Snowflake Inc. (SNOW), a cloud-based data platform headquartered in Bozeman, Montana, has lost more than 40% of its market value this year amid decelerating growth. The company announced a large convertible note offering on September 24 to repurchase stock, which seems like a questionable capital allocation strategy given my view that its valuation remains expensive. Although Snowflake seems well-positioned to grow, its capital allocation decisions call for caution. I am neutral on the prospects for Snowflake as I believe the company’s growth potential is already reflected by the stock’s current market price.
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Snowflake Issues Debt to Repurchase Stock
Snowflake’s questionable capital allocation strategy is one of the main reasons behind my neutral stance despite the company’s growth potential. On Sep. 24, Snowflake announced the pricing of $2 billion of convertible senior notes in a private placement. The company will use $400 million in proceeds to repurchase stock at $112.50 per share. Snowflake ended the last quarter with more than $3.23 billion in cash and short-term investments, which suggests the company could have easily carried out the repurchases with internal cash rather than tapping capital markets. Snowflake had no long-term debt until today, but the balance sheet will now reflect $2 billion in debt going forward.
A closer evaluation of Snowflake’s cash flow statement reveals that the company spent $972.5 million for stock buybacks in the last fiscal year at an average stock price of close to $150. Although buybacks have the potential to increase shareholder wealth, these need to be executed at value-accretive share prices after funding growth opportunities. Snowflake, which currently trades at a forward price-to-earnings ratio of 186x and a price-to-sales multiple of almost 12x is certainly not cheaply valued. The company may end up destroying shareholder wealth in the long term by aggressively repurchasing more stock at above $100/share.
In the last three months, Snowflake insiders have sold shares worth $6.3 million against no new purchases. Although insider transactions should not be used as a standalone indicator, investors should be concerned about the company’s strategy of raising new debt to repurchase stock at a time when insiders have been selling shares.
Snowflake Has Hit a Speed Bump
In addition to Snowflake’s recent capital allocation decisions, the company’s decelerating growth has also dented my sentiment. After registering triple-digit YoY revenue growth in Fiscal 2020, 2021, and 2022, the company’s revenue growth has decelerated to 69% in Fiscal 2023 and 36% in Fiscal 2024. Snowflake’s net revenue retention rate, which measures the revenue growth from existing customers, fell from a high of 178% in Fiscal 2022 to 131% in Fiscal 2024, suggesting that customers are not spending as aggressively on Snowflake’s products as they used to.
Some of these growth struggles can be attributed to challenging industry conditions such as inflationary pressures that have dampened corporate spending, but increasing competitive threats from newcomers such as Databricks have also played a part in this.
Coinciding with Snowflake’s revenue growth deceleration, the company has accelerated its AI investments, leading to a notable increase in operating costs. From a yearly average of just $333.6 million in research and development costs between Fiscal 2019 to 2023, R&D expenses surged to $1.28 billion in Fiscal 2024 as the company aggressively spent money to purchase GPUs that are required to roll out AI capabilities.
Silver Linings are Appearing Among Dark Clouds
Although Snowflake may have to improve its capital allocation decisions, there is no denying the massive growth opportunity that lies ahead for the company. The company has also identified the need to slow down AI investments until past investments yield expected results. Speaking at the Goldman Sachs Communacopia conference on September 12, 2024, Snowflake CFO Mike Scarpelli said that the company will not buy any new GPUs until there is evidence of revenue growth stemming from aggressive AI infrastructure investments. This expected slowdown in AI investments should boost operating margins in the next few quarters. However, I’m still cautious on the shares right now.
The improving macroeconomic outlook for IT spending amid rate cuts is another silver lining for Snowflake. According to Forrester, 90% of IT decision-makers expect an increase in IT infrastructure spending next year. Most of the budgeted investments are likely to focus on AI and cloud-native software, which is good news for Snowflake.
Snowflake has a Long Growth Runway
Although I am neutral on the stock, additional positives for Snowflake include its unique business model and its consumption-based pricing model. This pricing model has attracted both large and small businesses to Snowflake’s cloud-native data warehousing products as businesses are able to manage costs efficiently by paying for their usage rather than a fixed pricing model that does not factor in consumption.
Snowflake’s AI investments in the last couple of years have paved the way for the company to introduce innovative solutions such as Cortex AI; a fully managed data analysis and AI product development service. Snowpark Container Services is another innovative solution introduced by the company to allow its customers to deploy and manage generative AI models in a secure environment. These new features are likely to attract new customers once IT spending patterns normalize.
Is Snowflake a Buy, According to Wall Street Analysts?
Based on the ratings of 33 Wall Street analysts, the average SNOW price target is $169.25, which implies potential upside of more than 50% from the recent trading price. Wall Street analysts have 23 Buy ratings, 10 Hold ratings, and no Sell ratings on the stock.
Although Snowflake seems to be valued attractively according to analysts, I am neutral on SNOW stock as I believe the company’s capital allocation strategy needs improvement to align the interests of shareholders and key executives.
Takeaway
Snowflake has raised $2 billion from a private placement of senior notes, and the company is planning to use some of those proceeds to repurchase stock, at what I still deem an expensive price. This capital allocation strategy deserves scrutiny since the company was well-funded with zero long-term debt at the time of this decision. Snowflake enjoys a long growth runway but deceleration of that growth may persist into the foreseeable future. I am neutral on Snowflake.
