Confluent, Inc.

Hi, everyone. Welcome to the Confluent Q3 2023 Earnings Conference Call. I'm Shane Z from Investor Relations, and I'm joined by Jay Kraps, co-founder and CEO, and Rohan Sivaram, CFO. During today's call, management will make four looking statements regarding our business, operations, sales strategy, financial performance, and future prospects, including statements regarding our financial guidance for the fiscal fourth quarter of 2023, fiscal year 2023, and fiscal year 2024. These four looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those anticipated by these statements. Further information on risk factors that could cause actual results to differ is included in our most recent Form 10-Q filed with the SEC. We assume no obligation to update these statements after today's call except as required by law, unless stated otherwise. Certain financial measures used on today's call are expressed on a non-GAAP basis, and all comparisons are made on a year-over-year basis. We use these non-GAAP financial measures internally to facilitate analysis of financial and business trends and for internal planning and forecasting purposes. These non-GAAP financial measures have limitations and should not be considered in isolation from or as a substitute for financial information prepared in accordance with GAAP. A reconciliation between these GAAP and non-GAAP financial measures is included in our earnings press release and supplemental financials, which can be found on our IR website at investors.confluent.io. And with that, I'll hand it over to Jay.

Thanks, Shane. Good afternoon, everyone, and welcome to our third quarter earnings call. We delivered a solid Q3, exceeding the high end of total revenue, operating margin, and EPS guided range in a still challenging macroeconomic environment. Total revenue grew 32% to $200 million. Non-GAAP operating margin improved 22 percentage points. And non-GAAP EPS turned positive for the first time, a key milestone. We've now driven 36 percentage points of operating margin improvement over the last two years. I want to thank our entire employee base for the tremendous progress here. Though Confluent Cloud remains the fastest growing part of our business, with revenue up 61% to $92 million, it fell slightly below our guidance. Our Q4 revenue outlook is impacted as well. We expect revenue growth of 21% to 22%, with cloud revenue sequential out of 6 million, representing growth of 43%. The lower cloud revenue this quarter impacts the guidance for Q4 is primarily driven by two factors. First, the impact from two large digital native customers. One online gaming company moved workloads back to their own data center, and one of our largest customers ramped slower as they are in the process of being acquired. We believe consumption from these two customers was impacted by their company-specific events and accounts for roughly 50% of the expected consumption shortfall for Q4. Second, the continuing macro pressure, including the ongoing conflict in the Middle East, where Israel is a top 10 country for us, and the possible U.S. government shutdown, both of which add uncertainty and disruption in particular segments. Specifically, we've seen slower organic consumption resulting from a slower rate of new use case additions in some part of our customer base. Rohan will provide more details on our resulting guidance in the later section of the call. I want to spend some time now focusing on a critical change we're making to drive growth. Beyond just the friction in the current market environment, the critical project for Confluent is to capture the massive market opportunity in streaming. This is a $60 billion market where we are still just scratching the surface of even the existing open source Kafka usage. And we have additional expansion opportunities from Flink, our connectors and data governance, as I outlined in the earnings call last time. Critical to our execution against this opportunity is leveraging our go-to-market engine to rapidly land new customers, expand new workloads, and ensure the adoption of our full set of product capabilities. To this end, we'll be completing the transition to orient our cloud business around consumption. This will make cloud revenue rather than bookings or committed spend the primary goal of the go-to-market organization for Confluent Cloud. This was a planned transition. Indeed, we began changes in this direction this year, but it's a transition we'll be significantly accelerating heading into 2024. To explain what this means, let me start with a little background. In the traditional world of on-premise software, customers would make big upfront commitments. Salespeople worked with the customer to scope these commitments and were paid as a percentage of the resulting bookings. The marketing organization measured pipeline based on these commitments, and every internal system and process was oriented around measuring and managing the bookings that resulted. There was some misalignment between customer and vendor because customer might end up over-purchasing, but this was masked by the fact that the rest of the stack, such as servers that ran the software, were also fundamentally upfront and inelastic purchases. With the advent of the cloud and the elasticity and flexibility it offered customers, this model had to evolve. Cloud has a utility-like model where services are metered as they are used. However, in the early days, the go-to-market engine for cloud infrastructure software largely remained as it was previously, selling customer commitments or credits that overlaid this dynamic usage. Alignment between