The quality of SNOW's free cash flow

earslookin · June 7, 2022, 8:52am

From Snowflake’s (SNOW) annual report for 2022:

Free Cash Flow We define free cash flow, a non-GAAP financial measure, as GAAP net cash provided by (used in) operating activities reduced by purchases of property and equipment and capitalized internal-use software development costs. We believe information regarding free cash flow provides useful supplemental information to investors because it is an indicator of the strength and performance of our core business operations. The following table presents a reconciliation of free cash flow to net cash provided by (used in) operating activities, the most directly comparable financial measure calculated in accordance with GAAP, for the periods presented (in millions): Fiscal Year Ended January 31, 2022 2021 2020 ----- ----- ------ Net cash provided by (used in) operating activities 110.2 -45.4 -176.6 Less: purchases of property and equipment -16.2 -35.0 -18.6 Less: capitalized internal-use software development costs -12.8 -5.3 -4.3 ----- ----- ------ Free cash flow (non-GAAP) 81.2 -85.7 -199.4
--------------------------

Management at SNOW considers free cash flow a key indicator. They claim it illustrates the
power of their core business operations. Free cash flow, as defined by SNOW, has not only
turned positive in 2022, but has been rapidly rising the last three years. SNOW’s free cash
flow paints a rosy picture of performance!

But what happens if we drill down into the quality of the operating cash flows that contribute
to free cash flow? To judge quality, I look at least two things: are there any claims on the cash
flow and is the cash flow sustainable? Let’s break out SNOW’s cash flows in the operating section
of the Cash Flow Statement in a bit more detail.

					
                                                           Fiscal Year Ended January 31,
                                                              2022     2021      2020
                                                             -----    -----    ------
Net Loss                                                    -679.9   -539.1    -348.5
Plus: Stock Based Compensation                               605.1    301.4      78.4
Plus: Deferred Revenue                                       526.2    312.9     223.0
Less: Other Adjustments                                     -341.2   -120.6    -129.4
                                                             -----    -----    ------
Net cash provided by (used in) operating activities          110.2    -45.4    -176.6

Less: purchases of property and equipment                    -16.2    -35.0     -18.6
Less: capitalized internal-use software development costs    -12.8     -5.3      -4.3
                                                             -----    -----    ------
Free cash flow (non-GAAP)                                     81.2    -85.7    -199.4

Clearly the elephant in this free cash flow room is the explosive growth of Stock Based
Compensation (SBC). In fiscal year 2022, SNOW’s SBC was roughly 50% of revenues. To put
that in perspective, a survey in 2020 of the 1,000 largest US companies found that SBC
ranged from 1-15% of revenues. A 2020 survey of strictly SaaS companies found that SBC
ranged from 8-20%. SNOW is an overachiever when it comes to SBC.

SBC can be thought of as one number that combines two activities: an operating activity
where an employee provides a service to the company and a financing activity where the
employee buys shares or is given shares of the company in return for that service. SBC
is an estimate of the value of these transactions. It’s a promise to pay. An IOU. Which
means this cash flow is not really “free”.

It’s also not sustainable. To significantly increase free cash flow in future years,
SNOW would have to issue even greater amounts of SBC as a percent of revenue. SBC also
depends on the price of the stock. In a down market or if the multiple deflates, SBC
becomes a less attractive incentive for employees, and may decline as a percent of
revenue.

For a groundbreaking analysis of SBC, cash flows, and inflated valuations, see
https://www.cii.org/files/events/2020/Stock%20Compensation%2…

CONCLUSION

I’ve argued here that SNOW’s free cash flow is of poor quality because of the issues
with SBC. I didn’t even touch on the other elephant – Deferred Revenue – which has
problems of its own. Which means SNOW’s free cash flow number is suspect and multiples
based on its free cash flow may mean it’s overinflated. That’s enough to keep me out.
Even if I were right, however, so what? It may take the rest of the world a REALLY long
time to agree! Thus, SNOW may make a very lucrative investment for some.

Ears

kelbon · June 7, 2022, 5:44pm

Which means SNOW’s free cash flow number is suspect and multiples
based on its free cash flow may mean it’s overinflated.

For all the contortions SNOW has gone through with its cash flow reporting — and I completely agree with your take; recently I expressed my displeasure with how stock based compensation is expressed on the cash flow statement — stock price to free cash flow is just one of many measures investors look at to determine value. In SNOW’s case, it seems to be the company’s rapidly increasing revenues that has people’s attention.

