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Down 65%, Snowflake Still Has a Big Valuation Problem

Published 12/05/2022, 10:28 AM
Updated 07/09/2023, 06:31 AM
  • Once the most expensive stock in the market, SNOW still isn’t cheap
  • Upside potential is attractive — but hardly compelling
  • This is an outstanding business, but the lesson of this market remains: price matters

In 2021, the equity market completely threw caution to the wind when it came to valuation. Data software provider Snowflake (NYSE:SNOW) was one of the more extraordinary examples.

Not long after its initial public offering in September 2020, and then again in November last year, SNOW stock traded for well past 100 times revenue. Bear in mind that after the dot-com bubble burst, Sun Microsystems chief executive officer Scott McNealy famously detailed the logic against paying even ten times revenue.

It would seem close to impossible to make money buying a stock at 100 times revenue unless that stock is, say, a biotechnology firm with close to zero sales. Snowflake was and is not that kind of company: total revenue in fiscal 2022 (ending January) cleared $1.2 billion.

And, at least so far, it has been impossible to make money in SNOW at that multiple. Shares are down more than 60% from their peak. Yet, incredibly, after that decline, Snowflake still has a seemingly significant valuation problem.

Looking to 2029

Any investor buying or owning Snowflake stock obviously is doing so with a long-term focus. The stock is one of the most expensive in all of the software — but it’s also one of the fastest-growing. Revenue is expected to increase by about 70% this year. On the third quarter conference call last week, Snowflake gave preliminary guidance for 47% top-line growth in fiscal 2024.

The company itself sees a long runway. In its third quarter presentation, Snowflake reiterated its targets for fiscal 2029. Revenue should come in at about $10 billion, up from roughly $2 billion this year. Adjusted operating margins are expected to hit 20%, implying $2 billion in operating profit, with adjusted free cash flow at about $2.5 billion.

That’s the good news. The problem is that with a fully-diluted market capitalization above $50 billion, SNOW trades at roughly 20x FY29 free cash flow and perhaps 30x earnings even if it hits its targets.

That’s far from guaranteed, of course, but assume Snowflake does deliver on its promises. And assume that, six years from now, the stock trades at, say, 50x free cash flow and 65x earnings. Those multiples suggest a market capitalization in the $125 billion range.

The Case Against SNOW

That’s a 150% return from current levels — good if you can get it, certainly. But there’s another factor to consider: those adjusted figures exclude stock-based compensation.

Snowflake’s share count will increase substantially over this period as employees receive and exercise stock options. The company has granted more than 9 million restricted stock units just through the first three quarters of fiscal 2022, per figures from the 10-Q. A similar pace going forward would get the diluted share count in the range of 400 million by the 2029 target date.

To be sure, this rough model still suggests SNOW stock can double, or even a little better, over the next six years. But that’s only annualized returns in the range of 13% or so.

Again, that’s good if you can get it, but this model assumes that pretty much everything goes right. Snowflake hits its targets, the stock remains expensive six years from now, competition doesn’t arrive (or improve), and the broad market doesn’t tank. It’s simply difficult to see that kind of return as being compelling, given how much needs to go right to get it.

Buying Quality

To be clear, this is not an argument for shorting SNOW. Shorting a good business based solely on valuation concerns is almost always a fool’s errand — and this is a good business.

That’s putting it mildly. Increasingly, Snowflake looks like a transformative business, even in a ‘Big Data’ field with no shortage of innovators. Net revenue retention in the third quarter was 165%, showing that existing customers aren’t just sticking around but spending more heavily.

As SNOW bulls will point out, the company even garnered an investment from Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb). And even though Berkshire head Warren Buffett likely didn’t direct the investment himself — it seems likely to have been the work of lieutenants Todd Combs and Ted Weschler — the firm’s imprimatur is valuable. Few investors better hew to the rubric that “price matters” more than Berkshire.

Of course, that fact, in one way, only highlights the current valuation concern. Berkshire did invest in Snowflake, but at the time of the IPO and at the IPO price.

That price? $120 per share, or roughly 20% below Friday’s close.

Disclosure: As of this writing, Vince Martin has no positions in any securities mentioned.

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