customer and vendor improved somewhat, but the vendor still had incentive to maximally scope customer commitments. Over the last couple of years, businesses like MongoDB, Snowflake, Datadog, and Hyperscalers have all transitioned their go-to-market to a fully consumption-based model. In this model, the customer and the go-to-market organization are both oriented around the actual service usage, not the upfront commitment. This fully aligns the customer value realization with the vendor's revenue. Less obvious from the outside is how this completely upends the sales and marketing model. Pipeline is no longer oriented around maximum customer commitment, but rather new logos and new workloads. Salespeople aren't compensated for getting an upfront booking, but rather for what a customer actually uses, finding new workloads and driving new product adoption. This is an absolute win for customers and also a huge win for vendors who are actually able to grow faster by removing much of the uncertainty and risk from customer purchasing. With Confluent Cloud now at nearly 50% of our revenue, having NRR over 140%, and continuing rapid growth, it's time for Confluent to complete our transition to this fully consumption-based model. We've already made the transition to usage-based pricing that bills for what is used, but today our go-to-market is still primarily oriented around booking customer commitments. The final step in our consumption journey is to now fully align our go-to-market operations to the consumption motion. This directly attaches our go-to-market efforts to cloud revenue and to our customers' value realization. This is one of the most important possible growth levers for Confluent. It is also necessary that we do this now. As we've seen across the industry this last year, economic pressure combined with the changing norm in cloud means customers are increasingly reluctant to make large multi-year commitments ahead of their usage. This means over the course of this year, the misalignment between our subscription-based good market and the natural buying behavior of customers has increased, creating a drag in our cloud growth. This is shown up in the dislocation between RPO and cloud revenue, but ultimately affects both as our interaction with customers are directed in a way that is out of sync with the customer's natural buying behavior. We believe this change will turn what is currently a drag into a tailwind. This is not a new plan for Confluent. We'd originally planned to make this shift over a three-year period, beginning with steps this year. However, in light of the change we've seen in buying behavior, we'll be accelerating this and completing the transition next year. In practical terms, here's what this means. First, beginning in Q1 of FY24, we're shifting from our current model where 10 to 15% of cloud sales compensation is based on consumption to a model where 100% of cloud sales compensation is based on incremental consumption and new logo acquisition. We will keep the vast majority of our customer revenue under committed contract as we do today. However, we will not be attempting to get commitments ahead of the usage. Rather, commit amounts will be customer driven as customers choose to commit in exchange for greater discounts. Second, we're fully orienting our field-facing teams towards landing new customers and driving new workloads with customers. Third, we'll be adapting our product and pricing to enable customers to frictionlessly try and adopt new products, enabling easier lands and adoption of new features. Finally, we'll be undergoing a significant reworking of our systems for planning, growth, building, and measuring pipeline and forecasting performance as all shift to drive directly off cloud revenue. A number of our cloud-oriented peers have made this transition to very positive effect. So the path and benefits are clear. Like the transition to the cloud we began several years ago, we expect to emerge stronger on the other side, more aligned with our customers, and better positioned to capture the $60 billion opportunity in front of us. In September, we held Current 2023, the only industry event dedicated to the data streaming ecosystem. It was a high-energy event and a fantastic illustration of the excitement and innovation around data streaming. The event included speakers from BMW, NASA, Nationwide, Snowflake, and Uber, and many others, as well as thousands of practitioners who gathered to discuss the state-of-the-art in data streaming. One of the things I'm most proud of is the velocity of product innovation the team has sustained over this last year. And I think our announcements at Current are a great illustration of this. We announced a new tier of Kafka cluster, enterprise clusters, which offer many of the advantages of our dedicated clusters like private networking and enhanced security, but include instant elasticity and are served multi-tenant off our Quora stack. This allows a better price point for customers and significantly lower serving costs for Confluent. These lower cost clusters are perfectly aligned to our consumption transformation since they lower the entry point price, but scale up automatically as you need them. Data Portal is an important new addition to our stream governance suite that brings our vision for discoverable and reusable data streams to the forefront of Confluent Cloud. The excitement around Flink at current was palpable. Flink sessions were among the highest rated and most attended sessions at the entire conference, highlighting the hunger Kafka users have for Flink. That's why we're so pleased with the launch of