SNOW is a “story stock” in the same vein as Tesla and Amazon. And, innumerable other forgotten companies with a big visions and poor financials. Morningstar seems to have bought the story and the analyst that covers SNOW is a clearly on board. Morningstar believes SNOW’s fair value is $295 and that it’s allocation of capital is “exemplary”. On the other hand Value Line sees SNOW as having “elevated risk” and a below average safety rating coupled with an uninspiring return potential.

So, take your pick. On the upside SNOW has ample cash (for the moment) and no long term debt.

It’s of note that Berkshire Hathaway has dipped its toe into SNOW, but this little flutter represents less than 0.4 % of their stock holdings.

leaderoftheback · June 7, 2022, 7:20pm

Thanks, Ears!
Having admitted my accounting rustiness, please help me out.

In my day, I would work up a cash flow analysis to make sure I didn’t run out of money when I needed it sometime during the year (Christmas to Christmas…it was a toy store). It was simply a tool to manage the business.

As they account for these IOUs, owing money becomes a cash benefit. What? What is the logic for an IOU contributing to cash flow? They are suggesting that “we will give you, Ms. Employee, a share of stock, but in the meantime you gotta give the company whatever the current share price is…in cash.”
I doubt that is happening.
So where is the cash in this “free cash” flow?

Regarding deferred revenue, I am more sanguine. They are in fact generating future revenue through recurring income (a powerful cash generator), from now until infinity. But they should also expect some percentage of impairment which I would want to be enumerated.

-Randy

Smurfdogg · June 7, 2022, 10:11pm

Hey kelbon!

Nice to see you back at it. Gave thought to you a few months back and wondered if you’d just wandered off the range or something more insidious.

still in Ulster County? grabbing any Novo foundation $$$ for our post-capitalist future (yuk, yuk)…

Cheers,

SD

kelbon · June 7, 2022, 11:11pm

Hi Smurfdogg

grabbing any Novo foundation $$$ for our post-capitalist future (yuk, yuk)…

No Novo Foundation dollars… yet. But, perhaps we should make a plan?
Got to get that Buffett family to support us apart from appreciation in that
stock; what’s it called?

kelbon

earslookin · June 8, 2022, 11:20am

Hi Randy,

So where is the cash in this “free cash” flow?

It’s the cash in your bank account that you retain because you don’t have to use it to
pay your employee. Instead, you promise to pay them with company stock down the
road. My view => It’s an IOU. SBC is the estimated fair value of the IOU.

Regarding deferred revenue…

Just like SBC comes with an asterisk regarding free cash flow, so does deferred revenue.
It’s another IOU. The customer pays cash up front and the company is obligated to deliver
services over the life of the contract period. In other words, you haven’t earned that
revenue yet so there’s a potential claim on the cash.

By the way, I have nothing against SBC or deferred revenue. If fact, they serve a useful
purpose. SBC encourages loyalty, effort, and sense of ownership. Deferred revenue gives
a company flexibility in attracting and retaining customers. We just need to keep in mind
that they may distort valuation based on free cash flow.

Ears

GreenblattsHare · June 8, 2022, 10:07pm

SBC is not an IOU it‘s a continuous equity raise to pay employees in stock rather than cash. It works well enough if the stock is trading at a high valuation but becomes anti - fragile when you stock is in a slump.

kelbon · June 8, 2022, 11:44pm

By the way, I have nothing against SBC or deferred revenue. If fact, they serve a useful
purpose. SBC encourages loyalty, effort, and sense of ownership.

Makes some sense from the point of view of a company’s executive suite, though it’s only part of the story. But, perhaps not so much from the point of view of a prospective shareholder? And, after all, it’s the POV of investors that is usually discussed in these parts.

Here’s a taste of what Buffett opined in Berkshire’s 1998 letter on the subject of SBC, from his POV; that of a prospective investor.

https://www.berkshirehathaway.com/letters/1998htm.html

Snip:

The earning revisions that Charlie and I have made for options in recent years have frequently cut the reported per-share figures by 5%, with 10% not all that uncommon. On occasion, the downward adjustment has been so great that it has affected our portfolio decisions, causing us either to make a sale or to pass on a stock purchase we might otherwise have made.

A few years ago we asked three questions in these pages to which we have not yet received an answer: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

earslookin · June 9, 2022, 9:33am

Here’s a taste of what Buffett opined in Berkshire’s 1998 letter on the subject of SBC

In the same letter he said…

"Though options, if properly structured, can be an appropriate, and even ideal, way to
compensate and motivate top managers, they are more often wildly capricious in their
distribution of rewards, inefficient as motivators, and inordinately expensive for shareholders."

