Snowflake Q1: Weak Growth Outlook To Compress Lofty Valuation Multiple

Investment Thesis

Snowflake Inc. (NYSE:SNOW) tanked more than 10% aftermarket on May 24 as the management provided lower-than-expected Q2 and Full Year 2024 guidance, despite decent 1Q results. SNOW is a cloud data warehouse leader that has achieved a CAGR of 115% from FY 2019 to FY 2023.

The company stands out with its exceptional performance in the field of multi-cluster compute instances, which separate storage and compute functions, and its availability across three public clouds. Moreover, Snowflake distinguishes itself by providing a cost-effective model that charges customers only when they are using the platform only when they are using the platform. This approach has contributed to a net revenue retention rate (NDR) of over 150% since its IPO.

While the Snowflake Inc. track record looks impressive, the company is expected to face challenges and muddle through in the coming quarters. Due to the disappointing growth outlook in FY2024 and the stock trading at a lofty valuation of over 20x EV/Revenue FY2024, I have a neutral view on the company. Valuation adjustments should be made accordingly.

Q1 2024 Takeaway

Despite better-than-expected 1Q results, SNOW has issued a weak growth outlook. The company expects product revenue of $2.6 billion, which is below both previous company guidance and street estimates of $2.71 billion. This implies a 34% YoY growth in FY2024, down from the 70.1% YoY growth in FY2023. The weakened growth outlook will significantly impact SNOW's valuation, as hyper-growth stocks are particularly vulnerable to top-line growth weakness.

Furthermore, the company has warned of a potential EBIT margin contraction to 5%, down from the previous outlook of 6%. However, on a positive side, the company boosts its free cash flow ("FCF") margin outlook to 26%, which is 100 bps higher than FY2023.

Downtrend In NDR

SNOW has consistently achieved an impressive NDR of 150% since Q1 FY2023, demonstrating a steady flow of cash generated from its recurring revenue. A sustained high NDR is generally associated with an increase in a company's valuation. According to Stats For Startups, a NDR exceeding 110% is considered best in class, while a reading above 130% indicates a top-performing SaaS company. Therefore, Snowflake's NDR consistently surpassing 150% since its IPO is regarded as a "crown jewel" achievement.

I believe SNOW's exceptional customer retention rate is primarily attributed to its consumption-based model. Unlike a subscription-based model where revenue is recognized evenly over the contract term, Snowflake charges its customers only when they actively utilize the platform. This approach reduces hidden costs and ensures that customers pay solely for their usage, which contributes to the company's high NDR over time.

As mentioned earlier, a strong and consistent NDR history can justify a premium valuation for a company, which explains why SNOW demands higher multiples compared to its peers. However, we can observe a downward trend in NDRs over the past four quarters, which raises caution, especially considering the management's lowered growth outlook for FY2024. Therefore, I believe that the company's NDR will dip below 140% in the coming quarters.

Bookings Slowdown

Bookings play a significant role as a forward-looking growth driver in the software industry, representing the additional contract value that customers commit to a company in a given period. Bookings consist of two components: revenue and remaining performance obligations (RPO). RPO refers to the remaining obligations from contracts that the company will fulfill in the future, and these obligations can be converted into future billings and ultimately contribute to revenue generation. As the management disclosed "% Expect to Recognize as Revenue in the Next Twelve Months" in the past press releases, we can calculate current RPO and current bookings.

As shown in the 1Q FY2024 presentation, the Current RPO was $1,943 million, resulting in a QoQ dollar change of -70.87 ($1,943 minus $2,014). This marks the first time the company has experienced negative growth in the past two years. Additionally, the current bookings amounted to $519.2 million, up from $401.8 million in 1Q FY2023. The table shows the growth trend of SNOW's current bookings, which has been decelerating from 58.7% YoY in 1Q FY2023 to 29.2% YoY in 1Q FY2024, indicating a slowdown in demand for its core products.

Valuation

It's very important to understand that the valuation multiples of early-stage hypergrowth stocks are highly sensitive to the momentum of top-line growth rather than margin expansion. In the case of SNOW, if investors perceive a slowdown in its growth momentum, it can lead to negative sentiment in the short term.

The table from 05/22/2023 shows that SNOW is trading at 20.4x EV/Revenue FTM, which is the highest multiple in the group, compared to 8.8x of large cap software average. While some investors may argue that the lofty valuation can be justified by its hypergrowth outlook, I find it overstretched due to a disappointing growth outlook in FY2024, especially considering that the stock is trading significantly higher EV/Revenue FTM than CrowdStrike Holdings, Inc. (CRWD) of 10.7x with FTM growth of 34%, Zscaler, Inc. (ZS) of 9.7x with FTM growth of 33%, and Cloudflare, Inc. (NET) of 14.2x with FTM growth of 30%.

Therefore, I would be cautious on a potential demand slowdown due to macro headwinds. Moreover, as U.S. inflation is still running hot at 4.9% YoY, the Fed is aiming to bring it back down to the 2% target by hiking interest rate to 5.25% or even higher. In the face of raising interest rates, high multiple stocks like SNOW are expected to face significant challenges.

In conclusion

In sum, despite delivering better-than-expected 1Q results, Snowflake Inc.'s weak growth outlook has dampened investor sentiment, resulting in more than 10% post-market selloff. The company's projected product revenue of $2.6 billion for FY2024 falls below both previous company guidance and street estimates, signaling a potential slowdown in current bookings growth and NDR compared to the previous year. Therefore, this pessimism is expected to have a material impact on SNOW's valuation, as hyper-growth stocks are particularly sensitive to any weakness in top-line growth.

Additionally, the warning of a potential EBIT margin contraction to 5%, down from the previous outlook of 6%, raises further operation concerns. However, there is a silver lining as the company maintains its FCF margin outlook of 26%, representing a 1% improvement over FY2023. Nevertheless, I rate neutral for Snowflake Inc. stock as the overall outlook for SNOW is tempered by the cautionary signals in its growth trajectory and margin contraction, suggesting the need for careful monitoring in the coming quarters.