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With the Nasdaq close to 30% off its peak, the market continues to be very challenging, particularly for growth stock investors.
By some measures, it’s been the worst start of the year for stocks since the Great Depression. In addition, the American Association of Individual Investors shared that more than half of individual investors are bearish.
The market is already assuming the chance of a recession is higher than 50%. Therefore, it leads us to wonder what the impact could be on the growth of software businesses in the near term.
Jamin Ball, a partner at Altimeter, recently shared how the fundamentals of software stocks were affected during the 2008 Great Recession. His research shows public SaaS companies saw a revenue growth slowdown in 2009 before re-accelerating in 2010.
With a potential recession and rising interest rates on the horizon, many investors wouldn’t touch fast-growing technology stocks with a ten-foot pole. As a result, many of them are down 40%, 60%, or even 80% from their high.
And the stock du jour, Snowflake (NYSE:SNOW), is no exception. The share price is now more than 70% off its peak and at an all-time low after reporting Q1 FY23.
Cloud software valuations have come down toward the lower end of their historical spectrum. While things could get worse before they get better, some high-quality companies are offering their most attractive entry points in 10+ years.
Of course, cheap can always get cheaper.
Let’s use an example with Salesforce (CRM), a company already public during the Great Recession and has had a relatively stable growth profile. Salesforce has been trading from 6x to 12x revenue in the past 12 years and is currently below 6x. But if we look at 2009, the revenue multiple collapsed to 3x for a few months.
Recessions don’t last forever. They last 11 months on average, as I recently discussed in my article about How To Invest In A Bear Market.
In this context, if you have a multi-year time horizon, developing a buyer mentality is essential. After all, Warren Buffett said we should be “greedy when others are fearful.”
Would I go “all-in” today? No, I wouldn’t.
I’m a rule-based and process-focused investor. I explain my approach in my article covering 4 Rules To Protect Your Portfolio. I invest a fixed amount every month, so I’ve been a happy buyer lately. However, focusing on quality is paramount. And talking about quality, Snowflake checks many of my favorite boxes.
Let’s review what makes SNOW an elite company, digest the numbers behind the recent quarter, and put its expensive price tag in perspective.
Snowflake’s mission is to enable every organization to be data-driven.
The company offers a cloud-built data warehouse that delivers instant elasticity and secure data sharing across multiple clouds. It combines the power of data warehousing, the flexibility of big data platforms, and the cloud’s elasticity at a fraction of the cost of traditional solutions.
Snowflake operates as a Data PaaS or Data Warehouse as-a-Service (DWaaS).
It partners with leading IaaS data service providers or “hyperscalers” (Amazon Web Services, Microsoft Azure, Google Cloud Platform) and delivers additional features. While it relies on these giant cloud providers, Snowflake also competes with several features they offer. The company defines its ecosystem as Data Cloud.
Snowflake’s architecture has three layers:
Snowflake’s decoupled architecture allows for storage and compute to scale separately. Customers can use the storage from any cloud provider. Snowflake is faster and more efficient by using massively parallel processing or MPP. Management calls this a “virtual data warehouse.” A virtual warehouse can access the storage layer independently. It allows the company to quickly process a massive amount of data and scale based on the customer’s needs. Snowflake’s competitors combine compute and storage, making them costlier and harder to scale.
Snowflake Architecture (Investor Presentation)
Snowflake’s customers can scale up or down their storage and compute needs.
The role of the data cloud is to cover all data-related functions under one roof:
Snowflake’s Platform (Investor Presentation)
A critical aspect of Snowflake’s success is its expanding ecosystem of integration and the ability for customers to use it across any cloud provider:
Snowflake Partner Ecosystem (Investor Presentation)
But the most exciting part of Snowflake’s Data Cloud is the breadth of innovation ahead. Here are a few topics discussed at Snowflake Summit:
Snowflake also shows its international ambition with more than 26 offices worldwide, including 18 outside of the United States.
In 2021, Snowflake received an NPS (Net Promoter Score) or 68, more than three times higher than the industry average. The company also sports a perfect Dresner Customer Satisfaction Score in the past four years, with 100% of customers recommending Snowflake.
Let’s not forget that Snowflake has been celebrated as a fantastic employer and one of the World’s Most Innovative Companies (Fast Company, 2021).
Snowflake employee reviews (Glassdoor)
Snowflake bills customers only for what they use. Therefore, most of the revenue is consumption-based (93% in Q1 FY23). Revenue is recognized as consumption occurs and is primarily billed annually in advance. Contract durations increase over time based on customer commitments.
