Enterprise – I/O Fund

Dell Q2: Exceptional AI Growth yet AI Margins Miss the Mark

Posted on August 29, 2025June 30, 2026 by io-fund

Dell raised AI server shipments for the fiscal year from $15 billion to $20 billion, for a raise of 33%. AI servers are expected to account for nearly 19% of Dell’s revenue in FY26 following ISG growing an impressive 63% QoQ.

Management stated it was the “single largest number of customers that we sold in a quarter” and “it is the most revenue we generated to enterprise customers in a quarter to date.”

The size of AI revenue is impressive and ranks Dell in the top 10 companies on the public markets by size of AI revenue. Consider that Broadcom will deliver a similar number this year.

However, the key difference with Dell is the margins are slim – with one analyst asserting that AI server margins could be as low as 2.5% calculated off the guide. The GAAP numbers show gross margin dipped although operating margin held steady. The CFO did state margins would improve into the second half.

There were some notable comments around the enterprise AI market heating up, plus a mention of having 6700 unique customers in their pipeline (sounds like a large number when you think of the high customer concentration most hardware companies must contend with).

Overall, the margins overshadowed the otherwise exceptional AI growth. Until the margins improve, the market will not be rewarding the stock the same as its AI peers.

Revenue Growth Accelerates to 19% YoY

Dell reported $29.78 billion in revenue in Q2, coming in above the high-end of its guided $28.5-29.5 billion range and beating estimates of $29.2 billion by 2.7%. This corresponded to growth of 19.1% YoY, a sharp 14 point sequential acceleration, driven primarily by outperformance in AI servers with record shipments.

This growth is expected to be somewhat of a one-off, with Dell guiding for just 11% YoY growth in Q3 to $26.5-27.5 billion in revenue.

For FY26, Dell boosted its revenue outlook by $4 billion at midpoint, now seeing $105-109 billion, up from $101-105 billion previously; this corresponds to growth of 11.9% YoY. This places Q4 revenue at a tentative $26.8 billion, or $0.8 billion ahead of estimates.

On closer view, Dell’s FY26 guidance raise was $1 billion lower than its AI server guidance raise of ~$5 billion, suggesting that there may be some demand-related headwinds in PCs or other segments it needs to parse through.

Key Segments

Infrastructure Solutions Group (ISG) up 63% QoQ, Server Shipments up 356% QoQ

As expected, Dell’s ISG revenue experienced significant growth in Q2, up 44.2% YoY and 62.8% QoQ, driven by strong outperformance in AI server shipments in the quarter. For Q3, Dell guided for ISG growth in the low-20% range YoY, likely driven by normalizing AI server shipments.

Q2’s AI server shipments came in well above Dell’s $7 billion guide, rising 356% QoQ and 165% YoY to $8.2 billion. Although orders more than halved sequentially to $5.6 billion, Dell’s AI server backlog remained elevated at $11.7 billion.

As a result of the strong shipments in Q2, taking 1H to $10 billion, Dell raised its AI server shipment outlook for the year from $15 billion to $20 billion. While this is a welcome increase, the dichotomy between shipments and orders raises some concern, with Dell shipping only $10 billion of its $18 billion in orders booked so far this fiscal year.

Additionally, the FY guide again points to normalizing AI server shipments of ~$5 billion/quarter in 2H, a slight uptick from our Q1 readthrough of $3.5-4 billion, but still a bit soft when factoring in backlog and orders.

Within ISG:

Servers and Networking revenue: $12.94 billion, up 68.7% YoY and 104.8% QoQ. This is the strongest combination of YoY and QoQ growth for the subsegment since Q2’25, driven primarily by that AI server strength.
Storage revenue: $3.86 billion, down 3.0% YoY and down 3.5% QoQ.

ISG operating income was $1.47 billion, up 14.5% YoY and up 47.3% QoQ. However, this reflected an operating margin of 8.8%, down from 9.7% in Q1’26 and down from the 11.0% reported in Q2’25.

The CFO stated margins would improve in H2: “Our ISG operating income rate was down year-over-year to 8.8% of revenue. As we have outlined before, the mix of our AI business will have an impact on our margin rates. In the second quarter, we saw a significant shift in our mix to AI as the team executed very well and drove record AI shipments. This was the primary driver of our operating income rate this quarter, partially offset by lower operating expenses. Given our engineering differentiation and integration, we expect our AI margin rates to improve in the second half.”

Client Solutions Group (CSG)

CSG revenue rose less than 1% YoY and was approximately flat QoQ to $12.50 billion, as Commercial momentum faded. CSG operating income was $803 million, or a 6.4% margin, up from 5.2% in Q1’26 but down from 6.6% in Q2’25.

