SNOW: Great Company, Bad Stock

Snowflake, SNOW ($157.38)

• Idea
  • Brief company description
    • Snowflake provides a cloud-based data platform in the United States (79% of total sales) and internationally (21% Asia-Pacific & Japan and 12% Europe, Middle East & Africa). The company’s platform offers Data Cloud, which enables customers to consolidate data into a single source of truth to drive meaningful business insights, build data-driven applications, and share data. Notably, the company charges customers on a consumption basis (fixed price with variable component that is more directly tied to usage) vs. a subscription basis (fixed price with typical variable component based on licenses). Product sales make up the majority of revenue (94%) with Professional Service and Other Revenue making up the rest. The company’s gross margin of 66% is also driven by Product (72% gross margin), while Professional Service and Other weighs on margins (-32%). The company is a strong grower with revenue growth averaging 100% per year over the last three years. This is driven by strong Net Revenue Retention (NRR) that has averaged 170% and customer growth that has averaged 50% over the same time period. In terms of public cloud exposure, the company has noted that 80% of their business is with AWS, 18% with Azure and 2% with Google Cloud.
  • Is this stock a long, a short, or neither?
    • Snowflake is a classic example of the phrase: “great company, bad stock”. The company has a strong leadership position in the data-as-a-service space with high growth rates and strong margins. Despite the fact the stock is much cheaper than it once was on a NTM EV/Sales basis (17.1x vs. 78.9x), it still embeds a ton of upside and is more expensive than peers. Of course, it’s expensive valuation makes it an ideal security to benefit from the change in monetary policy from tightening to easing. Given the above, I believe the stock is neither a long, nor a short especially after disappointing cloud guides from AMZN and MSFT, which could spell trouble for the company’s next earnings. Notably, I think the stock could be a long at some point this year when earnings expectations and valuation embeds more negativity, which is why I chose to do this analysis now vs. later.
  • Do you have an opinion on the upcoming earnings?
    • SNOW is reporting 4Q23 earnings after market close on Wednesday, 3/1. I lean negatively given AMZN’s and MSFT’s recent reports. AMZN reported AWS Y/Y growth of 20%, which was short of expectations. The company noted that thus far in the first month of the year, Y/Y growth has slowed further to mid-teens for AWS and for the year is dependent on more macro factors vs. company-specific, which is not ideal. MSFT reported faster-than-expected Y/Y cloud growth in Azure (38% vs. expectations of 37%) for the quarter, but noted on their earnings call that growth had slowed to the mid-30s in December and is expected to decline another 4-5% in the March quarter (from the exit rate of 38%). This implies a growth rate of 33.5%, down from the 50% range just a few quarters ago. As a result, investors will be focusing on SNOW’s guide for revenue growth and any commentary on quarter-to-date/future trends.
• Thesis
  • What information or data justifies each element of your thesis?
    • At 17.1x NTM EV/Sales, SNOW is the most expensive stock among its peers. The only stock that comes close is Cloudflare (NET) at 15.5x NTM EV/Sales. Datadog (DDOG) is valued at 11.8x NTM EV/Sales, MongoDB (MDB) is 10.0x, Crowdstrike (CRWD) is 8.9x, Confluent (CFLT) is 8.2x and SentinelOne (S) is 6.2x. Meanwhile, the blue-chip cloud stocks are much cheaper GOOGL (4.1x) and AMZN (2.1x) with the exception of MSFT (8.6x). As an aside, it’s crazy to think that MSFT is valued similarly to CRWD, CFLT and S. It’s show the shift from preference of growth to value over the last year. Given SNOW’s premium valuation relative to peers, investors expect the company to have a better growth, return and/or risk profile. Said simply, SNOW’s stock embeds a high expectations and, therefore, risk/reward is skewed to the downside.
    • The biggest reason for investors high expectations for SNOW is their long runway of growth, which can be seen across various measures.
      • Total addressable market (TAM)/Market share
        • The company has noted their total addressable market multiple times during their history as a public company. In their S-1, they called out a TAM of $56B as of FY21, which would give them market share of 1% (using the company’s product revenue vs. total revenue). More recently, the called out a TAM of $84B in FY24, which is expected to grow to $248B by FY27. The earlier means they their market share has grown to 3.6% and the latter is expected to result in market share of 3.1% using the company’s own long-term forecast. The decline in market share does not make sense given the company’s history and reflects management’s conservatism with their own public forecast. Notably, the market growth from FY23 to FY27 represents a CAGR of 43%, which should be a floor for SNOW’s product revenue growth rate.
      • On-prem vs. Cloud data spend mix
        • Currently, cloud as a % of database management systems is 41% with on-premise systems making up the rest. Cloud is expected to grow to 71% of the total market by FY26. SNOW will benefit from the mix growth cloud systems will achieve. Furthermore, when looking at the type of systems SNOW’s new customers are migrating from 56% are on-premise and 44% are from the cloud. I think it’s surprising that 44% of new customers are coming from an existing cloud solution. This shows that SNOW is not just winning vs. older technology, they are also beating out competitors’ cloud offerings, which is critical for them to continue to take share and grow at a rapid pace.
