Snowflake ( SNOW -2.59% ) was arguably the hottest tech stock of 2020. It went public in September as the biggest software IPO in history, attracted big investment from Warren Buffett Berkshire Hathaway and salesforce.comand doubled in value on the first day.
It’s easy to see why investors fell in love with Snowflake. Its revenue jumped 174% in fiscal 2020 and increased another 133% to $242 million in the first half of fiscal 2021. It had a net retention rate of 158% in over the past six months – the highest retention rate of any cloud software company at the time of its first public appearance.
Snowflake’s technology is also disruptive. Its core service pulls all of a company’s data onto a central cloud-based platform, where it can be analyzed and fed into third-party data visualization software. This solution, which is easier to scale than on-premises data warehousing services, has helped businesses break down restrictive silos and rationalize their activities.
Snowflake’s growth potential is still impressive. Its total number of customers more than doubled year-over-year in the second quarter, but it still only serves 146 of the Fortune 500 companies. The data warehouse-as-a-service market could grow at a growth rate annual compound of 23.8% between 2018 and 2023, according to market research firm Markets and Markets, so its total addressable market is still expanding.
All of these seem like good reasons to buy Snowflake. Unfortunately, I think investors should still avoid this buzzy stock for three simple reasons.
1. You shouldn’t pay the wrong price for the right company
Snowflake went public at $120 a share, valuing the company at $33 billion, just over 80 times its past 12-month sales. It was already a nosebleed valuation, but the stock now trades at around $260, giving it a market capitalization of around $73 billion, or 181 times its 12-month sales.
Analysts expect Snowflake’s revenue to grow 114% to $565.8 million this year. But even if it achieves that lofty goal, it will still trade at 129 times this year’s sales and remain one of the most expensive tech stocks out there.
By comparison, the darling videoconference Focus on video communications (ZM -2.99% ) expects its revenue to rise 281% to 284% this year, but its stock is already considered expensive at 50 times that estimate.
Therefore, Berkshire and Salesforce might have considered 80x sales an acceptable price for Snowflake, but they probably aren’t accumulating more shares at its current valuations.
2. He could lose his first mover advantage
Snowflake’s main competitors include Amazon Web Services‘ ( AMZN -2.11% ) Red shift and Microsoftit is (MSFT -1.46% ) Azure SQL Warehouse, both of which are integrated with their cloud infrastructure platforms.
This is problematic for two reasons. First, Snowflake’s services run on AWS, Azure, and others cloud infrastructure platforms. Therefore, much of Snowflake’s operating expenses actually fund its biggest rivals.
Second, AWS and Azure may reduce Snowflake prices and bundle their competing services with other cloud services. Amazon and Microsoft can also afford to take losses on their data warehousing solutions for years to drive Snowflake out of the market.
Snowflake initially grew because Amazon and Microsoft did not prioritize the growth of their data warehousing solutions in the past. Snowflake’s service is also generally faster and more efficient because it handles compute and storage tasks separately, whereas Redshift and Azure bundle them together.
This technological edge has given Snowflake a first-to-market advantage, but Snowflake’s successful IPO is likely causing the two tech giants to rethink their data warehousing strategies.
3. A path to profitability is missing
Snowflake’s revenue growth is explosive, but it remains deeply unprofitable. Its net loss widened last year and fell only slightly year-over-year from $177.2 million to $171.3 million in the first half of 2020.
Snowflake could struggle to pare those losses if Amazon, Microsoft and other big rivals cut its prices. Bulls might argue that Snowflake’s record net retention rate indicates it’s sustainable, but retention rates typically decline over time, even for the highest-growth tech companies.
For example, the cloud-based cybersecurity company CrowdStrike ( CRWD 0.54% ) went public last June with a net retention rate of 147% over the previous 12 months. By the last quarter, that rate had fallen to just over 120%.
Datadog (DDOG -2.15% )another decompartmentalization company which brings together all of a company’s data on a unified dashboard, went public last September with a 146% net retention rate over the past 12 months. This percentage dropped to around 130% last quarter.
Snowflake could buck that trend, but competitive headwinds and the law of large numbers suggest its net retention rates are peaking.
The Key Takeaway
Snowflake is still an impressive growth stock, but glaring flaws are hard to ignore. I would consider buying this stock in the event of a stock market crash resets its valuationbut it’s still too rich for my blood at those levels.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end advice service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.