Snowflake (SNOW -1.10%) was one of the most hyped stock IPOs in recent memory when it went public in late 2020; the company's rapid growth, a euphoric market, and the involvement of Warren Buffett, who bought shares through his holding company Berkshire Hathaway, all contributed to the stock's valuation, one of Wall Street's highest at the time.
But none of that hype has saved the stock from the bear market that picked up steam in 2022. Share prices are down 66% from their highs, and investors are left wondering whether the stock can rebound or if it was just another bubble gone bust.
While Snowflake is a legitimately awesome company, investors should consider some important facts before deciding whether to buy shares.
Snowflake justifies the hype to a large extent
Many hyped companies never deliver the goods, but Snowflake's role in enterprise software has the potential to deliver years of growth. Snowflake is a data warehousing and analytics platform. A company generates all sorts of data, including customer data, market info, system logs, and third-party data. Back in the day, it would all be isolated in silos; in other words, a company might go here to access some data or there to access other data.
Snowflake's platform takes all that data initially kept in different locations and on different platforms and stores and organizes it under one roof, letting companies easily manipulate it to find whatever they're looking for. Companies can use their data, purchase access to someone else's, and use it with countless software integrations.
Data is quickly becoming a core resource for how business works -- Congress was grilling TikTok's CEO just last week over whether Americans' data is protected. Data is big business, and Snowflake could become a central piece in how it's stored, analyzed, and protected.
Management estimates the company's addressable market will grow to $248 billion by 2026, and it's rapidly capturing a large chunk of high-end clients; it currently serves 573 of the Forbes Global 2,000.
But its growth is tailing off
It's a great story, but it's becoming fair to question whether Snowflake will keep living up to its potential. You can see below that Snowflake's revenue growth steadily slowed over the past few years. Granted, it's hard to maintain a 120% growth rate, but it's dropping from 70% to just 40% for the upcoming fiscal year. Triple-digit growth is awe-inspiring -- but 40% doesn't justify Snowflake's eye-popping valuation.
A slowing economy out of Snowflake's control has contributed to the drop in growth, but expectations command perfection when valuations run high.
Image source: Snowflake Q4 FY23 earnings presentation.
Shares trade at a price-to-sales ratio (P/S) of 21; that's a far cry from the 183(!) P/S it once fetched, but again, Snowflake's growth is not super-human anymore. For example, you can buy CrowdStrike Holdings at a P/S of 13 (that's 38% less), and the company's guiding for similar 34% revenue growth. CrowdStrike is also converting more of its revenue into free cash flow and is far closer to positive net income than Snowflake.
And just because Snowflake's valuation is now much closer to realistic, (a P/S of 183 is insanely high) it doesn't mean it's a bargain. Based on how other technology stocks are valued, one could argue that Snowflake is still expensive today.
Meanwhile, the share count is growing
Stock-based compensation is something investors should also monitor moving forward. Growing companies, especially in technology where talent competition is fierce, often award employees stock options as compensation. This can save money by avoiding huge cash salaries, but it's also why Snowflake's free cash flow looks great while its net income looks horrible.
SNOW Stock-Based Compensation (TTM) data by YCharts
You can see that stock-based compensation over the past year was $861 million, more than 41% of revenue. That's pretty high, and it raises the number of outstanding shares over time, making your shares worth a smaller piece of the business (dilution). The number of shares outstanding has grown by 15% since the company went public less than three years ago. Dilution can hurt investment returns if it goes unchecked. Hence, investors should root for this percentage to come down moving forward -- fortunately, management recently announced its first share repurchase program for $2 billion, which will help.
The market is very volatile right now, which means that growth stocks like Snowflake could be very unpredictable. Berkshire Hathaway bought shares at the IPO price of $120; the stock trades a bit higher than that today, but the valuation has declined enough that you can probably get your feet wet. Investors should continue a dollar-cost average strategy and build a position slowly -- the stock could easily set new lows in this market.
