Month: December 2022

SentinelOne Q3 Earnings: FCF Positive by Next Year

Posted on by io-fund

SentinelOne had an excellent report minus the fiscal year guide of 50%. The market is likely digesting this, as are we.

The price action on SentinelOne was muted although there were some notable positives from the report. Key items discussed included the company becoming free cash flow positive next year (calendar year 2023) and profitable on an adjusted basis by the following year CY2024. The company beat sizably on adjusted margins.

With that said, the market is digesting lower cloud growth rates across the board, and although SentinelOne has maintained excellent growth this quarter and for next quarter’s guide, the next fiscal year guide is likely what’s causing the flat price action.

The guide at this time is for a baseline of 50% growth, marking a deceleration from 105% growth this year. This technically is a miss from the FY2024 analyst expectations of 64% growth, although “baseline” is vague and the company could meet the original expectations in time.

Other than this, the company beat across the board.

Q3 Financials & Key Metrics

SentinelOne beat on revenue with $115 million reported for growth of 106%. This was a 7% beat.

For next quarter, the company did not budge on guidance, which is likely weighing on the report.

The guide of $125 million met analyst expectations of $124.5 million, yet the market typically wants to see a stronger guide if the current quarter provides a beat.

This shows you how picky the market is becoming as fiscal Q4 guide is 92% which puts SentinelOne at the top of the cloud category as most cloud stocks are guiding for a 30% to 50% deceleration in growth rate, while SentinelOne is guiding for a 10% deceleration.

The company slightly raised full year guidance to $420.5 million for growth of 105%, up from 103.3%.

SentinelOne reported in line with EPS at ($0.35) and beat on adjusted EPS at ($0.16) versus ($0.22).

Gross margins came in as expected with 64% GAAP GM and 71% adjusted GM.

The positive surprise was the adjusted operating margin of (43%) compared to (57%) expected. This compares to (69%) in the year ago quarter. GAAP operating margin of (90%) reflects the high stock based compensation at 40% of revenue. This results in GAAP operating losses of ($104M) and adjusted GAAP operating losses of ($49.5M).

The company reported free cash flow of ($64.7M) and has $1.2 billion on the balance sheet.

Key Metrics:

Net new ARR was in the spotlight because of Crowdstrike which we covered here. SentinelOne reported net new ARR of $49 million compared to the guide for “mid-$50 million.” The company stated the miss was largely due to deals closing in Q4 that normally would have closed in Q3. To back this up, the company is guiding for 20% sequential growth. Crowdstrike guided for a YoY and QoQ decline.

“To be clear, we expect Q4 net new ARR to increase by at least 20% sequentially compared to the third quarter. We believe this is a prudent view and reflects a continuation of the macro headwinds we experienced in Q3, yet we are in a position to deliver a seasonally strong end of the year.”

ARR growth slowed to 106% down from 122% last quarter for $487.4 million. Customers over $100K grew 100% to 827 total, down from 117% last quarter. Total customers grew 55% down from 60% last quarter for 9,250 total customers.

As you’ve likely noticed, ARR tracks very closely to revenue for this company. Management provided a 50% growth rate for ARR next year, which translates to 50% revenue growth.

“Based on a prudent view of the current economic environment and expectations of further macro deceleration, we believe we will deliver at least 50% total ARR growth in fiscal year 2024.”

As noted above, 50% is lower than what analysts had for fiscal year 2024. This is one comment an analyst made:

“Alex Henderson

Great. Thank you so much. You gave a guide — preliminary guide, I guess, is the right way to say it for FY 2024, 50% ARR growth. The question I have for you is really without giving a forecast, can you give us some sense of the way you are thinking about the OpEx spend in that environment, will you still produce at a 50% type growth rate, the same or a similar degree of leverage or do you think the leverage becomes a little bit more muted as a result of the slower growth before the reacceleration?

Dave Bernhardt

We think that the ARR, let’s call it, tentative guidance for next year is really a floor. When I think about it, we believe it’s conservative. We are looking at it as something we can build from. In terms of our OpEx spend, we have always said and you have definitely seen this over the past couple of quarters where we beat by 17% and 14% in terms of operating margins. A lot of our spend is highly elective and we will invest when it makes sense and we will pull back when it doesn’t.”

Additional Notes:

The company provided bold comments regarding profitability and free cash flow, and essentially moved the target up by a year to become FCF positive by the end of next calendar year and adjusted profitability the following year after that (CY2024).

“We are on track to exit fiscal year 2023 with two quarters of about 25 percentage points at the year-over-year operating margin improvement. Continuing this progress forward, we expect another 25 points of operating margin improvement in fiscal year 2024 and our goal is to achieve profitability in fiscal year 2025.”