Snowflake Business Model (Snowflake Q1 FY23 Earnings Slides)
Billings are a critical indicator for companies that use a subscription model, such as UiPath (PATH). For Snowflake, not so much. The billings show the cash flow timing, but they do not indicate actual consumption on the platform. Instead, management focuses on:
Snowflake Key Metrics (Q1 FY23 Earnings Slides)
There are two ways to buy the Snowflake Service:
Snowflake has an elite dollar-based net revenue retention rate of 174%. It means customers have spent 74% more on Snowflake in the past 12 months than they did in the previous 12 months, net of churn (customer loss).
Snowflake NRR (Q1 FY23 Earnings Slides)
A substantial risk to keep in mind is that the consumption model can also turn against Snowflake one day. If new entrants or competitors offer a cheaper or better solution, customers would be able to scale down their consumption.
So now that we’ve established how Snowflake is increasing its revenue per customer quickly, let’s review how the company is growing its customer count.
At the end of the most recent quarter, Snowflake had:
Snowflake customer wins (Q1 FY23 Earnings Slides)
At this point, only 3% of customers spend more than $1M annually. However, this portion is likely to increase significantly over time as customer increase their platform use.
The sheer total customer growth (+40%) is impressive and was barely a slow down from +44% in Q4 FY22.
Management has excellent visibility on future customer commitments, with RPO reaching $2.6B in Q1 FY23 (+82% Y/Y).
Note that RPO was flat sequentially, which may have spooked some investors. While RPO growth can be a great indicator of future revenue growth as a backlog of customer commitments, it’s important to note that it’s not perfect. Snowflake shows all RPO as opposed to RPO looking one year out. This figure ultimately depends on the length of the signed contracts, which can differ from one quarter to the next. As a result, not all periods are comparable depending on incentives given to sales reps to extend the length of contracts. Management explained during the earnings call that Q4 FY22 was an outlier.
Snowflake RPO (Q1 FY23 Earnings Slides)
Snowflake is the fastest growing business of this scale on public markets. Annual revenue reached $1.2B in FY22 (+106% Y/Y). According to CFO Michael Scarpelli, the company is on track to be the fastest to reach $10B.
Note below that management separates product revenue (based on consumption) from professional services in their guidance.
Snowflake Revenue Growth (Q1 FY23 Earnings Slides)
It’s important to note that onboarding customers on Snowflake is time-consuming. It takes on average north of 200 days for customers to get up to the consumption rate they were contracted for. Database management takes time to set up. But once customers are up and running, they spend a lot more on Snowflake over time.
Let’s dig into the numbers with the most recent quarter.
Snowflake Q1 FY23 Highlights (Earnings Slides)
Q1 FY23 Highlights:
Full Year FY23
FY23 guidance shows growth normalization and continued margin expansion.
Let’s put the past year in context:
Management has a history of underpromising and overdelivering. That makes the FY23 guidance even more compelling.
The company’s consumption model can make growth lumpy. While the consumption model is uncapped and can lead to a higher revenue per customer over time, it’s also less predictable.
Despite this challenge, Snowflake has consistently beaten expectations on the top line (more on that in the valuation section below). It’s important to note that customer-friendly improvements lowered the cost of Snowflake, adversely impacting short-term growth (~$97M impact in FY23). In short, customers can do more with the same amount of Snowflake Credits. This type of headwind is a net positive for long-term growth because it increases the odds of customers moving their data to Snowflake. Customer-centric management favoring long-term over short-term outcomes is what I want to see in my portfolio.
Should we expect Snowflake to be impacted by a potential recession?
CFO Mike Scarpelli explained during the Q1 FY23 call:
Last year, we saw certain customers experience much higher than expected consumption — own businesses were growing extremely fast. Today, some customers face a more challenging operating environment. Specific customers consume less than we anticipated amid shifting economic circumstances, we believe are unique to their businesses, most notably consumer facing cloud companies.
Although these customers are still growing, we believe as long as they are impacted by macroeconomic headwinds their consumption will be impacted. Consumption patterns may fluctuate from quarter-to-quarter. This variability does not detract from our long-term opportunity. Customer’s overall demand for Snowflake remains unchanged. This is supported by the contractual commitments they are making with us and their longer-term plans for adopting the data cloud across their organization.
[…] What I will say is April, we did see weakness in week-over-week growth in our total revenue by customer. But to be honest, the last two weeks of March or May has been very strong. But just given everything in the macro headwinds we’re hearing, we’re going to be a little bit more cautious going into the full year.
