Is Confluent, Inc. the next rocket ship following the footsteps of MongoDB and Elastic?

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The Confluent, Inc. IPO is the next in the line of companies that have built successful businesses around open source technologies in distributed / cloud computing. MongoDB Inc. and Elastic Inc. have been recent successes, sporting valuations of $20B and $12B respectively. Here are some insights from Confluent, Inc’s recent S-1.

The Technology

Confluent describes its mission as “setting data in motion”. At a high level Confluent benefits from the move from traditional monolithic architectures to the microservices architecture in the cloud computing world. While the traditional architecture relied on batch processing of data, the modern data world is run on continuous and stream processing of data. With tens of microservices running, each needs to communicate with the other, this inevitably leads to the n-squared problem of building messaging conduits from and to each microservice. To solve this problem the three co-founders of Confluent built an open source project now called Apache Kafka while at LinkedIn. Kafka is a scalable messaging bus that sits between the microservices essentially publishers and subscribers of the calls / messages. In addition they tag / classify messages into topics, shard and offset them to provide scalability and relaibility. Apache Kafka has become the industry standard for data in motion. It is one of the most successful open source projects, being used by over 70% of the Fortune 500.

Business Model — Open Source to Closed Source

To be clear the Confluent platform has evolved into much more than Apache Kafka. As readers familiar with the travails of open source, both MongoDB and Elastic ran into challenges where public cloud vendors, particularly AWS launched competitive products given the open source nature of the underlying technology. Confluent cleverly side stepped this issue, quoting from the S-1 [Ref. page 129]

“Our software products are protected by our licensing policies, which include either our full proprietary license as well as our community license, which restricts others from offering our technology as a competing SaaS offering. Instead of opting for a traditional “open core” model, our core offering (Confluent Server) is substantially differentiated from Apache Kafka and was fundamentally re-architected to operate at cloud-scale, while being interoperable with existing Apache Kafka systems.”

There is no doubt they learned from MongoDB and Elastic. As a matter of fact Confluent and Elastic share a common board member.

Product Offering

The company offers both public cloud as well as on premise distributions of the product

• Confluent Cloud is a fully-managed cloud-native offering, available on all of the major cloud providers (AWS, GCP, and Microsoft Azure). Confluent Cloud is offered to our customers via a pay-as-you-go model with no commitment, or via an annual, or multi-year, subscription model where customers draw down upon a committed dollar amount.
• Confluent Platform is their enterprise-grade self-managed software offering, able to be deployed on-premises as well as across public and private cloud environments. Confluent Platform is offered to our customers via an annual or multi-year subscription.

Financials

Confluent has seen spectacular top line growth, but also substantial operating expense burn here is a summary of the financials

The financials are emblematic of a rapidly growing SaaS / enterprise company

• Annual revenues growth of 58% and 123% in FY2019 and FY2020 respectively
• High gross margins in the high 60’s low 70’s
• Spectacular burn rate in opex particularly Sales & Marketing and General & Administrative. S&M costs grew 114% and 43% in 2019 and 2020 and G&A grew 84% and 408% respectively. (The 2020 G&A increase primarily accounts for secondary sales by founders in 2020 being accounted for as stock based compensation).

While the opex burn is high, it does not seem to constitute a red flag, especially given the fact that revenues are growing fast and SBC (stock based comp) accounts for a large portion of these costs.

Growth & Prospects

Confluent has shown tremendous growth and diversity in the customer base. No single customer accounts for more than 3% of revenue. 36% of their revenues come from outside the US. The business model is driven by customer renewals and increasing existing customer subscriptions over time. The company has executed well on the “land and expand” model.

The chart below illustrates this by presenting the ARR (annual retention rate) from each customer cohort over the years presented. The cohort for a given year represents customers that acquired their initial subscription purchase from us in that year. For example, the fiscal year 2017 cohort represents all customers that made their initial subscription from us between January 1, 2017 and December 31, 2017. The fiscal year 2017 cohort increased their initial ARR from $15 million to $62 million in fiscal year 2020, representing a multiple of 4.1x.

The dollar based net retention rate for FY 2018, 2019 and 2020 was 177%, 134% and 125% on a rapidly increasing revenue base. This clearly shows the effectiveness of existing customers adopting the Confluent platform to expand their use of the offering in connection with migrating more data to the public cloud, identifying new use cases, and realizing the benefits of data in motion.

Capital Structure & Other

Benchmark, Index Ventures and Sequoia Capital own 15.3%, 13% and 9.3% of the stock respectively. The company has about 1,500 employees with offices in Mountain View CA, Austin TX, Bengaluru India, London UK and Dubai UAE.

Prospects

Confluent has 136 of the Fortune 500 companies as their customers. While overall trends with ARR are extremely favorable, even spectacular are the largest customers contributing more than $1M per annum whose numbers increased from 27 to 56 in FY 2020 representing a year-over-year growth rate of 107%. It appears that Confluent, Inc. will soon join the ranks of other successful public companies that have capitalized on the “open source” derivative model for services and tools related to cloud computing.