Here was the question on FCF:

Hamza Fodderwala:

“And then secondly, for Dave, you mentioned, operating profitability in fiscal 2024. I just want to be clear, is that for the full year of fiscal 2024 and would you expect free cash flow breakeven to proceed that by about four quarters? Thank you very much.”

Dave Bernhardt:

“And Hamza, to answer your second question, we have talked about timing of free cash flow, in creating free positive cash flow. We are still expecting that to happen at the end of next fiscal year and then what we are hoping for and really working to achieve is how to get breakeven in fiscal year 2025. So the following year. So we do expect free cash flow to hit before profitability and then those two will be much more mapped together.”

Conclusion:

You’ve probably seen by now that our cloud holdings are being reduced. The thought process around reducing exposure has been outlined going into Q3 when we’ve said a few times the market is nervous that enterprise spend/budgets will be the other shoe to drop. If this is true (I’m a messenger here), then we are at the beginning and not the end of a softer cloud market as Q3 marks the beginning of this new phase of economic slowdown (with phase one being the consumer).

For example, I said here:

“I also want to be a messenger and say that another reason we are seeing strong price activity is that analysts are concerned that enterprise spend will be the next shoe to drop. This concern was expressed across quite a few cloud companies’ earnings calls. The thinking is that enterprise spend will follow consumer spend, (eventually), yet is slower because budgets are cut more slowly and added back more slowly.”

Most of this will become evident when next year’s budgets are transparently disclosed with cloud’s full year guidance. Right now, if we are being real with ourselves, the Q4 guides are shockingly low. What the cloud category is guiding down on growth rates between Q3 and Q4 used to take a year or two (for example, a growth rate decel of 67% to 40% for SNOW or 47% to 26% for MDB — or choose any others, it’s rampant). This level of decel used to take a year or longer and we are now getting a 30% to 50% decel sequentially.

The market is probably due for a bounce (not my department) so we will likely reduce our exposure carefully. Despite what the market does in the near term, the predominant growth trend in cloud — from what I’m seeing – is down. As a category, cloud is providing the biggest decel it’s ever gone through. So, that’s important to not lose sight of.

What does this mean for next fiscal year and will there be a further decel given what we’ve seen from Q4 enterprise budgets?

Of course, we believe companies like SentinelOne, MongoDB, Snowflake, etc, will be around for the next 10 years. But if the trend is down and the growth rates are being slashed, a real recovery in this category will not be on the table until this is reversed.

A Member said on the forum the other day, sometimes it’s better to leave the 20% off the bottom on the table to improve timing on returns. I agree with this because cloud could need the better part of next year to recover and we can easily get back in (knowing that we will be leaving some money on the table).

This discussion is separate from how we go about this as the market has been deep in the red last three days so there may be a better opportunity to reduce exposure than right now.

December Stock Pick: Netflix Setting Up for a Strong 2023

Posted on by io-fund

The I/O Fund built a position in Netflix with real-time trade alerts starting with an entry at $220.71 on August 30th and at $255.08 on November 7th.

After seeing gains of 43.8% from the first entry and gains of 24.4% from the second entry, Knox then trimmed some of the position to take profits.

For our Essentials Members, Knox will release a private video next week that discusses our plan for building this position and/or our plans to take profits in the future. This video will be similar to the information provided above regarding our positioning but will be forward-looking on what entries we plan to do next OR if we plan to trim and add again at a later time.

Below, is a fundamental analysis on Netflix including the specific reason that Q1 and Q2 could be “the quarters” for Netflix to become a stock market darling.

Please note: We are not financial advisors and our disclosure regarding this is at the bottom of the article.

Our goal is to do the following:

  • Provide you with a December stock pick that we believe may be the top stock of 2023. We want to give you information around the specific catalysts we are expecting in Q1 and again in Q2 that has made Netflix a buy off the August lows.
  • We want to provide real investment tools to our Essentials members by providing the same level of technical analysis we use for our portfolio and we use on the Advanced Market Signals service to time entries and exits. This includes allocations (the #1 tool for risk management) and will be provided early next week on a recorded video presented by Knox, the I/O Fund portfolio manager.
  • We do not think blanket BUY recommendations are helpful as the market is tumultuous and complex. We are real investors and everything we do is actionable for stock investors. The material you receive on this site is anchored to real decisions we are making with our own portfolio. If it’s not impactful, we will not write the content or produce the video. This is different than other sites that simply fill content pipelines to “get something out” so their customers are satisfied. This is why we believe we offer some of the highest quality content across research sites — the content is being used for real investment decisions and there is zero fluff.

Background on Netflix in 2022:

Below is a brief overview of Netflix’s ad opportunity before we discuss the specific catalysts coming in Q1 and Q2 of 2023.

Netflix’s stock was down a staggering 71% this year. The stock’s fall from grace included dropping its FAANG-status as the company’s market cap has decreased from $300 billion to $75 billion. This was partly due to the company reporting it lost subscribers for the first time since 2011, with a loss of 200,000 subscribers in the most recent quarter. The company also forecast a decline of 2 million paid subscribers for the second quarter.

