Snowflake Inc. (SNOW, Financial) is a cloud software company that has demonstrated signs of enduring growth, driven by a robust product roadmap in the data cloud software space, promising a 30%-plus growth rate in revenue annually into 2029. The company has seen an increase in the share of its enterprise customers in a large and growing total addressable market and, at the same time, it is consistently improving its overall profitability. The stock was up 38% in 2023, outperforming the S&P 500.
While Snowflake is seeing a slowdown in its net revenue retention rate and remaining performance obligations, Snowflake's management has continued to exceed revenue and earnings expectations. As a result, it has led to a higher premium being attached to the stock price. Based on my analysis, I believe the company is undervalued at current levels. My bullish thesis is predicated on the company's strong product release roadmap, which I believe will allow it to gain more market share while growing its operating leverage amidst a favorable macroeconomic backdrop as IT budgets expand on falling interest rates.
About Snowflake
Snowflake is a cloud-based data warehousing technology that enables organizations to consolidate data into a single source to drive meaningful business insights and build data applications and products.
Its primary customer segment is large businesses and enterprises that require a highly scalable, powerful and secure data warehouse solution to manage and analyze vast amounts of data.
Snowflake generates the majority of its revenue from fees charged to their customers based on three types of technological resources consumed on their data platform, namely, compute, storage and data transfer resources. The company charges its customers usage fees based on how its clients utilize these technological resources in terms of the size of the data resource used and the period of time for which the resource is being used. As an investor, I believe such usage-based pricing gives Snowflake immense leverage while negotiating contracts with its clients, leading to stronger margins.
Building the bull case
Snowflake has an expanding market penetration in a growing total addressable market with a robust product pipeline. As per its latest Investor Day, Snowflake's TAM is expected to grow to $290 billion by 2027. This represents a compounded annual growth rate of 15% from 2022 to 2027. The TAM is calculated by adding the sizes of the following markets: Data Warehouse, Lake, & Unistore, Collaboration & Data Engineering, Cybersecurity and Data Science & Machine Learning.
Therefore, assuming that the TAM is $185 billion in 2024, Snowflake's market share is estimated to be approximately 1.4% should management meet its 2024 revenue expectations.
Management has also laid forth its long-term operating model, as per its latest earnings report, that it expects to grow its revenue to $10 billion by 2029, which would represent a compound annual rate in revenue growth of 30%. In other words, the company is projected to grow its revenue at twice the growth rate of its TAM. This would mean the market share of Snowflake should expand from approximately 1.40% in 2024 to close to 2% in 2027 as TAM grows to $290 billion and revenue grows annually by 30% during this period of time.
In my view, this will be driven by Snowflake expanding its presence with enterprises by acquiring and deepening relationships while driving adoption across its product portfolio. As per its Investor Day, Snowflake increased its penetration to 30% amongst Forbes 2000 companies in the first quarter of fiscal 2024 as compared to 16% during the same period last year. At the same time, the company now serves 436 customers, generating more than $1 million in sales each, which has grown 52% on a year-over-year basis with a net revenue retention rate of 135%.
Furthermore, if we look at the left chart below, we can see how customers ramped up usage of Snowflake's platform by almost 700% over a span of three years. I had noted earlier how higher usage is beneficial for the company due to its innovative usage-based pricing menu. Snowflake has an extremely busy product roadmap, with products and features being launched at least every week. To me, a constant product release cycle keeps users engaged on the platform, leading to higher utilization rates. High utilization rates help add to Snowflake's top line due to its usage-based pricing. Also note how over the same time period, trailing 12-month revenue has surged at a CAGR of almost 60% due to higher adoption and usage from its top 25 large customers.
In addition to regular data warehousing workloads, the company is also expanding into other forms of workloads, such as artificial intelligence and machine learnings-based capabilities. Moreover, Snowflake is building its own data ecosystem called Snowpark, enabling developers to build applications based on its data platform and market them to the company's user base. By creating this ecosystem, Snowflake leverages its existing data platform to build multiple forms of revenue and expand platform adoption. Again, since the early release of Snowpark, the highest adoption was seen in its customer segment, with over $1 million in product revenue, per its investor day presentation, which in my opinion is a big win for Snowflake.
Snowflake's management is focused on improving operational efficiency and profitability.
Snowflake produced stellar growth on both the top and bottom lines, smashing expectations by 3% and 56%, respectively, as per its third-quarter 2024 earnings report. Revenue grew 32% year over year to $734 million, while non-GAAP operating margin improved from 8% a year ago to 10%. While the company improved its underlying operational efficiency and profitability, it also managed to improve its non-GAAP gross margins from 71% last year to 75%, driven by economies of scale and a larger renewal mix.
