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

Thank you for joining us. I'm really happy to have Rohan here from Confluent.

The -- if you think a lot, Rohan, a lot of stuff happened in the last few weeks and you guys are more on cycle. And so people keep to -- tend to forget, because we had off-cycle guys now, and it's like -- everyday here look like a crazy movement. If you think about like to get everyone back up to speed, can you talk a little bit about your Q3? What you saw there and then we'll just take it from there?

Yes, for sure. First of all, great to see you and thank you for having us, and good afternoon to everyone. Well, when I think our Q3 quarter, it was a solid quarter, in general. We had a continued momentum from a top line perspective, grew north of 30% and we improved our margins by 22 percentage points. And while we were doing this, we also -- our net retention rates, which is a metric that I candidly look at all the time, was just shy of 130% for the total company. And our cloud business net retention rate were north of 140%. Another metric that I focus on is the health our installed base of our customers, which is gross retention, and we came in at 90-plus percent for another quarter. We've been consistently in that ZIP code post our IPO. Having said that, we also had some puts and takes as we provided guidance for Q4 and 2024. And we called out I would say 3 factors. The first one is a fairly idiosyncratic things happening with 2 of our customers. The second piece was around we've seen this slowdown in use cases for our digital-native segment, which is a small piece of our business. And the third piece was our transformation we are going through on the go-to-market side with respect to moving to a more consumption-based comp plan. These 3 had implications to Q4 and 2022, which we called out. But taking a step back, good solid Q3 with a few puts and takes that had an impact to our Q4 and 2024.

The question I got a lot from investors, was that something where the fundamental end demand changed for you guys? Or was this kind of like sometimes you get unlucky like unfortunate timing and those 3 things that you mentioned, they don't seem to be like a fundamental change, like how do you see it?

I mean, I always like to take a step back and look at the opportunity. And when you really think about it today, data streaming is something that's top of mind for every company out there. And when you couple that with just a secular tailwinds around cloud, I think those are the 2 biggest drivers for our business. That kind of shows up in our opportunity that we have, a $60 billion-plus market opportunity. And this really large open source ecosystem where greater than 150,000 customers are actually using open-source Kafka. So from an overall opportunity perspective, we're very excited with respect to the opportunity. How do you take advantage of this opportunity matters. And of course, we'll be talking about that piece. But that's also another point that we should talk about as we go through it.

Yes. Yes. Okay. And then the one that came up a lot was one of the customers you pointed out, it seems to be bringing everything back in-house. And that kind of created some fear in the market that people are like, "Oh, people can back to open source, open source Kafka, and it's you don't pay for it because open source or you pay differently." Is that like a beginning of a trend? Or -- how would you see it?

Yes. I think the customer you're talking about is just gaming customer we called out. And this gaming customer had made an independent architectural decision to move from cloud to on-prem. And the reason they did that was they had an outage driven by another cloud provider. So as a result of that outage, they made an independent decision to move on-prem. And Confluent happened to be a cloud provider and we got impacted by that. Having said that, we are in active discussions with them with respect to helping them with their on-prem workloads. And our Confluent Platform product is a meaningful differentiator with open-source Kafka with respect to not just on the streaming side, but also on the connectors, the governance, the security. So I'd say that's a dynamic. I mean we don't see this as a trend. [indiscernible] with respect to we don't see a whole lot of companies doing it.

Yes, yes. It looks like the -- and the other thing also there's one thing to go from a cloud to self-managed yourself, but then you also go from managed to open source, which somewhat seems like a step backward from there.

Yes. I mean these use cases of digital native customers being on-prem and doing open source is something that is very, very unique, like we said. So it's not a trend, one-off, and that's how [ it is called ] that's why I specifically mentioned that's fairly idiosyncratic versus being pervasive across the business.

And I apologize like if it's like another kind of case, but I better clear it up and then we can move forward from there. You talked about another customer that's saw it like a corporate action then kind of changed. The -- I think changed the ownership and kind of slowed down some of the rollouts there. Is there any updates there? It seems like just timing because if there is corporate action then everything freezes basically until it kind of opened up again?

Well, I wouldn't provide mid-quarter on this, but what I'll do is I'll provide a little more color around what I shared during the earnings call. This customer is a large customer, multiyear commitment partnership. And whenever you have relationships like this, it's typically engineering to engineering discussion. And post that discussion comes up with respect to a forecast, which is the forecasted consumption curve. The actual consumption curve actually happens to be slightly lower than the forecasted consumption curve. Or another way to think about it is our consumption curve is actually moving to the right and as a result of that, we saw a partial impact in Q3, even to see a full quarter impact in Q4 and some impact in 2024. That's the dynamic. I mean we're partnering with this customer to make them successful in their real-time data streaming journey. And that's where we are.