The earnings report caused the stock to lose 35% of its value over night. Bill Ackman sold his Netflix shares for a loss of $450 million in three months, with some critics goading him for his decision while others congratulated Pershing Capital for being bold and walking away from a losing position.

Meanwhile, our focus was elsewhere.Meanwhile, our focus was elsewhere.

In our Netflix coverage following its earnings report, we had stated “we can’t help but salivate” over which ad platform Netflix might choose to power ads to hundreds of millions of viewers. Primarily, this is because we have consistently discussed why the trend of CTV ads has plenty of runway even during an epic market selloff.

In other words, I would argue the day that Netflix’s stock price dropped 35% was consequently one of the most important days in the company’s history in terms of its chances for a boost in revenue and a renewed uptrend.

Patience, though, will be required, as Netflix has work to do. We prefer to get in front of the market instead of wait for the market to put the pieces together on what this global juggernaut is setting up to do.

The path to adding more subscribers is finally clear for Netflix and will pay off in 2023 especially during times of inflation or muted consumer confidence as it drives down household costs across fragmented subscriptions.

Ad-Supported Video on Demand (AVOD)

The acronyms AVOD and CTV ads (connected TV) should be added to your investment vocabular as this is the most investable trend in media today. Ad-supported video on demand (AVOD) refers to streaming subscription services that supplement with ads or streaming services that are entirely ad-supported. CTV ads are often synonymous with AVOD, however, it can also refer to Broadcast Video on Demand (BVOD) for when live broadcast content is streamed over the internet.

Mobile ads have flatlined yet AVOD is in its early stages of growth. This will become especially apparent during times of economic hardship as subscribers trim back on their many streaming subscriptions and turn to ad-supported content to drive down costs.

We had written an editorial a year ago on Forbes called the Crucial Difference between Netflix and Roku Stock. At the time, we pointed out that: “we believe first-party data for connected TV ads is a significant trend moving into 2021 and an important distinction from subscription-video on demand (SVOD) […] Ad-Video on Demand (AVOD) has an approximate ten-year runway as the trend began taking shape when Roku launched its ad platform in late 2018/early 2019. There were AVOD players in the space before this, but the budgets were negligible.”

Why was mobile capable of capturing such large budgets? Because of first-party data which traditional TV lacks. CTV ads are also capable of capturing large budgets because advertisers are willing to pay more for targeted ads.

Due to your viewing habits, Netflix knows a lot about you. Selling this to advertisers emulates more closely the level of ad demand a company like Facebook would see, who also powers ads with behavioral-level data.

The Market Mistakenly Thinks Netflix is Saturated

There is immense opportunity when a stock investor can prove the market is wrong about a company. With Netflix, a leading line item that investors must be confident on is that the company can grow its user base.

Source: Nielsen

Netflix is tied with YouTube on total viewing time but there’s a catch. Netflix has only 223 million subscribers and YouTube has over 2 billion due to its digital video app. For most purposes, these two are not truly competitors, rather YouTube is a hybrid between a social mobile app and a CTV streaming service. YouTube TV has a mere 5 million subscribers.

What matters most to advertisers is time spent watching content and Netflix clearly wears the crown in the streaming wars.

Netflix does not believe their market is saturated, rather that advertising opens up a new, sizable addressable market. The company offered the following information: “In the 190 countries in which we operate, our $30 billion-plus of annual revenue is roughly 5% of the combined estimated ~$300 billion pay TV/streaming industry, ~$180 billion branded advertising market, and $130 billion consumers spend annually on gaming. So, we believe that we have a long runway for growth if we can continue to improve our offering steadily over time.”

We had stressed in our previous coverage that the lagging discussion on Netflix is that there was a subscriber decline in Q1 of 200,000, excluding Russia and a subscriber decline of 970,000 in Q2.

While critics believe this is due to saturation, it’s much more likely the decline is coming from a pull forward due to Covid as all media stocks – both streaming and social media – demonstrated outsized audience growth through Q2 2021.

Therefore, Netflix is lapping some tough quarters for audience growth comps and announced in April their plan to have an ad tier to help combat this.

Management’s willingness to combat subscriber falloff with an ad tier is why we entered in August prior to the subscriber beat.

Another important point we had highlighted was there is already evidence that Netflix is taking more market share than its peers. In fact, Nielsen raised Netflix’s market share earlier this year for engagement to 7.7% from 6.6%, which puts Netflix in the lead over any other competing subscription service.

Q3 Netflix Earnings Results:

Netflix comfortably beat earnings estimates with 2.4M net adds compared to 1M to 1.2M expected. Consensus for next quarter was 4.1M with Netflix guiding for 4.5M. This will be the largest account growth since Q3 2021.

