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

All right. Let's get started. I'm Rob Owens with Piper. I'm the analyst covering the infrastructure and cybersecurity software segment. Really pleased to welcome our next presenting company here in Confluent. And with me, the CFO, Rohan Sivaram, and we've known each other for a few years at this point. So excellent to see you. Thanks for coming. And Confluent's in the news, I guess, which is yesterday, with the WarpStream acquisition. So love for you to give us some detail in and around what the company does, I guess, first of all, and then we'll kind of dovetail from there.

Absolutely. Well, good morning, everyone. Good to see everyone here. I mean I just want to step back and talk about like we have over 150,000 organizations using open source Kafka. And when you look at Confluent, we're just scratching the surface with a little over 5,000 customers. So our mission is to soak up the world's kafkas, what I like to say. And we do that by basically bringing every application from every customer into our ecosystem. So when we really think about the true north, that is our true north. How we've been doing this and taking advantage of this opportunity was with our self-managed solution, which is Confluent platform and our fully managed cloud native offering, which is Confluent Cloud. And then a third emerging category started coming up, which is bring your own cloud. And that basically takes, I would say, mitigate the operational challenges with respect to moving to a fully managed cloud solution and helps a lot of unique use cases from a BYOC perspective. So as we were looking at it, WarpStream was a company that was doing BYOC right. And they have this unique way of doing, I would say, a truly native BYOC solution, where they are building the solution in S3. And from a technology perspective, as we were looking at it, WarpStream by far, was best-in-class. They have an incredible team. So overall, that's why we decided to acquire WarpStream. I'll just give you like another lens, Rob, to think about. When we think about our TAM, we have a large TAM. Our SAM was less than our TAM. With the WarpStream acquisition and bringing BYOC under umbrella, we've actually increased our SAM, and we're getting to a point where the SAM and TAM is converging. So that's probably a little bit of color around WarpStream.

Siri doesn't believe you. I don't think...

That's right. That's right.

So how big was the organization? Was this more of an R&D tuck-in? Was there actually some scale of it to the group?

Yes, it's a small team, and it kind of falls right in our overall philosophy around acquisitions, which is acquire best-in-class technology, really high-quality people and that gives us an opportunity to kind of scale with what we have here at Confluent.

And was this end customer push? Was this something you felt you competitively needed to add to the portfolio? Because I think some of your competitors did have a bring your own cloud capability.

Right. And this essentially goes to the point I was making that is this gives us the opportunity to play in games that we were not playing and it truly expands our SAM. And when I really think about it, when you look at our overall strategy, it has been primarily focused around widening the aperture and kind of increasing the surface area for customers to land into the Confluent ecosystem. And we did that with enterprise SKUs. We did that with our [ freight ] clusters. We did that with WarpStream. And what it does is it just brings a lot more use cases in play that were not in play before.

Fair enough. And I guess the last question, where will this fit from a revenue perspective? Is this platform? Is this cloud?

Right. Yes. Early days, but our early hypothesis is this is going to fit in cloud under our subscription revenue. Yes.

Okay. Fair enough. Maybe to drill down a little bit on the second quarter, which was strong, but I think came in like a lion, went out like a lamb, if you will, just relative to the pace of what you saw. And you noted some weakness towards quarter's end. So just some of the puts and takes of where we're at from a spending perspective. I think you're not alone in saying that. But I do get the question quite often around prioritization of some of these transformational projects in streaming. So I just love to understand where the customer attitude and appetite is at this point?

Yes. For the second quarter, the puts and takes, I'll probably talk about it in 3 lenses. The first, just looking at the quarter, the Q2 results and the print was very solid. We grew our subscription revenue 27%, we grew our cloud revenue 40%. And when you look at our on-prem platform business, we saw a very healthy momentum there. And we were doing this while driving very meaningful operating margin and free cash flow expansion. So in general, the quarter was very solid. The second dynamic was around our digital-native customers. And this is a customer segment that has been a growth driver for us over the last 12, 15 months. The growth, however, has not been linear. There's a sawtooth pattern of growth, and that's something that we saw towards the end of Q2 that we called out in the call. However, when I really look at this segment, the digital native segment, looking forward, say, over the next 12 to 18 months, I expect this to be a growth driver. So that's category 2. And category 3 is around a couple of big initiatives that we've been focused on this year. The first is our consumption transformation. And we've implemented a bunch of these changes, be it the new comp plan, the operational changes at the beginning of the year. 6 months in, we feel good with where we are of all the changes and the momentum is good. Still a lot of wood to chop, but we feel really good with where we are in the transformation. And the second is around DSP. Beginning of the year, I mentioned that DSP is going to be a key growth driver for us. And for 2024, the focus will be twofold. Number one, we kind of come out with the product refreshes and the product announcements. Halfway through the year, we're on track. And number two, focus on adoption and that has been going in line with our expectations. So to summarize, I'll say that Q2 execution was solid. We called out dynamics on our digital native segment, but we expect that to be a growth driver. And the DSP and the consumption transformation are on track.