If we look at the margin trends, they are excellent. The gross margin and operating margin improved steadily. The company is spending less on Sales & Marketing over time, demonstrating an efficient go-to-market strategy.
Snowflake Gross Margin (Q1 FY23 Earnings Slides)
Non-GAAP gross margin improvements are attributed to scalability, product improvement, and cloud agreement pricing.
Snowflake Operating Leverage (Q1 FY23 Earnings Slides)
All non-GAAP operating expenses are falling, largely thanks to scalability.
Snowflake Cash Flow (Q1 FY23 Earnings Slides)
As a result, cash flow margins have continued to improve.
Now let’s look at the GAAP margin trends, which factor in stock-based compensation.
Stock-based compensation is the main difference between GAAP and non-GAAP margins:
I expect SBC to represent less in percentage of revenue over time. From a dilution perspective, the impact is relatively small (FY22 SBC was less than 2% of the market cap).
We can summarize the recent results as follows:
What should we expect from Snowflake’s margin over time?
Management previously shared their long-term operating model by the time they reach $10B in annual revenue. They significantly upgraded the margin targets for FY29:
During the investor presentation Q&A last year, CFO Michael Scarpelli clarified that the margin targets were worst-case scenarios. Since Snowflake is on track to achieve an FCF margin of 16% in FY23, the projection still appears conservative.
Snowflake Guidance (Q1 FY23 Earnings Slides)
Snowflake’s management breaks down the competition into four categories:
When I invest in a category, my preference generally goes to the best companies. And evidence shows Snowflake is among the very best performers in Data Warehouse. Below is the G2 Grid for Data Warehouse. You can find Snowflake in the top right of the chart as the best performer, alongside AWS.
G2 Grid Data Warehouse (G2)
Snowflake also appears as a leader in the Forrester Wave for Cloud Data Warehouse (see below). Other leaders in the field are AWS, Google, Microsoft, Oracle, and Teradata.
Cloud Data Warehouse (The Forrester Wave)
The Gartner Magic Quadrant for Data Management Solutions for Analytics has not been publicly updated for three years. At the time, it showed Snowflake among the leaders as well.
Magic Quadrant Data Management (Gartner)
So what is the moat? To fend off competition, Snowflake benefits from:
Snowflake provides the data cloud, analytics, and other services in one single provider. In addition, given Snowflake’s focus on improving the platform’s efficiency to keep customers happy, their competitive advantage is well-positioned to expand over time.
Competition is a fact of life for all the best businesses globally. However, I like Snowflake’s position and odds of success given its agnostic position with the big cloud providers and its headstart on the rest of the market.
Snowflake is addressing an important, emerging industry.
Management estimated the addressable market for Cloud Data Platform to be approximately $90B at the end of January 2021 (up from $81B a year prior). The runway ahead remains gigantic since Snowflake had a run rate of just over $1B in FY22.
Snowflake Market Opportunity (Q1 FY23 Earnings Slides)
IDC estimates the market for Analytics Data Management and Integration Platforms and Business Intelligence and Analytics Tools had a combined value of $56B at the end of 2020. It will grow to $84B by 2023 (+11% CAGR). The data sharing opportunity has not been defined or quantified, but it would add to this enormous market.
The explosion of data to drive business outcomes is a theme you’ll find across many positions in the App Economy Portfolio, such as MongoDB (MDB) and Datadog (DDOG).
The increasing role of data in the decision process is something I’ve witnessed firsthand through my gaming career as a Senior Director of Financial Planning & Analysis. Positions like Data Analyst or Data Scientist didn’t even exist 20 years ago. Even businesses that used to rely on superficial sales data to evaluate their performance are going much deeper.
Let’s use the example of the gaming industry. A game publisher used to have only access to the number of units sold to retailers to evaluate the success of a title. Gaming used to be a simple physical retail business with units on shelves, just like any CPG business. Today, the KPIs are vast across user acquisition, monetization, and retention. It’s a predominantly digital business migrating to the cloud. It now includes a plethora of data to drive operations, direct-to-consumer promotions, retention, and engagement tactics. Gaming is far from being the only industry shifting from the physical to the digital world with the explosion of data that comes with it. This logic applies to video and music entertainment, payments, shopping, work collaboration, healthcare, life science, banking, networking, etc. Data has become an essential tool to manage and improve CRM and business performance, and this trend is here to stay. Organizations across all industries are increasingly reliant on collecting, analyzing, and mobilizing data.