Commercial revenue of $10.78 billion declined (2.4%) QoQ and decelerated 7 points to 2.1% YoY, despite Dell noting that commercial PC demand grew YoY for the sixth straight quarter. Consumer revenue rebounded 17.7% QoQ but remained down (7.3%) YoY to $1.72 billion.

For Q3, Dell guided for CSG revenue growth to rebound to the mid single-digits.

Gross Margins Dip Below 20%, Operating Margins Show Strength

Dell’s gross margins dipped below 20% for the first time in three years, and this margin compression was a key focus point on the earnings call, as analysts wanted to understand underlying drivers and forward expectations.

Management indicated that margin degradation was driven by AI server mix shift but expects to see improvements into the back half of FY26. We will continue to monitor how gross margins trend in future reports.

In Q2, GAAP gross margin contracted nearly 300 bps YoY and QoQ to 18.3%, while adjusted gross margin was nearly 400 bps lower YoY to 18.7%. Operating margins showed some strength and reflected economies of scale driven by top-line growth, as GAAP operating margin expanded both YoY and QoQ.

GAAP operating margin was 5.9%, up from 5.4% in the year ago quarter and 5.0% in Q1.
Adjusted operating margin was 7.7%, down slightly from 8.1% in the year ago quarter but up from 7.1% in Q1.

GAAP net margin was 3.9%, up from 3.4% in the year ago quarter but down slightly from 4.1% in Q1.
Adjusted net margin was 5.3%, down slightly from 5.5% in the year ago quarter but up from 4.6% in Q1.

EPS

Dell reported $2.32 in adjusted EPS in Q2, a marginal $0.03 beat versus estimates. Adjusted EPS growth did reaccelerate to 22.8% this quarter, though this is likely to be the peak growth quarter for the fiscal year as the margin compression led to a soft Q3 EPS guide.

For Q3, Dell guided for just 11% YoY growth to $2.45 in adjusted EPS at midpoint, below estimates for 18.5% growth to $2.55. For Q4, analysts are projecting 11% growth to $2.98.

For FY26, Dell updated its adjusted EPS guidance to $9.55 at midpoint, up 25% YoY, ahead of estimates for $9.37. This will likely force revisions in Q4 to move 7-9% higher considering adjusted EPS is pegged at approx. $6.32 through Q3.

Looking out to FY27, EPS growth is expected to cool to 15.1% YoY to $10.79.

Cash Flow Margins Decline Sequentially as Accounts Receivable Surge

While Dell did report record 1H operating cash flow at $5.3 billion, cash flow margins contracted from Q1 as accounts receivables surged more than 50% QoQ.

Cash & Cash Equivalents were $8.15 billion in Q2, up from $7.7 billion in Q1. Debt was largely flat with Q1 at $28.7B.
Operating cash flow came in at $2.54 billion in Q2, down from to $2.8 billion in Q1 but nearly doubling against $1.34B in Q2’25. OCF margin was 8.5%, down from 12.0% reported in Q1’26 but up from 5.4% reported in Q2’25.
Free cash flow came in at $1.87 billion, down from $2.23 billion in Q1 and up from $1.28 billion in Q2’25. FCF margin was 6.3%, down from 9.5% reported in Q1’26 but up from 5.1% reported in Q2’25.

Behind the sequential decline in cash flow margins was a 53.5% QoQ increase in accounts receivable to $15.02 billion. On a YoY basis, AR was up 31.9% YoY. DSO as of Q2’26 was ~46 days, compared to ~41 days in Q1 FY26 and ~39 days in Q2 FY25. This jump corresponds with the explosion in AI Server shipments, as revenue recognition occurs at shipment and cash is collected later-on. AI server customers are large enterprise & CSP buyers which may negotiate longer credit terms compared to the consumer / SMB segments. The jump in AR nearly matches the $6.4B sequential increase in payables which largely offsets the impact to cash conversion. The combination in higher AR & AP should indicate to investors that Dell may be carrying larger working capital load tied to the ramp of Blackwell – both collecting later from customers and paying later to suppliers.

Inventories of $7.21B reflects a (2.8%) decline compared to $7.42B as of Q1’26 and 21% increase compared to the $5.95B as of Q2’25.

Share Buybacks and Dividends: $1.3B returned to shareholders through buybacks of $.9B and $.3B in dividends during Q2.