Why Q1 is Critical for Netflix’s 2023 Stock Trajectory

There are two chess moves on the table that can help propel Netflix to become a leading stock in 2023. The first is the moment when Netflix simultaneously cuts off password sharing while having the ad-supported tier available to the customers being cut off from sharing accounts.

Netflix has an estimated 100 million rogue subscribers who are sharing passwords with friends and family members. It’s this cohort of 100 million password sharing fans that the ad-supported tier is squarely aimed at converting.

Let’s look at what management has said:

“Finally, we’ve landed on a thoughtful approach to monetize account sharing and we’ll begin rolling this out more broadly starting in early 2023. After listening to consumer feedback, we are going to offer the ability for borrowers to transfer their Netflix profile into their own account, and for sharers to manage their devices more easily and to create sub-accounts (“extra member”), if they want to pay for family or friends. In countries with our lower-priced ad-supported plan, we expect the profile transfer option for borrowers to be especially popular.”

Translation: In early 2023, Netflix is going to cut off the 100 million and offer them two options: 1) pay to be an extra member on the family plan or 2) export your profile, keep your viewing data, and pay for a lower priced ad-supported plan.

Patience from investors is required because Netflix is the first tech company in our universe to report every quarter. Netflix will not have this rolled out for the Q1 guide coming in mid-January but we do believe it will show up by the full quarter Q1 report in April with an informed guide for Q2.

The Second Chess Move is called The Upfront Season

Every year, advertisers and agencies negotiate and sign year-long deals with TV networks as well as connected TV platforms to commit to spend an agreed amount on ads. They call this the upfront season. Last year, NBCUniversal clocked $7 billion in the upfront season and Roku grew it’s upfront spend from$500 million to $1 billion.

The 2023-2024 upfront season will take place in the late Spring and early summer of 2023.

Netflix is a $30 billion company and so something along the lines of a $7 billion upfront may seem small. However, if you go back to the Nielsen pie chart that shows viewing time, you’ll see that NBCUniversal doesn’t even make the list, representing less than 1% of viewing time. Disney makes the list at 1.9% and had a $9 billion upfront season.

I won’t give you an exact number on what this upfront season will pull for Netflix as their AVOD subscriber base will not be mature yet. Meaning, it may be more in the category of the lower percentage streaming services on the ad-supported side. What matters is that even a $7 billion or $9 billion up front (let’s think positive here based on the comps) would result in a 20%+ boost in revenue.

If the two chess moves line up, they will both be a strong statement the market is wrong on Netflix’s saturation. the market is wrong on Netflix’s saturation. 

Netflix is trading a historic low on both its sales valuation and earnings-based valuations. However, is now the time to buy or is it better to wait for a renewed uptrend? We fully believe the single most important time to buy is when the broad market participates (Nasdaq, S&P 500).

Next week, Knox Ridley will record a special Netflix webinar for you as part of your Essentials package going over Netflix’s technical setup in detail so our Essentials Members are as informed as possible.

As you know, we can’t control the market – what we can do is tell you what we do with our money including when we buy/sell/add/trim and why.

Look for that YouTube video published on our Essentials site next week.

Thank you for being a Founding Member to our Essentials Plan. We officially launched the plan last week are excited for this new tier to our analysis.

Disclosure: The I/O Fund conducts research and draws conclusions for the company’s portfolio. We then share that information with our readers and offer real-time trade notifications. This is not a guarantee of a stock’s performance and it is not financial advice. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis. The I/O Fund owns Netflix at time of writing.

Marvell Q3: Putting on Pause Until 2023

Posted on by io-fund

We are going to cut our Marvell position until next year. The company missed across the board on every line item and we think there are stronger horses in the stable (for now).

While I have your attention and before I lose anyone on the mundane numbers: Marvell is an exceptionally strong product story. That is hard to see right now … but it’s a top 5G semi and a top AI semi and has a solid entry into automotive and CXL. By 2024, the words “CXL” will be similar to 2022’s words “silicon carbide” for buzz and stock returns. I’m not wavering on conviction; I’m wavering on timing. Also, per the earnings call, 5G is closer than one might think as Nokia is expanding into India and Marvell is the exclusive infrastructure supplier.

So, Marvell is taking a commercial break in our portfolio and we will be back soon.

Q3 Earnings Report:

The current quarter came in slightly below expectations but the fiscal Q4 guide had a larger, unexpected miss.

Marvell reported revenue of $1.53 billion for growth of 27%. This compares to estimates of $1.56 billion and growth of 28.5%.

For fiscal Q4, Marvell is guiding for revenue of $1.4 billion compared to $1.61 billion expected. This will represent growth of 4.5% down from 20% expected.