Flink public preview in Confluent Cloud. Since the announcement, we've seen incredible uptake with hundreds of customers opting into the preview and trying out our cloud native and serverless Flink offering. The addition of Flink strengthens our position as the only complete data streaming product. We bring Flink together with the connectors that capture streaming data, the stream itself in Kafka, and the governance capabilities to manage streaming data across an organization. Each of these capabilities strengthens the other, and the combination comprise what we believe will be the most important data platform in a modern company. And finally, we introduced Data Streaming for AI, a set of new partnerships that span vector databases, CSPs, and SIs. It also includes new product capabilities, including the Confluent AI Assistant that will turn natural language inputs into helpful suggestions in code. We expect this initiative to address the demand we're seeing across our customers who are building innovative new AI applications. A great example of this is Notion. Notion is an AI-powered connected workspace where modern teams can create and share documents, take notes, manage projects, and organize knowledge all in one place. Given Notion's strong growth, a new data streaming platform was needed to meet its rapidly expanding needs. However, due to the lean engineering team, they required a fully managed service to focus on product development rather than managing Kafka. They began using Confluent Cloud for real-time data flows for internal analytics pipelines and to supply data into data lakes. After realizing the value it provided, Notion expanded the usage of Confluent Cloud to enhance product features, including search automation and Notion AI. Now Notion's customers can automate tasks in real time, such as adding summaries, extracting key points, and consolidating action items in meeting notes. This is only the beginning, as Notion continues to innovate and actively explore how data streaming can power new AI applications. Before turning things over to Rohan, I wanted to reiterate a couple of key points. We're incredibly excited about the tailwinds to the business Flink, data governance, AI, and the rest of the data streaming platform components add to our business. And while it may cause some short-term headwinds, I firmly believe our accelerated transformation to a fully consumption-oriented business will put us in an incredibly strong position to drive the monetization of these new offerings. I've never been more confident in our ability to be the leader in the emerging $60 billion data streaming market. With that, I'll turn things over to Rohan.

Thanks, Jay. Q3 demonstrates our ability to drive efficient growth in a challenging macroeconomic environment. Key highlights include robust subscription revenue growth, coupled with proactive management of rate and pace of investments, which drove record high gross margin, 20 plus point of operating margin improvements, and our first positive non-gap EPS quarter. I'd like to take a moment to thank our employees and partners for their contributions in delivering these key milestones for the company. Turning to Q3 results, total revenue grew 32% to 200.2 million, exceeding our guidance. Subscription revenue grew faster, up 36% to 189.3 million. Within subscription, Confluent platform revenue growth re-accelerated to 19%, ending the quarter at 97.7 million, or 49% of total revenue. and was driven by continued strength in regulated industries, as companies in those industries are still early in their journey of moving to the cloud. Confluent Cloud revenue grew 61% to 91.6 million, slightly below our guidance of 92.2 million, and ended the quarter at 46% of revenue compared to 38% of revenue a year ago and 44% last quarter. As Jay called out earlier, cloud revenue performance in the quarter was modestly impacted by two large customers. One large online gaming customer who moved workloads back to their own data center from the public cloud as part of a broad internal cloud strategy review. And one of our largest customers who rammed slower than expected as they are currently in the process of being acquired. Additionally, we saw lower than expected consumption in a few other large U.S. digital native customers. While these select customers did have an impact on Q3, especially in the last few weeks of the quarter, we expect to see a greater impact throughout Q4 and next year. I'll cover more on this in a second. Turning to the geographical mix of revenue, revenue from the US grew 25% to 119.4 million. Revenue from outside the US grew 43% to 80.8 million. We continue to be pleased with the relative balance of our business around the world. Moving on to the rest of the income statement, I'll be referring to non-GAAP results, unless otherwise stated. Total gross margins reached a record high of 76.4%, up 540 basis points. This translates to 80.1 subscription gross margin, up 320 basis points, despite a continued revenue makeshift to cloud. Gross margin outperformance was driven by continued improvement in the unit economics and in-product optimizations of our cloud business and our R&D investments in Cora, the cloud-native engine of our Confluent Cloud offering. Turning to profitability and cash flow, operating margin improved 22 percentage points to negative 5.5%, representing our fifth consecutive quarter of more than 10 points in improvement. Q3 operating margin outperformance was driven by discipline spending and ROI-focused investment philosophy across every function of the company. And we are pleased to achieve our first positive net