Snowflake (SNOW 3.69%) is a leading provider of data-warehousing services, and it could be positioned to play a crucial role in the artificial intelligence (AI) revolution. The company's data cloud platform allows information from different cloud infrastructure services to be combined, analyzed, and integrated into AI algorithms.
Even after climbing roughly 14% across 2023's trading, Snowflake's share price is still down 60% from its high. It looks like it has room to run, but investors should weigh the company's performance and valuation before going all-in on this potentially explosive growth stock.
Check out the following chart documenting the data software specialist's free-cash-flow (FCF) yield -- comparing free cash flow to enterprise value -- and read on for a deeper dive into whether the stock might be a worthwhile portfolio addition.
Snowflake's free-cash-flow picture is complicated
The chart above is based on data from New Constructs, a data specialist that provides investment research. In order to calculate free cash flow, New Constructs starts with a company's net operating profits after taxes and subtracts the company's net change in working capital (excluding cash) and its fixed assets. From there, its FCF figure is divided by the business's enterprise value to arrive at the FCF yield.
Snowflake had its initial public offering (IPO) in September 2020, and the business has continued to grow revenue rapidly, but it's notable that Snowflake's free cash flow has been negative on the basis of generally accepted accounting principles (GAAP) since its public debut. As a result, its FCF yield has also remained negative.
Its FCF margin, which reflects free cash flow as a percentage of revenue, has also remained negative on a GAAP basis.
However, looking at adjusted numbers paints a rosier picture.
Notably, Snowflake's relatively strong non-GAAP (adjusted) free cash flow margins are often used to support a bullish case for the stock. The company has positive free cash flow and FCF margins and yield when the company's adjustments are factored in.
The company posted an adjusted FCF margin of 13% in the second quarter of its current fiscal year, which ended July 31 and it anticipates closing out the year with an adjusted FCF margin of 26%. The data specialist has consistently posted annual FCF margins in the range of 25%, and it anticipates that it will reach an adjusted margin of roughly 30% by its 2029 fiscal year. The company's fiscal years end in late January.
Snowflake's strong adjusted FCF margins rely in part on stock-based compensation and one-time expenses being backed out of the calculation. The business is expanding at an encouraging rate and flashing promising profitability indicators, but there's still significant risk here.
Snowflake's negative FCF yield tells only part of the story
Even with macroeconomic uncertainty causing customers to take a more cautious approach to spending, Snowflake has continued to post solid sales momentum this year. In the second quarter, the company increased its product revenue 37% year over year to reach $640 million and recorded a 78% adjusted gross margin. Using GAAP, the business reported a gross margin of 74%.
Founded in 2012, Snowflake is still relatively young. Given its emphasis on rapidly growing its sales base and investing in building the foundations for long-term leadership in its key service categories, it's not inherently worrying that the FCF yield comes in significantly below what's being posted by other leading tech companies.
The long-term demand outlook for data warehousing and related analytics technologies remains very promising. The ability to access and integrate relevant data is crucial for building and improving AI algorithms, and Snowflake is currently the clear leader in a category of services that will likely be essential for pushing AI tech forward.
Is Snowflake stock a buy?
Snowflake stock is currently valued at 19.6 times this year's expected sales. The company has a promising long-term expansion outlook, but its growth-dependent valuation sets the stage for volatility if new economic or business-specific headwinds emerge.
SNOW PS Ratio (Forward) data by YCharts
With a valuation that already prices in some very strong growth, Snowflake probably isn't a good portfolio fit for more risk-averse investors right now. Even though the company is recording strong adjusted FCF margins, the extent to which the business will be able to shift into delivering consistent GAAP earnings and FCF growth remains to be seen.
Thus far, the business seems to be scaling effectively, and there's a huge runway over the long term. Snowflake has the potential to be a huge winner for patient investors, but it should be acknowledged that the stock comes with above-average risk.
