As long-term investors, it's important to envision what a business may be like in the future because that's why you're buying a business now; you're expecting it to grow into something better. In its life as a public company, Snowflake (SNOW -1.61%) has proliferated -- its revenue is up 362% since late 2020 -- yet the stock is down 42% from its IPO date.
Usually, those two metrics don't negatively correlate as Snowflake's have, but it sets the stage for an exciting investment. Will Snowflake continue this growth and stock decline pattern? Or will investors finally start to experience some returns? Let's find out.
Unrealistic valuations don't last long
While Snowflake's growth and price decline are facts, there's a missing piece: valuation. Snowflake debuted at a sky-high price-to-sales valuation of nearly 150. However, that valuation has been substantially reduced in 2022.
SNOW PS Ratio data by YCharts.
At 23 times sales, Snowflake's stock is still expensive, but its growth makes the valuation palatable. In Snowflake's third quarter of fiscal year 2023 (ended Oct. 31), its product revenue rose 67% year over year. If Snowflake can keep that level of growth up, then its valuation will quickly get reduced to a normal range just through expansion.
But what does Snowflake do that makes it grow so rapidly?
The data cloud is a massive market opportunity
Snowflake is a software company that's in the data cloud business. Its platform allows customers to collect and store multiple data types on the cloud. This data can easily be shared across teams or companies where data scientists can derive insights to make business decisions. Additionally, Snowflake can feed other applications, allowing real-time decisions to be made with the most updated data sets.
Unlike many other software companies, Snowflake doesn't charge on a subscription basis -- it bills customers on a usage basis. Customers can pay for cheap storage and utilize Snowflake when needed to save on costs. Snowflake offers discounts for continuous use and large accounts, but this flexibility is essential, especially when onboarding customers.
Getting customers to stick with the platform is critical because a large part of Snowflake's business model is centered around expanding usage. In Q3, Snowflake's net revenue retention rate was 165%, which means customers spent $165 this year for every $100 last year. Expansion can happen in multiple different ways, be it by consolidating solutions from other companies, new use cases, or by adding additional products.
In the next five years, I'd expect this metric to tick down (165% is one of the best in the industry) but still stay high because of Snowflake's massive market opportunity and available customers.
By 2026, Snowflake estimates its market opportunity will be about $248 billion, divided between its data warehouse, cybersecurity, data science and machine learning, and collaboration products. Now, it won't capture every penny in this market, but it gives investors how large of a space Snowflake is playing in.
There's still a large cohort of customers available too. Only 543 of the Global 2000 (the 2,000 largest companies worldwide) are Snowflake customers. With how prevalent data analysis is becoming, capturing a significant chunk of those customers isn't out of the question.
In Q3, Snowflake's Global 2000 customer count grew 18% year over year, so if it continues that pace, it will have captured 1,242 customers by 2027. If Snowflake can accomplish that, investors should be satisfied. Even if it only gets to 1,000, the number of new customers will drive massive revenue expansion.
However, Snowflake has one key area it must improve within five years to be a successful investment.
Stock-based compensation is a major hurdle
Currently, Snowflake is unprofitable, with a $206 million operating loss -- a 37% loss margin. That's a huge hole to dig itself out of. However, it is free-cash-flow-positive, producing $65 million in Q3. This discrepancy can only be caused by one thing: stock-based compensation.
In Q3, Snowflake handed out $229 million in stock to its employees, more than 40% of revenue. In five years, Snowflake had better cut that number down, or investors might be headed for the exits in droves. Investors will only tolerate a company losing money for so long before it gets dumped (kind of like what is happening right now).
So if Snowflake can capture a chunk of the Global 2000, get current customers to expand their usage, and vastly improve its margin profile to the point where it is producing real profits, then Snowflake will be a phenomenal investment over a five-year time horizon. I think all of these tasks are achievable, which is why I am personally invested. While the road may be bumpy over the next few years, Snowflake's trajectory is solid and will crush the market if it can accomplish the three tasks I laid out.