Earnings Call Q&A

The call was split between analysts poking around to see if the $20B fiscal year AI shipment guide was conservative or not, and other analysts finding creative ways to reaffirm the margins would improve in the second half of the year.

Commentary on AI Shipments

Dell asserted in their commentary they are winning deals due to the speed to market their company offers: “Customers are seeing real-time the value in our ability to deploy large-scale clusters quickly and reliability.”

They reiterated they were the first to stand up the GB200 NVL72 and GB300 NVL72s: ‘We were the first in the world to ship both the NVIDIA NVL72 solution last year and the NVL72 system in July.”

When asked right out the gate if the $20B was too low, the CEO stated it was not on their end rather the constraint is the complexity of the systems that are being stood up:

“You've heard us talk about the numbers, but I always sit back and like to reflect on so far through the first half of the year, we've sold $17.7 billion of AI infrastructure. then we shipped $10 billion of that, which would imply we'll ship about $10 billion in the second half equal to the 20. The 5-quarter pipeline continues to grow. — exciting in that pipeline as we saw the sovereign opportunities and the enterprise opportunities grow double digits. But there's complexity here and the complexity lies into these are large-scale deployments. Many have scheduled deliveries and those scheduled deliveries are dependent on things like buildings being ready, power being installed, cooling being installed. — and they are managing a very complex supply chain and a transition as you called out to Blackwall Ultra.”

Margins to Improve by Q4:

The CFO stated the margins would improve by Q4 for increased profitability due to a higher mix of storage and traditional servers.

“From a storage perspective, storage is expected to perform better sequentially in the second half. with more Dell IP as well as normal seasonal acceleration in the fourth quarter. that acceleration in the fourth quarter that storage weighting is what's driving a significant amount of that expected profitability that's implied in our fourth quarter guide. raditional servers are expected to grow in the second half. And of course, we expect our operating expenses to continue to come down as well. So net-net, we expect to be able to deliver more profitability in the second half, and you see that again weighted into the fourth quarter.”

However, for now AI servers are gross dollar accretive and rate dilutive, which we saw this quarter as Dell had a lower gross margin despite adding $500M in gross profits. Dell explained they do foresee their AI server margin expanding as they will have a higher mix of enterprise and sovereign customers compared to cloud service providers (CSPs) where the margins are lower.

“And then if I go back to your question about margins, it's what I tried to articulate earlier with [indiscernible] we expect the onetime costs in our supply chain to reconfigure and to expedite materials not to be in place in the second half. We think there's some opportunity for us to continue to value engineer the scaling of the P&L. And then lastly, the enterprise customers and shipping to enterprise customers and the opportunity to attach unstructured storage, networking and our professional services around that.”

How Low are AI Server Margins, Exactly?

One analyst stated their math implies server margins could be as low as 2% to 2.5% – hence the stock selling off despite the strong AI growth. This is because Dell guided for $4B raise in revenue but only $110M in net profit.

Dell raised their FY2026 revenue from $103B at the midpoint to $107 at the midpoint, with the assumption this from AI servers.
However, Dell only raised GAAP EPS from $7.98 at the midpoint to $7.99 at the midpoint. Adjusted GAAP EPS for the year was raised from $9.40 to $9.55.

This prompted the following exchange, which reveals just how slim the AI server margins are. Notably, the CFO did not deny this calculation.

“Amit Daryanani, Evercore:

I guess I just had a question on the fiscal '26 guide, the way you folks have raised it. You're raising the top line by 4 points or bottom line by about $0.15. It sort of looks like $4 billion more of revenues and about $100 million, $110 million more of net income. And I'm sure there's a lot of moving parts over here, but it almost looks like AI server margins are in the 2%, 2.5% zone for you folks. But maybe just talk about why is the conversion margin so low for the incremental revenues that are coming into the model what are the other puts and takes around it, assuming AI margins are better than that 2.5% matter imply?

CFO:

So if I think about the guide that we have for the second half, certainly, the demand dynamics play a key role in that. So if I think about the traditional server when I think about the AI mix, the biggest impact to the second half and the profitability and outcome is the seasonality within the ISG business and within storage. And so when I think through how we're going to drive more profitability, really do think it's holistic across the board, but it is weighted towards the standard seasonality in the fourth quarter from a storage standpoint. So that's what is embedded within the guide. That's what you can see. That's what we deliver historically, and we — we'll do that again this fiscal year.”

Conclusion:

AI server shipments were a highlight, but AI server margins are a lowlight. That muddies the outcome as typically an investor should be able to celebrate when a portfolio holding reports this kind of AI growth, yet there is very little to celebrate given such thin profitability from the AI segment.

