This Former Warren Buffett AI Stock Was a Market Darling in 2020, but Is Down 50% Today. Should Investors Buy the Dip?

Multibillionaire and legendary investor Warren Buffett isn't known as a fan of technology stocks. But even he couldn't resist getting in on Snowflake (NYSE: SNOW) when the company went public in 2020 as one of the hottest IPOs in recent history.

The cloud-based data warehouse platform was considered an obvious home run at the time in a world deep into the cloud era, with artificial intelligence (AI) enthusiasm growing and an AI revolution right around the corner.

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However, the stock has been a massive letdown. Approaching five years since its IPO, Snowflake stock trades down about 50% from its all-time high, and Buffett, who invested in the IPO via Berkshire Hathaway, has moved on, selling Berkshire's entire stake in Snowflake last year.

Why did Snowflake stumble, and should investors buy the dip with AI stocks front and center today like never before? Here is what you need to know.

Image source: Getty Images.

Snowflake grew fast, but the enthusiasm for it got overheated

Data is at the heart of most modern software, even AI, which gets its intelligence from training on vast amounts of data. Many companies store their data in various information silos or isolated software platforms that might not be compatible with each other.

Snowflake's agnostic cloud-based data warehouse platform combines all of that disparate data, stores it securely, and allows customers to query this data, combine it, or even introduce third-party data from its marketplace. Companies can get more value from their data when it's clean, organized, and easily accessible.

Such a narrative makes Snowflake seem like an obvious winner. So, why haven't things worked out for shareholders?

Snowflake's problems largely stem from the stock's initial valuation following its IPO. The stock's price-to-sales (P/S) ratio peaked at a mind-blowing 183, but the company was growing sales so fast that the market didn't care. It didn't help that the Federal Reserve's zero-percent interest rate policy was inflating a market bubble at the time, making it easy for the company to borrow money and grow fast (perhaps faster than its market could support).

Then, Snowflake's performance stumbled. Its primary competitor, Databricks, thrived, and interest rates skyrocketed to slow inflation, causing many of Snowflake's customers to tighten their wallets. Snowflake's growth slowed, and the stock price melted under the heat of its overheated valuation.

The story is still good, but there are still warts

Buffett gave up on Snowflake last year, but the company's long-term story is still quite compelling.

Data is central to AI now and in the future, and it's created exponentially. Snowflake's business is unique because its usage-based billing builds growth into the model. That's why, despite the mishaps, Snowflake's net revenue retention is an impressive 124%.

The P/S ratio is also down to about 17 today, which isn't a bargain, but it's at least on par with many other fast-growing tech stocks.

But things aren't perfect, either. The primary concern is Snowflake's unprofitability and whether investors can hope to see profits anytime soon. The company generates free cash flow, so sustaining the business is not a concern.

No, the problem is Snowflake's excessive stock-based compensation, which boosts cash flow, but shows in the company's net losses, which are steepening as the business grows:

Data by YCharts.

It's troubling that Snowflake's stock-based compensation is nearly 40% of revenue, almost five years after its IPO. The resulting share dilution means Snowflake has paid employees at the shareholders' expense.

Will Snowflake finally realize its potential? Here is how to approach the stock

The steepening net losses are also an issue because growth has continually slowed, to just 26% year over year last quarter. It would be different if net losses were shrinking as revenue grew, but they aren't. Steepening losses and slowing revenue growth are a bad combination.

Perhaps Buffett was on to something when Berkshire sold its stake in the company last summer. I wouldn't dismiss Snowflake over the long term, because the growth opportunities in cloud-based data management are too enticing to ignore in the AI era.

However, Snowflake has failed to translate that into profitable growth, making the stock difficult to buy right now. Investors would probably be wise to, like Buffett, stay away until Snowflake's financials head in the right direction.

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Justin Pope has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway and Snowflake. The Motley Fool has a disclosure policy.