When Snowflake (NYSE:SNOW) made its market debut last week, the things that immediately stood out were the overwhelming demand for its shares and the premiums investors were willing to pay to buy them. After management initially planned to price the IPO in the $75 to $85 range, the company boosted the range to $100 to $110 before the stock officially priced at $120 per share. Then, on its first day of trading, the stock more than doubled, gaining 113% to become the biggest software IPO ever.
On a price-to-sales basis, the data warehouse and business analytics provider currently sells for over 150 times trailing-12-month sales as of this writing when a ratio of between one and two is considered good.
All of this begs the question: Why are investors paying such a massive premium for Snowflake? Let's look at some of the reasons and what they mean for the company's future.
1. A large and growing opportunity
While the market may be more of a popularity contest short term, investors should buy into a company based on how they believe its business will perform over the long run. One of the ways market participants assess a company's prospects is by understanding its market opportunity.
In regulatory filings with the Securities and Exchange Commission, company management provided a pretty compelling view of that opportunity: "Based on our own estimates, we believe the addressable market opportunity for our Cloud Data Platform is approximately $81 billion as of January 31, 2020."
The company went even further, quoting figures from IDC and adding "the markets for Analytics Data Management and Integration Platforms and Business Intelligence and Analytics Tools [...] will have a combined value of $56 billion by the end of 2020 and $84 billion by the end of 2023." That would give the company a total addressable market of more than $160 billion in the coming years.
For the fiscal year that ended Jan. 31, Snowflake generated revenue of $265 million, a drop in the bucket compared to those numbers. Even if management's estimates are a little on the ambitious side, this illustrates that the company has a long runway for growth.
2. A massive secular tailwind
The digital transformation was ongoing before the pandemic struck, but the demand for cloud computing has taken a significant leap as remote work and distributed workforces became the rule rather than the exception. According to a recent survey by MariaDB, 40% of IT executives have accelerated their companies' moves to the cloud as the result of the pandemic.
Research company Gartner estimates that public cloud adoption will grow 50% by 2022, achieving a compound annual growth rate of 14% -- even as IT professionals pare back spending in other areas. As a result, more companies will need the data warehouse and analytics services that Snowflake has to offer.
3. A lower price for best-in-class offerings
Snowflake's data warehouse and business intelligence services are all the rage right now, and they're often mentioned in the same breath as Redshift, an offering by its much larger competitor, Amazon Web Services. The company's big-league rivals don't stop there -- they also include its other large infrastructure partners: Microsoft Azure and Alphabet's Google Cloud. Snowflake's offerings operate atop the cloud infrastructures of its biggest partners, which also happen to be its competitors.
Snowflake has several advantages over the competition, however. Storage and compute are bundled together in rival offerings, so if you need additional storage, you have to buy more nodes -- which means paying for more computing power whether you need it or not. Snowflake allows customers to pay separately for compute and storage uses, so they only pay for what they need. The company's pay-as-you-go plans let customers pay for the amount of data they have stored at any given time, rather than the subscription plans offered by competitors.
It's important to note that some aspects of Redshift are more tightly integrated with AWS, offering a more unified experience that would be hard for Snowflake to match.
4. Stunning growth rates
Investors have also been captivated by Snowflake's impressive growth. For the fiscal year that ended Jan. 31, revenue grew 174%. The company has kept up that triple-digit growth -- revenues were up 133% for the first six months of this fiscal year and up 121% for the second quarter.
Equally impressive is Snowflake's net revenue retention rate of 158% as of July 31. Put another way, existing customers are expanding their relationships with the company, spending on average 58% more so far this year than they did during the same period two years ago.
5. The Buffett factor
Another factor that caught the attention of investors was news that the Warren Buffett-backed Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) was making a significant investment in the fledgling public company. So did enterprise software powerhouse salesforce.com (NYSE:CRM). Each company agreed to purchase $250 million worth of shares at the IPO price, but Berkshire went even further, buying more than four million shares from former Snowflake CEO Bob Muglia in a private transaction. That ratcheted up Berkshire Hathaway's investment to an estimated $735 million, though those shares are worth twice that much now.
The star power of Buffett's name no doubt added to the feeding frenzy for Snowflake shares, though it's important to note that the investment decision was likely the work of Todd Combs, one of Buffett's trusted money managers.
What this means for the future
While some investors have balked at Snowflake's mind-boggling valuation, many others were obviously willing to pay up to get in near the ground floor. If the software-as-a-service (SaaS) company is able to keep up its revenue growth while also enticing existing customers to spend considerably more each year, it won't be long before its valuation looks far more reasonable.
On the other hand, there's already a significant amount of growth priced into Snowflake stock, so the company has a lot to live up to as well. Any failure -- whether real or perceived -- to meet investors' high expectations could be met with an equally stunning sell-off.
Let the buyer beware.