Snowflake (NYSE:SNOW) has been undoubtedly one of the year’s biggest initial public offerings (IPOs). With shares launching at a market capitalization of around $70 billion, investors paid a record sum for a company that produced just $400 million in revenues over the past year. Yet, that’s not as crazy as it sounds. So why are investors paying 170x sales for Snowflake’s shares?
![Snowflake IPO on the NYSE](https://investorplace.com/wp-content/plugins/lazy-load/images/1x1.trans.gif)
Simply put, the company is enjoying unprecedented revenue growth for a software-as-a-service (SaaS) company. It also has a tech legend running the firm.
With its focus on totally overhauling data management, Snowflake has the potential to be a true game-changer across the tech landscape. Here’s what makes Snowflake such a great company, but also a tricky one in terms of valuation.
Why the Snowflake IPO Is Better Than Rivals
Snowflake’s broad mission is to give users one cloud where they can store all their data seamlessly, then manage who has access to things. This solves many problems around having multiple databases, multiple user authentication schemes, and various security and compliance problems that come with a cobbled-together data network.
By contrast, with Snowflake, administrators set up just one unified cloud data network, and can run all their data analysis, processing, science, sharing, etc. from one place. Snowflake also has strong network effects because it allows customers to share data seamlessly with other Snowflake clients. In addition, Snowflake easily integrates with other related SaaS services such as Talend (NASDAQ:TLND), further making it easy to operate everything directly within Snowflake’s ecosystem.
What makes Snowflake unique? According to chief executive officer Frank Slootman, the difference is that most SaaS companies built their software to be platform agnostic. That is to say, it runs the same on-premise or in the cloud. Obviously, this is not optimal for performance as opposed to a native system.
Snowflake, by contrast was built cloud-only and the optimization allows it to handle huge quantities of data far more cleanly and quickly than spliced together offerings from rivals. This fundamental difference has paved the way for Snowflake’s present success.
Tremendous Performance
Just prior to the IPO, Snowflake had 3,117 different customers. That’s more than double last year’s count. Equally important, Snowflake is landing huge clients.
According to the prospectus, it already has seven of the top 10 Fortune 500 companies as customers, and 146 out of the 500. Snowflake’s net revenue retention rate is also a stunning 158%. This means that customers not only aren’t leaving the platform, instead, they are spending 58% more on Snowflake’s offerings than they did in the previous year.
When you attract many of the world’s biggest companies to your cloud, and then get them to increase their spending at an exponential growth rate, you’ve got a monster on your hands. Forget about snowflakes, this is an avalanche.
Valuation: The Sticky Point
The issue here, not surprisingly, is the valuation. At the current price, Snowflake is worth almost $70 billion. This is unprecedented for a firm with as small a revenue base as Snowflake. Even Zoom Video (NASDAQ:ZM) — the previous leader in high-growth high-priced stocks — only reached half the price-sales ratio that Snowflake obtained.
You can argue that Snowflake is unusually expensive because of its incredible potential. That’s true to a degree. There are other fantastic SaaS companies as well, yet Snowflake’s current valuation is in a league of its own.
I’d argue that this is because Snowflake has some superstar investors. Berkshire Hathaway (NYSE:BRK.B) invested in the IPO, helping to drive up demand — and thus the price — dramatically. Berkshire now owns 15% of Snowflake. Additionally, Salesforce (NYSE:CRM) bought a 10% stake, and Altimeter Capital Management picked up another 13% of the company. Add those together, and a large chunk of the stock has been purchased by institutions, reducing the free float dramatically.
However, as Snowflake matures and offers more stock while insiders sell off holdings, it will free up supply of trading shares. This will help the stock reach a more natural level than its current speculative heights. Snowflake is currently the hot IPO everyone wants a piece of, yet little stock is available. As new IPOs come along and more Snowflake shares hit the market, market dynamics will get back in line.
SNOW Stock Verdict
Snowflake is one of the best SaaS companies in the world. But now it’s trading for a $70 billion valuation. That’s despite not even doing a billion in annual revenues yet and running massive losses. It will take a few years of tremendous revenue growth and improving profit margins to justify today’s price tag.
Snowflake will probably eventually grow into its current market cap. I wouldn’t bet against Snowflake’s CEO Frank Slootman. He’s an absolute legend in the tech industry, as he led not one but two small companies up the growth curve to tremendous heights. His last company, Servicenow (NYSE:NOW) is up 20x since the Slootman took it public back in 2012.
Long-term, it’s smart to trust in his leadership. However, I’m skeptical that this is the best price Snowflake will ever be offered at. Look at the great growth stocks of history. All pulled back more than 50% multiple occasions, and 80-90% drops are hardly out of the question. For example, Amazon (NASDAQ:AMZN) stock dropped 93% from its dot-com peak to its post-2000 crash lows. Buying at record valuations always entails risk.
Keep Snowflake at the top of the watchlist. It’s going to be one of the SaaS leaders in coming years as much of the competition falls by the wayside. But investors buying at today’s price are unlikely to have good returns over the next three-to-five years. That’s not a call on where it trades tomorrow or next week, however there’s a good chance you’ll have a better entry point in coming months. I’m personally looking for a sub-$200 price to open a starter position.
On the date of publication, Ian Bezek held a long position in BRK.B stock.
Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek.