Confluent, Inc. – IPO of the leader of the data engineering industry

Confluent, Inc’s (NASDAQ: CFLT) business model belongs to the data engineering niche. It is the part of the data pipeline that sits between the receipt (cash register, smartphone, website) and the datastore from where the data Scientists will take this data.

Data Scientists are machine learning specialists. They can find it challenging to work with dozens of different types and formats of data, which are constantly changing.

The abbreviation “4V” describes big data problems formed from the first letters of the words Volume, Variety, Velocity, Veracity. Unfortunately, due to the second of the properties – a variety of formats and their constant change, extracting data from sources turns into an independent task that requires a colossal investment of specialists’ time.

Data Scientists find it much more convenient to take data from stable storage to know how to work (often using the SQL query language). Therefore, it is advisable to spend time on data extraction and training and debugging training models. Then, the data engineer solves the problem of delivery of various formats to the storage for them.

Confluent Inc. operates in four market segments: infrastructure software, database management systems (DBMS), data quality integration and analysis tools, analytics, and B.I. (business intelligence). According to research by Gartner, the combined volume of these markets is about $ 149 billion.

Confluent estimates its market potential (TAM) at $ 50 billion, of which $ 31 billion is for infrastructure support, $ 7 billion for DBMS, $ 7 billion for B.I., and $ 4 billion for integration and data quality control tools. Based on data from Gartner, the company concludes that market potential is growing by 22% per year and will reach $ 91 billion by 2024.

It is the most popular tool for organizing the data pipeline today, based on a standard log file model, where data from all sources is received. The company founders worked as programmers at LinkedIn, where they created the Kafka toolkit for working with such a log. In 2014, Jay Kreps (7 years of development experience on LinkedIn), Jun Rao, Neha Narhede left LinkedIn and created Confluent, which provides services based on Kafka.

Although Kafka is open source software licensed under the Apache license, and theoretically anyone can use it, in practice, it is far from easy. As the company’s website says, “Everyone loves Kafka, but don’t mess with it. Confluent puts you in control of your business, not data infrastructure management.”

Indeed, although Kafka is open-source, the server is written in Scala, which few people know. Instead, I wrote the clients in Java, which is now the most popular programming language, so today, there is no shortage of specialists that clients can use. Moreover, in recent years, support for C ++, Python, Go, and .NET significantly expands the number of engineers who are not afraid to work with the system.

The main products of Confluent:

• Confluent cloud (native cloud for maximum Kafka performance);
• Confluent platform – a toolkit for organizing data streams;
• SQL DB – SQL emulator helps to know less about Kafka and work as if there is SQL (known to all data scientists), and nothing else is needed.

Confluent Inc. solutions apply:

• to organize work with data in the cloud;
• to organize data processing flows;
• for CRM (customer relationship management);
• on the Internet of Things;
• for data management in information security.

Now the company has over 2.5 thousand corporate clients. Five hundred sixty of them pay more than $ 100 thousand a year for the company’s services, and 60 more than a million dollars a year.

The company’s business model resembles that of RedHat, which provides services based on the popular Linux version. Although free CentOS is freely available, enterprise customers require additional assistance. Recall that in 2019 the IMB corporation acquired the RedHat company for $ 38 billion.

There is a known competition with Kafka from Confluent, but a less popular tool – Rabbit M.Q. It is by Pivotal Software, which is by Vmware (VMW).

Financial results
Confluent, Inc.’s revenue in 2020 amounted to $ 236.577 million, 57.9% more than a year earlier ($ 149.805 million). At the same time, 88% of the revenue by software licensing, and 12% – additional services.

Sales value in 2020 was $ 75.476 million, an increase of 52.8% over the previous year when it was $ 49.369 million. Thus, sales value grew slightly slower than revenue, indicating a positive effect of economies of scale. Thanks to this, the gross profit in 2020 amounted to $ 161.101 million, or 60.4% more than a year earlier ($ 100.436 million). In addition, the gross profit margin was 68.0%, one percentage point (or 1.4%) higher than a year earlier when it was 67.0%.

In 2020, $ 105.399 million on research and development is 81.4% more than a year earlier ($ 58.09 million). These costs in 2020 amounted to 44.5% of revenue. A year earlier, they accounted for 38.7% of revenue. Thus, the share of spending on research and development over the past year has increased by 14.9%.

Marketing costs in 2020 amounted to $ 166.361 million – 43.6% more than a year earlier ($ 115.792 million). The share of marketing in 2020 was 70.3% of revenue. A year earlier, this share was 77.2% of revenue. It should note that the percentage of promotion costs over the past year has decreased by 9.0%.

The share of general and administrative expenses in the revenue is 51.7%. A year earlier, it accounted for 16.4% of revenue. Note that the percentage of general and administrative costs has increased by 215.2% over the past year.

Operating losses in 2020 amounted to $ 233.175 million. A year earlier, they amounted to $ 98.108 million.

Confluent posted a net loss of $ 229.828 million in 2020, up from $ 95.042 million in the prior year.

Confluent’s liabilities amount to $ 274.408 million.

The company has $ 280.098 million in cash.

Plans for the use of raised funds

The company intends to use the $ 671.9 million raised from the IPO when placed at the mid-range price for general corporate expenses, including working capital, operating expenses, and CAPEX. Can use part of the funds to take over companies purchasing technologies, services, and components.

