Traders who comply with data-software firm Snowflake (SNOW 1.52%) are seemingly nicely conscious of two information. First, the inventory has an expensive valuation. Second, it is a high-quality enterprise that seemingly warrants a point of expensive valuation.

I acknowledge that calling an organization like Snowflake high-quality is considerably subjective. Nevertheless, I imagine an goal power of the corporate is its capability to generate free money move. 

In its 2023 fiscal 12 months (which resulted in January), Snowflake transformed 24% of its income into free money move — few firms have a greater margin. This could possibly be one of many elements supporting the inventory’s valuation proper now. And for this reason I imagine it is necessary for traders to grasp why its free money move may drop in its fiscal 2024.

Why Snowflake’s free money move may go down

Talking on the Morgan Stanley Expertise, Media & Telecom Convention, Snowflake CFO Mike Scarpelli mentioned that greater than 80% of Snowflake’s prospects pay their payments yearly as an alternative of quarterly or month-to-month, despite the fact that the latter two prospects are choices.

When this occurs for Snowflake or different firms, it is generally known as deferred income. The corporate bodily has the cash however has but to ship the promised service. Due to this fact, it is not counted as income instantly. However it does instantly present up on the cash-flow assertion and offers a brief increase.

The chart under gives a transparent demonstration. Whereas its income is climbing at a steadier tempo, Snowflake’s free money move is lumpy. And the spikes are the results of when its prospects are inclined to pay for Snowflake’s companies.

SNOW Income (Quarterly) knowledge by YCharts

Within the fourth quarter of its fiscal 2023, Snowflake had deferred income of $468 million, an enormous 16% year-over-year leap. And this leap in deferred income was a contributing consider its free-cash-flow margin of 35% in This fall — considerably increased than its 24% margin for the 12 months.

Circling again to Scarpelli’s feedback, the CFO believes this cash-flow dynamic may go the opposite approach within the coming 12 months for a easy motive: rates of interest. Briefly, firms can earn curiosity on their money at a lot increased charges than they may earlier than, which could give them an incentive to carry on to it for longer.

Efficient Federal Funds Price knowledge by YCharts

Due to this fact, Snowflake’s prospects may change their conduct, shifting from paying for a complete 12 months up entrance and opting to as an alternative pay in smaller increments. And if there’s a big sufficient drop within the firm’s deferred income, that might seemingly end in a lower of free money move — however do not panic with out studying on.

Why traders ought to and should not care

The problem I am describing is a non-issue for long-term, buy-and-hold traders of Snowflake. It makes little distinction when the cash is available in, so long as it is available in. Due to this fact, it is extra necessary to take a look at the variety of prospects that it has and the way a lot they’re spending over time. For what it is price, these metrics nonetheless look fairly robust. 

Furthermore, Snowflake’s deferred income is not the motive it’s free-cash-flow optimistic. Quite, deferred income merely accounts for a few of the fluctuations within the firm’s free-cash-flow margin from quarter to quarter. However structurally, Snowflake has fast income progress, a excessive gross margin of 65% in fiscal 2023, and administration retains money bills low sufficient to have optimistic money from operations. All of those basic issues contribute to Snowflake’s free money move and are not affected by the timing of collections.

Briefly, if Snowflake’s free money move drops due to a change in buyer conduct, the scenario must be momentary and can easy out as the brand new cost conduct turns into the norm. 

The issue, nonetheless, is many traders fail to learn previous the headlines of earnings experiences. If Snowflake experiences a steep drop in free money move within the coming 12 months, it could lead on some to wrongly believing the corporate’s margins are falling aside just because they did not dig deeper. 

As talked about, Snowflake inventory trades at a premium valuation. For example, its price-to-free-cash-flow valuation is round 90 — fairly expensive and indicative of the market’s notion of the standard of Snowflake.

SNOW Value to Free Money Move knowledge by YCharts

I imagine it could be irrational to promote Snowflake inventory for modifications in when its prospects are paying their payments. However the market is usually irrational, which creates nice shopping for alternatives for extra stage heads. And though it is from sure, this complete situation may create such a chance for Snowflake inventory.

I personally imagine Snowflake inventory is overvalued, and I am blissful to attend for a less expensive worth at which the valuation is smart to me. Nevertheless, I readily concede it is a high-quality enterprise, and I can respect why some have already invested. For present shareholders, the above situation would current a chance to dollar-cost common by including to their positions.