Snowflake Stock Just Soared, but Investors Shouldn't Ignore This Red Flag

Snowflake (NYSE: SNOW), the data warehousing specialist, has traded like a typical software-as-a-service (SaaS) stock since its initial public offering in 2020. The stock soared out of the gate, delivering massive growth at a sky-high valuation as businesses turned to software solutions due to the needs of the pandemic era and as investors bid up any stock delivering rapid growth back then.

Like the rest of the tech sector, Snowflake stock then plunged in 2022 on concerns about slowing growth and a recession, and the stock has essentially traded sideways since then. You can see its history in the chart.

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SNOW data by YCharts

The cloud software stock jumped to a 52-week high on Thursday after it delivered some good news in its first-quarter earnings report. Revenue jumped 26% to $1.04 billion, maintaining its growth rate from the previous quarter, and was ahead of estimates at $1.01 billion. On the bottom line, adjusted earnings per share jumped from $0.16 to $0.26, beating estimates at $0.21.

Other growth metrics were strong, too, as the company reported a net revenue retention rate of 124%, meaning existing customers increased their spending by 24 percent over the last four quarters. Total customers rose 19% to 11,578, and it now has 606 customers with over $1 million in annual product revenue, up 27% from the year before.

For the full year, the company expects similar revenue growth of 25% with product revenue, which makes up nearly all total revenue, reaching $4.325 billion. It also guided to an adjusted operating margin of 8% and adjusted free cash flow margin of 25%, but those numbers deserve closer scrutiny.

Image source: Getty Images.

A free cash flow problem

Like many software stocks, Snowflake spends a lot of its revenue on share-based compensation. In the first quarter, the company spent $408.7 million on stock-based compensation, or more than 40% of its revenue, which is high even for an SaaS company. That compensation gets backed out of both free cash flow and adjusted profits to make Snowflake look profitable, even though it reported a generally accepted accounting principles (GAAP) net loss of $430 million in the quarter.

While excessive spending on share-based compensation isn't unusual for a software company, what is notable about Snowflake's cash management is that it spends heavily on stock buybacks as well, presumably to offset the effect of the stock-based compensation.

In the first quarter, the company repurchased $490.6 million in stock, the equivalent of nearly half of its revenue. Typically, such an aggressive buyback would be reserved for a mature, highly profitable company whose stock is cheap. Snowflake is none of those things. Management may believe the stock is undervalued, as it's been repurchasing stock in most quarters since the board of directors made its first share repurchase authorization in February 2023.

However, according to any reasonable metric, Snowflake is an expensive stock and shouldn't be spending half of its revenue on share buybacks. The stock trades at a price-to-sales ratio of 16, and it's still deeply unprofitable on a GAAP basis. Even ignoring the share buybacks, it still trades at a price-to-free cash flow multiple of 70.

Snowflake took on $2.3 billion in debt last year, and it will have to keep borrowing if it wishes to continue spending on share buybacks at this level.

Know what you're buying

The upshot of Snowflake's financial shenanigans is that the company is losing gobs of cash just to keep its share count flat, and it's deeply unprofitable on a GAAP basis.

Snowflake touted a bright future in the artificial intelligence (AI) cloud on its earnings call, but 25% revenue growth isn't enough to justify burning half of your revenue on buybacks, especially at a time when consumer and business sentiment is rapidly weakening, and a recession could be around the corner.

Snowflake is on an unsustainable path, and investors should be wary of its current approach to cash.

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Jeremy Bowman has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Snowflake. The Motley Fool has a disclosure policy.