Attractiveness factors

• The company was created by the developers of Apache Kafka – the most popular set of software tools for data engineering.
• The total potential of the markets in which Confluent operates at $ 50 billion.
• Now, the company has over 2.5 thousand corporate clients. Five hundred sixty of them pay more than $ 100 thousand a year for the company’s services, and 60 more than a million dollars a year.
• Revenue of Confluent, Inc. in 2020 amounted to $ 236.577 million, which is 57.9% more than a year earlier ($ 149.805 million). On average, revenue has grown by 51% per year in recent years.

The main risks

The company’s risks on 42 pages of the prospectus, we briefly list the most important ones:

• A common problem for the niche companies in which Confluent operates is when they have to change their software licenses to improve their financial performance. The army of developers uses the latest versions of a large number of tools from such companies for free. Changing the terms of use destroys the developer community.
• Confluent Cloud terms of service depend on cloud infrastructure providers who may start promoting competing solutions.
• Operating losses in 2020 amounted to $ 233.175 million. In 2020, Confluent incurred a net loss of $ 229.828 million.
• 90% of the economic share will be by the existing shareholders. Due to the double structure of claims, they will also control 99% of the votes of the shareholders’ meeting.

We also note the relatively low productivity of the Confluent employee compared to other companies in the industry. For example, the average employee of a comparable company brings her $ 283 thousand per year.

However, a Confluent employee brings the company only $ 169,000, almost half the average for the TMT sector. Thus, it can contribute partly to the company’s youth, which has not yet reached the maximum level of revenue. However, another explanation may be that the company’s business model includes a significant consulting component.

In I.T. consulting, the average revenue per employee is an order of magnitude lower (by hiring a large number of qualified specialists in third-world countries). Examples of companies with large numbers of employees are giants such as IBM, Cognizant, and Accenture. Of course, they could potentially one day become strategic buyers of Confluent.

IPO details

The company intends to list 23 million common shares on NASDAQ. During the IPO, a group of investors, led by Altimeter Growth Partners, wants to purchase shares of the company in the amount of 3.450 million for $ 106.95 million.

The company has two classes of ordinary shares: class A and class B. Each Class A share has one vote of the shareholders meeting, and a class B share has ten votes. Following the IPO, the company will issue 23 million Class A shares and 229.365190 Class B shares.

After the IPO, the total number of shares will be 252.36 million ordinary shares.

Free float will contain 9.1% of ordinary shares.

Following the IPO, Benchmark Capital Partners will become the largest institutional shareholder, which will control 15.1% of the shareholders’ votes. The other largest shareholders are Index Ventures (12.9%), Jun Rao (10.5%), and Sequoia Capital (9.2%).
The founder and CEO of Jay Kreps will own 12.6 million Class B shares (12.4% of the vote).

The offering ranges from $ 29 to $ 33 per share, with an average price of $ 31. The volume of placement will be $ 713 million.

The company’s capitalization estimate by the organizers of the placement ranges from $ 7.318 billion to $ 8.328 billion, on average – $ 7.823 billion.

Recall that the company’s revenue for 2020 amounted to $ 236.577 million. Thus, the organizers of the placement use a very high capitalization-to-revenue (P / Sales) multiple of 33.06.

Assessment of the company’s capitalization

The sector in which Confluent, Inc. operates is big data. To assess the company’s capitalization, we will use the multiples typical for this area. We took as a basis the same list of peers that previously used for IPOs of companies in the big data and business intelligence sectors. The median P / S for this sector is 19.0, and the weighted average for capitalization is 6.55.

For comparison, we point out that the P / S multiple of Elastic N.V. (ESTC) is 21.42 and JFrog, Inc. (FROG) is 26.83.

Using the median multiple and revenue for the last 12 months of the year ($ 236.577 million), Confluent, Inc. can buy at $ 4.494 billion, and the value of the share – at $ 17.81, that is, 42.55% lower than the average valuation of the claim by the organizers of the placement.

Additionally, we will conduct a rough alternative estimate of Confluent’s capitalization. It is that venture capitalists have invested $ 456 million in the company. Our statistics show that the median ratio of companies’ capitalization to IPO to the volume of venture investment is 9.0. is the so-called multiplier to the amount of “burnt cache.” Applying this median multiplier, we can conclude that, on average, venture capitalists expect such a company to at no less than $ 4.104 billion.

The values ​​obtained two methods are close to each other, and the press announced the estimate of $ 4.0-4.5 billion in April. A large segment of the data engineering market.

Discussion of IPO prospects

The period of some cooling of interest in IPO seems to be over. With the victory over the coronavirus pandemic, the traditional economy is not recovering so quickly that the I.T. sector loses its attractiveness.

Confluent by the creators of Apache Kafka, the world’s most popular data engineering tool. Her story has received widespread press coverage. One of the co-founders, Neha Narkhede, who previously worked as a programmer at LinkedIn and now became a venture capitalist, attracts particular sympathy. Although the volume of the offering is large ($ 713 million), recent IPOs have shown that this is not a problem due to the surplus of money in the market.

Considering the combination of the above factors, we expect the value of Confluent, Inc. shares to rise. (CFLT) to close on the first day of trading by 25% about the average of the range. The share price may increase to $ 38.75. At the same time, the valuation of the company’s capitalization will increase to $ 9.773 billion.