Snowflake Beat Expectations in Q3, but This Is Why I'd Still Avoid the Stock

Snowflake (NYSE: SNOW) stock is showing signs of life after releasing some encouraging quarterly results last month. It's been a tough year for the data storage company, whose CEO retired unexpectedly in February, leading to a stock sell-off. At a time when many artificial intelligence (AI) stocks are thriving, shares of Snowflake remain in negative territory this year.

There does appear to be some renewed enthusiasm, however, after the company posted a solid earnings beat, resulting in a big rally in its share price. But despite the seemingly strong performance last quarter, I'd still avoid the stock. Here's why.

Snowflake still isn't showing a path to profitability

There are lots of growth opportunities for Snowflake. As more businesses move their operations to the cloud, especially with AI, there'll be a need for not just data storage, but also for analytics and processing. Snowflake can help with all of this. But the company needs to demonstrate that it can do that profitably, and right now, that isn't evident through the numbers it's been releasing.

The stock rallied recently on news that the company beat expectations for revenue ($942 million versus $897 million) and adjusted earnings per share ($0.20 versus $0.15) in the third quarter, which ended Oct. 31.

What's troubling, however, is that while revenue rose by 28% year over year during the period, the company's cost of sales increased by more than 40%. The net effect was a worsening bottom line, with Snowflake's net loss ballooning from $214.3 million a year ago to $324.3 million this past quarter.

Investors need to pay close attention to stock-based compensation

Snowflake and many other tech companies use stock-based compensation heavily, and that often gets backed out of adjusted earnings numbers and even cash flow. But by doing so, it can give investors the impression that a business is much more profitable than it otherwise would be if it paid those expenses in cash.

While stock-based compensation is not an outlay of cash, it's still an expense that's relevant to the company's overall profitability and can be dangerous to ignore. A company could theoretically increase its reliance on stock-based compensation, thereby boosting its adjusted earnings numbers while also improving its free cash flow in the process. But issuing shares is dilutive for investors and can weigh on the stock's value.

SNOW Shares Outstanding data by YCharts.

Snowflake reported stock-based compensation, net of amounts capitalized, totaling $363.3 million last quarter, which was an increase of 22% from a year ago. As a percentage of revenue, it has decreased, but it's still a big reason why the company's cash flow is positive and Snowflake is able to report positive adjusted earnings.

Snowflake is still a risky stock to own

If a company is growing its top line, but its losses are rising at a faster rate, that's a potential red flag for investors. For a company such as Snowflake, which is now generating close to $1 billion in quarterly revenue, I'd expect to see much more efficiency at this stage of its growth and for there to be at least some path to profitability.

But that isn't the case. Instead, the company's losses are getting bigger, and until that changes, this is a stock I'd avoid. While Snowflake's gross profit margin may seem strong at around 66% of revenue, the company's overhead and operating expenses need to come down significantly before breakeven will be within sight. That's still a big problem for Snowflake, regardless of what its adjusted earnings numbers say.

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David Jagielski has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Snowflake. The Motley Fool has a disclosure policy.