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Tuesday, July 5, 2022

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Snowflake: Is there opportunity after its epic fall?


If you're a "value investor", you probably don't own shares of Snowflake (SNOW). It has always looked expensive using traditional metrics such as Price/Earnings and Price/Sales. However, Software/Cloud analyst Bert Hochfeld believes that SNOW is trading at attractive levels after its steep and lengthy decline. 

Snowflake — No, its growth engine isn’t broken and its free cash flow margin is impressive.

Courtesy of Bert Hochfeld, Ticker Target

Snowflake shares fell by 4.5% last Thursday in the wake of an earnings report and guidance that was, for the most part, viewed as disappointing. The fall was more significant as Thursday was a day in which most cloud names advanced. Snowflake shares are now down by about 50% since the start of April, and down by 69% since their high.

When reviewing some research about Snowflake I often see headlines about slowing growth. It is true that Snowflake is no longer growing in triple digits. Its growth slowed to 85% last quarter and is forecast to slow to 67% this year. Some commentators, who have little understanding of software business strategies, have written about declining new customer count. Companies of this scale have to pivot customer acquisition to larger enterprises if they want to grow. The management of this business who helmed Service Now and Data Domain are well aware of what it takes to keep a large business growing. It takes emphasis on new, large customers because they are the only ones who can make a difference in terms of growth. Last quarter the company landed at 16 new global 2000 customers, up from 12 in the prior year. The company booked four deals greater than $10 million, up from two the year earlier, and it is those users who have sustained the company's strong momentum.  

As an investment, Snowflake is far removed from what investors seem to want at this time. That said, some of the research I have seen since the company’s earnings report seems to veer considerably off base. Snowflake exceeded its prior guidance on revenue, but not by much. It did a bit better in terms of earnings, and better still in terms of free cash flow. The shares were weak because guidance was not raised, as is expected for hyper growth companies, and because of its comments about usage.

Snowflake essentially offers what it calls a Cloud Data Platform. Snowflake’s primary offering is a database management system that runs in the cloud and is used to create data warehouses for a variety of different vertical markets. Snowflake is not a SaaS [software as a service] company. Its pricing model is very straightforward; users pay for the usage of compute resources which run their applications and also pay for how much data they store.

Once users start with Snowflake they typically wind up growing their monthly bill at prodigious rates. That shouldn’t be terribly surprising; data usage is one of those items that never ceases to grow, and most users wind up using more and more compute as they develop new applications that analyze the stored information. SNOW is a partner of Alteryx, for example, and the data it collects and stores is used for data analytic applications. The company probably has the highest dollar based expansion rate at its scale than has ever been seen in the enterprise software industry. 

There are alternatives to Snowflake. The alternatives most often considered include Amazon Redshift, Google BigQuery, Oracle’s Exadata appliance, and some of the services available on Microsoft Azure. There are some smaller companies whose products are designed more to meet the requirements of developers than as production data warehouses. Most industry observers would add Databricks and Firebolt to the list of alternatives. However, Snowflake is fast, very fast, and it has the pole position in the market that doesn’t look like it will be challenged any time soon.

Huge growing market, dominant positioning. What could go wrong? Last quarter's issue was the growth of usage. Usage is not the easiest metric to forecast. Some companies with usage models have found a seasonal pattern, particularly around holiday periods. Other companies saw their usage growth fall during the pandemic. Snowflake, in particular, has a lengthy history of providing its users with improved technologies that optimize the need for storage and compute; announcing that last quarter led some observers to talk about the company’s waning growth.  

This is the passage in the conference call script that impacted the shares,

“Last year, we saw certain customers experience much higher than expected consumption — own businesses were growing extremely fast. Today, some customers face a more challenging operating environment. Specific customers consume less than we anticipated amid shifting economic circumstances, [which] we believe are unique to their businesses, most notably consumer facing cloud companies."

But the counterpoint to the conference call script is this answer to a question,

"Well, I know all the customers that are going to be going into production that are the new ones because we’ve been working on these. That gives me the confidence. And I literally look at the revenue on a daily basis for all of our customers, and that’s how we based our forecast. And as I said, the last two to three weeks has been very strong and week-over-week growth in revenue that gives us the conviction.

The outperformance in Q4 led us to increase our booking spend [plan] for fiscal 2023, and we still achieved our internal target in Q1. As a reminder, revenue is the leading indicator of our growth. Bookings and RPO follow consumption as our customers purchase more capacity."

While Snowflake has thousands of users, it is still of a size where a few weekly events can move the needle. Given all that has been published about the economy and macro trends, being prudent in terms of guidance, regardless of specific trends is a reasonable strategy.  Snowflake doesn’t exist outside the broad economy. And there are some verticals where the correlation between their own business and usage is strong.

In this environment, there is still plenty of pushback with regards to Snowflake’s valuation. These days, Snowflake shares have an EV/S [enterprise value/sales] of a bit less than 17X. However, given the company’s strong and rising cash flow margin, the shares are actually a bit below average when aggregating cash flow margin and growth vs. valuation. Because Snowflake already has a free cash flow margin in the mid-teens, its NPV as I calculate that metric, is double the current share price. I don't know if the trends the company saw in May will continue. If they do, and Snowflake beats estimates, then I believe there is significant upside to the shares, even in the short-term. Based on how the forecast was presented, I think headlines of doom and gloom and the concept that this company’s growth is falling rapidly are far off base.

(For more, you can subscribe to Ticker Target here.)


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