Snowflake Has A Great Business Model, But Is It A Buy?

Cloud computing. Data science. Artificial intelligence. Machine learning. Business insight. Analytics.

These are some of the hottest buzzwords in computing. And they are the trends are practically re-defining IT as we know it in enterprise businesses.

Whenever you see an ad tailored to your browsing or social media history. When Google presents its search results for a particular term directly tailored for you. When Netflix presents a list of shows, or Amazon presents a list of Kindle titles "you might like". When you interact with a business in a chat you could swear was a real person (but isn't).

ALL of these scenarios - and countless others - are made possible by DATA. Data about your browsing history. Data about your purchases. Data about what posts, brands, ads, or influencers you have followed or "liked". Data about where you live and the inclinations of others that live close to you. Data about what websites you've visited recently. And TONS more.

It's not just about marketing to consumers, either. Businesses use data analysis for almost every single thing they do. Planning expenses based on anticipated revenues. Deciding where to put links or buttons on a website. Deciding what image to show for a product ad. The list really goes on ad infinitum - I don't want to be-labor the point, the fact is that almost no decision in business today is made without underlying data driving it.

It is in this backdrop that we take a look at a new Green Screen stock: Snowflake (SNOW).

What does Snowflake do? You guessed it. It allows businesses to store, organize, access, sell, and generate valuable business insights from obscene amounts of digital data. Let's take a look!

How Snowflake Makes Money

Snowflake allows its clients to store enormous amounts of digital data, access it from anywhere (it is cloud-agnostic, you can get to Snowflake data from AWS, Google, Azure, etc.), present it for sale to outside businesses if you like, and write applications to generate business insights from it.

Drilling down a bit, the Snowflake platform has 3 layers. The core layer is data storage. It brings all of a company's data, structured (as in a relational database like Oracle), or unstructured (as in log files or performance metrics), into a single unified data record. Above that is a computing layer that provides massive compute power to run applications that are built and run on the third layer, the "services layer". These applications are where the value is to a company - where they generate the knowledge that will allow them to plan, market, and sell more effectively.

So how does the firm make revenue? It is pretty simple really. Snowflake charges you in two ways. First, there is a monthly fee for your data storage needs (currently, that's $40 per terabyte, less if you pay for longer upfront). Second, customers pay for how many compute resources they use in executing their business analysis applications. This is based on a "credit" system that is charged based on how much time your applications take to run and how large of a data set they are run on. In general, customers pay Snowflake on a volume basis, based on how much data they are storing/accessing and how much time they spend running analytics tools on it.

Snowflake is a global company. The firm currently counts over 8,500 customers, with 647 of the Forbes Global 2000 onboarded.

Revenue Growth and Recurrence

We just talked about how customers pay Snowflake on a metered monthly basis based on their data size and compute time used. That is what I refer to as a "toll booth" revenue model, and it is one of the most desirable of all the recurring revenue sources. Snowflake passes the recurring revenue test with flying colors.

One reason the "toll booth" model is so attractive is that it is essentially unlimited. The amount of digital data being produced and stored has doubled every 2 years over the past decade. As Snowflake clients grow, they generate more data, which in turn generates more revenue for Snowflake. This can be seen in the company's impressive 135% net revenue retention rate. Not only doesn't the firm lose customers, but those customers are spending 35% more year-over-year!

What about long-term growth? To date, Snowflake has generated some pretty impressive figures. Its 3-year compound average annual revenue growth is 98%! This has slowed some in 2023 as macroeconomic headwinds have put a lid on enterprise spending, but when 35% revenue growth is considered "slow", you know you have a rapid grower.

This is one where the opportunity is very large. Snowflake estimates its current addressable market at an enticing $80 billion, growing to nearly $250 billion (!!) by 2026. These are pretty crazy numbers for a firm doing about $2.8 billion in run rate at present. I don't know if the opportunity is that large, but when you consider that data-driven analysis and decision making has permeated every enterprise business and even down to small start-up firms, there is almost no company in the world that wouldn't benefit from Snowflake's offerings.

The big-picture trends are also tailwinds for the company. The cloud compute transition has huge momentum, with the AWS CEO estimating it was only "10% of the way there". AI, a visible a trend as there is, requires huge amounts of data to be effective. I think Snowflake could easily continue to deliver 25-30% annual revenue growth for the foreseeable future.