We have a tiny placeholder on this stock of 1% until management can prove there’s an attractive AI business to invest in. We are on the lookout to make sure AI servers have not become a race to the bottom in the competitiveness of winning the Blackwell business.

Should Dell revive its margins, which according to management will be accomplished through the storage attach rate and thier IP portfolio, the stock could become more attractive especially given $20B in AI revenue is nothing to scoff at. Basically, Dell is one to watch but we will not be adding to the position at this time.

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

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SentinelOne Q3 Earnings: FCF Positive by Next Year

Posted on December 7, 2022June 30, 2026 by io-fund

SentinelOne had an excellent report minus the fiscal year guide of 50%. The market is likely digesting this, as are we.

The price action on SentinelOne was muted although there were some notable positives from the report. Key items discussed included the company becoming free cash flow positive next year (calendar year 2023) and profitable on an adjusted basis by the following year CY2024. The company beat sizably on adjusted margins.

With that said, the market is digesting lower cloud growth rates across the board, and although SentinelOne has maintained excellent growth this quarter and for next quarter’s guide, the next fiscal year guide is likely what’s causing the flat price action.

The guide at this time is for a baseline of 50% growth, marking a deceleration from 105% growth this year. This technically is a miss from the FY2024 analyst expectations of 64% growth, although “baseline” is vague and the company could meet the original expectations in time.

Other than this, the company beat across the board.

Q3 Financials & Key Metrics

SentinelOne beat on revenue with $115 million reported for growth of 106%. This was a 7% beat.

For next quarter, the company did not budge on guidance, which is likely weighing on the report.

The guide of $125 million met analyst expectations of $124.5 million, yet the market typically wants to see a stronger guide if the current quarter provides a beat.

This shows you how picky the market is becoming as fiscal Q4 guide is 92% which puts SentinelOne at the top of the cloud category as most cloud stocks are guiding for a 30% to 50% deceleration in growth rate, while SentinelOne is guiding for a 10% deceleration.

The company slightly raised full year guidance to $420.5 million for growth of 105%, up from 103.3%.

SentinelOne reported in line with EPS at ($0.35) and beat on adjusted EPS at ($0.16) versus ($0.22).

Gross margins came in as expected with 64% GAAP GM and 71% adjusted GM.

The positive surprise was the adjusted operating margin of (43%) compared to (57%) expected. This compares to (69%) in the year ago quarter. GAAP operating margin of (90%) reflects the high stock based compensation at 40% of revenue. This results in GAAP operating losses of ($104M) and adjusted GAAP operating losses of ($49.5M).

The company reported free cash flow of ($64.7M) and has $1.2 billion on the balance sheet.

Key Metrics:

Net new ARR was in the spotlight because of Crowdstrike which we covered here. SentinelOne reported net new ARR of $49 million compared to the guide for “mid-$50 million.” The company stated the miss was largely due to deals closing in Q4 that normally would have closed in Q3. To back this up, the company is guiding for 20% sequential growth. Crowdstrike guided for a YoY and QoQ decline.

“To be clear, we expect Q4 net new ARR to increase by at least 20% sequentially compared to the third quarter. We believe this is a prudent view and reflects a continuation of the macro headwinds we experienced in Q3, yet we are in a position to deliver a seasonally strong end of the year.”

ARR growth slowed to 106% down from 122% last quarter for $487.4 million. Customers over $100K grew 100% to 827 total, down from 117% last quarter. Total customers grew 55% down from 60% last quarter for 9,250 total customers.

As you’ve likely noticed, ARR tracks very closely to revenue for this company. Management provided a 50% growth rate for ARR next year, which translates to 50% revenue growth.

“Based on a prudent view of the current economic environment and expectations of further macro deceleration, we believe we will deliver at least 50% total ARR growth in fiscal year 2024.”

As noted above, 50% is lower than what analysts had for fiscal year 2024. This is one comment an analyst made:

“Alex Henderson

Great. Thank you so much. You gave a guide — preliminary guide, I guess, is the right way to say it for FY 2024, 50% ARR growth. The question I have for you is really without giving a forecast, can you give us some sense of the way you are thinking about the OpEx spend in that environment, will you still produce at a 50% type growth rate, the same or a similar degree of leverage or do you think the leverage becomes a little bit more muted as a result of the slower growth before the reacceleration?

Dave Bernhardt

We think that the ARR, let’s call it, tentative guidance for next year is really a floor. When I think about it, we believe it’s conservative. We are looking at it as something we can build from. In terms of our OpEx spend, we have always said and you have definitely seen this over the past couple of quarters where we beat by 17% and 14% in terms of operating margins. A lot of our spend is highly elective and we will invest when it makes sense and we will pull back when it doesn’t.”

