I have decided to change my mind about Snowflake (NYSE:SNOW) stock. I no longer think it’s so wildly overvalued. What changed my mind? The company’s latest quarterly results came out on May 26, showing that Snowflake is now generating free cash flow (FCF). As a result, I suspect that SNOW stock will continue to perform well over the next year.
In my last several articles on SNOW, I argued that its $60 billion-plus market value was probably too high. This was based on analyst estimates that revenue would be just above $1 billion this year. Since then, though, two things have shifted my view.
So, here’s what you should know about Snowflake stock moving forward.
SNOW Stock: Snowflake’s Growth and Solid Q1
For the first quarter, revenue from Snowflake’s data cloud products came in at $213.8 million. However total revenue, including server and other hardware sales, was $228.9 million. This was significantly higher than estimates of $212.9 million for the quarter. But what is important here is the software product growth rate. Why?
First, the product revenue growth rate was 110% year-over-year (YOY). In addition, the $213.8 million in product sales was 19.9% higher than the prior-quarter product sales of $178.3 million. Therefore, this implies that the run-rate product revenue growth rate going forward will be 106.6% on a compounded basis (i.e., 1.199^4 – 1 = 106.6%). This is roughly in line with the respectable 110% YOY rate it just had.
Second, though, the product growth rate gives credence to analysts’ estimates for 2022 sales of $1.8 billion. That is 65% over the low estimate of $1.09 billion in revenue forecast for this year. In fact, total sales of $228.9 million this quarter were 20.19% higher than the $190.45 million in total sales last quarter. That works out to an annual run-rate of 108.7% on a compounded basis, assuming this growth continues.
This also implies that Snowflake could exceed the $1.8 billion estimate for next year, 65% over the present low estimate of $1.09 billion in total sales forecast for 2021. Mike Scarpelli, the CFO of Snowflake, said this about the incoming Q2:
“[W]e expect product revenues between $235 million and $240 million, representing year-over-year growth between 88% and 92%.”
This is in line with the Q1 19.9% product growth. For example, hitting $240 million in Q2 will be 12.25% above Q1’s $213.8 billion product sales. That represents an annualized compound growth rate of 58.8%. This is lower than the YOY rate of 88%, but still represents substantial growth. Basically, it shows that this company is still in high growth mode.
Free Cash Flow on Track
This is not the only reason I like SNOW stock now, however.
The May 26 earning release also indicated that, for the quarter, Snowflake produced $12.9 million in free cash flow (FCF). On an adjusted basis, FCF was $23.4 million for the quarter. This is very significant and helped change my mind about the stock’s valuation.
First, it shows that the company’s adjusted FCF margin is now significant at 10.2% (i.e., $23.4 m / $228.9 m). That margin is bound to grow. In fact, last quarter, Snowflake produced its first positive FCF of $7.3 million and adjusted FCF of $17.3 million.
So, in the past two quarters, this company has made $40.7 million in adjusted FCF on total sales of $419.35 million. That is an FCF margin of 9.7% and shows that the FCF margin is growing as well (i.e., 10.2% now vs. an average 9.7% in the last two quarters).
In fact, we can probably use this to project out FCF in the future and, from that, estimate SNOW’s underlying value.
Valuing SNOW Stock Using FCF
Based on analyst estimates, Snowflake is forecast to hit $4.21 billion in sales by January 2025 and $5.76 billion in sales by January 2026. Therefore, using an estimated 15% FCF margin by then (assuming it grows from 10% to 15% with operating leverage), we can estimate its free cash flow.
For example, by January 2025, total FCF would be $631.5 million (i.e., $4.21 billion x 15%) and $864 million in FCF by January 2026.
The market is effectively assuming this right now. For example, using a 1% FCF yield (which would be typical for such a high-growth stock) the market value works out to $63.15 billion (i.e., $631.5 million / 0.01 = $63.15 billion). With $864 million by January 2026, the market value estimate is $86.4 billion.
SNOW stock had a market value of $67.5 billion at $235.25 per share on May 26. Using that data, it can be projected to rise by as much as 28% over the next four and a half years to January 2026. That puts its target price at about $300 per share (i.e., 1.28 x $235.25).
ROI Estimates For SNOW Stock
Of course, that does not sound particularly stellar at first. A 28% return on investment (ROI) over 4.5 years is nothing to get excited about.
But let’s think this through more carefully. In four and a half years, the stock market will be looking forward to another four and half years of growth from Snowflake. They will not be stuck on my target price of $300. They will be judging growth estimates three to four years in the future.
So, the real return in SNOW stock will be much higher than just its target price of $300 now. I estimate, for example, that SNOW stock could hit the $300 price target within one to two years. That gives it an annual ROI of 20% to 27% — and possibly higher.
On the date of publication, Mark R. Hake did not hold (either directly or indirectly) any position in any of the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.