Confluent, Inc. (CFLT): Why Are Analysts Bullish on This Cloud Stock Right Now?

We recently compiled a list of the 11 Best Cloud Stocks to Buy According to Analysts. In this article, we are going to take a look at where Confluent, Inc. (NASDAQ:CFLT) stands against the other cloud stocks.

The surge in internet speed and usage has created a plethora of new industries in its wake such as eCommerce, social media, and online streaming. On the business side, one of the biggest beneficiaries of advances in communication is cloud computing. Cloud computing in its simplest terms is the use of computing resources virtually, where companies host expensive hardware and data servers and sell this capacity to customers.

Naturally, it's unsurprising that some of the biggest companies in the world either directly offer cloud computing software products or the hardware that powers these systems. In fact, out of the five most valuable companies in the world in terms of market capitalization, three have leading cloud computing divisions (Google Cloud, Amazon AWS, and Microsoft Azure) while the other is a hardware company that is Wall Street's AI darling.

In fact, cloud computing is so valuable that research from Bloomberg shows that AWS alone can reach a whopping valuation of $3 trillion. To wit, only the world's biggest companies have crossed this metric, so this figure shows the potential that's present in this industry. This isn't the only time that a trillion dollar figure has been chosen to describe cloud computing's potential. One of the biggest benefits of cloud computing is that it allows businesses to save on costs by outsourcing their hardware procurements.

These benefits will be worth quite a bit as research from McKinsey shows that by 2030, they can enable cloud computing companies to capture up to $1 trillion in run rate operating income (EBITDA) from Fortune 500 firms. Run rate EBITDA is a key metric in cloud valuation, as it projects current earnings into the future to make an estimate of value. Another mention of the enticing trillion dollar valuation comes in the form of market research. This suggests that the global cloud computing market was worth $484 billion in 2022, and from 2023, it can grow at a compounded annual growth rate (CAGR) of 14.1% to be worth $1.5 trillion.

Looking at these estimates, it's clear that there's at least some value in cloud computing stocks. The next question to ask is, how does one pick out the right cloud computing stocks? On this front, there are several valuation metrics that can be relied upon. Standard models such as the discounted cash flow (DCF) often do not capture the potential of cloud computing stocks since there are few reasonable estimates to measure their growth. These stocks differ from traditional companies since they don't have to fork out massive capital to buy equipment and prime themselves for growth. Instead, software development is a margin heavy business with low development costs and stable, recurring revenue. This makes management focus on growing market share, and since this also leads to higher operating costs, many cloud computing stocks remain unprofitable for years.

The direct implication of this fact on valuation is that cloud computing stocks cannot be valued by traditional metrics such as the price to earnings (P/E) ratio. Instead, the enterprise value to sales is used as it captures the market and debt value minus cash and compares its scale with the revenue that the firm generates. Investors also have to nevertheless measure the 'value' a firm is generating even though it's unprofitable. This is captured through the free cash flow. One of the most well known cloud computing stock valuation metrics is the Rule of 40. This combines the FCF with the revenue growth rate to evaluate the margins that such firms achieve. The logic is that the revenue growth rate plus the FCF margin (FCF divided by revenue) should be greater than 40 for a cloud computing firm to be sustainable. Combining these together, the ideal cloud computing stock should have a high Rule of 40 scores but a low EV/Sales, as this principle shows that a sustainable business is available at a cheap entry price.

Looking at the data, the EV/Sales multiple varies with a firm's growth rate, and those with higher growth naturally command a higher multiple. For instance, as of recent market close, data shows that stocks with a Rule of 40 score greater than 40 and a revenue growth rate greater than 30% (Category 1) have a median EV/Sales multiple of 12.5x. On the flip side, those that fall below both of these have a median multiple of 5.1x (Category 2). Crucially, though, the category of stocks that have a growth rate higher than 30% but a Rule of 40 scores lower than 40 (Category 3) have a median EV/Sales ratio of 12.2x in today's market which implies that investors are valuing growth more than profitability.

Why do we say "today's market"? Well, when we compare this to the era of low interest and inflation rates in, say October 2021, the picture is different. Back then, Category 1 firms had a median EV/Sales ratio of 27.7x (!) while Category 3 firms had a ratio of 24.9x. This difference was even sharper in September 2020, with a ratio of 42.3x for Category 1 stocks and a value of 29.1x for Category 3 firms. To conclude, it appears that investors place a higher premium on growth than profitability when inflation tightens the belt and higher rates place a premium on attracting business spending for cloud computing stocks.

Our Methodology

To make our list of the best cloud stocks according to analysts, we ranked the holdings of First Trust's cloud ETF by their average analyst percentage share price upside and picked out the stocks with the highest upside.

We also mentioned the number of hedge funds that had bought these stocks during the same filing period. Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).

A team of consultants in suits, discussing the importance of stream governance for real-time data.

Confluent, Inc. (NASDAQ:CFLT)

Number of Hedge Fund Investors  in Q1 2024: 37

Analyst Average Share Price Target: $35.64

Upside: 36%

Confluent, Inc. (NASDAQ:CFLT) is a data focused cloud stock that enables customers to consolidate and manage their data on a singular platform. It is one of the few companies in the cloud industry that offers a data streaming platform to allow for real time data processing. This allows businesses to generate real time insights and improve their decision making. While this offers Confluent, Inc. (NASDAQ:CFLT) a lot of runway for future growth by capturing market share via the early mover advantage, in the short term, share price performance is dependent on customer acquisition, product launches, and customer retention. Therefore, Confluent, Inc. (NASDAQ:CFLT)'s shares lost a stunning 44% in November 2023 when it guided $205 million in revenue for Q4 2023. Wall Street had expected $213 million, and investors were further spooked when management shared that an online gaming company moved back to on site data processing and another customer lowered its spending as it was being acquired. Yet, as a classic illustration of the highly volatile nature of cloud stocks, Confluent, Inc. (NASDAQ:CFLT)'s shares gained 34% in February 2024 after Q4 revenue sat at $213 million to smash analyst estimates of $205 million. The firm added that it expects to become profitable in FY2024.

Confluent, Inc. (NASDAQ:CFLT)'s Q1 2024 earnings call also shared more details about its customer retention and recurring revenue with management sharing:

Customers with 100K plus in ARR grew 17% to 1,260 and continue to account for greater than 85% of our revenue. Customers with 1 million plus in ARR grew 24% to 168, reflecting the power of our network effect and customers’ continued standardization on our data streaming platform. NRR was healthy and in line with our target range of 120% to 125% for this year. Gross retention rate remained strong and was above 90%. As discussed last quarter, we expect NRR to exceed our midterm target threshold of 125% starting fiscal year 2025 as we exit the consumption transformation. RPO was $840.2 million, up 13%.

Overall CFLT ranks 7th on our list of the best cloud stocks to buy. You can visit 11 Best Cloud Stocks to Buy According to Analysts to see the other cloud stocks that are on hedge funds’ radar. While we acknowledge the potential of CFLT as an investment,  our conviction lies in the belief that some AI stocks hold greater promise for delivering higher returns and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than CFLT but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.

 

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Disclosure: None. This article is originally published at Insider Monkey.