Additional Notes:

The company provided bold comments regarding profitability and free cash flow, and essentially moved the target up by a year to become FCF positive by the end of next calendar year and adjusted profitability the following year after that (CY2024).

“We are on track to exit fiscal year 2023 with two quarters of about 25 percentage points at the year-over-year operating margin improvement. Continuing this progress forward, we expect another 25 points of operating margin improvement in fiscal year 2024 and our goal is to achieve profitability in fiscal year 2025.”

Here was the question on FCF:

Hamza Fodderwala:

“And then secondly, for Dave, you mentioned, operating profitability in fiscal 2024. I just want to be clear, is that for the full year of fiscal 2024 and would you expect free cash flow breakeven to proceed that by about four quarters? Thank you very much.”

Dave Bernhardt:

“And Hamza, to answer your second question, we have talked about timing of free cash flow, in creating free positive cash flow. We are still expecting that to happen at the end of next fiscal year and then what we are hoping for and really working to achieve is how to get breakeven in fiscal year 2025. So the following year. So we do expect free cash flow to hit before profitability and then those two will be much more mapped together.”

Conclusion:

You’ve probably seen by now that our cloud holdings are being reduced. The thought process around reducing exposure has been outlined going into Q3 when we’ve said a few times the market is nervous that enterprise spend/budgets will be the other shoe to drop. If this is true (I’m a messenger here), then we are at the beginning and not the end of a softer cloud market as Q3 marks the beginning of this new phase of economic slowdown (with phase one being the consumer).

For example, I said here:

“I also want to be a messenger and say that another reason we are seeing strong price activity is that analysts are concerned that enterprise spend will be the next shoe to drop. This concern was expressed across quite a few cloud companies’ earnings calls. The thinking is that enterprise spend will follow consumer spend, (eventually), yet is slower because budgets are cut more slowly and added back more slowly.”

Most of this will become evident when next year’s budgets are transparently disclosed with cloud’s full year guidance. Right now, if we are being real with ourselves, the Q4 guides are shockingly low. What the cloud category is guiding down on growth rates between Q3 and Q4 used to take a year or two (for example, a growth rate decel of 67% to 40% for SNOW or 47% to 26% for MDB — or choose any others, it’s rampant). This level of decel used to take a year or longer and we are now getting a 30% to 50% decel sequentially.

The market is probably due for a bounce (not my department) so we will likely reduce our exposure carefully. Despite what the market does in the near term, the predominant growth trend in cloud — from what I’m seeing – is down. As a category, cloud is providing the biggest decel it’s ever gone through. So, that’s important to not lose sight of.

What does this mean for next fiscal year and will there be a further decel given what we’ve seen from Q4 enterprise budgets?

Of course, we believe companies like SentinelOne, MongoDB, Snowflake, etc, will be around for the next 10 years. But if the trend is down and the growth rates are being slashed, a real recovery in this category will not be on the table until this is reversed.

A Member said on the forum the other day, sometimes it’s better to leave the 20% off the bottom on the table to improve timing on returns. I agree with this because cloud could need the better part of next year to recover and we can easily get back in (knowing that we will be leaving some money on the table).

This discussion is separate from how we go about this as the market has been deep in the red last three days so there may be a better opportunity to reduce exposure than right now.

Confluent Update and Q4 Earnings

Posted on February 24, 2022June 30, 2026 by io-fund

Below, we do another overview of Confluent’s product and an update following the Q4 earnings report. Here are two resources we recommend reading from our premium site for more information on the company.

Confluent Product Overview and Q3 Earnings

Big Data, Analytics and the Importance of ML

We believe open source with enterprise-grade features will become a key market moving forward as it solves for the downside of open source such as a lack of technical support. In Kafka’s case, the downside are things like a lack of data verification and having to manually connect to various data warehouses and other platforms to import/export data. Confluent also makes the argument that multi-cloud and hybrid cloud architectures are best served with a supported enterprise version for multi-tenancy security and data residency.

Notably, from my perspective, we are not betting on Confluent being used over the open-source version of Kafka in a direct competition, rather we are betting that Kafka will increase in importance. In this case, if Kafka continues to grow, Confluent will take a percentage of this market share should more enterprises prefer a managed version of Kafka. 70% of the Fortune 500 use Kafka and 80% of the Fortune 100. According to this site it has a 12.5% market share.

