SNOW - Snowflake: Why The Partnership With Microsoft Is A Game Changer

2023-07-27 11:47:09 ET

Summary

• Those thinking that the AI boom would immediately benefit Snowflake were surprised when management lowered full-year guidance.
• Customers are beginning to delete data in reaction to tough macro conditions.
• Snowflake continues to generate strong cash flows and has a net cash balance sheet.
• Management reiterated long-term revenue guidance, but the growth story is starting to look a little shaky in the near term.
• I explain why the partnership with Microsoft may reignite the growth engine.

Snowflake ( SNOW ) plunged after its most recent earnings release in spite of strong results, but has since recovered its losses. Wall Street appears concerned about management's conservative guidance, which calls for a sizable slowdown in the company’s growth rate. Customers are adapting to the high interest rate environment by undergoing “data optimization,” but management is of the view that these headwinds are near term in nature. It's curious that the company is facing headwinds given its perceived exposure to the growth of artificial intelligence, but it's possible that its role in enabling AI is overstated. The company's recent announced partnership with Microsoft ( MSFT ) may help to clarify their AI positioning. I reiterate my buy rating but again emphasize that this name trades quite richly relative to tech peers.

SNOW Stock Price

SNOW has lost some of its hype, but even after the steep correction from highs, the stock still trades at rich valuations.

I last covered SNOW in April, where I rated the stock a buy on account of the solid growth and strong cash flow margins. The growth story is facing some near-term hiccups, but the strong balance sheet and cash generation help to even out the story.

SNOW Stock Key Metrics

In its most recent quarter, SNOW generated 48% YOY revenue growth to $624 million, with product revenues of $590 million coming ahead of guidance for $573 million.

SNOW saw remaining performance obligations (‘RPOs’) decline sequentially - a surprising development given the company’s historically high growth rates. Many tech companies have reported elongated sales cycles including smaller deal sizes - these headwinds have finally caught up with SNOW.

SNOW continued to rapidly grow its customer base, something that I expect to help revenue growth accelerate as the tough macro environment subsides.

The company’s dollar-based net revenue retention rate declined yet again down to 151%.

SNOW delivered yet another quarter with strong free cash flow generation - prepaid revenues are nice perk of being an enterprise tech business.

Unlike many tech peers which have slowed down hiring or engaged in large headcount reductions, SNOW continues to invest aggressively in growth, with headcount continuing to expand sequentially. It's highly impressive that the company can keep driving margin expansion in spite of both a tough macro environment as well as continued aggressive investment.

SNOW ended the quarter with $5 billion of cash and investments vs. no debt, representing a strong balance sheet.

Looking ahead, management reduced full-year guidance to $2.6 billion in revenue (down from $2.7 billion) and its operating margin to 5% (down from 6%). Analysts on the call seemed concern that this latest set of guidance was not conservative enough to which management stated that they have not changed their forecast methodology, which typically aims for preciseness without much upside surprise. That said, management did state that they are assuming continued weakness through the end of the year.

Management noted that some of its customers are choosing to delete data to save costs where they otherwise would not have previously. Management believes this to be a near-term trend, especially given the rising enthusiasm for generative AI. Regarding that last point, management views SNOW as being attractively positioned for the growth of generative AI due to models needing to be trained on large amounts of data.

Yet I must wonder why the company is not seeing stronger fundamentals given what should have been an easily understandable correlation with generative AI. It appears that Wall Street has begun to hold some doubt and the company has moved quickly to address these issues, notably announcing a partnership with AI leader Nvidia ( NVDA ) subsequent to the quarter. Management noted that they did not see material headwinds to their business until in April, explaining the guidance miss. The company repurchased $192 million of stock at an average price of $136 per share. Management stated that the program is in place in order to reduce dilution, but I'm of the view that external M&A is a superior choice given the relative premium of the stock price. Management has targeted around 2% in annual dilution starting in fiscal 2024.

At their investor day, management reiterated confidence in their ability to achieve $10 billion of product revenue in fiscal 2029 with ever-increasing margin expectations.

I suspect that part of the stock’s initial weakness may be due to specific commentary regarding the company having greater exposure to AWS ( AMZN ) than Azure ((MSFT)). That problem appears to be resolved. Subsequent to the quarter end, SNOW announced an expanded partnership with MSFT with a focus on generative AI . Given MSFT's head start in generative AI, I see this expanded investment in Azure solutions and integrations as being very important to ensuring that SNOW can fully capture the generative AI opportunity. SNOW already is viewed as being one of the clear leaders in managing data and by partnering with the clear leader in generative AI, SNOW positions itself to grow alongside this new market (and separately, also fixes any prior damage to the growth story).

Is SNOW Stock A Buy, Sell, or Hold?

As a data warehouse and data lake, SNOW offers direct exposure to the growth of data. And with the company's partnership with Microsoft Azure, it has become a legitimate play on generative AI as well.

Backed by investors like Warren Buffett, SNOW has historically been something of “tech royalty,” with a secular growth story considered cleaner than most.

This is reflected by the fact that the stock is still trading at around 21x revenues.

Based on 25% growth exiting fiscal 2029, a 30% long-term net margin, and a 1.5x price to earnings growth ratio (‘PEG ratio’), I could see the stock trading at 11.3x sales by then. That implies a stock price of around $405 per share in January 2029, implying around 16.5% potential annual upside over the next 5.5 years.

What are the key risks? Valuation is an obvious risk as I can see the stock declining 40% to trade in-line with peers on a growth-adjusted basis. At this point, a new risk is if the data optimization headwinds prove to be more long term in nature. What if the “data can only grow” thesis falls apart? Lastly, we mustn’t ignore competition risk as cloud providers improve their own data offerings, something that they may be more incentivized to do due to rapid interest in their LLMs. I reiterate my buy rating for SNOW though note the rich relative valuation and high reliance on the company to hit consensus estimates.

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