The Height of Hypocrisy

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Jason’s Random Words

I know it's going to be a little hypocritical that, after a couple of newsletters talking about minimizing our focus on quarterly earnings, I'm going to – you guess it – write about quarterly earnings. 

But I do want to demonstrate how quarterly earnings can be useful and informative. I'll use Confluent (CFLT) as an example, and one that's particularly relevant. If you listened to or watched last week's podcast (or read the transcript) then you'll know it's a stock that I have a lot of conviction in, but a business that I don't know as well as I want to. More specifically, as a bit of an atechnologist, I just don't know much more than the generalities and buzzwords around its business. I couldn't tell you the name of its three largest competing products, for example (I know they’re the streaming products from the three big cloud providers, and new offerings from legacy data infrastructure software players, but I’d have to look up the names).

What do I know? Its founders helped create the data streaming category when they built Apache Kafka and made it open source. Then they founded Confluent a few years later when it became apparent that most companies wanted to still pay someone else to build and manage the software for them, not pay internal developers to do so. Open source is nice, but off-the-shelf is far more scalable. I also know that the trends around data are only accelerating and deepening. Data is coming in ever-faster, and there's more of it, and businesses need to be able to act as quickly as possible on that data. 

And since I follow the company very closely, I have a decent read on the opportunities and the challenges they are facing. For instance, when it reported third quarter last fall, the stock, well, fell. There was some customer churn that convinced a lot of investors that Confluent wasn't going to necessarily be the category-defining business a lot of us are expecting (read: hoping) it will be. 

This is where quarterly earnings can help us: A company can start giving us answers about their ability to execute and deliver — nor not — on an investing thesis. And if you were to look at Confluent's stock after reporting the fourth quarter last week, you'd think it resoundingly answered those questions. 

This is where being as objective as you can, and being a business analyst comes in. Yes, Confluent gave us some good answers. Growth is still slowing, but certainly not as much as feared. Maybe more importantly, its cloud product continues growing at about double the rate of its legacy (but also still growing) on-premise Kafka product. Management – I'm a fan of Jay Kreps, the co-founder and CEO, who has several other co-founders still with him, building the business – reaffirmed their outlook that the company will make the transition from burning cash to being cash-flow-neutral in 2024. 

But let's be honest. This wasn't a binary-outcome quarter, despite the stock going up more than 30%. It was more a “we told you so” quarter, where the business essentially performed as management told us to expect a few months before.

This included some really important stuff, like more customers using its products, existing customers increasing their spend (the "land and expand” playbook working) and most of those customers sticking around. We also saw the company deliver the financial results management told us. It generated a modest GAAP profit, and one that wasn’t financial engineering, with positive operating and free cash flow. And maybe most importantly, it looks like the days of big net losses and burning cash are over.

But…

It’s just one quarter. There are a lot of unanswered questions still, and it’s roughly 90 days of business operations. That is what keeps me from making Big Decisions from a single quarter.

The money is made in the decades, and I believe, lost in the moments. This is why I am so glacial about selling. I’d rather wait to long to sell than be too quick to cut bait and miss a whale.

It’s also why, for the Confluents of the world, I build out my position over time. These non-proven companies need to demonstrate that they are really onto something big, and that the big thing can actually deliver big returns for investors, too.

Since this Sunday is the day of the big American Professional Football Championship Extravaganza and Mid-Point Musical Performance, i’ll use a bad sports metaphor. This quarter moved the ball up the field for Confluent. It was more of the first-down variety than a home run. Incremental progress. A sign that they could put the puck in the net. Not a guaranteed knock-out punch. (I can hear the cringing from here. It pleases me greatly.)

Progress, not a promise.

Keep that context in mind when you feel the urge to Do Something the next time your favorite company reports The Best News Ever next quarter. Or as a friend of mine in the real estate business put it, the deal of a lifetime only comes along once a week.

You can do it.

Jason

Jeff’s Random Words

Taking a page from Jason’s book (no, I’m not making terrible investing decisions), I would also like to write about earnings. However, I’m taking a more structural approach and sharing a few things I’ve learned that I think are helpful. As a loyal listener of our podcast, and reader of this newsletter, you know I love me some spreadsheets. I keep track of a bunch of data on all the companies I own. Most of this is easily found on the free and paid aggregating websites out there, but I prefer to have it in a spreadsheet because I can make charts and color-code things. #nerdalert

The data I keep is split into two sections, which I think of as “Highlights” and “Company-Specific Metrics”. The highlights are all the usual suspects; revenue, revenue growth, gross margin, operating margin, net income, EPS, operating cash, and free cash flow. For most businesses (banks, REITs, and insurance companies being the most common exceptions), these metrics are pretty universal in their usefulness.

The company-specific metrics are where it gets a little less clear and takes a little more time. There are two ways I would recommend gathering this data. The first, which is more labor-intensive, at least initially, is to pull the data from press releases, investor presentations, and SEC filings. For some companies, this is cut and dry. For others, it’s overwhelming. 

One of the things I sometimes struggle with is which metrics are most important. Sometimes there are things right up at the top of a press release that don’t appear in the SEC filings. Sometimes there’s something in the SEC filing that doesn’t get mentioned in the press release. This is where some critical thinking comes into play. It’s up to me to think about, and decide, what I want to track.

One helpful trick I have found is to go to the 10-K or 10-Q and read the “Management’s Discussion and Analysis”. Often there is a section that lists what the company thinks is important. Using Procore (PCOR) as an example, since I discussed it on this week’s episode, this section is called “Certain Factors Affecting our Performance”. Here, management essentially says that it wants to acquire new customers, expand existing customers’ use of the platform, expand the products and services it offers, and grow internationally.

Most of these are easy to track. Management reports total customer growth, organic customer growth, annual recurring revenue (ARR), gross retention rate (GRR), and remaining performance obligations (RPO) as metrics for tracking customer growth and the rate at which they’re sticking around. As for international expansion, the company splits its revenue between “U.S.” and “Rest of World”, making it clear how international growth is going.

There’s another easier way to gather this data, and it’s by using our new sponsor, FinChat.io. This platform is cool for several reasons but one of the most helpful features is that it does the work of gathering these company-specific metrics (they call them KPIs) for you. If that’s of interest to you, I encourage you to visit our landing page at finchat.io/unscripted to get 25% off any paid plan.

One last thing I will note. Sometimes companies stop reporting certain metrics and/or start reporting new ones. This isn’t necessarily a bad thing, but I do like it when management teams are clear about why they’re no longer reporting a certain metric. When something that has been reported for a long time suddenly disappears from the quarterly release, I become instantly skeptical.

This is a quick explanation of what works for me. It may be too much work or the wrong kind of work for you. I share because I am a systematic and structural thinker, so frameworks, examples, spreadsheets, and processes, all help me think and make decisions. I hope that there are some people out there for whom this might be helpful. For others, you may prefer another method of tracking the progress of the companies you own. I would LOVE to hear from you if you would like to share your process. I’ve tweaked mine pretty much every quarter for the last four years and I expect to make changes in the future as well.

Jeff

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