On Tuesday after the markets closed, unicorn cloud data provider Snowflake announced the pricing range for its initial public offering at $75 to $85, which implies a market cap of $21 billion at the midpoint.
This value estimate includes two private stock sales of $250 million apiece to Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) and Salesforce (CRM, Financial). Based on an assumed IPO price of $80, this would translate to 3,125,000 shares apiece. On top of the initial $250 billion investment in the IPO, Warren Buffett (Trades, Portfolio)'s conglomerate has agreed to purchase more than 4 million shares from one of Snowflake's investors in a secondary transaction at the IPO price, which will close immediately following the IPO.
While Salesforce's investment seems to fit with its history, Buffett's latest move comes as a surprise to many investors, as the guru has typically made it a point to avoid tech startups in the past. Not only does he define tech as being outside of his circle of competence, he has always been hesitant to make investments when he is unable to access sufficient information on the company, which is often the case with IPOs since they have not yet reported a quarter as a public company.
"In 54 years, I don't think Berkshire's ever bought a new issue," Buffett said in a CNBC interview last May.
"They don't even call us," added Charlie Munger (Trades, Portfolio), Buffett's business partner.
Some may speculate that Buffett and Munger had less to do with this investment than Berkshire's two other portfolio managers, Todd Combs and Ted Weschler. We will have to wait for word from Buffett himself to confirm his thoughts on Snowflake, as well as who was mainly responsible for the purchase. Regardless, this is still an investment of Berkshire Hathaway, and it could be a sign that the company's investment team is beginning to look more toward the future. Let's take a look at what might have attracted Buffett to the stock, as well as how the investment deviates from the Oracle's norms.
A potential moat
We know that among upcoming tech IPOs, Snowflake seems to be one of those creating the most buzz, but what exactly does the company do?
Snowflake's core product is a cloud-based data warehouse that seamlessly operates across the three major public clouds. Founded in 2012, it seems that the founders of the company anticipated the shift to the cloud, as they began to build a cloud computing data warehouse right near the beginning of the cloud's rise in popularity.
Taking advantage of the trends of big data processing and the public cloud, Snowflake can take all of the data from a company (regardless of the source) and make sense out of it, essentially providing unique value-added services that competitors have yet to replicate.
This could become a potential source of moat for the company, if it can continue its rapid growth and become the undisputed leader in its niche before direct competitors can get a foothold.
Snowflake's growth has already been phenomenal over the past year. In the six months through July 31, the company reported a 133% year-over-year revenue increase to $242 million, and it estimates that revenue for full-year 2020 is on track to reach $500 million. As of the end of July, the company had 3,117 customers, up 101.5% from the same time last year.
One of Buffett's core investing principles is to look for a company with a sustainable moat. During the 1995 Berkshire Hathaway shareholder meeting, he said, "The most important thing [is] trying to find a business with a wide and long-lasting moat around it… protecting a terrific economic castle with an honest lord in charge of the castle."
Given Snowflake's unique cloud product offerings, the amount of time the company has spent independently before going public and the way revenue has skyrocketed over the past year, it may be able to maintain its moat in the long term, which Buffett would certainly consider a selling point.
Good management
Going back to the quote above, another one of Buffett's investing principles is to look for a business with an "honest lord" (also known as good management) in charge of operations.
Buffett holds that an extraordinary business has a high chance of succeeding even without good management, and that "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." However, just because a business can succeed with bad management doesn't mean this is ideal for anyone (except maybe the bad management). Good management can often be what makes or breaks a company that does not fall neatly into the "extraordinary business" or "bad business" baskets.
Snowflake was founded by two former Oracle (ORCL) employees, Benoit Dageville and Thierry Cruanes, as well as Marcin Zukowski, one of the co-founders of Dutch data startup Vectorwise. All three came from industry-leading data companies, which is an encouraging starting point in terms of the company's future prospects. Additionally, Snowflake's current CEO, Frank Slootman, came out of retirement for the position in 2019. Slootman has extensive executive experience as the former CEO of ServiceNow (NOW), an industry leader in cloud-based, back-end software vendors for large enterprise customers.
From this, we can reasonably assume that the management at Snowflake knows the industry well, so shareholders will not face the risk of executives that are not even familiar with how to run the business. The fact that the founders had the foresight to get a CEO with industry experience on board before structuring itself to go public is also a positive sign.
Berkshire's history with IPOs
Though it does not receive as much attention as Berkshire's other investments, we know that Buffett's conglomerate has invested in at least one other IPO – StoneCo Ltd. (STNE). Originally founded in 2012, the Brazilian electronic payment processing company went public in October 2018. Buffett purchased 14 million shares at the IPO price, giving him an 8% stake in the company.
The investment turned out to be a prudent one. Although Buffett has not upped his stake in the company since the initial investment, GuruFocus estimates that the holding has returned approximately 120.74%.
Thus, while Buffett typically steers clear of tech companies, its one previous example of a tech IPO investment appears to have been successful.
Buffett's biggest tech investment, Apple (AAPL, Financial), also turned out to be a good call. Representing 44.18% of Berkshire's equity portfolio as of the end of the second quarter, GuruFocus estimates that the stake in Apple has returned approximately 216.73%.
Typical red flags
Despite Snowflake's strong selling points, which even include a few aspects that have attracted Buffett and Berkshire into making an investment, the company is still flashing a few red flags that the guru typically tries to stay away from.
One of these is the eye-watering valuation. If Snowflake can achieve its goal of $500 million in revenue for 2020, then the IPO price will represent a price-sales ratio of around 40. While this certainly wouldn't be the highest valuation these days – Zoom Video Communications (ZOOM), for example, trades at a price-sales ratio of 77 – it is still quite high, as it assumes that revenue will need to more than double in the next year alone in order to have any hope of growing into the price paid.
Another danger is that, despite its current moat, the tech industry is infamous for unsustainable moats. A tech company needs to continuously evolve in order to stay ahead of the competition because once it falls behind, it could easily see its revenue flow to a new company with more appealing products.
These are some of the main reasons why Buffett typically avoids tech companies, especially at their IPO prices.
Conclusion
Buffett doesn't often make tech investments, but he has made a few successful ones, including Apple and StoneCo. These companies normally fall outside of the Oracle of Omaha's circle of competence, but he has invested in tech in the past.
Regardless of whether it was Buffett himself or one of Berkshire's portfolio managers that pulled the trigger, it seems that the conglomerate is looking to the future with this IPO by investing in a high-growth industry. The U.S. market has not really left many options to deploy large amounts of capital, as most good companies are overvalued, many of the "value" opportunities are trading at low prices due to a significant risk of bankruptcy and even opportunities to loan to businesses are not appearing due to the Fed's willingness to provide cheap liquidity even at the cost of inflation.
Though investing in tech IPOs may not be the way to go for everyone, Snowflake appears to have a decent advantage in its industry, as well as a wide runway for growth and even a vote of approval from Berkshire.
Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.
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