If you put his letter in the context of the times, it was the Wild West. The use of stock options
had exploded in the 1990’s. They had become corrupted by carelessness and greed. Buffett’s two
major objections:

At the time, SBC was not required to be expensed on the income statement. It was only after
scandals like Enron in 2001 that finally in 2006 companies were required to show SBC as an expense
on the income statement. In that 1999 letter, Buffett asked his famous questions: “If options
aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And,
if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”
At the time, many companies geared their awards to how the stock price was doing rather than
business performance. This gets to Buffett’s point about “properly structured”.

From the point of view of we as shareholders, SBC can be a good thing, if properly structured
and accounted for, because it can help improve business performance. But we also need to keep
an eye out for companies like SNOW where the primary way to increase free cash flow appears to be
granting more and more company shares.

Ears

kelbon · June 13, 2022, 4:42pm

This is how earslookin chose to express this sentence:

“Though options, if properly structured, can be an appropriate, and even ideal, way to
compensate and motivate top managers, they are more often wildly capricious in their
distribution of rewards, inefficient as motivators, and inordinately expensive for shareholders.”

What I choose to focus on now in this sentence is the second half. Buffett is stating clearly that rather than options being properly structured and appropriate more often they are wildly capricious in their distribution of rewards, inefficient as motivators, and inordinately expensive for shareholders.”

I don’t dispute that sometimes options can be “properly structured and even an ideal way to compensate and motivate top managers”. What I believe was true when Buffett wrote this, and what is still true now, is that very often options disadvantage shareholders. How so? Companies often buy back shares on the open market at above their fair value to keep an otherwise expanding share count in check. Share buy-backs are touted by companies, and Wall St., as if buy-backs are always good and smart. Yet, It’s not smart to buy back shares unless a company is purchasing them for less than they are worth. Often companies buy back more shares than they issue as options, this affords them the opportunity to crow about their diminishing share count while remaining mum about their options.

It seems to me that generous options can also discourage a company from a dividend policy which might be sensible for their circumstances. For those insiders who benefit from options their focus is likely to be on the share price. If a company pays dividends those dividends usually come from earnings. Dividends are distributed (they are gone), not retained. Therefore the value of the company is literally smaller. Lesser value; lower share price, one would suppose. Some companies imply, or even suggest, that they don’t pay dividends because buying back stock is “better” than issuing dividends.

Finally, here’s a snip from an article from Harvard Business Review:

Because stock options do stimulate risk seeking behavior, as we know from academic research. Options, as you might know, represent a right to buy shares at a certain price at some fixed point in the future. If you are given the right to buy a share in Company X for $100 in January 2010 and by then the share price is $120, you will have made 20 bucks. However, if the company’s January 2010 share price has instead dropped to $90, your option is worthless, or what we call “out-of-the-money”: you’re not going to exercise your right to buy at $100 when the market price is cheaper.

In that situation, if the CEO of Company X has many stock options, it stimulates him to be very risk-seeking. For example, if by August 2009 the share price is $90, he will be inclined to engage in risky “win or lose” moves. If the risk pays off and the share price rises well above $100, the stock options will become worth a lot of money. However, if he loses, and the share price plummets even further, say to $60, no worries — it doesn’t matter. The stock options to buy at $100 are equally worthless whether the stock trades at $90 or at $60.

https://hbr.org/2009/04/why-stock-options-are-a-bad-op.html

TheHorse212 · June 14, 2022, 9:52am

Hi Ears –

Clearly the elephant in this free cash flow room is the explosive growth of Stock Based
Compensation (SBC)

Here is an excerpt and a few other data points from SNOW’s first quarter 10-Q filing:

As of April 30, 2022, total compensation cost related to unvested stock-based awards not yet recognized was $2.5 billion, which will be recognized over a weighted-average period of 3.3 years.

They have disclosed just under 16 million shares available for grant under the existing option plan.

I didn’t see disclosure of the number of restricted shares that were available for future awards, but they awarded 5.8 million shares in the first quarter.

The following potentially dilutive securities were excluded from the computation of diluted net loss per share calculations for the periods presented because the impact of including them would have been anti-dilutive (in thousands): 54,821

So, there is quite a bit of SBC yet to be recognized and quite a few shares that will likely become outstanding in future periods as well.

TH (long SNOW)