Shifting gears to fiscal 2024 guidance, Snowflake management is expecting revenue of $2.65 billion, which represents 36% growth on a year-over-year basis. While this marks a slowdown in revenue growth from prior levels, I believe its commitment to innovation in its product portfolio, while penetrating further into the enterprise space, will enable the company to maintain a revenue growth rate in the higher 20s region over the next five years. Meanwhile, as per the long-term operating model, Snowflake management believes it could grow to a $10 billion company by 2029, which would represent a CAGR of 30% over the next five years. At the same time, management expects to improve its non-GAAP operating margin to 7%, with a target of a non-GAAP operating margin of 25% by 2029. This would require the company to grow its non-GAAP operating income annually at 60%, twice the rate of revenue growth over the next five years, by further harnessing its economies of scale and customer relationships.
Snowflake's bullish narrative is further aided by a strengthening macroeconomic tailwind. While 2022 and 2023 were tough for companies as management cut back spending and optimized cost structures on the back of one of the toughest interest rate hiking cycles, broad economic indicators point to inflation trending lower from current levels. Meanwhile, the software and IT services segments are expected to see double-digit growth in 2024, driven by cloud spending at 13.8% and 10.4%, respectively, as per Gartner. This should bode well for Snowflake as enterprises will increasingly transition from legacy data warehouses to its data platform as they prepare to leverage data through the company's AI and ML workload capabilities.
Building the bear case
On a more negative note, Snowflake's net revenue retention rate & RPO is slowing down. While net revenue retention is still strong at 135% for all customers, there is an overall decline. A year ago, overall net revenue retention was 172%. This is indicative that while existing customers are still excited about the company's product launches, there is a growing spend fatigue amongst them. Moving forward, should we see further deterioration in net revenue retention, it would be an early indication that Snowflake's ability to retain its customers' spend is falling behind, which will weigh down on overall investor sentiment and raise concerns about management's five-year target.
In addition, Snowflake may have already seen the best days of its 70%-plus growth rates, as can be observed by the stalling trend in its remaining performance obligations.
I see RPO as an important metric for Snowflake because, like any other cloud company, usage contracts are generally multiyear, leading cloud companies to spread the cost for the customer over time in the form of subscriptions.
While I expect Snowflake to return to higher growth in its RPO, driven by higher adoption and usage in a much better-looking macroeconomic environment, I believe its 70%-plus growth rate days are over and we should expect to see normalization in the higher-20s range in revenue and RPO growth rate moving forward.
Tying it all together
Taking the management's long-term operating model, where revenue and non-GAAP operating income grow annually at 30% and 60%, respectively, over the next five years, Snowflake should generate revenue of $3.6 billion and non-GAAP operating income of $311 million, or adjusted earnings per share of $1.36 in fiscal 2025. In that case, the stock is currently trading at a forward price-earnings ratio of 140. While this may look steep in the beginning, if we benchmark it against the S&P 500, the companies in the index are expected to grow their earnings on average by 10% to 11% in 2024 ,as per Factset, with a forward price-earnings multiple of 20. Under the assumption the U.S. economy grows moderately, as per the Federal Reserve's projections, I don't see a multiple compression for the S&P 500 in 2024.
Therefore, if we linearly extrapolate the S&P 500's earnings expectations and its forward price-earnings multiple to Snowflake's earnings growth rate, the stock should be trading at a forward earnings multiple of no more than 120. Since Snowflake is currently trading at a forward price-earnings multiple of 140, there could be a short-term downside of 16%. The other way to look at it would be that the current pricing of Snowflake is factoring in the optimism that earnings for 2025 will surprise at least 16% on the upside. The company has been consistently beating its consensus earnings estimates over the last four quarters. As a result, I believe the optimism that Snowflake will produce an earnings surprise of 16% is partially baked into the valuation.
Looking over a five-year investment horizon, I believe Snowflake is undervalued at current levels. Taking management's long-term operating model into account, the company grows its revenue to $10 billion by fiscal 2029 with a non-GAAP operating margin of 25%. Snowflake should produce approximately $2.50 billion in non-GAAP operating income by 2029, which would equate to a present value of approximately $1.7 billion if discounted at 8%, or an adjusted earnings per share of $5.20.
Taking the above assumptions into consideration, I believe the price-earnings ratio for Snowflake in 2029 will be at least 45. Taking the S&P 500 as a proxy, where it has grown its earnings by 8% on average over the last 10 years, as per Factset, with a price-earnings multiple in the range of 15 to 18, I believe the stock will be trading at a multiple that is at least 3 times that of S&P 500 in 2029, as the company matures and earnings start to trend more in line with revenue growth. As a result, I believe that over a five-year investment horizon, the company is still undervalued and has room for at least a 20% upside to $235.
Conclusion
There is no doubt Snowflake has a high premium attached to its forward price-earnings ratio. While that can be partially explained by management consistently beating the top and bottom lines, it is possible to see short-term volatility in the stock price. As an investor, I will be watching the usage and growth rates of Snowflake's enterprise customer segment to continue to assess its positioning and management's five-year roadmap. However, at the moment, my belief is the company will continue to gain deeper penetration into its TAM. Coupled with management's laser-sharp focus on driving operational efficiency as well as a favorable macroeconomic backdrop, I believe the stock is currently undervalued with an upside of at least 20% from its current levels.