Kafka is popular because of its high-performance real-time data streaming capabilities for mission critical applications. It is distributed and fault-tolerant, which means if one component fails, the system will still work. It can also scale to hundreds of clusters and billions of messages.

As discussed in our original write-up, Kafka was developed at LinkedIN to process the large number of messages per second the social media company handles. The framework enables event streaming, which helps messaging and data integration. There is high scalability with a publish/subscribe model that allows applications to share and create data in a serverless and microservices architecture. What Kafka solves for is the ingestion of events data in real-time with low latency with continuous read/write. If data remains at rest and/or in a mainframe environment, then companies cannot be truly data-driven. Kafka on the other hand can scale from a billion messages per day to a trillion messages per day.

Machine Learning and Kafka

Confluent opens up the amount of data that can integrated. The thesis is the increase in the number of companies that will need real-time data processing and real-time data analytics due to the increase in software driven architectures. The idea is that “data in motion” will replace data at rest, or batch data processing from traditional databases. This is also important for the real-time data streams that machine learning requires.

Kafka is more than a messaging system as discussed in this article and is used for business applications, streaming ETL middleware, real-time analytics and edge/hybrid use cases for the framework.

Here are some examples of how Kafka can be used outside of messaging systems:

Fraud detection through a machine learning pipeline for Paypal’s billions of messages
Data correlation in real-time for Lyft for matching maps, estimated time of arrival and cost calculations
Unity uses Confluent to be internally data-driven across R&D and cloud-services, plus to help drive the monetization network by rewarding players for watching ads and incorporating banner ads
Continuous calculations for betting platforms
Drug discovery that is automated and scalable

Machine learning requires model training from historic data and also model deployment for scoring and predictions. Training can be done with batch yet scoring is partial towards real-time data. ML-powered applications run inferences on large volumes of data to return predictions very quickly (milliseconds). Rather than use Remote Procedure Calls (RPC) and frameworks like gRPC, some companies use a Kafka streaming model.

Here is how the company states the problem that Confluent seeks to solve:

“By becoming more software driven, more businesses will rely on real-time data. Confluent believes that data in rest is not able to meet the current and future demands of software-driven businesses. Daily batch processing and static real-time queries or “point-in-time” queries with stored data lead to an unnecessarily large and tangled architecture that is not capable of data flow between applications.”

Enterprise-grade Features

As with Spark and other open-source projects, there is a marketplace for making the frameworks easier to use. Confluent Kafka opens up the amount of data that can be integrated, for example, to combine transactional data (orders, inventory) with sentiment-driven data (likes, page clicks). This helps with predictive analytics and also machine learning because the “data flow” allows for algorithms to work as they are intended to.

In order for data to be in motion, Confluent’s platform connects data from many different sources. The company has over 50 fully managed connecters with Big Data and Analytics from Azure, Amazon/AWS, Google and Databricks. Without these connectors offered by Confluent, integrations between systems on an open-source framework can take months and also require intensive resources to manage.

Confluent is attempting to stave off competitors through “completeness of product” which touches on our multi-cloud and hybrid cloud discussion. We’ve discussed hybrid for a few years, yet our most recent write-up was here and here on Datadog. The recent write-up is worth a read if you want to know exactly why agnostic, best-of-breed products are sometimes outpacing Big Tech when it comes to cloud services and products. Datadog is the best example of a product where customers are avoiding vendor lock-in.

The completeness of product goes beyond multi-cloud and hybrid as Confluent is attempting to hold off competitors through data security and data governance, as well. Because data is often an organization’s most prized asset, it often has internal processes for compliance. There is often external, geographic compliance required by governments and industry agencies, as well, for global companies.

In order for completeness of product to work, Confluent needs to have a large geographic footprint. The company has added eight more regions for Confluent Cloud with an emphasis on APAC. There is also a new partnership with Alibaba Cloud. This can help offer differentiation for multinationals who have operations in China.

Competitors:

Regarding direct competitors, one example is Amazon MSK which offers a competing managed streaming service. This competitor is a good option for developers provisioning a Kafka cluster and a new streaming platform may not be needed in this case.

Rather than re-architect Kafka to be cloud-native, Amazon MSK cloud-enabled it as provisioned infrastructure. This means Confluent is stronger than MSK with scaling elastically by offering elastic quotas, which eliminates the need to size clusters for spikes. It’s also stronger on multi-tenancy security. Amazon MSK also does not offer Kafka Connect or Kafka Streams.

For more enterprise uses where Kafka Connect or Kafka Streams is required, then Confluent is more likely to be used to save development time and learning curve in writing Kafka Connects sinks and source.