Yes. And I wanted to go -- to get those questions out of the way. Because the other thing I want to talk about is like in general, like the demand or interesting clients because I was at your conference in San Jose. And I mean I have to say I was -- like excitement was clearly visible there. People want to do more stuff but I also realized people are -- they need Confluent, because Kafka is complex as [indiscernible], language is not to say like that. But it is complex. I'm struggling, sitting in the session. What are you seeing from the field or like in general from the field when you're talking to people out there?

I mean I said it. The demand for data streaming real-time data is great. We have a huge opportunity. And I touched on that how you take advantage of this opportunity matters. And we are doing it with meaningful differentiation, not only on the technology side, but also on the cost side. Let me spend a little bit of time on each of them because it's important.

Yes.

On the technology side, we -- you've heard me say this, our products are cloud native, complete and everywhere. What do we mean by that? Cloud native is our Kora engine that powers our Confluent Cloud and our products, helps it elastically scale up and down, provides really high SLA and obviously that is a differentiator from a cost perspective as well. When I say complete, Confluent is not just a streaming solution, we're a complete platform where in addition to streaming, we have connectors, we have governance and we have our stream processing product. And last but not least, we are everywhere that means we can take care of your workloads on-prem in any cloud and in a multi-cloud environment. So those are the differentiators that obviously helps us gain more traction in the marketplace. I mean on top of that, we provide meaningful ROI and TCO benefits, which obviously is very helpful.

And then if you have events like the conference, does that kind of show up for you like in terms of pipeline, pipeline interest? Like it's early stage so we don't talk numbers here. But like does that -- how much of a kind of impact does it have for you guys?

Yes. Any time you have a big event, I'd say, top of the funnel you see some activity. And there is a cadence to these events. So for example, how we think about our guidance, how we think about our forecasting, these kind of events are baked into it and they're all part of the process. But to answer your question, yes, when you see these events, of course, more people are hearing about Confluent, more people are hearing about our products and that shows up in the numbers from top of the funnel perspective.

And if you think about, like if you compare the conferences in just the last few years and the impact it had on top of the funnel, you see an increase? Like how does it play out? Does it -- do you see an increase there in terms of top of the funnel, because there's more people out there, more interest, more understanding of what you can do there?

Yes. I won't compare year to year, but what I'll tell you is top of the funnel sign-ups, we have our internal forecast and what we are seeing say over the last few quarters it has been at or above our internal forecast. So that's good. I mean we are seeing that traction, we are seeing the interest and we're not surprised, but we're seeing that.

Yes. Yes. Play out. Okay. Perfect. Yes. And then if you think about like your customer base, like, obviously, the first adopters for Kafka were like the Internet companies, the digital natives. But as we speak about like the follow-on adopters were like banks that kind of used it for credit card fraud, money laundering, et cetera. If you think about those kind of classic customers like the banks et cetera like, where are they on the adoption journey?

When I reflect on it, it's interesting because you speak about every company today is becoming a data company. And every company today is becoming a software company. And data is at the heart of what they're doing. And how they are able to harness their data actually is a competitive advantage for these companies. So from our perspective, what we do is we help these companies basically realize their data in a real-time manner, we help them do it in an economic manner and we help them do it in a safe manner. So with that as a preview, I mean, the regulated industries in general, we've seen really good traction over the last couple of years. And some of our customers here, I'll give you 2 examples. I would say probably a year back, we called out this Fortune 50 bank, which started off as a small customer with a handful of use cases, ended up being a $10 million-plus ARR customer. And that customer is -- probably still has a huge amount of runway ahead of it. And those are use cases that we've seen. I mean our $5 million and $10 million-plus customers, although we don't share their data, they're kind of moving in the right direction, right? Another customer we called out was this job search company, which started off as actually a pay-as-you-go customer, self-service, and they ended up being a $10 million plus ARR customer. So I think the momentum is there. And the best way to think about it is when you look at our customer cohorts, the $100,000-plus and $1 million-plus cohorts over the last 12-odd months, we've seen good traction. And that tells you that our customers are progressing in their journey to be the central nervous system or data in motion journey, they're progressing well. So the momentum is good.

Yes. Yes. Okay. And then flip side of that question is like digital natives. Obviously, that was always -- that will always be like the holy grail. I mentioned like they give up on doing open source Kafka. Where are they on that journey of like do I really need to do it myself?

