Confluent’s IPO brings a high-growth, high-burn SaaS model to the public markets

Slowing growth and cash consumption balance a history of blistering expansion

Confluent became the latest company to announce its intent to take the IPO route, officially filing its S-1 paperwork with the U.S. Securities and Exchange Commission this week. The company, which has raised over $455 million since it launched in 2014, was most recently valued at just over $4.5 billion when it raised $250 million last April.

What we can see in Confluent is nearly an old-school, high-burn SaaS business. It has taken on oodles of capital and used it in an increasingly expensive sales model.

What does Confluent do? It built a streaming data platform on top of the open-source Apache Kafka project. In addition to its open-source roots, Confluent has a free tier of its commercial cloud offering to complement its paid products, helping generate top-of-funnel inflows that it converts to sales.

Kafka itself emerged from a LinkedIn internal project in 2011. As we wrote at the time of Confluent’s $50 million Series C in 2017, the open-source project was designed to move massive amounts of data at the professional social network:

At its core, Kafka is simply a messaging system, created originally at LinkedIn, that’s been designed from the ground up to move massive amounts of data smoothly around the enterprise from application to application, system to system or on-prem to cloud — and deal with extremely high message volume.

Confluent CEO and co-founder Jay Kreps wrote at the time of the funding that events streaming is at the core of every business, reaching sales and other core business activities that occur in real time that go beyond storing data in a database after the fact.

“[D]atabases have long helped to store the current state of the world, but we think this is only half of the story. What is missing are the continually flowing stream of events that represents everything happening in a company, and that can act as the lifeblood of its operation,” he wrote.

That’s where Confluent comes in.

But enough about the technology. Is Confluent’s work with Kafka a good business? Let’s find out.

A high-burn model

There are a number of venture capital bets riding on Confluent’s IPO. Benchmark owns 15% of the company, while Index can lay claim to 13%. Sequoia Capital owns 9.3%.

It’s not hard to see why so many investment firms were willing to put capital into the business; it has grown rapidly in recent years. From $65.2 million in 2018 top line, Confluent grew to $149.8 million in revenue the next year. In 2019, then, Confluent grew by 130%. For a company already at scale, that was a very impressive growth rate.

Confluent continued to grow in 2020, albeit at a slower pace. After recording $236.6 million in revenue, Confluent notched growth of 58% in the year. While a dramatic deceleration from its 2019 pace of revenue accretion, the company still managed solid growth during the COVID-19 pandemic.

But that growth came at a steep cost. The company’s net losses expanded from $41.4 million in 2018 to $95 million in 2019 to $229.8 million in 2020. The 2020 result was impacted by outsized, one-time share-based compensation expenses worth $111.9 million.

Tuning out certain costs to provide what may be a clearer look at the company’s operating performance, Confluent’s adjusted operating losses were a more modest $79.4 million in 2019 and $89.3 million in 2020.

Confluent also consumed cash during 2018, 2019, 2020, and its most recent quarter. Its free cash flow worsened from 2018 through 2020, when it recorded yearly tallies of -$22.6 million, -$71.8 million and -$86.7 million.

Capping off the bad news, Confluent’s growth rate slowed to 51% in the first quarter of 2020, while it recorded a steeper net loss of -$44.5 million against revenues of $77 million.

There’s good news in Confluent’s numbers as well. The data-movement company’s gross margins are on the bounce, rising from 65% in Q1 2020 to 69% in Q1 2021, for example. And its free cash flow margin was a much-improved -28% in the first quarter of this year, compared to a year-ago result of -64%.

The company’s remaining performance obligations, or RPOs, also grew to what appears to be an all-time high of $280.9 million in the first three months of 2021, up from $166.3 million in the year-ago quarter.

Finally, despite some declines, Confluent’s net retention rate closed the March 31, 2021, quarter at 117%. That’s just fine, even if its 130% result from the year-ago Q1 was far superior.

What we can see in Confluent is nearly an old-school, high-burn SaaS business. It has taken on oodles of capital and used it in an increasingly expensive sales model. Indeed, Confluent’s sales and marketing costs grew from $54.5 million in 2018 to $115.8 million in 2019 to $166.4 million in 2020, though that final number includes an elevated amount of share-based compensation expense.

Do not think that we’re being sharply critical in our discussion of the company’s history of operating deficits; Confluent’s investors gave it money to invest in growth. Our general concern regarding the company’s slowing growth rate is merely a valuation question. How Wall Street will balance the two is simply what’s next.

So how should we expect public investors to value Confluent? It’s a SaaS business, so rather richly we presume. nCino, Datadog and Cloudflare are rough growth analogs in the public market, leaning on Bessemer’s Cloud Index for comp data. They are worth 24x to 45x their current run rate on an enterprise value basis. At those very loose figures, and Confluent’s Q1 2021 run rate of $308.1 million, the company would be worth between $7.4 billion and $13.9 billion.

Can a range that broad tell us anything? It can. In this case, what it indicates is that Confluent should not have a hard time besting its final private valuation when it does price its IPO. Precisely how investors will value its high-cost growth remains to be seen, but $4.5 billion should be a bar that it can clear easily.

For now, Confluent is ending its journey as a startup and heading toward the public company exits, and all that entails. Wall Street may insist on a more disciplined approach to spending, but as the company matures, that should be the way it trends regardless. More when it prices.