Snowflake’s complicated ties to Amazon present a long-term risk to IPO investors

Snowflake‘s stock market debut on Wednesday has generated buzz on Wall Street because investors almost never see a company with close to $500 million in annualized revenue that’s still doubling every year. The company raised its IPO price by about 50% in the week before its debut, and demand for the stock sent it soaring more than 100% out of the gate, giving it an early valuation over $60 billion.

Yet one of Snowflake’s biggest growth catalysts is also among its greatest risks.

Snowflake sells a database in the cloud that primarily relies on infrastructure from Amazon Web Services and has committed to spending $1.2 billion on technology from AWS over five years. At the same time, AWS is making heavy engineering and promotional investments in its own competitor, Redshift.

To lessen its reliance on AWS, Snowflake is also using cloud services from Microsoft and Google. But AWS is still, by far, Snowflake’s biggest vendor. That could concern investors who have seen Amazon use pricing power in its dominant consumer and enterprise businesses to drive out competition.

“The relationships with the public cloud companies is one of frequent inquiry,” Snowflake CEO Frank Slootman said in his videotaped presentation for investors. “We are becoming large customers and consumers of public cloud capacity, as well as partners and competitors, all at once. It can be frustrating, sometimes even bewildering, from one day to the next. But we are now trending better with all three.”

Investors are excited about the growth the company has demonstrated recently under Slootman, who joined in May 2019 and previously ran ServiceNow. Berkshire Hathaway and Salesforce are buying shares as part of the IPO, and on Tuesday Snowflake priced shares at $120, higher than the $100 to $110 range it estimated on Monday, and way up from the $75 to $85 range it proposed in a filing last week. 

At $120 per share, Snowflake would be debut at a valuation of $33.3 billion.

Companies ranging from Capital One and McKesson to Adobe and DoorDash use Snowflake’s data storage and analysis tools on top of cloud infrastructure. Since its founding, Snowflake has worked exclusively on public cloud services, giving customers the ability to quickly access data from anywhere, share data easily and add or subtract capacity as needed.

Through Snowflake’s website, employees at companies, universities and government agencies store and run queries on a variety of data, which can then be charted using visualization tools such as Salesforce-owned Tableau. In July, according to Snowflake’s IPO prospectus, people ran an average of 507 million queries per day in the software, up from 254 million a year earlier. As a result, Snowflake is increasing its consumption of storage and computing services from major cloud vendors.

The deal with AWS is particularly hefty. In the contract’s first year, which ends in July, Snowflake is required to spend $115 million on cloud infrastructure, a number that climbs to $350 million by 2025. To bolster its gross margin, or the percentage of revenue left after subtracting the cost of goods sold, Snowflake’s sales have to grow faster than its cloud costs.

In its prospectus, Snowflake said the “cost of product revenue” accounted for 94% of its total cost of sales. Much of that is going to Amazon.

“Cost of product revenue consists primarily of third-party cloud infrastructure expenses incurred in connection with our customers’ use of our platform and the deployment and maintenance of our platform on public clouds,” the filing says.

In addition to its Amazon contract, Snowflake has an agreement with a different unnamed cloud provider to spend at least $550 million over 64 months, which works out to $103 million per year. Slootman said in the investor presentation that Microsoft is “our second biggest and also our fastest-growing platform.”

Snowflake’s bottom line is moving in the right direction. Revenue surged 121% in the second quarter from a year earlier to $133 million, and its gross margin increased to 62% from 53%. Net loss in the quarter narrowed to $77.6 million from $93.4 million.

While Amazon clearly benefits from Snowflake’s big checks, it has conflicting incentives.

Redshift, Amazon’s cloud data warehouse, gives AWS the ability to lock customers in to its suite of services. AWS CEO Andy Jassy introduced Redshift at the inaugural Reinvent user conference in 2012, telling the crowd that Amazon’s own retail business evaluated Redshift and found that it could deliver 10 times faster performance than its legacy data warehouse for a fraction of the cost.

In a press release last month, AWS said it’s working with Moderna in its pursuit of Covid-19 therapeutics and vaccines, helping the pharmaceutical company’s “scientists and engineers aggregate results from dozens of experiments that are running in parallel.” Those Moderna workers are using Redshift.

But Snowflake, which launched its product in 2014, has taken business away from Redshift, Slootman told CNBC in February. 

According to several people familiar with the situation, Snowflake employees worked well with their AWS counterparts and received good support for the pieces of cloud infrastructure they used. In negotiations with customers, Amazon took a fairly passive approach, with some salespeople happy to let customers choose Snowflake on the AWS marketplace.

In 2018 that changed: Amazon started paying more attention as Snowflake kept growing and winning business from Redshift and established a sales team to address the problem. These people asked not to be named discussing matters internal to their organizations.

AWS also sought to make Redshift a stronger competitor. At Amazon’s Reinvent show in December, Jassy introduced a service called Aqua that can speed up queries inside Redshift. Aqua “lets you have 10x better query performance than any other cloud data warehouse solution out there,” Jassy said. 

Snowflake declined to address Amazon’s competitive moves, and Amazon didn’t respond to a request for comment.

But Slootman addressed the broader situation during his presentation.

“It is a settling and maturing process for all of us to come to terms with these realities and learn to work through the apparent contradictions in these relationships,” he said. “It requires a coherent set of priorities and a lot of discipline in the execution. It’s a never-ending focus for all sides.”

Snowflake is among the biggest partner-competitors to AWS, but it’s far from alone. In recent years, AWS has also become more competitive with other customers and partners, such as Confluent, Algorithmia, MongoDB and Elastic.

There is always a risk that companies paying AWS can wind up getting “Amazoned,” said Jay Heglar, a former U.S. enterprise sales lead at AWS and now chief business officer at Domo, a data analytics company. Domo has committed to using $60 million over five years, according to the company’s most recent annual report.

Slootman acknowledges the challenge and embraces it. The way he views it, public cloud is clearly the future for databases, and Snowflake just has to build the premier product and provide the best service. By doing that, Amazon can win, too.  

“The relationship has grown considerably in size and improved much as well,” Slootman said. “AWS is now compensating their field staffs on Snowflake consumption, which is a first. They have never done this before with us.”

— CNBC’s Ari Levy contributed to this report.

WATCH: Renaissance Capital’s Kathleen Smith discusses boom in IPO market