GAAP EPS of $0.02 this quarter missed estimates of $0.05-$0.13 that was provided by management. Adjusted EPS of $0.57 was reported compared to $0.59 expected. Adjusted EPS guidance for next quarter at $0.46 missed estimates of $0.61, at the midpoint.

On average, there was a one point miss across the top line and bottom line margins. GAAP gross margin of 50.6% compared to 51.1% guidance. Adjusted gross margin of 64% compared to 65% guidance.

The GAAP operating income of 6.9% compares to 8% expected. The adjusted operating margin of 36.7% compared to 37% guided. This resulted in $105.8 million in GAAP operating income and $561 million in adjusted operating income.

The company has operating cash flow of $411 million and free cash flow of $363 million. There is $723 million on the balance sheet.

Revenue Segments:

Marvell beat/met on data center and carrier infrastructure and missed on enterprise networking and automotive.

  • Data center grew 25% for revenue of $627M compared to 20% growth expected.
  • Carrier infrastructure was in line and grew 26% for revenue of $271M compared to mid-20% growth expected.
  • Enterprise networking missed with growth of 52% for revenue of $376M compared to 70% expected.
  • Consumer declined (2%) compared to (10%) for revenue of $178 million
  • Automotive missed for growth of 26.6% and revenue of $84.2 million compared to 40% growth expected.

Additional Notes:

China greatly impacted Marvell’s guide for next quarter, especially the enterprise networking segment. Per the opening remarks:

“Just to give you a sense of the magnitude of that change, we estimate that our revenue in the fourth quarter from our OEM customers based in China will decrease by over 1/3 compared to the second quarter. We expect revenue from China OEMs will account for less than 10% of our total company revenue in the fourth quarter.”

Despite the beat, storage weighed on the data center segment yet cloud was robust, per management:

“Our storage products, including fiber channel, HDD and SSD, all saw demand decline during the quarter. However, our cloud business continued to grow sequentially, driven by strength in our electro-optics and switch products.”

There is a disappointing guide for data center though for Q4:

“We are seeing the growth rate of the data center end market decelerate and customers have started adjusting their inventory to address the changing demand picture. As a result, for the fourth quarter of fiscal 2023, we are expecting our data center revenue to decline year-over-year approximately in the mid- to high teens on a percentage basis and sequentially decline in the mid-20% range [..] In particular, we are projecting a very large reduction in shipments of our HDD controllers and preamps, as HDD OEMs deal with a broad-based inventory correction.”

Carrier infrastructure is an area where Marvell is likely to positively surprise investors next year. Nokia is beginning to ramp using Marvell’s OCTEON 10 DPU, which we have covered in the past. In addition, Marvell helped pioneer OpenRAN for Layer-1 processing capabilities. Nokia/Vodafone and Samsung/Vodafone are partnering on OpenRAN with Marvell and using the company’s accelerator chip, the OCTEON Fusion processors.

Next quarter, automotive is expected to be strong with 30% YoY growth and mid-20% QoQ growth.

Carrier infrastructure is expected to grow mid-teens next quarter and to grow low single digits sequentially.

Marvell continues to provide clues on when it could possibly become a semiconductor leader again in the market. In addition to CXL ramping at some point next few years, the company also stated: “We expect that our cloud optimized silicon programs will build from the initial ramp that started in the second half of this fiscal year and continue to grow approximately $400 million in aggregate revenue in fiscal 2024 and $800 million in fiscal 2025 […] In addition to our cloud optimized programs, we expect that our 5G products in our automotive business will drive strong year-over-year revenue growth in fiscal 2024. Offsetting this growth to an extent, we expect a few quarters of inventory adjustments in some of our businesses as customers realign their demand.”

My translation: Give Marvell one to three quarters through Q2 of next year at the latest and come back to the stock somewhere in that window.

Marvell also gave us a good gauge on what to expect next year on Big Tech CapEx:

“Matt Murphy 

Yes. Great question. So let me take it from the top. So, first point would be that if you look over the last few years, cloud CapEx has been on fire. It's been growing 30% kind of plus for the last few years. This year, if you look at reports and kind of what we see is probably something in the 15% range for '22 and then it depends on who you talk to, but probably down in the low to mid-single digits or maybe mid-single digits for next year.”

Conclusion:

We will revisit Marvell again sometime next year. To understand why we like the company in the face of lumpy earnings reports, please reference our last deep dive here. Perhaps it’s because I know the stock well at this point, but it’ll be a top pick for us on 5G in the near term. They spoke about Nokia expanding into India, as well as Europe. Given we may see few growth stories next year, Marvell may be one that finds a new growth trajectory from deep telecom pockets. The other segments are also to not be overlooked, especially if the China headwinds clear.

