Enterprise data company Snowflake (SNOW -1.61%) had its initial public offering (IPO) in Sept. 2020, and it may have been the buzziest IPO of all time.
Consider that in 2019, Warren Buffett said his company Berkshire Hathaway wasn't buying Uber's IPO. As he told CNBC at the time, "In 54 years, I don't think Berkshire has ever bought a new issue."
But one year later, Berkshire Hathaway bought Snowflake's IPO, and this vote of confidence from the famous investors caused many others to jump into the stock as well.
The hype was so intense that Snowflake stock started trading at $245 per share even though its IPO had been priced at $120. And it closed its first day of trading at almost $254 per share. For the sake of simplicity, let's say you bought Snowflake stock on day one at $250 per share. A $10,000 investment bought you 40 shares.
Those 40 shares of Snowflake are only worth $6,507 as of this writing. Therefore, this IPO investment is down about 35% after more than two years. And there's a good explanation as to why this is the case.
Snowflake buzz: explosive revenue growth
Snowflake provides software that allows businesses to store, analyze, and monetize their enterprise data. And its services are seeing fast-growing demand. For fiscal 2021 (ended Jan. 31, 2021), Snowflake's revenue jumped 124% year over year.
That growth hasn't stopped since the company went public. Total revenue was up 106% in fiscal 2022. And through the first three quarters of fiscal 2023, revenue is up 77% year over year.
Finally, Snowflake is a leader in what many research firms believe is a huge growth industry for the coming decade, and that's why management is so bullish on its future.
Snowflake's management believes its revenue will enjoy about a 32% compound annual growth rate (CAGR) between now and the end of its fiscal 2029. Considering it's already achieved an annualized revenue run-rate of about $2 billion, this is massive growth at scale -- no wonder investors went nuts for Snowflake's IPO.
However, here's where I'll insert Buffett back into this discussion. Snowflake's growth has undoubtedly been stupendous. But in writing to Berkshire Hathaway's shareholders in 1982, Buffett said, "For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments."
When it hit $250 per share on its first day of trading, Snowflake's market capitalization was already over $70 billion. But the company had generated less than $500 million in trailing-12-month revenue at the time. This pushed Snowflake's price-to-sales (P/S) valuation past 140 -- perhaps the highest I've ever seen for a company this big.
Data by YCharts.
To me, Snowflake stock's valuation was simply too rich at IPO, even when factoring in a decade of the most optimistic growth projections. Therefore, it's not surprising that shares have fallen since going public, even though it's continued to report sensational numbers.
What about now?
To be sure, having dropped to a market cap of about $52 billion as of this writing, Snowflake's valuation has become much more attractive. But it's still really expensive on an absolute basis, especially when looking at free cash flow (FCF).
If everything goes according to management's plan, Snowflake will generate $2.5 billion in FCF in fiscal 2029. Some investors consider a stock expensive when it trades at 20 times trailing FCF. But Snowflake stock already trades at more than 21 times what it's projecting for FCF about six years from now.
I'm not necessarily saying Snowflake stock is a bad investment today because of its valuation. As a general observation, I find that high-quality companies have a tendency to unlock new revenue growth opportunities in areas that investors don't anticipate. And Snowflake is a high-quality business, in my opinion. Therefore, perhaps it will grow beyond management's already lofty projections.
Moreover, Snowflake's business is already FCF-positive with $305 million in adjusted FCF through the first three quarters of fiscal 2023. And it's poised to generate billions of dollars of cumulative FCF over the coming decade. This is a lot of money at management's disposal. If allocated well, it could create tons of shareholder value.
What Snowflake stock doesn't give investors today is a high margin of safety. To beat the market, I believe the company will need to outperform management's current projections, and management will need to be great capital allocators. Neither of those is a given. For this reason, I remain content watching Snowflake stock from the sidelines for now.