      • Expected growth from existing customers
        • Given SNOW’s consumption revenue model, customers’ total spend grows meaningfully over their lifetime using SNOW. In fact, the company noted that the median initial capacity contract size for customers who currently spend over $1M was $100K, $100K and $180K in FY18, FY19 and FY20. As such, there is a lag between when the company lands a customer and when that customer materially starts to spend on the platform. This differs from a subscription model where wallet share growth is not as meaningful. This is important because revenue growth from existing customers is less risky than from new customers aka SNOW’s revenue growth is less risky than peers’ with subscription-based revenues. Another metric that shows this is the company’s net revenue retention or NRR, which has averaged 175% over the publicly available information and was most recently 165%, which is incredible for a company as big as SNOW although this metric should decline over time.
      • Expected growth from new Fortune 2000 customers
        • The company’s current focus for new customers are Fortune 2000 companies. As of their most recent quarter, they have 543 or 27% of the total. In addition, the average spend of Fortune 2000 customers ($1M) vs. customers who spend over $1M ($3.7M) shows material spend growth for existing Fortune 2000 customers. Note, this comparison is admittedly somewhat stupid: of course, the biggest customers spend more than other customers. However, it does show SNOW can grow wallet share in addition to land more customers on the Fortune 2000 list.
      • U.S. vs. international revenue mix
        • The company’s revenue mix from the United States is 79%. The United States’ GDP as a % of the world’s is 24%. Although SNOW’s U.S. revenue mix will never be 24%, it shows that SNOW can continue to grow international revenue meaningfully in the future.
    • A note on margins
      • If you are buying or selling SNOW, it’s because you have an opinion on growth, not margins. However, in order to be thorough, I will touch on margins. The company’s current gross margin is 66% with a product gross margin of 72%. The company has called out 78% to 80% as the peak for product margins, which in my opinion is definitely doable and should be expected. As such, there’s not much upside in the stock from margins. The bigger uncertainty is what is the company’s long-term EBIT margin. However, expect significant operating leverage over the longer-term. I am modeling an EBIT margin of -40% in FY23 and +32% in FY37.
  • What do you believe that is different from the market?
    • Given I believe the stock is neither a long, nor short, I do not believe anything this is materially different from the market. However, longer-term consensus estimates for revenue look low given the company’s long runway of growth.
• Opportunity
  • What do you think drives the market’s mispricing of this stock?
    • As noted above, I do not think the market is mispricing this stock despite long-term estimates look too low especially given AMZN’s and MSFT’s recent commentary on the cloud market.
• Key Metrics
  • What are the drivers and metrics/data you would monitor to determine if your thesis is tracking?
    • Customer growth (total and Fortune 2000)
    • NRR
    • Product sales per customer (total and Fortune 2000)
• Expected Value
  • My expected value using the company’s long-term (conservative) forecast is $135.99, which I calculated via a traditional DCF, or -14% relative to the company’s current price. However, I believe the company’s forecast is overly conservative. My calculated expected value is $393.07 or +149% of upside relative to the current price.
    • The biggest difference between my own model and management’s is expected sales growth. Everything else is the same. More specifically, I expect sales to growth on average 29% per year, while management expects sales to grow 19% on average per year or 10% less. As I noted above, when using annual average sales growth of +19%, the company’s market share actually falls 50 bps from FY24 to FY27. This doesn’t make any sense given SNOW’s competitive positioning. When annual sales growth averages +29% per year, the company’s market share increases 30 bps over the same time period, which is more in line with history and the company’s competitive positioning.
    • Although gross margins between both scenarios are the same, I am modeling operating expenses via annual growth vs. as a % of sales. As a result, the company is EBIT margin positive a year earlier (FY26 vs. FY27) under the scenario with faster revenue growth, which makes sense given operating leverage. Again if you have an opinion on this stock it’s most likely related to sales growth vs. margins.
• Management
  • Can you form a view on management?
    • I do not have an opinion on management. However, I think their strategy of targeting larger customers vs. smaller is the right one and I prefer conservative estimates to aggressive ones given a positively skewed risk/reward with the earlier and a negatively skewed risk/reward with the latter.
  • What are 3 questions you would like to ask management?
    • How do we measure success of new products like app development?
    • Is consumption continuing to grow for your oldest/biggest customers?
    • What are the keys to growing international revenue?
• Key Risks
  • What are the primary reasons you could you be wrong on this investment?
    • Faster-than-expected revenue growth despite slower-than-expected cloud growth from AWS and Azure would cause shares of SNOW to increase meaningfully. It would show investors that the company can continue to grow even when the public clouds are not and the stock is trading at a trough valuation relative to its history.
  • What could you do to hedge against the key risks associated with a position in this name?
    • Pair trade the name with a larger, slower grower like MSFT.
• Data
  • If you had access to data to confirm your view, what would you use?
    • Marketplace providers/listings
    • CIO surveys
    • Job listings data
    • Venture capital funding data
• Laterals
  • What do you think are the company’s laterals and comps?
    • In terms of competitors/laterals, I am looking at DDOG, NET, CRM, CFLT and SPLK. These companies should grow at a similar rate, trade at similar valuation and shed light on the leading edge of the cloud market. To get a better opinion on the overall health of the cloud market, I am looking at how AWS (AMZN) and Azure (MSFT) perform given SNOW’s mix of the public cloud market (80%/18% AWS/Azure).