Blockchain and Metaverse Potential

We’ve written at length about Confluent’s core use. However, there is a blockchain potential with Confluent with one case study right now with Dapper Labs.

“These are steps that attracted Dapper Labs. They're one of the most innovative NFT companies delivering fun and games on the blockchain. They have a number of decentralized apps, but one that's risen dramatically in popularity is called NBA Top Shot. To date, there have been over 10 million digital collectible transactions and Confluent is at the center of their data streaming architecture to facilitate these purchases. Dapper chose us to run their mission critical workloads because of the scalability and security of our cloud solution.”

There’s also a case for 5G networks needing data in motion. Here’s what was said about Dish on the call:

“A significant customer for both AWS and us is DISH Network. With their new 5G smart network, DISH is transforming how people and enterprises leverage data. They deployed Confluent Cloud over AWS to connect their network systems and customers with real-time data. This means that Confluent is a key part of their network's data backbone, starting with fault management and network resiliency functions to ensure network availability, and our enhanced collaboration with AWS is making it easier for customers like DISH to unlock data in motion everywhere.”

Confluent Q4 Overview

Confluent has been accelerating in revenue for four consecutive quarters and also across other key metrics.

The company reported fiscal year 2020 revenue growth of 58% year-over-year and fiscal year 2021 revenue growth of 64% year-over-year. Confluent Cloud revenue growth for fiscal year 2020 was 117% compared to FY2021 revenue growth of 200% year-over-year.

If we look at Q4, total revenue is outpacing the fiscal year growth for 2021 and also outpaced Q3. Revenue growth for Q4 was at 71% — the highest growth rate from publicly available information which dates back two years to Q1 2020.

Cloud revenue did decelerate on a sequential basis, however, the company stated Q4 is often seasonal due to engineers being out of the office and on vacations. We will see if this picks back up in Q1. Regardless, on an annual basis there was a significant improvement. Notably, if we look at 2020 cloud revenue, we can see it’s lumpy at times with Q3 2020 being the weakest and Q2 2020 being the strongest.

In regards to “sandbagging” which is essentially the company guiding low and blowing out the guidance, which has happened a few times now, the company has a lot of moving pieces in terms of business model and likely wants to win trust with institutions. We are not opposed to this even if it means the price action was somewhat severe after the earnings report due to the guidance. What we are more concerned with is that Confluent continues to raise and beat, and that the underlying key metrics help us to substantiate the company’s longer-term strength.

Bradley stated the following in our last write-up and got pretty close to the revenue growth that Confluent actually reported:

Looking forward, management guided that Q4 revenue will rise 55% YoY $109 million, which would mark a deacceleration from the most recent growth rate of 67% YoY growth. However, this estimate is likely conservative, as management guided that Q3 sales would grow 46% YoY to $90 million and actual Q3 sales grew 67% YoY to $103 million. If we assume that Confluent beats it guide by a similar amount in Q4 as it did in Q3 ($13 million), then Q4 sales growth will accelerate to 73% YoY (this is merely an observation – no guarantees).If we assume that Confluent beats it guide by a similar amount in Q4 as it did in Q3 ($13 million), then Q4 sales growth will accelerate to 73% YoY (this is merely an observation – no guarantees).

Most notably, the company is reporting high remaining performance obligations growth of 91% year-over-year. This is higher than the 75% year-over-year we saw in Q3.

Bradley discussed this in our last write-up:

Confluent also states that RPO is an important metric to monitor in order to measure the health of the sales pipeline. In Confluent’s first conference call as a public company (Q2), CFO Steffan Tomlinson explained that:

“Given the various revenue components and billing terms in our model, remaining performance obligations or RPO and current RPO rather than billings, are important metrics to measure the health of the business. RPO provides insight into the organic momentum of our business as it represents contractually committed revenue to be recognized in the future regardless of billing terms and variability in cloud consumption pattern”. RPO provides insight into the organic momentum of our business as it represents contractually committed revenue to be recognized in the future regardless of billing terms and variability in cloud consumption pattern”

Financials Deep Dive

By Bradley Cipriano

A slight blemish during the quarter was Confluent’s customer growth, which lagged the growth in sales. Customers increased 65% YoY to 3,470, which lagged the 71% YoY growth in total sales. This drove subscription revenue per customer up 4% YoY to $31,000/customer, implying the recent acceleration in sales was driven by higher spending rather than customer growth.

Generally, growth from new customers is more sustainable and higher quality relative to growth from increased spending. However, DBNRR remained robust at over 130%, signaling that customers are increasing their spend over time.