Can you double click into that go-to-market transformation. And I think that one of the things that's been unique to your story, at least from our purview, is customer acquisition has been relatively strong, too. So is it driving behavioral changes? Was that compensation focused?

Yes, it was compensation focused. And a little bit of a 30-second preview, like when I look at the different software models, back in the day, we had this hardware license or a fair model, right? Then we had the SaaS model.

I'm beyond that. I don't remember that.

That's right. That's right. Then we had the SaaS model, and now we have the consumption model. In the first 2, the true value-creating event happened when the sale was done. You're guaranteed to take revenue and you're guaranteed to get the cash. That's actually not really -- does not apply for consumption business models. Consumption business models, you need to be joint at the hip with your customer, and you need to drive and partner with the customer to drive consumption. And that was basically the thought process behind our changes that we made. And the changes we made was mostly around compensating our reps to drive incremental consumption and drive net new logos and that kind of makes sense given what I just shared, and the early feedback or rather the early results have been positive. As you mentioned, we exited last year with -- our customer count was not where we wanted it to be. First half of the year, we accelerated our customer count and our goal will be to continue the momentum as we go through the year. So overall, we feel good with the changes we implemented. And 6 months in, we still have a lot of wood to chop, but we feel really good where we are.

What do you think are some of the deciding factors for those customers? I mean there's half-full, half-empty. You've 5,000 of 150,000, massive opportunity or open source is good enough. So I guess, help us understand the customer journey and what becomes either the pain point or the decision point that they say, "I need a Confluent?

Yes. I mean there are obviously quite a few, right? When I look at our opportunity set, right, the biggest opportunity set is in the open source where we have these huge set of open source users, and I would say, when you think about the levers with respect to how we convert them, there's this misnomer that open source is free. Open source is not free. In open source, typically, customers spend their money on hiring expensive Kafka engineers. They spend their money in essentially paying for infrastructure, and they spend their money in driving like the bolt-on applications around security. And what we do with a managed service is we take care of all of this at a better ROI and TCO. So typically, there is a point where the complexity in organizations go up, and we obviously play a very important role in reducing the complexity. And the second area would be our product differentiation over the last couple of years has been increasing and that gap with open source is increasing. So that's another vector where we see these conversions happen. So when you really -- I'll just finish off by saying giving you a time line, when you look Apache Kafka is, give or take, 13 years old. Confluent, we're celebrating a decade, so that's 10, and our cloud-native version of the product is probably a little over 5 years. So the expansion of cloud and innovation around our cloud product with every passing year is more and more meaningful. That creates that true driver for open source users to convert.

What about the ability to sell this? And obviously, there's a lot of hand-to-hand combat in terms of direct sales, but evolution of channels, systems integrators. Where do you feel you are in that journey? And where should that be when we look a few years out?

Yes. Big opportunity for us, big opportunity. So when we -- when you look at companies that have scaled to multibillion dollar revenue, channel has played an important role. And it's nothing different for us as we think about our evolution when we look ahead. So specifically to your question around the channel and the partner ecosystem, there are probably 3 areas which we feel are big drivers. Number one, our close, strategic partnership with the hyperscalers and that partnership is not only on the technology side, but also on the go-to-market side. And the results we've been getting with the marketplace momentum, with us winning Partner of the Year multiple times, that area is going really well. The second area, which candidly is probably an opportunity for us ahead is the GSI and SI and the partner ecosystem on that front. We're getting to a size where we are being meaningful with respect to and we're getting their attention. And our partner ecosystem team is closely aligned with some of the larger GSIs and SIs to kind of build that partnership. So as I look ahead, that's going to be a future vector of growth. And the third category is, we're driving a lot of programs around connecting with Confluent, partnering with Confluent. And most of these programs are essentially helping our partners integrate our technology with their solutions. And that area has been early days, but we've expanded our data pretty significantly as it pertains to what's going through our partners. So overall, I think it's a big opportunity, but we're probably in the early innings of it.