Let’s recap the two key trends:
Trend 1) Explosion of data
Snowflake management argues that the proliferation of connected devices and applications results in an explosion of digital data. In turn, businesses have new needs that come with it:
According to IDC, there will be 175 zettabytes of data by 2025, representing a CAGR of 27% from 33 zettabytes of data in 2018. This data contains valuable insights for organizations, including key business and performance metrics, customer attributes and behavior, and product strengths and capabilities.
Trend 2) Cloud migration
Organizations are shifting from static on-premises IT architectures to a multi-cloud architecture. This migration is accelerating:
According to IDC, 49% of data will be stored in public cloud environments by 2025, an increase from approximately 30% today. […] 90% of Global 1000 Organizations will have a multi-cloud management strategy by 2024.
According to Gartner:
Cloud migration (Snowflake Investor Presentation)
Snowflake’s key leverages to drive growth looking forward are simple:
US Cloud computing alone is expected to grow at +18% CAGR, illustrating the runway ahead for the leaders in these categories.
Cloud in % of IT Spending (Benedict Evans)
Snowflake raised $3.4B at a $30B valuation for its IPO in 2020. However, Public investors never traded SNOW at the offering price of $120 per share. Instead, shares popped +112% on their first trading day. Unfortunately, the company left close to $4B on the table.
As soon as its first day as a public company, SNOW had a valuation north of $60B. Yet, as I write this line almost two years later, SNOW is down 13% in after-hours, trading at $115, below its pre-listing price. So far, SNOW has not been a great investment for public investors, but it doesn’t mean it will stay that way.
SNOW is now trading on the low-end of its valuation spectrum, at about 15 times forward sales (if we factor the after-hours sell-off).
More context on Snowflake’s valuation (after-hours sell-off included):
As you can see, even assuming the company merely meets Wall Street’s expectations moving forward, it will “grow into” its valuation multiple pretty quickly. Since going public, the company has a stellar track record, beating expectations by 6% on average over seven quarters.
SNOW Revenue Surprise (Seeking Alpha Premium)
This type of outperformance can compound over time. To illustrate, Q1 FY23 estimated revenue was $350M when the company went public 18 months ago. Instead, the company just delivered $422M. So in a matter of 18 months, the difference between Wall Street’s estimates and reality was more than 20%. So when I say SNOW is trading at 7 times FY25 revenue estimates, it might be even less if the uptrend continues.
SNOW Consensus Revision (Seeking Alpha Premium)
Snowflake’s revenue multiple will compress significantly in the coming years. But that’s beside the point. Multiple compression and strong stock performance are not mutually exclusive.
Management projected $10B in annual product revenue by FY29 (i.e., Jan-2029). Importantly, this figure is simply a conservative extrapolation of the trend from the existing product offerings. Moreover, management now has a documented history of underpromising and overdelivering, so I wouldn’t use this number to model a discounted cash flow analysis.
In seven years, with an annual revenue run rate of $10B, Snowflake might generate ~$4B of cash flow at scale while still growing at +30% Y/Y. Assuming dilution is entirely offset by the cash flow generated along the way, what will be Snowflake’s market cap by then?
For giggles, we can look at what Adobe (ADBE) looked like when it crossed $10B in revenue at the end of 2019 (pre-COVID). The company grew revenue in the low 20s and was valued at ~$170B or about 40 times free cash flow.
So what to expect from Snowflake if management can deliver on their path to $10B? Given SNOW’s ~$32B valuation, it has the potential to more than triple in the next seven years, even by just meeting the $10B by FY29 target and assuming margins are on the low-end of expectations.
If management is conservative about its FY29 goal the same way they were about their FY22 goal, the potential returns could be much higher.
I want to avoid false precision and be directionally correct when looking at an opportunity. If Snowflake truly is on a path to being the fastest enterprise software company to reach $10B in annual revenue, I believe the returns will come in due time.
Snowflake is a stellar business that checks most of my favorite boxes.
Given its explosive customer growth and exceptional retention metrics, I believe it’s only a matter of time before it grows into its valuation.
The company has proven to be capital efficient and has ample opportunity to fund its growth path forward.
Let me know in the comments!
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Discipline and consistency win the game over time. Unfortunately, many investors violate their own model or strategy when their portfolio performance is temporarily disappointing. I would rather sell too late than too early, so I tend to never sell. I let my winners compound to a significant portion of my portfolio and let my losers become insignificant over time.
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Disclosure: I/we have a beneficial long position in the shares of SNOW AMZN CRM CRWD DDOG GOOG MDB PATH either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.