7 Red Flags for Snowflake's Future

Snowflake (SNOW -1.00%) posted its first-quarter earnings report on May 25. The cloud-based data warehousing company's revenue rose 85% year over year to $422.4 million, which beat analysts' estimates by $9.4 million. Its net loss narrowed from $203.2 million to $165.8 million, but its corresponding loss of $0.53 per share missed expectations by two cents.

Investors didn't seem impressed by those mixed headline numbers, and Snowflake's stock on May 26 briefly slipped below its IPO per-share price of $120. That might seem like an attractive entry point for new investors, but seven red flags suggest things might get worse before they get better.

Image source: Getty Images.

1. Another quarter of decelerating growth

Snowflake's revenue surged 124% to $592 million in fiscal 2021, which ended last January, and soared 106% to $1.22 billion in fiscal 2022.

But if we track Snowflake's year-over-year growth in product revenue, total revenue, and remaining performance obligations (RPO), we can see that its momentum is gradually fading.

Data source: Snowflake.

Snowflake expects its product revenue to rise 71%-73% year over year in the second quarter of fiscal 2023, and 65%-67% for the full year.

2. Its retention rates are peaking

Snowflake's net revenue retention rate, which reflects its year-over-year growth per existing customer over the previous 12 months, has climbed above 170% over the past three quarters.

Data source: Snowflake.

However, Snowflake has repeatedly warned that those retention rates would decline as its largest customers slowed down their spending.

During the fourth-quarter conference call, CFO Mike Scarpelli predicted that rate would "stay above 150%." But during the first-quarter conference call, Scarpelli reined in those expectations even more by saying its retention rate would "remain well above 130% for a very long time."

3. Its gross margins are peaking

Snowflake's product and total gross margins have consistently expanded on a non-generally accepted accounting principles (non-GAAP) basis.

Data source: Snowflake. Non-GAAP basis.

But in an investor day presentation last year, Snowflake estimated its non-GAAP gross margin could rise to about 75% by fiscal 2029, which suggests it's already reached its peak gross margins. For fiscal 2023, it expects its non-GAAP gross margin to come in at 74.5%.

4. No clear path toward profitability

Snowflake's peaking gross margins wouldn't be too worrisome if its operating margins were positive. However, its GAAP operating margin came in at negative 59% in fiscal 2022 and negative 45% in the first quarter of 2023. It will be difficult for Snowflake to narrow those losses, for two reasons.

First, it faces intense competition from similar data warehousing platforms like Amazon (AMZN -1.11%) Web Services' (AWS) Redshift and Microsoft's (MSFT -0.66%) Azure Synapse, which are both integrated into their respective cloud infrastructure platforms. Amazon and Microsoft, which ironically power Snowflake's platform with their own cloud services, can easily afford to offer their competing services at lower prices. 

Second, Snowflake spent 50% of its revenue on stock-based compensation (SBC) expenses in fiscal 2022. That ratio only dipped slightly to 41% in the first quarter of 2023. Unless Snowflake reins in those staggering SBC costs, it will continue to burn cash and bleed red ink.

5. Ongoing dilution

Snowflake's liberal use of SBC caused its number of weighed-average shares to surge 112% in fiscal 2022 and 8% year over year in the first quarter of 2023. Investors should expect that trend -- which will repeatedly dilute the value of its existing shares -- to continue this year as it increases its headcount to support its new growth initiatives.

6. An unattractive valuation

Snowflake's ongoing dilution wouldn't be troubling if its stock were reasonably valued. Unfortunately, the stock still trades at 20 times this year's sales, which makes it an unreliable investment as rising interest rates crush the market's frothier growth stocks.

By comparison, SentinelOne (S -1.25%) -- the AI-powered cybersecurity company that is expected to generate 83% sales growth this year -- trades at 18 times that estimate. In other words, Snowflake's stock has nearly dropped back to its IPO level, but its upside potential remains limited.

7. Its insiders aren't buying the stock

Snowflake's stock has declined nearly 50% over the past 12 months. Yet during that period, its insiders sold more than six times as many shares are they bought.

That lack of insider confidence suggests Snowflake still isn't a screaming bargain yet. That's not surprising, since its IPO was initially priced between $75 and $85 before market hype propelled its debut price to $120.

It's still a speculative investment

Snowflake is a promising company, but it's arguably been overvalued ever since its IPO. Investors should be well aware of these problems before they pick up some shares of this speculative cloud stock.