Despite a fiercely competitive enterprise software market, and a massive pivot to artificial intelligence (AI)-powered work, Snowflake's (SNOW 0.88%) reputation as a high-growth business has been durable. The data platform exceeded expectations for the first quarter of fiscal 2025 (the three months ended in April 2024), with product revenue increasing 34% year over year (guidance was for just 26% to 27% growth). Management also raised guidance for the full fiscal year, with product revenue now expected to be up 24% (from 22%).
Nevertheless, there were reasons for caution in this last report. The cost of software business growth is rising during this new AI arms race, with most of the financial benefits flowing to Nvidia right now. I was cautiously optimistic about finally nibbling on Snowflake three months ago. But I'm quickly changing my mind.
The cost of keeping up with the Jones AIs
Snowflake's most recent quarterly revenue beat and raise to its full-year guidance were good indicators that the software market has indeed stabilized from a big slowdown in 2023. Granted, Snowflake's expected product growth rate of 24% for this current year is still a slowdown from 38% last year. But that's to be expected for a company now hauling in well over $3 billion in annualized sales.
However, below the headline financial figure, another more important story is simmering. In this new era of AI, enterprise software companies are being squeezed from a new direction: the cost of buying Nvidia's GPU-powered AI systems.
Snowflake CFO Michael Scarpelli said this on the last earnings call:
We are lowering our full year margin guidance in light of increased GPU-related costs related to our AI initiatives. We are operating in a rapidly evolving market, and we view these investments as key to unlocking additional revenue opportunities in the future. As a reminder, we have GPU-related costs in both cost of revenue and R&D.
Specifically, Snowflake has a number of needs for Nvidia's hardware. Snowflake needs these systems for training and optimizing new AI services, like the launch of Cortex (an AI assistant for users of big data), Arctic LLM (a large-language model), and Snowpark (announced last summer with Nvidia).
In all, spending on these Nvidia GPU systems is going up, which means Snowflake had to lower its guidance for adjusted operating profit and free-cash-flow profit margins for this year. Management now expects an adjusted operating margin of 3% for this year (6% was the guidance before), and a free-cash-flow margin of 26% (29% before).
More patience required
Slowing revenue and declining profit margins -- even if adjusted and free-cash-flow profits in absolute dollar terms are going up -- isn't a great combination in this market. As a result of the updated guidance, Snowflake stock is little changed from where it has been in recent months.
In the meantime, there are other software stocks that do have the right winning combination of growth and rising profit margins. I'm starting to feel I may have jumped the gun on buying a little bit of Snowflake stock a few months ago. Shares trade for a premium of 6 times trailing-12-month free cash flow as of this writing. More patience will be required as the company looks to fire up a new round of AI-powered data management software innovation.
It seems the same story is continuing, much as it has since the Snowflake IPO back in 2020. The company is simply valued too richly for investors' collective taste right now. Perhaps when signs emerge that profit margins are rising again, the narrative will shift.
