SNOW - Snowflake - Slower Growth Higher Expectations

2024-01-09 17:57:44 ET

Summary

• Snowflake's growth has decelerated as GAAP operating losses are not narrowing significantly, despite increased margin discipline in the wider technology sector.
• The company's valuation has increased, pushing up expectations, but progress on margins is still in the early stages.
• The combination of slower growth, lackluster margin progress and a higher valuation makes me very cautious here.

When I covered Snowflake Inc. ( SNOW ) in April of last year, I wondered if margin progress was finally in the works, as increased attention and discipline on margins was a widespread theme in the technology sector.

The company saw slower growth, which was not surprising given the macroeconomic conditions and law of large numbers slowly catching up with Snowflake as well. While that was not unexpected, the issue is that GAAP operating losses were no longer narrowing, the combination of which made me a bit cautious.

Ever since, Snowflake has seen growth decelerate further and while some tiny progress on the margin front has been achieved, that is still in the early innings. The combination of all this with a higher share price has pushed up valuations and expectations, making me very cautious at current levels.

Huge Potential, Hype

Ahead of the artificial intelligence and the hype surrounding ChatGPT, it was Snowflake which enjoyed its moment of fame. The promise of Snowflake is that it provides artificial intelligence-like solutions by reimagining data management for cloud solutions.

The basic premise is that data should be seamlessly accessible, organized and shared in order to unlock the real value of this data. The company believes so much in this model, that it offers these solutions in a WaaS subscription model under which Snowflake's revenues are tied to the consumption of the services, rather than fixed upfront or monthly fees.

In its prominent public offering in 2020, shares were sold to the public at $12 per share, as they hit the $300 mark on the first day of trading publicly, even trading at $400 in 2021.

This hype was backed up by a business which posted $265 million in sales in 2019, although accompanied by a huge $358 million operating loss. Growth has been spectacular ever since, as the company posted sales at a run rate of $2.2 billion as of the end of 2022, and that is even before accounting for an increase in the remaining performance obligations at over a billion as well.

For the fourth quarter, product sales rose 54% to $555 million, with total revenues reported at $589 million. Despite the continuation of spectacular growth, the company still posted an operating loss of $240 million for the three-month period.

For the fiscal year 2024, the company guided for product sales to increase by some 40% to $2.70 billion, with adjusted operating profit margins seen around 6%, but this comes ahead of substantial stock-based compensation expenses which cause a massive gap between reported and adjusted profit metrics.

The company was granted a $43 billion enterprise valuation around $150 per share, a nosebleed valuation given the projected revenues, as the margin picture remained complicated. The problem was that while adjusted operating profit margins were expected, this was ahead of large stock-based compensation expenses, and in fact were in line with the results reported recently.

Expectations Rise

Since April, shares of Snowflake have traded in a $140-$200 range, now changing hands at $189 per share.

In May, Snowflake reported a 48% increase in first quarter sales to $624 million, yet GAAP operating losses rose sharply to $273 million as well, equal to about 44% of sales.

Over the summer, a nearly 36% increase in second quarter sales to $674 million was reported and while operating losses increased to $285 million in dollar terms, they fell slightly to 42% of sales.

For the third quarter, a 32% increase in third quarter sales to $734 million revealed a continuation of sales growth in dollar terms, but slower relative pace of growth. Promising was that operating losses narrowed to $260 million, equal to about 35% of sales, and that is ahead of interest income being received on net cash balances, reducing net losses to a still substantial $214 million number.

Looking into these numbers, the company grew remaining performance obligations by 23% year-over-year to $3.7 billion, as the pace of growth is rapidly coming down.

By now the 329 million shares of the company grant it an equity valuation of $62 billion here, as this number includes about $4.5 billion in net cash, for about a $57.5 billion enterprise valuation. This still marks a very lofty valuation at nearly 20 times sales, with revenue growth having slowed down to about 30% here. This stands in sharp contrast to over 50% growth rates reported about a year ago, while the company was valued at low double-digit sales multiples.

What Now?

The truth is that the operating performance of the company feels utterly soft in comparison to the share price momentum seen since the spring, pushing up valuation multiples along the way.

While the company touts upbeat developments, including in its recent third quarter conference call, the question can be asked if AI is really an accelerator of the business, or AI-related business models might actually pose a competitive threat to Snowflake. After all, growth is slowing down rapidly and the company sees competition from the likes of Databricks, as this private company has fetched a valuation largely at par with Snowflake here.

Given all these trends, I have some real concerns with a nearly 20 times sales multiple in combination with 30% growth rates and still large realistic losses. This does not pose a very pretty and balanced risk-reward proposition here.

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