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7 Red Flags for Snowflake&x27s Future | The Motley Fool

snowflake (snow -5.94%) released its first-quarter earnings report on May 25. The cloud-based data storage company’s revenue rose 85% year-on-year to $422.4 million, topping analysts. estimates at $9.4 million. its net loss narrowed from $203.2 million to $165.8 million, but its corresponding loss of $0.53 per share missed expectations by two cents.

Investors seemed unimpressed by those mixed headline numbers, and Snowflake’s shares on May 26 briefly fell below their initial public offering price per share of $120. That may seem like an attractive entry point for new investors, but seven red flags suggest things could get worse before they get better.

Reading: Snowflake future

1. another quarter of growth slowdown

Snowflake revenue rose 124% to $592 million in fiscal 2021, which ended last January, and soared 106% to $1.22 billion in fiscal 2022.

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but if we track snowflake’s year-over-year growth in product revenue, total revenue, and remaining performance obligations (rpo), we can see that its momentum is gradually fading.

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data source: snowflake.

snowflake expects revenue from its products to grow 71% to 73% year over year in the second quarter of fiscal 2023 and 65% to 67% for the full year.

2. your retention rates are peaking

Snowflake’s net revenue retention rate, which reflects its year-over-year growth per existing customer over the prior 12 months, exceeded 170% over the past three quarters.

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data source: snowflake.

However, snowflake has repeatedly warned that those retention rates will decline as its largest clients cut back on spending.

During the Q4 conference call, CFO Mike Scarpelli predicted the rate would “stay above 150%. But during the Q1 conference call, Scarpelli further curbed those expectations by saying his retention rate “would stay well above 130% for a long time.”

3. your gross margins are peaking

Snowflake’s total gross margins and product have consistently expanded on a non-GAAP basis.

data source: snowflake. non-gaap basis.

But in an investor day presentation last year, snowflake estimated that its non-gaap gross margin could rise to around 75% by fiscal 2029, suggesting it has already reached its maximum gross margins. for fiscal 2023, it expects its gross margin without gaps to reach 74.5%.

4. there is no clear path to profitability

Snowflake’s top gross margins wouldn’t be too much of a concern if its operating margins were positive. however, its overall operating margin was negative 59% in fiscal 2022 and negative 45% in the first quarter of 2023. snowflake will struggle to cut those losses for two reasons.

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First, it faces intense competition from similar data storage platforms such as amazon (amzn -2.62%) web services’ (aws) redshift and microsoft‘ s (msft – 0.58%) azure synapse, both built on their respective cloud infrastructure platforms. Amazon and Microsoft, which ironically power Snowflake’s platform with their own cloud services, can easily afford to offer their competing services at lower prices.

Second, Snowflake spent 50% of its revenue on share-based compensation (SBC) expenses in fiscal 2022. That proportion only dropped slightly to 41% in the first quarter of 2023. Unless Snowflake controls those staggering sbc costs, it will continue to burn cash and bleed red ink.

5. continuous dilution

snowflake’s liberal use of sbc saw its weighted average number of shares rise 112% in fiscal 2022 and 8% year-over-year in the first quarter of 2023. investors should expect that trend , which will repeatedly dilute the value of its existing shares – to continue this year as it ramps up its headcount to support its new growth initiatives.

6. an unappealing valuation

Snowflake’s ongoing dilution would not be a concern if its shares were at fair value. Unfortunately, the stock is still trading at 20 times this year’s sales, making it an unreliable investment as rising interest rates crush the frothiest growth stocks in the market.

By comparison, sentinelone(s -3.98%), the AI-powered cybersecurity company expected to generate 83% sales growth this year, is trading 18 times that estimate. In other words, Snowflake shares have almost fallen back to their IPO level, but their upside remains limited.

7. your experts are not buying the shares

Snowflake shares are down almost 50% in the last 12 months. however, during that period, their internal employees sold more than six times the number of shares they bought.

That lack of internal confidence suggests that the snowflake is still not a bargain. that’s not surprising, as its initial public offering had an initial price of between $75 and $85 before market hype pushed its debut price to $120.

remains a speculative investment

snowflake is a promising company, but it has arguably been overvalued since its IPO. Investors should be acutely aware of these issues before buying some stocks from this speculative cloud.

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