Podcast on Cloud Stocks: Consumption Model Vs. Subscription Model

Posted on by io-fund

In October, I/O Fund CEO and Lead Tech Analyst Beth Kindig joined Jeremy Owens, Tech Editor, and San Francisco Bureau Chief of MarketWatch, on Barron’s Live. They discussed cloud valuations including those that are trading at 2X above Covid lows, what metrics matter when evaluating cloud companies, and what to watch for in upcoming earnings season — including a few comments on ad-tech.Barron’s Live. They discussed cloud valuations including those that are trading at 2X above Covid lows, what metrics matter when evaluating cloud companies, and what to watch for in upcoming earnings season — including a few comments on ad-tech.

Metrics and Valuations

As discussed in the podcast, the FOMC decisions have forced tech investors to look for cloud stocks that are expanding their margins and also have positive free cash flow. If you look at the best-of-breed companies that command the top 10 in valuations, the majority of them are free cash flow positive.

We had discussed with our premium research members back in May in a special report Compartmentalizing Cloud Stocks that “It’s true that cloud is deflationary but it’s also true that cloud can have profitability issues […] cloud is quite resilient in terms of growth, due to being deflationary, but those weak bottom lines may be questioned over time. Cash came easy over the past decade, and as cloud investors, we need to reframe our thinking on what constitutes an attractive cloud stock.”

Free cash flow is emerging as an important metric because cash gets rerated in a rising rate environment. As stated, not only were many cloud companies were not public during the previous rising rate environment of 2017 to late 2018 – but in addition to this, the previous rising rate environment was quite tame and we are currently in a more aggressive rising rate environment.

Along with free cash flow, GAAP operating margins are being closely examined. This has resulted in companies with high stock-based compensations being penalized during earnings.

The takeaway is that a best-of-breed company with a 10X or higher valuation must remain FCF positive or it will immediately lose its category high valuation. Revenue growth alone is not determining the top spots in this category any longer. This may seem obvious at first thought but we have found it’s better to close a stock at a higher valuation if it has contracting margins. 

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The difference between Subscription and Consumption Models

Consumptions models occur in the Big Data and Analytics trend where data storage, processing, and analytic solutions are based on usage rather than on a recurring subscription fee. This trend is becoming popular because with consumption-based pricing model, revenue is uncapped. The consumption billing model does not have a ceiling on revenue, so if customer consumption rises, so does sales. There is what is meant by uncapped revenue potential.

We covered Snowflake’s Consumption Model in January of 2022 when we said in our free newsletter: “While Snowflake uses a “land -and-expand” sales strategy, it also uses a consumption billing model. For instance, Snowflake bills customers based on the amount of data they store and transfer and what resources they use. Accruing revenue based on consumption rather than a ratable subscription model decreases the predictability of quarterly revenue, but it leaves revenue uncapped. This provides revenue upside, because if consumption soars, then so will revenue.”

Some of the drawbacks, however, include the revenue growth being less predictable than subscription revenue. There also isn’t a floor on revenue because if consumption declines, then so will sales. Contracts help protect against this but are often only 1/3 of next 2.5 years of revenue.

The drawbacks were also discussed in the Snowflake’s Consumption Model article in January of 2022, “Another risk is the company’s consumption billing model, which is inherently unpredictable. This can make growth lumpy and some quarters may disappoint the Street. Investors should expect increased volatility in growth from Snowflake in the near term as new customers ramp consumption. However, management does expect revenue growth to smooth and become more predictable in the aggregate as customer consumption scales and matures on the platform.”

The lack of predictability is seen in Snowflake’s earnings history with Q1 earnings reporting revenue growth of 85% YoY to $422.4 million (beat estimates by 2.3%). However, the GAAP EPS missed by $0.02. The management had a hard time convincing the analysts in the earnings call that the company’s revenue was not discretionary and the consumption was lower due to shifting economic circumstances that impacted certain customers, particularly consumer facing cloud companies. 

The company’s CFO, Mike Scarpelli, said in the earnings call, “Consumption patterns may fluctuate from quarter-to-quarter. This variability does not detract from our long-term opportunity. Customer’s overall demand for Snowflake remains unchanged. This is supported by the contractual commitments they are making with us and their longer-term plans for adopting the data cloud across their organization.”

Our update on Q3 cloud earnings will come next week following the last round of cloud earnings reports. We still have MongoDB, Zscaler and SentinelOne to report, among others. However, we are still seeing variability with Snowflake’s growth rate as the company reported 67% growth in Q3 and guided for 50% product revenue growth in Q4. Due to beingn consumption based, this variability will be to the upside when economic conditions improve.

In the podcast, we also discussed how net retention rates are often higher for consumption models as spending ramps over time and is uncapped. It’s easier to re-accelerate here for that reason and it’s not the best apples-to-apples comparison for subscription NRR. The net retention rates for subscription-based companies are in the range of 130-140 range while Snowflake has remained in the 170 range. The recent Q3 net retention rate is 165.

