Snowflake‘s (NYSE:SNOW) massive growth — and the interest of a prominent investor — have helped to boost the stock since its IPO. Its data cloud product’s dominance of its niche should bolster Snowflake for the foreseeable future. However, despite the company’s value proposition, its shares could still put investors in a deep freeze over the next year.
The state of Snowflake
Before the data cloud, data resided in silos, or repositories accessible to only a few. Not only does this data structure force redundancy, but it calls reliability into question as updates do not necessarily reach every silo.
Snowflake can place data in one scalable source, eliminating most of these issues. Furthermore, Snowflake has built a competitive advantage over cloud giants such as Amazon.com, Microsoft (NASDAQ: MSFT), and SAP, since its software can run on all of their services.
Given this edge, it is easy to see why Snowflake controls almost 59% of the data warehousing market, according to Slintel.
This dominance also attracted the early attention of Warren Buffett’s investment team at Berkshire Hathaway. In late September, Berkshire held more than 6.125 million shares, a stake of just under 2.2%. This includes an initial investment of $250 million as well as an additional purchase before the IPO. Berkshire paid between $80 and $120 per share for Snowflake.
However, average investors need to remember that Buffett’s deal was not available to most. With its successful IPO, Snowflake closed at $253.93 per share on its first day. Although it plateaued for a short time following the IPO, it has not fallen below $208.55 per share as a public company.
Still, its earnings have likely helped to drive much of its growth. In the most recent quarter, total revenue grew by 119% from year-ago levels. Snowflake also benefited from a 162% net revenue retention rate. This means that Snowflake not only retained its clients but also persuaded them to spend more.
The company lost $1.01 per share during the same period — not surprising for a fast-growth company in an emerging industry. Moreover, it represented a tremendous improvement over Snowflake’s $1.92-per-share loss in the year-ago quarter. Additionally, most of the company’s expenses increased more slowly than revenue growth.
One exception was research and development (R&D) spending, which more than tripled. Management did not explain the increased R&D spending on its earnings call, but even the $74.1 million Snowflake spent in this area cannot compare to tech giants such as Microsoft, which spent $4.9 billion on R&D in its most recent quarter.
Nonetheless, this R&D spending could become an investment that boosts revenue in future quarters. The company’s outlook calls for product revenue growth of between 113% and 115% over the next year.
Unfortunately for investors, that increase may not drive further gains in Snowflake stock. Since peaking at $429 per share in early December, it has fallen more than 35%. The expiration of the lock-up period for non-employee insiders in late December may have led to some of the selling.
Nonetheless, the company’s valuation remains Snowflake investors’ biggest danger. Even after the pullback, it sells at a price-to-sales (P/S) ratio of more than 160. This is more than 30 times higher than Amazon’s or SAP’s P/S ratio; both trade for less than five times sales. It also leaves the stock with little margin for error, meaning that any bad news could lead to further selling.
Snowflake in one year
Snowflake will likely remain the dominant data cloud company for the foreseeable future. Though it will probably not turn profitable over the next year, it should benefit from massive growth.
However, the increases will not likely justify the stock’s triple-digit sales multiple. Moreover, the fact that average investors could not buy at Warren Buffett’s price probably means that they should not follow Berkshire’s example.
Should a market shock allow investors to buy at Warren Buffett’s price, investors might consider Snowflake. Alternatively, other cloud high flyers such as Zscaler sell for 54 times sales, while Crowdstrike has a P/S ratio of around 58. Investors might look to buy Snowflake stock if it falls to a comparable multiple in the near term.
Although the future of Snowflake looks bright, the current valuation makes this software-as-a-service stock’s prospects over the next year too uncertain for new buyers.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
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