Maybe level set for us, just Flink and how it's progressed. I went to -- you have your user conference next week. Obviously, a lot of competing user conferences going on at that time. I was at your session a year ago and you're fusing people to get in the room. I think there was a fire code issue around the different Flink sessions. A lot of excitement, but it's been okay, right? It's been good. I understand it's early. Why do you think it didn't take off as quickly as maybe investors wanted or perceived? And how are customers looking at the benefit? Is it still a very evangelical sale? Or do they get it as part of the broader platform here? It was standing remotely. It was crazy.

Yes. I mean we're very excited about Flink. And when I look at it, even from our early days as a company, streaming and stream processing, both were part of our core strategy. And we acquired Flink because over the last few years, we have seen this Flink open source ecosystem thriving. In fact, the open source ecosystem, the growth of Flink open source has been very similar to that of Kafka. If you look at the shape of the curve, it's very similar. They are probably a few years apart. So overall, there is a lot of momentum there. There is overlap in the open source, overlap in the customer base. So that's probably a little bit of a background. We GA'd the product in earlier this -- Q1 of this year. And in our Q2 call, we mentioned that we have about 1,000 customers and prospects trying out Flink. So overall adoption has been going in line with our expectations. And Rob, I've mentioned this before, 2024 from a Flink perspective is going to be the year of adoption. And the monetization and the material contribution to revenue will be a 2025 event and that has not changed. So when you look at the opportunity for Flink, what it was, say, to your example, around 12 months back to today, it remains the same, and we continue to be excited.

Excellent. What other areas can we see the platform evolve into. So data streaming, data stream processing, you've got the security angle. What are other things that -- as you look on the horizon that would make sense for a Confluent?

Yes. It's interesting for us or when you look at our revolution. The first phase of our company, be it the first 5-odd years was all about Confluent platform. The next 5-odd years was around Confluent Cloud. And you might remember this during the time of our IPO, our Confluent Cloud business was in the mid-teens, and our hypothesis was we'll probably get to a majority of the business. Fast forward, it played out. So as we stand today and look ahead, we're making this transition from a single product company to a multiproduct platform. And that includes basically product on logs for connectors, Flink GA that happened this year and our governance product. So that's our data streaming platform. We also announced a product called Tableflow which is obviously early days, which kind of uses the concept of Apache Iceberg where most of this data gets analyzed in tables. And when you kind of combine streaming, processing and Tableflow, it provides real value to downstream applications. So to come back to your question, I think our focus will be around solidifying the different components of our data streaming platform, which are in their earlier stages of their S curve. And looking ahead, obviously, there are a lot of adjacencies that we can look at. But right now, the focus is mostly on the data streaming platform.

And let's weave GenAI now into the discussion on how it benefits you in a lot of different ways, and how you're a beneficiary because I think that investors have been hot and cold around your GenAI story, to be honest. Then you've come out with big production use cases of customers using -- GenAI customers leveraging your technology. So how do you think it fits now? And how do you think it fits longer term into the Confluent story?

Yes. For GenAI, there are probably 2 ways to look at it. The larger LLM vendors are using Confluent, like OpenAI as a customer of ours. And they are more like a large company with a big infrastructure footprint. From my perspective, the bigger tailwind for GenAI, for the industry is going to be when mainstream organizations kind of adopt GenAI. And when you look at that architecture, you basically have some applications which are wrapped around an LLM. You have the vector databases and you have these RAG pipelines that are getting created. And for these to work well, you need real-time organizational context. And that's where Confluent comes in and provides that real-time context to basically reduce the number of hallucinations that happen. So that's where we are playing. And we feel that we're probably in the earlier stages of the growth curve here, and we have a seat at the table, and we probably see this as a tailwind over the long term. But to your point, some of the use cases that we are seeing right now are just powering chatbots, for example, is a lot of our customers are using Confluent or you can think about providing AI-related prompts to drivers to avoid accidents, that's also driven by some kind of real-time technology or you could think about data science teams actually using AI and machine learning tools to provide automated AI-driven fraud detection. So there are a lot of use cases that we are seeing, but I think the opportunity is big as we look ahead.