It is odd that customer spending increased but cloud growth deaccelerated during the quarter. Since cloud is a usage-based revenue model, increased spending should have driven cloud outperformance. However, cloud spending slowed from 245% YoY growth in Q3 to 211% in Q4. On the Q4 call, management explained that cloud was impacted by seasonality due to relatively lower spending over the holidays which lead to slightly slower rates of usage. While this may be true, it doesn’t explain the YoY deacceleration, as this trend would have existed in the year-ago quarter. Nevertheless, there is inherent variability in a usage-based model so investors should not expect an acceleration in sales every quarter.

Given the slowdown in customer growth and slight deceleration in cloud sales, the Street may be concerned that Confluent’s growth may be somewhat cannibalistic. This would explain the sell-off in its stock following otherwise strong results which reported a beat and raise. Investors may be wondering if cloud growth is coming at the expense of platform growth, or vice versa?

CEO-Founder Jay Kreps discussed this concern on the call and stated that the company is growing both in the cloud and in hybrid environments. He said that “we don't really view this as kind of a transition where we're just shifting from platform to cloud and just kind of swapping out customers from one product to the other. Effectively, we have to have kind of an outpost in each environment a customer is in. So, we expect to continue to see growth in Confluent Platform throughout this, and we think that's not a bad thing. That's a good thing.” CFO Steffan Tomlinson added that “what our customers are telling us is, by and large, they're running hybrid environments”.

A common issue with ramping cloud sales is that sales in other parts of the business stagnant, but we do not believe this is the case. For example, Confluent’s financial results remain high quality which suggests that cloud/platform sales are not cannibalistic.

For example, net deferred revenue (deferred revenue less accounts receivables) increased 105% YoY to $109 million, or 31% of TTM subscription sales. This was an improvement from the 26% and 23% level in Q4 2020 and Q4 2019, respectively. The rise in net deferred revenue relative to subscription sales signals that the company is receiving relatively more cash upfront, improving the quality of topline growth. If sales were cannibalistic, we would have likely seen a reduction in cash receipts and/or a deacceleration in growth. Instead, cash improved and sales accelerated.

Furthermore, RPO also increased 91% YoY to $501 million, an acceleration from the 75% and 72% YoY growth rates in Q3 and Q2, respectively. While we need the 10K to fully assess the quality of RPO, total RPO represents 92% of management’s NTM guide, up from 81% in Q3. This improves the quality of forward sales and suggests that there is conservatism in management’s forward guide.

However, we do note that cash support for RPO declined slightly during the quarter. Total deferred revenue-to-RPO fell from 52% in Q3 to 49% in Q4. This trend is likely driven by the rise of cloud bookings, since cloud is a usage-based model and new cloud customers are typically on pay-as-you-go plans, which are billed in arrears. On the Q4 call, CEO-Founder Jay Kreps explained that cloud accounted for 50% of ACV bookings in Q4, highlighting how cloud will be the majority of revenues going forward. As customers become more familiar with Confluent’s products, they will likely increase their commitments and convert from pay-as-you-go customers to larger customers that pay upfront. As a result, we view the slight decline in upfront cash receipts as a natural progression for the firm and not a major concern at this time.

Cash Levels and Stock Based Compensation

Confluent recently raised nearly $1 billion in cash following a convertible debt offering in December. Following this raise, the company has over $2 billion in cash, which is well above its current cash burn of ~$108 million (based on TTM free cash flow). The company is focused on growth, so investors should be prepared for continued losses and cash outflows. On the Q4 call, management highlighted that their near-term priorities are to continue to invest in innovation and to expand its geographic footprint, signaling that growth is being prioritized over near-term profitability.

Nevertheless, given Confluent’s relatively large cash balance, we likely should not expect an equity raise in the near term. However, the company will still be dependent on capital markets until it is sustainably cash flow positive. Looking forward, the Street expects EBITDA (a proxy for cash flows) to remain negative through at least FY2023, suggesting that Confluent will remain reliant on capital markets for the next few years. Importantly, there are signs of improvement, as free cash flow margin improved from -30% in the prior year to -22% in the current quarter.

Furthermore, Confluent has relatively high levels of stock-based compensation (SBC), which subsidizes cash used for working capital but dilutes shareholders. Stock-based compensation has trended near 48% of quarterly sales for the last two quarters and was 40% of TTM sales. This is relatively high and ranks in the top 10 for cloud (shown below), but is a function of Confluent recently going public (which frontloads SBC). We expect SBC to decline as a percentage of sale going forward as it laps the IPO and topline growth outpaces expenses.