Snowflake (NYSE: SNOW) was arguably the hottest tech title of 2020. It went public in September as the biggest software IPO in history, attracting big investments from Warren Buffett. Berkshire Hathaway and salesforce.com, and doubled in value on the first day.
It’s easy to see why investors have fallen in love with Snowflake. Its revenue jumped 174% in FY2020 and grew a further 133% to $ 242 million in the first half of FY2021. It had a net retention rate of 158% during in the past six months – the highest retention rate of any cloud software vendor during its public debut.
Snowflake’s technology is also disruptive. Its core service pulls all of a company’s data to a central cloud-based platform, where it can analyze and integrate it with third-party data visualization software. This solution, which is easier to scale than on-premises data warehousing services, has helped organizations break down restrictive silos and streamline their operations.
Snowflake’s growth potential is still impressive. Its total number of customers more than doubled year over year in the second quarter, but it still serves only 146 of the Fortune 500 companies. The data warehouse as a service market could grow at a compound annual growth rate. by 23.8% between 2018 and 2023, according to market research firm Markets and Markets, so its total addressable market is still expanding.
All of these seem to be good reasons to buy Snowflake. Unfortunately, I think investors should always avoid this buzzword for three simple reasons.
1. You shouldn’t be paying the wrong price for the right company
Snowflake went public at $ 120 a share, which valued the company at $ 33 billion, just over 80 times its sales in the past 12 months. It was already a thorny valuation, but the stock is now trading at around $ 260, giving it a market cap of around $ 73 billion, or 181 times its sales over the past 12 months.
Analysts expect Snowflake’s revenue to climb 114% to $ 565.8 million this year. But even if it achieves that ambitious goal, it will still trade at 129 times this year’s sales and remain one of the most expensive tech stocks around.
By comparison, the beloved videoconferencing Focus on video communications (NASDAQ: ZM) expects its revenue to increase 281% to 284% this year, but its stock is already considered expensive at 50 times that estimate.
As a result, Berkshire and Salesforce may have considered 80 times sales to be an acceptable price for Snowflake, but they’re probably not racking up more stock at its current valuations.
2. He could lose the advantage of his first comer
Snowflake’s main competitors are Amazon Web Services‘ (NASDAQ: AMZN) Redshift and Microsoftof (NASDAQ: MSFT) Azure SQL Warehouse, both integrated with their cloud infrastructure platforms.
This is problematic for two reasons. First, Snowflake’s services run on AWS, Azure, and other cloud infrastructure platforms. As a result, a large portion of Snowflake’s operating expenses actually fund its larger competitors.
Second, AWS and Azure can lower Snowflake’s prices and bundle their competing services with other cloud services. Amazon and Microsoft can also afford to suffer losses on their data warehousing solutions for years to drive Snowflake out of the market.
Snowflake first grew because Amazon and Microsoft had not prioritized growing their data warehousing solutions in the past. Snowflake’s service is also generally faster and more efficient as it handles compute and storage tasks separately, while Redshift and Azure bundle them together.
This technological advantage has given Snowflake a leading edge in the market, but Snowflake’s successful IPO is likely prompting the two tech giants to rethink their data warehousing strategies.
3. A path to profitability is missing
Snowflake’s revenue growth is explosive, but it remains deeply unprofitable. Its net loss widened last year and declined only slightly year over year, from $ 177.2 million to $ 171.3 million in the first half of 2020.
Snowflake could struggle to cut those losses if Amazon, Microsoft, and other big rivals cut prices. The Bulls might argue that Snowflake’s record net retention rate indicates he has power, but retention rates typically decline over time, even for the fastest growing tech companies.
For example, the cloud-based cybersecurity company CrowdStrike (NASDAQ: CRWD) went public last June with a net retention rate of 147% over the previous 12 months. In the last quarter, this rate had fallen to just over 120%.
Datadog (NASDAQ: DDOG), another company that breaks silos and pulls all of a company’s data onto a unified dashboard, went public last September with a net retention rate of 146% over the past 12 months. This percentage dropped to around 130% in the last quarter.
Snowflake could reverse that trend, but competitive headwinds and the law of large numbers suggest his net retention rates are peaking.
The key to take away
Snowflake is still an impressive growing stock, but glaring flaws are hard to ignore. I would consider buying this stock if a stock market crash resets its valuation, but it is still too rich for my blood at these levels.