt offering in November of last year. So we are very well capitalized. And then the last thing I'll say is we are very much attuned to what's going on in the macro world, right? We've been very deliberate around controlling rate and pace of hiring. We've messaged to the investment community that 2021 was a year of catch-up investment, 2022 was a year of like high investment as well. And in 2023 and beyond, there's going to be a more moderated pace of investment. And we're focused on the unit economics of our sales organization. We're looking at productivity per head, not only in sales but across other groups. And we feel like we've made appropriate investments for the opportunity we're going after, and now we are also focused on the productivity of the folks that we've brought on.

You mentioned productivity, like that -- that's what I'm seeing a lot at the moment from other software guys. And it's not you, but more guys that kind of went -- kind of spread the money everywhere. And now, it's like, oh, I should really look at unit economics. You guys and you as the CFO, have always done that. Is it just kind of -- because the market has changed? Or what's driving your kind of work there?

Well, on the unit economic front, yes. When we think about the opportunity at hand and we think about the drivers of our business, Confluent Cloud is right at the heart of what we're trying to do going forward.

Yes.

It's not the only thing that we're trying to do. But so given the importance of Confluent Cloud, the focus on Confluent Cloud gross margins and the unit economics of Confluent Cloud isn't -- it's incredibly important operationally that we get this right. We've had a demonstrated track record over the last couple of years of greatly improving our gross margins for Confluent Cloud. And that will be important for us going forward, especially given the revenue share shift that has been happening and that will happen on Confluent Cloud. For more of the sales-related metrics, making sure that we are investing in the right countries, in the right regions and then seeing that time to productivity to getting to fully ramped, coming down. And we've invested a lot from a sales operation standpoint, in a sales infrastructure standpoint to decrease the time it takes for our salesperson to become fully ramped.

Yes.

And just as a data point, several years ago, it would take 5 quarters for a sales -- all right, I'm used to a lot shorter. But through the great work that Erica Schultz and her team have been doing, now that's roughly a 4-quarter ramp for enterprise class sales people. For our commercial sales team, it's a little bit less time. But that type of focus and rigor is super important for us to able -- to be able to achieve our margin goals.

And from a CFO perspective, we say we're living in uncertain times. What do you track internally and again how much kind of -- what's the framework for you to change like, I okayed the investment and I kind of -- let's pull it back a little bit. Like how do you think about that?

It's a topical question. As we're going through our finalizing our '23 plan and our long-range plan that we update annually, we always have a list of funded and unfunded projects. But like in this environment today, that scrutiny has -- it's always been there, but there is a different level. Especially around like what's the trade-off between something that will have a payoff multiple years out versus, well, we'll have a payoff in the next like 12 to 18 months. So our investment lens has shortened in terms of time horizon to make sure that we're delivering on projects that will help move the needle in the short to medium term while never losing sight of the longer-term things that we're going to be doing to really go after the business. So the innovation engine at Confluent has always been funded at a -- like at a good level. And the mixture of short to medium term versus longer term, there's been a balancing act there. And I feel really good about the prospects of that development road map.

Yes. Okay. Perfect. And then last question for me, and then I need to let you go. You have a very healthy cash position. Obviously, we need to have a couple of quarters until we have the proper cash flows coming through. But how do you think about M&A in this environment? I was asking a question earlier and the private asset prices are maybe not coming down as quickly as the public wants yet. But how do you think about that opportunity set there? And is there -- like if you think about what you're doing, let's say, even stuff out there that is kind of meaningful or is it more like small tuck-in because like it does feel like you have like a really good platform there?

Yes. So the first step I think about it in terms of just broad capital allocation and in the 3 traditional pillars of capital allocation, like invest in the business has been primary number one. That's going to continue to be the case. For the M&A pillar, we are -- we'd be very selective. We haven't been very active at all. But things that we have shared with you in the past has been like if we identified something that would accelerate time to market, on our product road map, that's something that we would take into consideration. We'd be very disciplined in terms of like valuation and everything else. But our point is like those types of opportunities would tend to be on the smaller side, technology tuck-in or acquihire.

Yes. Okay. Perfect. I think we have like 15 seconds left. There's a real German effort here to be on time.

Thank you so much. Thanks. Appreciate it.

Good to see you again. Thank you.

Thank you.