Within your customer set, where is the discussion around how much needs to be real time versus nearly just in time. So I think there's definitely a line of bifurcation there. You guys have spoken to just what you think the TAM opportunity is within spend here as a result?

I think it's a good point, and I'm going to weave this into my prior comment around GenAI. So what GenAI will do to the broader industry is we are going to see acceleration of these applications moving to real time. And that's -- we're going to see that secular trend when GenAI actually adopted from a mainstream perspective and that's going to benefit Confluent as well. So yes, I think as the data landscape becomes more and more complex, the link between operational databases and analytical databases becomes even more important. And that's also a catalyst for more and more applications moving to real time in addition to my GenAI comment.

And sitting in the CFO seat, how should we think about growth versus profitability. And you've made some amazing strides relative to margins and free cash flow at this point. So how are you thinking about balancing that moving forward? Obviously, it's a difficult environment right now, but the hope knock on wood as the things start to open up a little bit more. So what can investors expect to hear from you relative to that balance in that argument?

Right. My philosophy around resource allocation has been fairly consistent over the last few years, which is to drive durable and efficient growth and both are important. And as we think about resource allocation, it is all around making sure that you're kind of investing the right amount in your go-to-market functions to drive short- and medium-term execution. And you're investing from a technology perspective, that kind of provides consistent flow of innovation from a product standpoint. So to your point, over the last few years, we've improved our margins 40-plus percentage points. And while we've done it, we've also continued to make sure that we are innovating at a very, very healthy clip. If you look at 2024, the amount of product innovations we've seen and the momentum of it has been really good. So as part of my resource allocation strategy, I think that will continue to be there, where you're trying to invest in technology that typically has ROI in 18 to 24 months. And as it pertains to the short and medium term from a go-to-market perspective, that's something in our control. You can turn the knob left or right, depending on where you are to make sure that you have the right capacity on board to deliver on your plan. So that's the high-level way that I think about it.

Pause real quick and see if there's any questions from the floor while we have a couple of minutes left. I think you guys noted a couple of large platform deals last quarter. What drives that decision at this point of platform versus cloud? And I realize they do carry different retention rates as well typically. So question one, really around just what's the decision point for customers and what you're seeing from a retention rate standpoint?

Yes. I think overall, we've not broken down retention rates, but our health of our customer base remains very solid. We've had our gross retention rates, which have been north of 90%, and it's been fairly consistent. So with that -- from a customer perspective, Confluent platform continues to be very relevant for us, primarily in some of our regulated industries, be it financial services, be it the Fed. It's been a driver of that business as we look back, and we continue to see that kind of behavior as we look ahead as well, right? And it's funny because a few years back, we did think that the movement from on-prem to cloud will be accelerated and then we'll have nothing on-prem. That's something that -- not we are seeing, right? That's not what we are seeing. So the Confluent platform side of our business will continue to be relevant as we are thinking about internally with respect to investments and what we expect out of the business.

And one final one, since you mentioned Fed, we are in the Federal Fiscal fourth quarter for the U.S. government. Just broader thoughts on what that has meant historically, some of the different programs as you work on FedRAMP that you have in place and what those could mean and just where the federal government is from a data stream or a data stream processing perspective?

Yes. I think we partner and we have a bunch of these Federal Government agencies who are customers of ours and we're in the process of getting FedRAMP certified. It typically is a process where it's Confluent and then you have a government partner, and we're making that progress. And once we get FedRAMP certified, of course, it will open up a new set of opportunities, mostly on the cloud side. So I think that's been a business that is -- we feel good about. And with FedRAMP, we'll have even more opportunities as we look ahead.

When you look at the opportunity, could this be outsized for Confluent? Could this be one of your larger or largest verticals if we were to look a couple of years out?

Post FedRAMP? I wouldn't say one of the largest verticals. The good part about Confluent is when you look at industry verticals, we're not overexposed in any of the industry verticals. So I don't see this as a huge outlier, but it is going to be a contributor for us.

All right. Well, I think that's time, Rohan. Thank you so much.

Thank you very much.