What We Can Learn From Snowflake’s IPO
Investors drove up Snowflake shares 150% during their first day of trading
There is something awfully familiar about the software company’s initial share offering, except it isn’t 1999.
18 September 2020. Cloud-based data warehouser Snowflake rocked its stock market debut this week, raising $3.4bn in the largest software IPO in market history. The offering, initially priced at $120 per share, had a breathtaking first day run that briefly saw the stock brush $320 before pulling back to close at $260.
The $120 initial share price was available only to institutional buyers and was 50% above the original price target of $75-85 set a few weeks earlier.
That didn’t stop individual investors tumbling over themselves when the shares hit the market. Trading opened at $245 per share and quickly moved higher, giving Snowflake an initial market value of $70bn and vaulting it past many of the S&P500’s largest companies, including Colgate Palmolive ($66bn), Goldman Sachs ($69bn) and General Electric ($59bn).
The IPO drew comparisons to the frothy dotcom days of 1999, when tech shares routinely skyrocketed on their first day of trading, only to quickly fall back and leave retail investors worse off than if they had waited for the hysteria to susbide.
A Startup With A Strong Start
Unlike the IPOs of yore, Snowflake isn’t an unknown startup flogging a dud product with no revenues. The cloud-based software provider is fast becoming a major force in the data warehousing market with its more flexible platform and better pricing than competitors. Snowflake has ramped up sales with lucrative clients and results are impressive: Year-over-year sales jumped 173% in the latest fiscal year ending 31 January 2020, from $97mn to $265mn, and increased 133% in the first six months of 2021, from $101mn to $242mn, compared to the same period in 2020.
Snowflake also scores points for its customer retention rate, a key metric in the tech world which is notorious for low levels of loyalty. The company boasts a net retention rate of 158%, the highest for any cloud company at the time of its IPO, including Zoom Video and Crowdstrike.
That’s the good news. Now for the worrisome: Snowflake’s momentum masks some pretty humbling financials, especially compared to more established software companies with solid earnings under their belts. Make that any earnings at all. Snowflake has yet to turn a profit and chances are it won’t do so anytime soon. The company posted losses of just under $350mn for 2020 and a loss of $171mn for the first half of 2021. That’s slightly better than a year ago, when losses were $177mn for the first half of 2020, but it’s clear Snowflake has a lot of work ahead.
Negative earnings are the norm in the tech world, especially in the early years when the company is gunning for growth with high levels of spending on marketing and customer retention. In Snowflake’s case, its losses only intensify the spotlight on what, exactly, is driving investors’ fervor in the software maker’s future that makes it worth the risk right now.
And that’s where things get murky. Launched in 2012, Snowflake is not a newcomer to the Silicon Valley investment scene. The company has already raised $1.4bn through several rounds of venture capital funding. Its new CEO, Frank Slootman, is an IPO veteran, having led two software companies through the public offering process, first at DataDomain and then with cloud servicer ServiceNow.
The Not So New Kid On The Block
Slootman’s predecessor, Bob Muglia, was responsible for growing Snowflake from 80 customers to more than 3,000, with 146 of the Fortune500 among its clients. Those are some promising figures and all, but are they really worthy of a $70bn valuation? Snowflake has a massive task ahead if it is to fulfill the expectations inherent in its current stock price, let alone any future price growth. After all, investors don’t buy tech shares in hopes the company’s stock moves sideways for years to come.
The trouble for investors in IPOs like Snowflake’s is the company’s growth trajectory is front-ended, with the bulk of revenue and customer growth occurring in the early years. There are exceptions (Amazon, Google), but none has been in the business of data software. Snowflake offers a unique platform that seamlessly combines different cloud data warehouses, but it’s still dependent on those underlying providers. In other words, Snowflake’s role in the cloud warehousing space is not guaranteed, and there are risks of one or more of its competitors raising the bar with its own products or slashing costs which would put pressure on Snowflake’s pricing and margins. With so much growth already priced into the shares, Snowflake needs to keep packing a revenue punch even when it comes under competitive pressure in the future.
IPO Investing: Day One Spells Trouble
People go nuts for tech IPOs, especially the highly anticipated ‘unicorn’ offerings (when the startup is valued above $1bn) like Snowflake. I’m genuinely not sure why. As investment opportunities go, they’re rarely a sure winner, especially for individual investors that pay a significant premium to the offering price, and especially when they buy the shares on the first day of trading.
