Unlike many investment trends, artificial intelligence (AI) investing spans multiple industries. There are hardware investments, software companies, and end-use opportunities to take advantage of, but one company often discussed is Snowflake (SNOW 3.69%).
Snowflake is a software company that gives its users the ability to handle large data sets, a key part of the AI value chain. But is the stock worth an investment? Or is its popularity overshadowing the investment quality? Let's find out.
Snowflake's stock-based compensation is out of control
Data is the lifeblood of AI, as it's required to train AI models. Collecting this data from its various sources and storing it efficiently can be complicated, especially if it's in an unstructured format. Snowflake provides the software clients need to accomplish both tasks and tools to perform various data analytics on the information.
Furthermore, if a company has a large dataset, it can sell it on the Snowflake marketplace so other companies can utilize the dataset without needing to collect it themselves. Perhaps the most attractive part of Snowflake is that it is cloud agnostic, so clients can easily go from one cloud provider to another. This is key, as it protects companies from getting locked into one cloud provider, where they must deal with unreasonable terms because it would be extremely painful to migrate cloud providers.
If this product sounds like it should be a home run, that's because it has been. Snowflake has been one of the fastest-growing companies in the market, and Q2 of FY 2024 (ending July 31) was no exception. Snowflake grew product revenue by 37% year over year to $640 million. Additionally, large customers are expanding their spending, as the number of clients who spend at least $1 million annually with Snowflake rose 62% to 402.
But the problem with Snowflake as an investment isn't its revenue; it's the profits. Snowflake is nowhere near profitable and posted an atrocious 42% operating loss margin in Q2. A massive part of this loss is stock-based compensation, which Snowflake spent $300 million on this quarter. Without that line item, Snowflake would have posted a profit, which is why management champions its non-GAAP (generally accepted accounting principles) operating profit metric (which excludes stock-based compensation).
While this means Snowflake is free cash flow positive and can operate without external funding, Snowflake shareholders are constantly being diluted. As management creates new shares to compensate its employees, each share investors hold becomes less valuable. This effect can be likened to the effect of printing more money making each dollar less valuable, causing inflation. Since its IPO, Snowflake's share count has risen 17%, causing each share to be worth a lot less.
SNOW Shares Outstanding data by YCharts
Over time, this can devastate long-term shareholders. The company may grow, but if each share controls less of the company, they aren't as valuable. This risk, alongside Snowflake's massive operating loss, goes hand in hand, but are they enough to avoid the stock?
Snowflake's stock demands a massive premium
Because of the massive growth Snowflake is expected to experience, thanks to cloud migration and AI proliferation, the stock has a hefty price tag of 20 times sales. However, it has come down significantly over its life on the market.
SNOW PS Ratio data by YCharts
This sales ratio conveys huge expectations, but with Snowflake's vital product in the data cloud, it will likely deliver on the growth. The problem is achieving profitability, and it will be some time before Snowflake can achieve that goal. In the meantime, excessive share-based compensation will continue to dilute shareholders and reduce long-term gains.
While I don't think these factors should deter investors from purchasing Snowflake stock, it should be a strong consideration. I think Snowflake is an OK buy for a small position in a portfolio due to the risk involved, but investors should keep a watchful eye on this company.