income per share of two cents for Q3 using 303.9 million basic and 347 million diluted weighted average shares outstanding. Fully diluted share count under the Treasury stock method was approximately $355.4 million. Free cash flow margin improved 24 percentage points to negative 6.5%. We ended the third quarter with $1.87 billion in cash, cash equivalents, and marketable securities. Turning now to other business metrics, in Q3, we added 80 net new customers, 41 customers with 100K or more in ARR, and eight customers with 1 million or more in ARR, bringing our total customer count to approximately 4,910, up 16%. Our 100K plus customer count to 1,185, up 25%, and our million dollar plus customer count to 155, up 38%. NRR in the quarter was healthy, just under 130%. NRR for hybrid and cloud were both comfortably above 130%, with cloud NRR continuing to be the highest. Gross retention rate remained strong and was above 90%. Consistent with Jay's comments about the drivers behind the shift to consumption, RPO was 824.1 million, up 24%. Current RPO, estimated to be 65% of RPO, was 535.1 million, up 31%. RPO growth was impacted by a decline in both average deal sizes and average contract duration, a continuation of the trends we had called out last quarter. In the current macro environment, we believe customers have less appetite for larger upfront commitments and prefer consumption against smaller commits, reflecting a consumption first trend in how our customers derive value from Confluent. Now turning to our Q4 outlook, we have factored in our guidance the impact of the following. First, we expect to have a full quarter impact from the two large customers mentioned earlier, whose consumption is impacted by their company-specific events around the shift of workloads back to on-prem and an acquisition. We estimate that these two customers account for roughly 50% of the expected consumption shortfall in Q4. Second, the macro uncertainty, including the ongoing geopolitical tensions, will likely persist, impacting new use case deployments into production and driving lower-than-expected consumption. As Jay discussed earlier, the current macro has increased the misalignment between our subscription-based go-to-market and the new buying behavior of customers, which creates a drag in our consumption growth. We believe our accelerated move to a fully consumption-oriented comp model for Confluent Cloud will turn this drag into a tailwind for our business. Turning now to guidance, for the fourth quarter of 2023, we expect revenue to be in the range of 204 to 205 million, representing growth of 21% to 22%. Cloud revenue to be approximately 97.5 million, a sequential add of 6 million, representing growth of 43%, and accounting for approximately 48% of total revenue based on the midpoint of our guide. non-GAAP operating margin to be in the range of 0% to 1%, and non-GAAP net income per share to be approximately $0.05. Additionally, we expect the free cash flow margin to be in the range of 0% to 1%. For the full year 2023, we expect revenue to be in the range of $768 to $769 million, representing growth of 31%, non-GAAP operating margin to be approximately negative 9%, and non-GAAP net loss per share in the range of negative one cent to zero cent. Looking ahead, I'd like to provide an early read into our outlook for next year. Our fiscal year 24 preliminary outlook assumes the impact of a continued volatile macroeconomic and geopolitical environment, the dynamics mentioned earlier for Q4 continuing into 2024, and risk associated with our transformation to a fully consumption-oriented business. If macro were to improve, we would expect to benefit from it, but it is too early to tell. Given these factors, for the full year 2024, we expect revenue to grow approximately 22% year over year, non-GAAP operating margin to break even, improving approximately nine percentage points year over year. This is despite a two to three point headwind associated with our move to a consumption-based sales commission plan, resulting in higher upfront expense recognition. And we expect free cash flow margin to break even. I'd like to highlight a few things about our consumption transformation. Despite potential near-term top-line impacts on our fiscal year 24 outlook, we expect the transformation will enhance our ability to drive durable and efficient growth over both the mid-term and long-term, and will put us in a stronger position to capture our 60 billion market opportunity. We believe subscription revenue, which captures ACV from Confluent Platform and consumption from Confluent Cloud, will be the best indicator of our success. Starting Q1 next year, we will include subscription revenue in our key financial metrics and move our quarterly and annual revenue guidance metric to subscription revenue. And consistent with that, RPO and CRPO will be less relevant as a forward-looking indicator, given the greater emphasis on consumption over ACV-based commits for cloud. We expect our non-GAAP operating margin mid-term target of 5% to 10% and long-term target of greater than 25% to be firmly intact and for free cash flow margin to continue to trend roughly in line with operating margin. In closing, we are pleased with delivering a solid Q3 in a challenging environment. Our net and gross retention rates remain strong, reflecting the durability and resiliency of our growth. We remain committed to driving growth and improving profitability while transforming our cloud business to be fully consumption oriented. And we are excited about capturing our market opportunity ahead. Now, Jay and I will take your questions. Thanks, Rohan.