Another metric often heavily relied on to predict slowing or accelerating revenue is the remaining performance obligation (RPO). When customers sign onto the platform, they purchase consumption at specified prices, which gets recorded as remaining performance obligations (RPO). These contracts are for about 2.5 years. Although these key metrics are important, as mentioned earlier, what the market will reward or penalize most in a rising rate environment are operating margins and free cash flow. 

Over the last two weeks, we've been discussing the broad market on our premium site where we hedge with ETFs with real-time trade alerts provided. Become a premium member to unlock real-time trade notifications on every entry and exit.Over the last two weeks, we've been discussing the broad market on our premium site where we hedge with ETFs with real-time trade alerts provided. Become a premium member to unlock real-time trade notifications on every entry and exit.premium site where we hedge with ETFs with real-time trade alerts provided. Become a premium member to unlock real-time trade notifications on every entry and exit.

Ad-tech opportunity

In the interview, Jeremy Owens reminds me that I was the first person to warn him about how the Apple’s IDFA changes that would negatively impact Facebook’s revenue many years ago. It was a bold call at the time because I called the top for Facebook when it was a stock market darling in 2018. Despite the odds, it turned out to be accurate.

We discuss how ad-tech stocks are trading at historically low valuations with many 50% lower than where they have traded during times of economic uncertainty. The share prices of these ad-tech companies can grow over 100%. When the market senses a bottom is in — which I believe was either Q2 or will be Q3 — buyers will step back in to support higher valuations. 

We discuss why CTV ads is the most investable trend in media right now.

Note: as we’ve gotten more earnings reports, it appears the bottom is more likely to occur in 2023. We will be monitoring this and update you as we go along.

What to look in the upcoming Q3 earnings season

The podcast was recorded prior to Q3 earnings, and next week, we will reflect back on the takeaways following cloud earnings. Sign up for our free newsletter here.

Microsoft’s results are to be closely watched since the company is a bellwether for Cloud. Its suite of Cloud products drives down costs and it’s the most insulated cloud company. It benefits from cloud migrations and also the need for organizations to reduce costs.

Analysts in the earnings call are concerned that the enterprise sector is the next shoe to drop following consumers. The consumer cycle is very short, whereas for Enterprises, it depends on the renewal cycle and there is a period of negotiation. In addition to constrained enterprise budgets, many startups are not able to raise funding and are going out of business, which can weigh on cloud, as collectively startups are a sizable customer for cloud companies.

The cybersecurity sector has reported exceptional fundamentals given the economic headwinds. Many companies have been reporting high growth rates and are cash flow positive. This sector also has no exposure to discretionary spending, which will help the category sustain long-term.

For cybersecurity, we have earnings reports next week and the recap will be included in our free newsletter.

Bargain Cloud Stocks

Cloud valuations are trading very low and our analysis next week dives into forward fiscal year estimates and why 2023 is likely to provide returns for growth investors who find quality cloud stocks right now.

Snowflake Q3 Earnings Report: Bold FY2024 Guide

Posted on by io-fund

The stock initially sold off about (13%) on lower product revenue, which went from 67% reported in Q3 to a guide in Q4 of 49% to 50%. This implies total revenue will follow as the two are closely related with product revenue making up 94% of total revenue. Technically, the product revenue guide implies a miss for Q4 as estimates were for 52.78% growth.

On the call, the stock regained some ground to finish at (6%) AH once management stated the full year 2024 product revenue would be 47%. Technically, this is also a miss as analysts had the number at 51% growth.

I'm not confident SNOW can resist further decel throughout FY2024; that's a bold guide with little to back it up.

It requires a lot of faith in management because they are essentially saying even though Q3 to Q4 dropped by 17% on product revenue growth (67% to 50%), they will only see a 3% drop for the following four quarters or an average decel of less than 1%.

It's also odd to get a FY guide right now as I looked at Q3 2022 call and it was not provided at that time. Yet, we are in even more uncertain macro backdrop than last year.

My concern is if the guide was intentionally provided to soften the blow for Q4’s product revenue meanwhile management has zero visibility to provide reliable guidance of this kind. I bring up zero visibility because at one point, management admitted to not having enough visibility to know how RPO will turn out for Q4, and yet they’re guiding early on FY2024 revenue.

The Q4 guide of 50% is only acceptable if there is no further decel. Otherwise, analysts will model a lower FY2024 and that would have hurt the price quite a bit. The motivation here is clear to me (give a full year guide that implies no deceleration) but how realistic is this? I discuss my thoughts in more detail below under Additional Notes.

Snowflake Financials Overview:

Snowflake beat on product revenue in Q3 with revenue of $522.8 million, and growth of 67%. Management had guided for $502.5 million, at the midpoint. Total revenue tracks in line with product revenue for revenue of $557 million and growth of 67%.