Yes. And when you asked the previous question you briefly touched on it. I think it's important for folks here to understand just the overall journey. Our founders wrote Kafka while they were at LinkedIn and they put it out for open source. That's step one. Confluent was formed after that. And we started off as on-prem -- we started off our first product was on-prem. And then Confluent Cloud is about 5 years old. So that's important to understand, because the digital-native segment in general, the early adoption in the digital native segment was all open-source Kafka, right? And when you think about that how are they spending their money on and time on, 3 things. Number one, they're spending their resources on infrastructure. Number two, they are spending their resources on very, very expensive Kafka engineers. And depending on the size of your shop, it could be from a handful to up to 20. And the third category is they are spendings their resources on bolt-on applications on security and governance to make sure the right data is accessed by the right people. So what we do with Confluent Cloud is we are managing this as a service. So obviously, our view is, over the long term, a huge chunk of this open-source Kafka market will eventually be cloud managed. And we are in pole position to actually take advantage of this opportunity. We're in pole position to take advantage of this opportunity. So that's how I think about it from an overall digital native perspective. And if you ask me where are you on the opportunity, I'd say just given the timeline I showed, right? The bigger opportunity is actually in front of us versus behind us from the digital-native segment perspective.

Yes. For sure. And then the other thing in like last question on product side is like Flink, really nice adjacency to Kafka. You guys had a small acquisition there and now kind of trying to build out the cloud platform there. Where are we on that Flink journey in terms of that product ready and then like we can talk about like how customers are adopting it?

Yes. What we've noticed is increasingly, today, engineers not only want to focus on streaming, they want to make sure the streams are enriched and you're building applications on it for real-time data, real-time analysis. So that's why stream processing continues to be really, really important part of what we're doing. And what we've also seen is that Flink is fast becoming a standard. And that's one of the drivers why we acquired Immerok earlier this year. And our acquisition candidly has gone very well. Across the board we're hitting all our internal TAT timelines. And the product in our conference that you recently attended, we had a public preview of our product where a large chunk of customers are actually using it and we've gotten good feedback. And we expect to GA this early next year in Q1 and we're excited about it.

And then like how -- like if you think it's a subscription offering, stuff like it is not like necessarily your numbers are going to explode next year, it is just like it is going to ramp up with adoption. Is that the right way to think about it?

That's right. Any time you have these applications or infrastructure software products, right, there's obviously a time to ramp that it takes. And this basically means that you've got to build some applications. And our expectation is there is going to be a rough and tough ramp of about 6 months, purely because the dynamics that you called out, right? And so we're going to see contribution from Flink towards the end of 2024. However, the real monetization will actually happen in 2025.

Okay. And then the -- how big is that Flink mark -- I mean like when you kind of brought the company, you kind of probably had to put the case together -- for the acquisition presented at Board et cetera, like how big is that Flink adjacency to the Kafka adjacency?

I mean, it's interesting because when we were looking at the Immerok acquisition, the Flink open-source community is really large. And 2 other observations that we had was there was some overlap between Flink and Kafka community, and there was also an overlap within our customer base between Flink and Kafka. So there's obviously a decent amount of overlap. And I touched on it, Flink is starting to be a standard for stream processing. And we feel today, probably there is more spend happening in stream processing than streaming itself. And so that's a real opportunity for us. And obviously, it matters how you take advantage of the opportunity. I keep saying that. And our Flink product will be one of the first commercially available products out there, which is going to be truly cloud native, it's going to be a complete and it's also going to be everywhere.

[Should be ] interesting. Okay. And shifting gear to the last few -- well we still have a little bit of time. Shifting gears a little bit. On the earnings call, you talked a little bit about the changing of the incentivization for the sales force towards more like a consumption model. A lot of people, I think, misunderstood it as something that you're changing like your revenue model or something. Can you speak to what you're actually trying to do there? And how that fits in?

Yes. That's a good question. And there are probably different ways I could answer it, but I'll start off with the why. When you look at the current macro environment, how our customers want to consume our product is they want to consume our products and they want to commit to the level of their consumption and don't want to commit way ahead of time. So let's hold that thought. Now when you compare that with how are we incentivizing our sales people? We're incentivizing our sales to sell the largest ACV deal possible. And that is basically driving an inherent friction in the go-to-market model. So that's the why. And so what are we doing? We're doing a couple of things. First of all, I want to call out that this is not a business model transformation. This is a go-to-market change, primarily on the incentive structure side that also has some operational implications that I'll talk about. And what we are doing is last year we had about 15% of our sales incentive structure for our sales people [ before ] cloud. And we are moving to a more complete 100% incentive structure for cloud. So all your compensation, 100% of your variable compensation will be driven by cloud consumption and cloud [ new logos]. So that's the change we are making. And another thing I want to call out is the changes are not happening in Q4, they're happening in January of 2024. So how we end the year will be on the old comp plan and old model. And the last piece is the Confluent Platform business, there are absolutely no changes to that. The model what we have this year, will be the exact same thing for next year as well.

So you're removing friction in terms of [ forward ] adoption. Yes, yes.

