Snowflake stocks caught our attention because Berkshire Hathaway actually has a stake in it. Not only is it a tech company that Warren Buffett usually avoids, it is also a loss-making business currently. Albeit its strong growth in revenue, it seems to be the kind of business that Buffett traditionally avoids.
So we went to dig deeper to understand its economics and examine if it is a really good investment opportunity. Let’s check it out!
Snowflake Stocks Business Overview
Source: Snowflake Q3 2021 Quarterly Results Investor Presentation
Snowflake’s business is engaged in providing a cloud data platform for its customers, which is a solution for data warehousing, data lakes, data engineering, data science, data application development, and data exchange.
From Cloud Data Platform To Data Cloud
In essence, the company first integrates data sources in one place. Big enterprises have data from multiple sources, especially in today’s data-driven businesses working to drive valuable insights. These data sources can come from myriad places such as web sources, SAP or even Amazon S3 cloud storage.
Through its cloud-native architecture, it creates a unified record of massive data, enabling access of data sets without delay, and intelligently optimizes each use case’s performance requirements without any administration. It allows customers to access meaningful business insights, build data-driven applications, and share data efficiently and conveniently.
Users can share data internally within the organisations or externally with third parties or their own customers. Moreover, there is no need to move or copy the underlying data which is a limitation that traditional solutions impose.
Source: Q3 FY21 Snowflake Earnings Presentation – Evolution of Snowflake’s Business
Snowflake’s Partner-Competitor Relationships
It is important to note that Snowflake’s platform runs on public cloud infrastructure provided by Amazon Web Services (AWS), Microsoft Azure (Azure), and Google Cloud Platform (GCP).
This is an interesting partner-competitor relationship, because these partner companies are key competitors in the cloud data platform as well. For instance, AWS has Redshift which directly competes with Snowflakes. These bigger players have much greater resources and capacity to compete if they want to.
Another critical element we need to know is that Snowflake is not a Software-as-a-Service (SaaS) model. In fact 93% of its revenue is consumption-based, meaning that revenue is recognized only as consumption occurs.
Does Snowflake Commands Competitive Advantages?
Snowflake Stocks: Cloud Data Warehouse And Platform
Snowflake’s customers will spend a lot of resources to set up the various data bases and business analytics interfaces. Given these huge upfront investment, key potential barriers to entry will be the high switching cost involved.
However, given the rapid growth in the market, the question is if Snowflake will be able to capture substantial market share before its key competitors do. To do that we need to take a look at the company’s growth trajectory.
Source: Snowflake SEC IPO Filing
Understand that Snowflake is still making losses. They will continue to do so for the foreseeable future as it tries to capture more market share. Therefore, a key metric that the company tracks is its revenue growth rate.
From the chart above, we can see that during its IPO filing, the company achieved a revenue growth rate of more than 100%. Based on the recent quarterly earnings report, we see that the company is still maintaining the momentum. In fact, the company hit a revenue of $160 million for Q3 FY21.
Source: Q3 FY21 Snowflake Earnings Presentation – Revenue Growth
The company’s FY21 YTD (representing a nine-month period from 1 February 2020 to 31 October 2020) revenue of $401 millions already surpassed that of the whole of FY20 which stood at $265 millions.
Snowflake’s Key Competitors
Indeed an impressive growth for Snowflake. However, we need to put these numbers in perspective. Yes, its key competitors are not experiencing such triple-digits growth in revenue. But their revenue bases are already in the range of billions, and still experiencing double digit growth.
Moreover, given the size of the competitors, their R&D spending dwarfs that of Snowflake’s. Although the exact make-up of the R&D spendings by these large corporations can differ significantly, it should still give us a good perspective of where Snowflake is positioned.
Source: Forbes: Don’t Get Snowed In By The Hype For Snowflake
Acquiring Large And Strategic Customers Is Key
Seems like Snowflake is going to have a tough fight with its partner-competitors. But we do see some good progress in Snowflake’s ability to capture large customers. We can see below that the company is actively sealing deals with large customers. These are big enterprises who are generating more than $1 million product revenue for the company. Moreover, the number of strategic customers in the Fortune 500 list is growing fast as well.