I’ve got a miss on Q4 in my notes as the product revenue growth of 49% to 50% will cause total revenue to fall short of estimates at 53.4%. MarketWatch also confirmed this is miss on product revenue with management guiding for $537.5 million at the midpoint while analysts were expecting $553 million.

The full year is in line with management guiding for $1.91 to $1.92 billion in product revenue, compared to analyst expectations of $1.92 for growth of 68%. Total revenue for the fiscal year is expected to be $2.04 billion for growth of 68%.

GAAP EPS was in line at ($0.63) although this is steeper than the ($0.51) EPS in Q3 last year. The adjusted EPS of $0.11 beat estimates of $0.04.

There were no surprises with the gross margins, GAAP and adjusted GM across total revenue and product revenue were all in line.

GAAP operating margin of (37%) was better than previous quarters. Adjusted operating margin of 8% was also better than previous quarters and came in higher than the 2% guidance offered by management.

GAAP net margin of (36%) was also better than previous quarters.

Snowflake silences the debate on if stock-based compensation affects stock price. The company paid SBC of $229 million in the most recent quarter, or 43.8% of revenue. Yet, the market overlooks this high SBC margin and Snowflake trades at the highest valuation in the cloud universe.

Key Metrics:

RPO was in line at $3 billion with a slight acceleration from last quarter, at $2.7 billion. As stated on the forum prior to the earnings report, “For Snowflake, the market has accepted flat sequential growth on RPO as it really comes down to Q4 for Snowflake — this is where the majority of RPO growth happens sequentially. Last year, the company had sequential Q3-Q4 RPO growth of 30%.”

Net retention rate of 165% is lower than 171% reported last quarter but still a category leading number.

Within customer growth, Global 2K customers accelerated from 15% last quarter to 18% this quarter. The customers with TTM > $ 1million decelerated although still healthy at 94% growth.

Total customer growth was at 34% compared to 36% growth last quarter.

Additional Notes:

My contention is that with the 51% growth estimates — and now management’s guide for 47% — this assumes consistent consumption as we move into a possible recession.

The estimates pictured above help to reveal how little variation there is built into throughout FY204 estimates, and yet this year has shown us Snowflake is capable of wide variability. There are some flat quarters, such as Q1 to Q2, but inevitably there was a strong decel and it’ll require serious trust in management to assume no further material decel from Q4.

Here is what was discussed in the call:

“Sanjit Singh

This is Sanjit Singh for Keith. I wanted to go back, Mike, to some of the guidance framework that you laid out for us, particularly with respect to fiscal year '24, I think you talked about 47% growth. Is there any way you can sort of draw the bridge for us in terms of next quarter you're guiding to think about 49% at the high end; and then for the full year next year, approximately 47%. What sort of gives you the confidence that your Q4 exit growth rate is going to be durable going into next year?

Mike Scarpelli

Sure. Well, I'll say Q4 is — it is a quarter that has a lot of holidays in it, and we do think we've lived through COVID that people are traveling more. There is a big human component as well, too. So we all along have been forecasting that Q4, we'd see the impact of that, but we also have a number of significant customers that we have signed up, that we see them ramping up next year on Snowflake as well as some of the things we're doing with Snowpark with Python, we're starting to see traction in that as well, too. But we think that's going to be more of a 2024 impact.”

Product revenue is expected to grow 3% between Q3 and Q4. Last year, it grew 15.3% sequentially. So, even with the holidays being in Q4, the slowdown is much more prevalent this year than last year’s comps.

Notably, we covered Snowpark with Python last quarter and agree it’s a strong offering that investors should pay attention to. General availability went live Nov 7th.

There was a moment that Snowflake discussed October being weaker than expected, which further complicates a bold FY2024 guide.

“Gregg Moskowitz 

Congratulations on delivering very healthy product revenue in this environment. My question relates to Q4, where obviously the product revenue guidance was below where consensus was. And I'm curious, how much of this Mike is a reflection of a moderation in consumption in the month of November or over the last six weeks, as you said, in APJ and across the SMB as opposed to embedding more conservatism amid the existing macro uncertainty. Would you say it's tilted more towards one versus the other?

Mike Scarpelli

Well, the way we do our forecast is based upon historical performance, and we definitely did see a slowdown in the month of October, not that dramatic, but we typically would see week-over-week growth and we saw a number of weeks where it was pretty flat. I will say November is starting to tick back up again, and that's all factored into the guidance given the macro backdrop we have right now.”

Conclusion:

Thankfully Snowflake is not down 20%+ right now like many of its cloud peers. Yet, I can’t quite get comfortable with the FY2024 guide as it assumes no further decel from a company that decelerated quite a bit from the last year’s Q4.

As you saw today, we are not looking to go to the river with a stock that is priced 30% higher than its peers in a cloud-conscious market and that has now provided a guide that is hard to believe. Snowflake is capable of exuberant price action so we will us technicals for entries and exits.