Measuring the Moat

We mentioned the company's 135% net revenue retention rate above, and Snowflake has reported a 99% gross customer retention rate in the past. The company simply doesn't lose customers once it onboards them.

This is due to the tremendous SWITCHING COSTS inherent in the business. Companies rely on insights gathered from data for business goal planning, marketing optimization, technology planning, incident resolution, and much more. It is a critical facet of modern business, but it is also extremely difficult to migrate given the massive volumes and custom nature of analytics tools. Once a firm commits to Snowflake, builds their analysis tools on it, and packs zetabytes of data onto the platform, moving would be incredibly painful.

The switching costs moat is reinforced by the fact that Snowflake services some large clients. Currently it has over 436 customers spending more than $1 million a year. Moving off the platform for large clients is particularly difficult.

I also think Snowflake has a chance to build some semblance of NETWORK EFFECTS. Its Data Marketplace offering allows clients to sell certain sets of their own data to third parties. Some examples might be COVID-19 data from government organizations, or map data from various aggregators. This additional data can add further business insight for a potential buyer, and create a new revenue stream for sellers. Once large enough, sellers will flock to it to reach the most buyers, and buyers flock to it to access the largest variety of data sources.

There is competition in the space. The legacy database providers like Oracle are trying to get into cloud data warehousing, and the platform-as-a-service vendors like Amazon are rolling out similar offerings (although for AWS only). Any business with growth and margins like this will attract competition, but I feel Snowflake has some strong moat factors that protect it competitively.

Management and Financials

Snowflake attracted veteran ServiceNow (NOW) CEO Frank Slootman to run the company. This guy has a great track record - he took ServiceNow from a small startup to a $20 billion tech behemoth. That firm is now worth over $144 billion and one of our best performers. Slootman brought along his CFO, Mike Scarpelli, as well, where he serves the same role for Snowflake. This is a seasoned, no-nonsense tech management battery.

We still have founder presence here, as well. French tech wizards Thierry Cruanes and Benoit Dageville started Snowflake in 2012. Today they remain in leadership positions, with Cruanes as chief technical officer, and Dageville as President. Insiders at large own 8% of the company, a reasonable figure for a $63 billion dollar company.

This team has been in place through Snowflake's explosive growth since 2018, going from $97 million in sales to nearly $3 billion. The company is sitting pretty financially. It has over $4 billion in cash and investments on the balance sheet, and no debt. Free cash flow has turned strongly positive in the last 2 years, with margins exceeding 25% of sales. While the firm has made a few acquisitions, they have been measured and not outrageous. Free cash return on invested capital is excellent, at 33% for the last 12 months.

Everything checks out here, no concerns.

Risks

I like to focus on business risks for the most part, but easily the largest risk for investors in Snowflake is buying at too rich a valuation. This has been one uber expensive stock for its entire public run. While the business has performed very well, the stock has been extremely volatile and generated poor returns for retail investors (it trades at $190 vs. a first day open of $275). Even today, we're talking about a stock trading at 24 times sales!

We will touch more on valuation in a bit.

As for the business, I'd consider Snowflake as a "lower" risk proposition in our cohort of stocks. Macro conditions have proven to be a challenge to Snowflake, as clients cut back their spending in times of uncertainty. While I don't see this as a long-term risk, it is something that will cause volatility in both the stock and business.

The competitive landscape is just evolving now. I fully expect Amazon, Google, and Microsoft to build similar functionality into their cloud PaaS systems. There will be disadvantages (inter-operability) and advantages (simplicity, probably lower price) for clients considering those. It is unclear what kind of traction they may get, but clearly it could challenge Snowflake's growth ambitions.

There are also the usual IT risks, like data theft, security breaches, etc. Still, at large, Snowflake's business risks are less than most in my opinion.

Conclusion and Price Target

It should be little surprise that Snowflake passes our "green dot stock" criteria with ease. This is one great business and an easy add to the Watch List.

Now the key question becomes - at what price is the stock a buy?

My expectations call for 28% annual revenue growth for the next 5 years, tapering down to 17%. I see free cash margin reaching 30%, and given the manageable risk profile, a standard 10.5% discount rate seems appropriate. Share dilution is pegged at 4% annually - the company does use stock based compensation liberally.

Plugging these into the DFCF calculator, I get a fair value price of $134. That's about 42% under where the stock trades today at $190. Given that, we will stick Snowflake on the Watch List and wait for a better price before jumping in.