Should You Buy the Dip in Snowflake Stock?

One of the hottest companies in the last few years is, ironically, called Snowflake (SNOW -2.43%). The company operates in the cloud computing sector, specifically developing data-warehouse-as-a-service technology.

Companies of all sizes across all industries are investing heavily in digital transformation. Therefore, data is quickly becoming more integral to drive executive decisions. Like many of its cohorts, Snowflake enjoyed an influx of business during the peak of the COVID-19 pandemic.   

The company recently reported earnings for its fourth quarter and full year fiscal 2023, ended Jan. 31. After the earnings release, Snowflake stock witnessed a pretty material sell-off. Let's dig into the report and analyze the company's results and overall health. At its current valuation, Snowflake looks tempting and may deserve a second look for your portfolio.

The current economic environment is cloudy 

For the last several months, lingering inflation and fears of recession have led to waning consumer demand as well as tighter corporate budgets.

Given the cloudy outlook of the current macroeconomic environment, corporations cannot justify big-ticket items such as new software tools as quickly. The domino effect is that sales cycles are getting longer, directly impacting revenue streams and cash flow. Snowflake is not immune to these roadblocks. 

Despite these challenges, Snowflake reported some pretty impressive metrics. One important thing to note is that like many software companies, Snowflake often underscores certain key performance metrics over traditional generally accepted accounting principles (GAAP) figures.

For example, instead of highlighting total revenue, Snowflake often draws attention to remaining performance obligations (RPO). Like many software businesses, Snowflake sells multiyear contracts with built-in price increases. For this reason, today's revenue rarely accounts for the entirety of a company's book of business. RPO is important because this metric accounts for how much business a company like Snowflake has already booked, but has not yet recognized the revenue for.

Net revenue retention (NRR) is also an important number for Snowflake, as it measures how much the company is expanding its current customer base, as well as selling to new customers, net of any churn it experiences.

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Despite a tough environment, results were strong

The table below illustrates Snowflake's NRR over the last several quarters:

Data source: Snowflake Q4 FY23 investor presentation.

Do you see what I see? While NRR is consistently over 100%, implying that the company is outselling its churn, this metric is slowing down. Don't worry -- the company's CFO, Michael Scarpelli, addressed this dynamic on the fourth-quarter earnings call:

First of all, the 158% was the exact net revenue retention, just as a reminder, when we went public. And I think there was a little bit of a reacceleration in our business in 2021, 2022, where there's a lot of customers that maybe had spending out of control. Now that costs are a much bigger focus within almost every company today, I think people are using Snowflake more efficiently. Customers are having very detailed methodical deployment plans on
Snowflake, which is slowing down that growth rate of customers' consumption as they're going through their implementations. But we're not seeing any customers decrease their spend in any material way in Snowflake.

Scarpelli's explanation should ease investor concerns. He echoes the point made above, that Snowflake's business was kick-started due to the anomaly of the pandemic. However, corporations are instituting much tighter controls around spend, which has led to a normalization in Snowflake's sales. This directly impacts NRR as the pace of net new business is slowing down. 

On the flip side, the table below illustrates an interesting picture of the company's RPOs:

Data source: Snowflake Q4 FY23 investor presentation. RPO $figures in millions. 

Investors can see that Snowflake has grown its RPO from $2.6 billion in Q4 2022 to $3.7 billion currently, which represents 38% year-over-year growth. It's interesting to see that while the company's NRR is tightening, implying slowing top-line growth, Snowflake's future commitments are growing.

This may appear a bit convoluted on the surface; however, it actually makes sense given Snowflake's business model. Unlike other software providers, Snowflake does not sell contracts over set terms such as 12 or 24 months. Rather, Snowflake charges its end customers based on consumption. This means that as a company grows, the reliance on data theoretically increases. As a result, if Snowflake's customers require additional storage, they may roll over unused capacity into new, larger purchases.

The table above implies that the consumption needs of Snowflake's customers are rising, but the near-term recognition of this business is slowing. At the end of the day, however, Snowflake's long-term revenue demand looks promising.  

Keep an eye on valuation

Over the last month, Snowflake stock is down 19%. Moreover, since the company reported earnings, the stock is down over 8%. And during the earnings call, the company provided little visibility into profitability targets over the next 12 months. The lack of clarity around the profit margin coupled with slowdowns in growth was clearly enough for investors to sell the stock. 

Like many of its tech counterparts, Snowflake is not net-income-positive yet. For this reason, the price-to-earnings ratio is not entirely useful for Snowflake. On the other hand, price-to-sales may also be misleading because the company's revenue growth has fluctuated quite a bit over the last few years. Given these challenges, assessing Snowflake's intrinsic value can be daunting.

While nearly all of the Wall Street analysts covering the stock lowered their price targets, virtually all of them are keeping buy or buy equivalent ratings on the stock. Morgan Stanley and Citigroup each believe that Snowflake stock has over 50% upside from its current price of $130 per share. Meanwhile, J.P. Morgan is a bit more conservative with an estimate of 27% upside. 

Regardless of the actual stock price, the common denominator is that reputable institutions believe that now is a chance to lower your cost basis and buy the stock. Long-term investors should be encouraged by the sell-off and take advantage of the dip in a seemingly undervalued equity.