Confluent IPO: Analyzing the High-Growth SaaS Model

Confluent's IPO Filing: A Deep Dive

Confluent has recently joined the ranks of companies preparing for an Initial Public Offering (IPO). This week, the company formally submitted its S-1 filing to the U.S. Securities and Exchange Commission.

Since its inception in 2014, Confluent has secured over $455 million in funding. Its most recent valuation exceeded $4.5 billion, achieved during a $250 million funding round last April.

Understanding Confluent's Core Business

Confluent specializes in a streaming data platform constructed upon the Apache Kafka open-source project. The company leverages its open-source foundation with a complimentary free tier for its cloud services.

This tiered approach supports lead generation and facilitates the conversion of potential customers into paying clients.

The Origins of Kafka

Apache Kafka originated as an internal initiative at LinkedIn in 2011. It was initially developed to handle substantial data volumes within the professional networking platform.

As previously discussed in 2017, during Confluent’s $50 million Series C funding, the project was designed for high-throughput data movement.

The Vision Behind Event Streaming

Jay Kreps, CEO and co-founder of Confluent, articulated the importance of event streaming. He stated that it is fundamental to modern business operations.

He emphasized that event streaming extends beyond traditional data storage, impacting real-time activities like sales and other critical business functions.

According to Kreps, conventional databases primarily capture the current state, but they often lack the continuous flow of events that represent a company’s dynamic activity.

He described this event stream as the “lifeblood” of an organization.

Confluent's Role in the Data Ecosystem

This is precisely the niche that Confluent aims to fill.

However, beyond the technical aspects, a crucial question arises: does Confluent’s work with Kafka represent a viable and sustainable business model?

Further analysis will determine the potential for success.

A Rapid Growth, High-Expenditure Model

Significant venture capital investments have been made in Confluent, anticipating its IPO. Benchmark holds a 15% stake in the company, while Index possesses 13%. Sequoia Capital controls a 9.3% ownership share.

The substantial interest from investment firms is readily apparent given the company’s rapid expansion in recent years. Revenue increased from $65.2 million in 2018 to $149.8 million in 2019. This represented a 130% growth rate for Confluent, a particularly impressive figure for a company of its existing scale.

Confluent’s growth trajectory continued into 2020, although at a reduced rate. The company reported $236.6 million in revenue, achieving 58% growth for the year. Despite this deceleration from the 2019 revenue increase, Confluent demonstrated robust performance throughout the COVID-19 pandemic.

However, this expansion was accompanied by considerable expenses. Net losses widened from $41.4 million in 2018 to $95 million in 2019, and further to $229.8 million in 2020. The 2020 figure was significantly affected by one-time share-based compensation costs totaling $111.9 million.

Adjusting for specific costs to gain a clearer view of the company’s operational performance, Confluent’s adjusted operating losses were $79.4 million in 2019 and $89.3 million in 2020.

Throughout 2018, 2019, and 2020, as well as its latest quarter, Confluent experienced negative cash flow. Its free cash flow deteriorated year-over-year, recording -$22.6 million, -$71.8 million, and -$86.7 million respectively.

Adding to these challenges, Confluent’s growth rate slowed to 51% in the first quarter of 2020, alongside a larger net loss of -$44.5 million against revenues of $77 million.

There are also positive indicators within Confluent’s financial data. For instance, the company’s gross margins have improved, rising from 65% in Q1 2020 to 69% in Q1 2021. Furthermore, the free cash flow margin saw substantial improvement, reaching -28% in the first quarter of this year compared to -64% in the prior-year period.

Confluent’s remaining performance obligations (RPOs) also increased to a record high of $280.9 million in the first three months of 2021, up from $166.3 million in the same quarter of the previous year.

Moreover, despite some fluctuations, Confluent’s net retention rate stood at 117% as of March 31, 2021. While lower than the 130% achieved in the year-ago Q1, this remains a favorable result.

Confluent exemplifies a classic, high-burn SaaS business model. It has secured substantial capital and deployed it into an increasingly costly sales strategy. Specifically, Confluent’s sales and marketing expenses grew from $54.5 million in 2018 to $115.8 million in 2019 and $166.4 million in 2020, with the latter figure including elevated share-based compensation.

It’s important to note that our assessment of the company’s operating deficits is not overly critical; Confluent’s investors provided funding specifically to fuel growth. Our primary concern regarding the slowing growth rate centers on valuation considerations. The manner in which Wall Street will weigh these factors remains to be seen.

How should public investors approach valuing Confluent? Given its status as a SaaS business, a relatively high valuation is anticipated. nCino, Datadog, and Cloudflare serve as comparable companies in the public market, utilizing data from Bessemer’s Cloud Index. These companies are currently valued at 24x to 45x their current run rate based on enterprise value. Applying these figures to Confluent’s Q1 2021 run rate of $308.1 million suggests a valuation between $7.4 billion and $13.9 billion.

Does this broad valuation range offer any insight? Indeed, it indicates that Confluent is likely to surpass its final private valuation when its IPO is priced. The precise valuation will depend on how investors assess its high-cost growth, but $4.5 billion appears to be a readily achievable benchmark.

Currently, Confluent is transitioning from a startup to a publicly traded company, with all the associated implications. Wall Street may demand a more disciplined approach to spending, but this trend is expected as the company matures. Further analysis will be provided upon pricing.