Snowflake's (SNOW 0.71%) cloud platform is experiencing tremendous demand as businesses continue to rely more on cloud services to process and store data. Cloud infrastructure spending grew 37% year over year in the third quarter, with services from Amazon, Microsoft, and Alphabet's Google controlling 63% of the market. That's good news for Snowflake since its cloud-based data warehousing system is compatible with these cloud services. Snowflake is piggybacking the growth of the market.
Some of the largest companies in the world use Snowflake to organize, share data, and gather insights to optimize their operations. Let's look at three reasons to buy the stock before considering why investors might want to take a pass.
1. Snowflake is reaching critical mass
Snowflake offers several features, including data warehousing, data lakes, data engineering, data science, data application development, and data sharing. There are many reasons that a company would choose Snowflake, but a few key benefits are ease of use, good security features, and a consumption-based business model that only charges customers for what they use.
A previous story from Harvard Business Review explained how Kraft Heinz benefited after moving half a trillion records over to Snowflake's platform through Microsoft Azure. Since making that move, Kraft Heinz has been able to better understand its supply chain to get the right inventory to supermarkets during the pandemic.
Nearly half of the Fortune 500 uses Snowflake. Since its initial public offering in September 2020, Snowflake has posted revenue growth rates above 100% every quarter. While past performance shouldn't be used to predict future growth, the business has a lot of upside. Management previously estimated the long-term addressable market at $81 billion as of January 2020. That's massive compared to its trailing-12-month revenue total of $1 billion.
2. A widening competitive moat
One risk to Snowflake's growth is that it competes with Amazon Web Services and other top cloud providers that offer similar solutions. But one way Snowflake separates itself is by enabling expanding use cases on the platform through data sharing.
For example, Snowflake's data marketplace allows advertising and media companies to access viewership data across hundreds of sources without having to build costly data pipelines. By simply joining Snowflake's platform, companies can exchange and share data with other Snowflake clients, which is enormously valuable.
Data sharing gives Snowflake a network effect competitive advantage. The more businesses join the platform, the more data other customers can access, which increases the value for all customers. Eight new Fortune 500 companies joined Snowflake in its Q3 -- a sign its competitive moat just got a little wider.
3. Management's long-term outlook
Snowflake's growing network effect should lead to another competitive advantage -- switching costs. As it builds a greater marketplace of shared data, it incentivizes companies to stick with Snowflake because switching to another platform would mean losing access to data that wouldn't be available elsewhere.
A growing market coupled with Snowflake's strengths explains why management sees a path to reach $10 billion in product revenue by fiscal 2029 (which ends in January). That translates to an annualized growth rate of about 39% from calendar 2021. Management believes revenue can still grow at 30% per year beyond fiscal 2029, with the business generating a 15% free cash flow margin.
Beware of Snowflake's high price tag
Based on management's long-term target, Snowflake should be generating $1.5 billion in free cash flow by fiscal 2029. It seems investors are banking on that outlook, and then some.
Snowflake's current market cap (total shares outstanding times the stock price) is $101 billion. That is 67 times what management believes free cash flow will be in seven years.
To understand how expensive that is, let's compare Snowflake's valuation to another top cloud provider, Alphabet. Google's parent company just posted revenue growth of 41% year over year in Q3, but its share price trades at 30 times trailing-12-month free cash flow.
Even the high-flying chipmaker Nvidia, which sells graphics processors to the top cloud providers, trades at 107 times trailing free cash flow. I would rather pay a high multiple for free cash flow already booked than pay a high valuation for a future promise that is years away.
Ultimately, valuation matters. Snowflake is a promising investment opportunity, but investors should consider other software stocks that offer better value before buying shares of Snowflake.