Even Amazon finished its first day of trading back in 1997 near its $18 offering price before dropping even lower in the days that followed. It took nearly two months to claw its way back to its first-day high. Sure, Amazon has since risen more than 120,000% over the past 25 years, and $1,000 of AMZN at $18 per share would be worth more than $1.2mn today. But Snowflake is hardly the fledgling bookstore startup being run out of Jeff Bezo’s garage.
If there’s any takeaway for investors from Snowflake’s stock debut, it’s: Wait. Be it a day or a week, a month, or longer. Jumping into a new share on the first day and paying a premium to the company’s own valuation is like taking on additional risk with no reward.
SNOW: Breaking Down The Stock’s Price
If, like me, you get frustrated reading about IPOs that are delivering jackpot returns on their shares, take a moment to check if the figures are based on the stock’s initial price or the one that was actually available to retail investors. The price at which the company raised capital - the initial price - can be very different from the price normal investors pay when the shares begin trading in the market, which can in turn can have a massive impact on those fabulous reported returns.
In Snowflake’s case, the share began trading at more than double the initial price, at $245. Within the first minute it had risen to $269.50, according to Robinhood; on E*Trade it was higher at $275.22. Those prices are so bulked up with layers of premiums, none of which add any actual value to the shares themselves:
The 50% increase in share price value from $75 to $120 prior to the IPO;
The trading price premium above the issue price from $120 to $245; and
The retail broker premium paid by small investors from $245 to $275.22.
The investor who paid $275.22 bought the same exact slice of the Snowflake pie as the one that paid $120, in the same company on the same day with the same growth prospects. I don’t know about you, but that doesn’t sound like a fantastic deal on any level, regardless if Snowflake is a great company or not. If a hotel offered me a rate that was 150% higher than what others were paying, I’d find another place to stay. Shopping for stocks is no different; savvy investors need to buy shares with the same scrutiny as any other purchase.
A Tale Of Two Investments
Warren Buffett’s stake in the Snowflake IPO was a well publicized curiosity of the deal, as the Oracle From Omaha is famously anti-IPO and frowns upon companies that haven’t yet turned a profit. Yet Buffett’s stake was not a pure play investment in a promising business so much as a no-brainer arbitrage opportunity to double his money. Buffett’s Berkshire Hathaway paid $120 for shares that were worth $260 by the close of the first day of trading. Warren may not be a fan of unprofitable startups, but he knows a good deal when he sees one, and turning his initial investment of $250mn into $550mn in the space of a few hours isn’t a shabby day at the office. Sadly for us retail investors, the case for buying Snowflake is much different than it is for Buffett: He’s already made more than 100% without having to worry if Snowflake will deliver on its future promises.
Imagine in twelve months’ time SNOW is trading at $340. That’s a return of 184% - but only for investors like Buffett who got in at the initial price of $120. If you bought your shares through Robinhood and paid $269.50, you’d have made 26%. And if you were one of the unlucky buyers who jumped in at the top of the first day of trading at $319, you’d only be up 7%.
The Gap Between Issue And Market Price Is Widening
There is growing concern about the disparity between what institutional investors pay for their initial shares and what normal investors pay when the shares begin trading in the market.
Some critics believe investment banks are purposely underpricing shares and leaving too much capital on the table that winds up lining the pockets of institutional investors who then can sell the shares in the open market for massive profits. Others argue the pricing gap is more the fault of irrational retail investors willing to pay ever-higher premiums for new technology companies.
Back in 2011, the New York Times famously accused the investment banks behind LinkedIn’s IPO for ‘scamming’ the company out of millions by underpricing its shares and selling them at too steep a discount to their networks of institutional investors. The article fueled a vigorous debate among Wall Street pundits, academics and behavioral psychologists about how IPOs are priced, and if there’s any wrongdoing involved. What is clear is investors really do need to do their own homework and ensure they’re not overpaying for shares that may already be too expensive by the time they start trading.
A Final Word
Watching Snowflake shares this week feels akin to shopping for real estate in New York City, where sky-high pricing means buyers need to weigh the current opportunity against the risk of achieving incremental value in a reasonable time frame. Even if a buyer can afford $3mn for a 2BR/2Bath apartment today, will there be a market 5-10 years down the line with buyers willing to spend even more - say, $4mn - for the same apartment? The time frame for making a solid profit in New York real estate is growing longer and longer – and so too with tech shares. The question isn’t if a well-nourished startup like Snowflake has a solid business under its belt (it does) but how long until regular investors can safely realize value at current market prices? If buying new shares in the current market does feel anything like it did back in 1999, the answer isn’t worth waiting around to find out.