MSFT - Snowflake: Stock Surge Shows Why Overvaluation Fears Were Overstated

2023-12-06 08:30:00 ET

Summary

• Snowflake stock has surged nearly 40% from its October 2023 lows, outperforming the S&P 500 significantly.
• The company's fiscal Q3 report helped alleviate concerns about consumption normalization and showcased growth in Snowpark adoption.
• Management remains confident that the downtrend in net retention rates will stabilize, and adjusted operating margin guidance for the current fiscal year has been increased.
• Given Snowflake's high-quality growth profile, I discuss why investor fears about its implied overvaluation were overstated.
• I argue why, while the worst is likely over, Snowflake is still not a buy at any price after the recent surge.

Investors in leading data cloud company Snowflake Inc. ( SNOW ) have had much to cheer over the past two months, as SNOW surged nearly 40% from its October 2023 lows through its highs last week. As a result, SNOW has also significantly outperformed the S&P 500 ( SPX , SPY ) since my previous update in late September. As a reminder, I informed readers that the "rally is just getting started," as I gleaned more constructive buying sentiments nearly two months before it reported its third fiscal quarter or FQ3 earnings release in late November.

It was a solid report, as the company helped allay investors' fears about the ongoing consumption normalization that affected its growth momentum. Management indicated it had leveraged the AI tailwinds, capitalizing on its high-quality data cloud advantage. Snowflake has also experienced significant growth in Snowpark adoption, surging 47% QoQ. In addition, Snowflake also gleaned that "more than 30% of Snowflake's customers used the platform to process unstructured data." As a result, it mitigated the consumption normalization headwinds, which management articulated has "stabilized."

As a result, management remains confident that the downtrend seen in its net retention rate or NRR could bottom out, "possibly with a slight dip before stabilizing." Accordingly, the headwinds that afflicted Snowflake's consumption-based model are expected to be less intense moving ahead, which should lift its NRR metric as it fell to 135% in FQ3'24. Observant investors should note that Snowflake's NRR reached a peak of 178% in FQ4'22. However, Snowflake management remains reticent about providing guidance for FY25, although it offered a more robust adjusted operating margin guidance for the current fiscal year.

Accordingly, management expects an adjusted operating margin of 7%, up markedly from its previous outlook of 5%. Snowflake saw increased adoption from larger enterprise customers as benefiting its ability to gain operating leverage. These customers are expected to be less prone to overspending, providing more predictable spending patterns and revenue generation for Snowflake.

Snowflake's cloud-agnostic data cloud continues to see increased adoption from Microsoft ( MSFT ) Azure, which has been instrumental in Snowflake's momentum in FQ3. CEO Frank Slootman accentuated, "There has been a notable increase in energy and activity from the Azure platform during the quarter." CFO Mike Scarpelli articulated that Azure is the "second-largest (hyperscaler) and represents 21% of the business."

Scarpelli emphasized that "Microsoft Azure is experiencing the fastest growth among the three (hyperscalers)." As a result, I believe it's clear that Microsoft's proliferation of the AI co-pilot throughout its business has likely helped Snowflake gain momentum, diversifying its reliance on AWS, representing 76% of its business in FQ3.

With the sharp recovery in SNOW as it re-tested its June 2023 high ($194 level), I believe it's timely to assess whether the current levels can still provide buyers with an attractive risk/reward profile.

SNOW's "D-" valuation grade suggests it's still valued with a steep growth premium. However, its cloud-agnostic opportunity could continue gaining traction as more large enterprises migrate to a multi-cloud posture. With the need for high-quality data and robust data governance, Snowflake is well-primed to serve these needs, with the increased AI fervor bolstering its consumption-based revenue model. As a result, I believe its best-in-class "A+" growth grade is high-quality, with the market increasingly confident about its ability to justify its growth premium.

SNOW re-tested its June 2023 highs last week as buyers attempted to break decisively above the $194 level again.

Therefore, it's clear that SNOW dip-buyers bought into its late October 2023 lows, well before its recent earnings release, as they anticipated the worst to be over. Investors should realize it's crucial to anticipate (as the market is forward-looking). By the time Snowflake releases its earnings, the risk/reward would have been much less attractive, as seen above.

I've yet to glean sellers returning to stem SNOW's upward momentum, suggesting further upside is still likely. Despite that, with SNOW close to re-testing a critical resistance level, I believe it's apt to be more cautious and wait for a resolution before reassessing the buy levels again.

Rating: Downgraded to Hold.

Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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