Source: Q3 FY21 Snowflake Earnings Presentation – Large Customer Growth
Source: Q3 FY21 Snowflake Earnings Presentation – Strategic Customers Growth
These are important progress. Because big enterprises are the ones going to experience high switching costs once they adopt the technology. And this is where we see Snowflake is going to build a strong moat around its business.
Snowflake Stocks: Data Cloud
The company unifies data sources and help customers derive business intelligence from its Cloud Data Platform. But with more data migrating to the Data Cloud, customers can also consume and exchange more data.
Source: Q3 FY21 Snowflake Earnings Presentation – Market Size and Opportunity
This can potentially create a very powerful network effect, hence a barrier to entry, if the company can capture the majority of the market quickly. With more data suppliers entering its data cloud, it will make more sense for new customers to join in instead of competitors’ data cloud.
However, it is highly uncertain to what extent such data sharing and monetization will work out. The first penetration may be the access of financial information that will be beneficial for the financial industry. Or perhaps in the health care sector where we see companies benefiting from shared data to help cope with Covid-19 pandemic situation.
The benefits of cross-organizational data sharing without giving away competitive information can be a key obstacle for the data sharing economy to boom. It may make sense for some and specific data markets, but not all. Hence, the market size for the data sharing economy is unclear at the moment.
Snowflake Stocks Opportunity Vs Valuation
Source: Q3 FY21 Snowflake Earnings Infographic
Size Of Market Opportunity
Snowflake estimated that the total addressable market opportunity for their Cloud Data Platform is about $81 billion as of January 31, 2020. You can read its SEC Filing on how the company derives this figure if you are keen. However, given the strong competition from major players like AWS, Azure and GCP, it will be very challenging for Snowflake to capture the entire addressable market.
For estimation purposes, let’s say the company is able to capture half of the addressable market. In another word, the company will generate $40 billion in revenue eventually. Assume also that the company can continue to maintain its current revenue growth rate at about 100% every year. Starting from the estimated FY21 revenue of $0.5 billion, it will take 6.5 years to capture this revenue base.
Looking at the similar competing companies, we will assume an eventual operating profit margin of 20%. This will translate to an operating income of $8 billion. Assume a 30% tax rate, the net operating profit after tax (NOPAT) will come in at $5.6 billion.
Projections And Valuations
Assume that once the company reaches a more established status and equilibrates to an average P/E of 20. Just for simplicity and quick estimation, we will take the eventual NOPAT as the company’s earnings. Along with a multiple of 20, we will derive an estimated market capitalisation of $112 billion.
This is very close to the current market cap of $110 billion at around $390 a share. What this means is that it seems like the market has pretty much priced in the growth element. In another word, Snowflake is expected to capture about half of its estimated addressable market. And this seem to have already been captured into the current market price.
Oh yes, just for your information, Buffett invested in Snowflake stocks during its IPO at about $120 a share. Definitely a better entry position given much uncertainty in the company’s growth trajectory and eventual market dominance.
Source: Q3 FY21 Snowflake Earnings Presentation – Market Size and Opportunity
Risks And Opportunities
No doubt Snowflake’s business model is very appealing. The high switching cost from its cloud data platform can become very powerful barrier to entry in the future. Similarly, strong network effects attributed to the ability to exchange data can be a powerful competitive advantage as well.
However, the key factor to consider is whether management is able to execute its plan to capture the market quickly. It must be fast enough before the big boys like Amazon, Microsoft and Google can come in to take share. This is a critical aspect that needs to be managed well to quickly form and protect its barriers to entry.
Current Valuation Vs Potential Size of Data Cloud Market
The current market valuation seems to have already priced in the expectation of Snowflake capturing half of its addressable market. Based on this account, we feel that there’s limited upside for an investment at this point in time.
We also discussed the potential market for data exchange, can potentially be a huge one, albeit uncertain. Perhaps once we have more visibility of its potential, we will be able to reassess Snowflake stocks investment potential again.
On the whole, we feel that the current valuation is relatively high. Also, there is much uncertainty as to whether the company will be able to capture substantial market share eventually. Therefore, it may not be advisable to invest at the moment. Nonetheless, any new insights on the cloud data platform and data cloud market will justify for a re-evaluation. Do drop a comment to share your thoughts 🙂
Keep learning and happy investing!
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