Right.

Yes. And that -- I've seen other vendors like I think MongoDB has done it before. The one thing that is always an issue there where the some stuffs like sales guys they want the highest commission, they want a big check. How do you like -- how do you make them [ comfortable ] or in terms of this model versus like the old model?

Yes. Anytime you go through a change like this, obviously you need to make sure that you're running the right focus groups, you're doing your outside analysis. And I can you tell you a vast majority of the field is very excited about this change. And we also looked at outside and some of the companies that you called out, most recently MongoDB went through the change. And it's been successful because ultimately, Raimo, when you think about it, thinking first principles, what are the drivers of consumption? In my mind, there are 3 drivers of consumption. Number one, you have your existing use cases and there's more volume flowing through existing use cases. Number two, it's all about the net new workload, net new use cases and that candidly is the larger driver. And for us, the third driver is our ability to sell different components of our data streaming platform, be it the connectors, governance and stream processing. So what we are doing is we're focusing time on what matters the most to drive consumption, which is net new use cases and selling components. So that's why while we're being prudent in our guidance and taking care of -- anytime you go through a change like this, there's an adjustment risk. We've included or rather taken into account that adjustment risk for 2024. But exiting next year we feel that it's going to be a tailwind for our business.

Yes. So anything you say -- sorry, just in practical terms. So its your job as a CFO to do that, like. So adjustment is basically okay, so this is like [ what I ] think I am selling, but like I'm taking a discount because there might be some disruption or something and so there is a new number that kind of the way to do it?

Yes. I think it's -- I'd say, multiple things. It's about making sure that are you're baking in any kind of -- if there is any kind of attrition you're thinking through that as well. Although it said that vast majority of our sales force and go-to-market team is excited about it. There's probably going to be a small number that might weed out. So here we need to take care of that, right? You need to obviously take care of operationally, I'll say, there are a bunch of changes I touched on it earlier, the definition of a pipeline in today's world is ACV dollars. The definition of a pipeline in 2024 is going to be -- for the cloud business, is going to be net new workloads. So those are the adjustments we just need to go through as a company. But again, this is something, which is 100% in our control. And the fact pattern of some of the other consumption players doing it has been very positive. So we feel confident with respect to flawlessly executing against it.

Yes. Yes. Okay. The next one is like last couple of minutes, I want to talk about the margin and costs. If you think about the -- like you [ kind of went into ] dramatically quicker towards the breakeven scenario. Like how did you achieve it and the risk that I hear from people is like, look, if you do that kind of quick move very quickly, like how does it impact kind of future growth opportunity? Can you maybe speak to that?

Absolutely. The last 7 quarters as a public company, we've shown 35-plus points of margin improvement. And you actually cannot do that if you don't have a company-wide philosophy. And our philosophy has been very clear, we want to allocate resources to drive efficient and durable growth. And you do that by having this maniacal focus on unit economics and you do that by having a maniacal focus on ROI-based investing. And that's been our focus. Specifically, we've obviously got leverage in our go-to-market teams, we've seen leverage in how our cloud business has become more efficient overtime. And these are probably the bigger drivers over the last 7 quarters. And we'll probably be the leading drivers as we look ahead from an overall efficiency perspective. Now your question around growth. Any time you're going through annual planning cycle or a resource allocation cycle, it's never about the next 12 months. It's all about the next 3 years. And I'll give you some proof points. In 2024, you heard us talking about technology unlocks that are going to happen, be it our Flink and GA product in Q1, networking unlocks, our FedRAMP. These are all investments we've actually made in prior years. So you absolutely have to think ahead not only from an R&D perspective, but also from a go-to-market perspective with respect to how you're allocating your resources to drive the durable and efficient growth.

Yes, if you think about it, like the evolution from here, like you had, that was kind of a heavy lift, like I haven't really seen a lot of companies kind of be able to kind of turn so quickly. Like what do you think is going to be going forward? How do you think about this going forward? Like not next year, like you talked about like more like what's the cadence that you kind of expect going forward for you guys?

Yes. For next year, I provided early color, we're going to be margin neutral for the full year, which if you compare guidance to guidance, it's about a 9-point of improvement, and we said that our op margin and free cash flow will probably be in the same ZIP code. And over the medium term, we want to get our operating margin between 5% to 10% and long term north of 25% and we'll be on a journey to get there. And we also don't want to lose sight of the opportunity that is ahead of us with respect to the large $60 billion TAM. So it's a balance. And what's in my control is the rate and pace of investments and the rate and pace of investments will always depend on how we are doing just balancing growth and profitability.

Yes. Hey, Rohan, we have 40 seconds left. So I will give you that back. I really enjoyed our conversation. Thank you.

Thank you very much.

Thank you. Good to have you here.