The Palantir Report
Can Palantir overcome scalability concerns?
Good morning investors!
Today’s Due Diligence report covers Palantir.
Palantir has ballooned in popularity ever since it was listed on the NYSE at $10 per share last September.
Yesterday, Palantir closed at $26.51 — a 165% increase from its opening price, but a 41% decline from its 52-week high.
What’s going on?
Before we get into the report, don’t forget to subscribe if you haven’t already!
Now, without further ado...
Palantir Technologies Inc (PLTR) uses software to help government agencies and commercial companies make better decisions. That’s the simplest description of Palantir.
Do you know the origin of the Palantir company name? It’s a nod to the Lord of the Rings series — a “palantir” in this fantasy world is an omnipotent seeing stone that’s used by Saruman to watch his enemies. Despite the cheekiness, it’s actually an apt name.
Now, let’s dig a little deeper.
When it was founded in 2003, Palantir worked exclusively with the Central Intelligence Agency, designing software to help the government’s counterterrorism operations. The CIA was even responsible for some of the company’s initial funding through its nonprofit venture-capital arm, In-Q-Tel.
Peter Thiel, the co-founder of PayPal and one of the founders of Palantir, injected the remaining capital necessary to develop Palantir’s first platform, Palantir Gotham (“Gotham”), for customers in the intelligence sector. In essence, Gotham is a central operating system that enables government entities to screen and analyze massive databases in order to identify patterns. The platform then helps its users plan and execute real-world responses to threats. For instance, one of the initial uses was helping protect soldiers from improvised explosive devices (IEDs).
Gotham was and is primarily used by U.S. government agencies and its allies, however, Palantir also offers this platform to companies in the financial services industry — particularly for fraud investigations. That said, Palantir extended its offerings to the commercial space in 2016 when it launched its second platform, Palantir Foundry (“Foundry”).
The system that powers these platforms is known as Apollo. As Palantir describes it, it’s “the layer that sits between our applications and the underlying infrastructure.”
Apollo, our continuous delivery platform, helps to ensure that our software works wherever our users are and under a variety of conditions: on oil rigs and submarines, on disconnected laptops in Humvees in theater, and on more than 9,000 aircraft around the world.
During its last earnings call, Palantir announced its latest software product: meta-constellation. This software integrates with satellites and enables users to answer time-sensitive questions across the globe. For instance, meta-constellation can help target wildfire indicators or the movements of naval fleets.
As of June 30, Palantir had 169 customers — up from 137 customers a year prior. Palantir divides its business into two customer segments:
Government: agencies like the U.S. Food and Drug Administration, Centers for Disease Control and Prevention, and National Institutes of Health.
Commercial: large corporations across 40 industries. More recently, Palantir launched Foundry for Builders, which caters to startups.
As you can probably infer from its platforms, Palantir’s primary source of revenue has historically been government agencies, dating back to its founding. That has shifted ever since Palantir launched Foundry in 2016, as its commercial business has grown significantly.
From FY19 to FY20, commercial revenue grew 22%.
Through the first six months of 2021, Palantir’s commercial customers accounted for 39% of total revenue.
U.S. commercial revenue alone grew 90% year over year in Q2.
Let’s highlight some of the ensuing events that have led to Palantir’s rapid ascension.
Tons of interest from retail investors. So, is Palantir a meme stock?
Metaphorical truckloads of outstanding shares. Is shareholder value diluted?
Palantir is funneling money into SPACs (and...gold?). Could it pay off?
Is Palantir a meme stock?
Many people like to slap the “meme stock” label on Palantir due to its popularity among retail traders. If you scroll through Reddit threads, it doesn’t take long to find plenty of anonymous posts about certain aspects of Palantir’s past, present, and future.
Coupled with earnings metrics, it’s easy to wonder if Palantir is a meme stock that’s inflated by retail investor interest.
While retail investors are partially responsible for the company’s share price appreciation over the last year, it’s not like the rise has been totally unwarranted. Despite being nearly two decades old, Palantir still aligns with the characteristics of a growth stock. It’s even adding to its sales team and upping marketing spend.
We hired more than 100 salespeople in the first half of the year and expect hiring to continue at a strong clip in the second half of 2021. Marketing spend nearly doubled in Q2 compared with Q1 as we continue to build out both brand and performance marketing to drive both sales and recruiting funnels.
Plus, it expects to grow revenue by 30% each of the next five years (including 2021).
Palantir has lots and lots of outstanding shares (with even more unexercised options), which ultimately dilute shareholder value.
How many? Almost 1.9 billion.
That doesn’t even include options. As of June 30, there were 417.6 million options outstanding, which are expected to be exercised over the next 8-9 years; this represents an unrecognized expense of approximately $1 billion.
For reference, here are a few outstanding share totals from other software companies:
Salesforce: 979 million
Alteryx: 67 million
Splunk: 163 million
From a compensation standpoint, Palantir rewards its executives and employees with shares. That’s not necessarily a bad thing. Employees receive assets with the upside of potential appreciation, while Palantir keeps cash in its bank accounts (since stock-based compensation is a non-cash expense). Of course, there’s a flipside: by consistently issuing loads of shares, individual shareholders get a smaller slice of the pie — in other words, value is diluted.
However, the significance of the dilution depends on how rapidly the company grows. If Palantir outpaces its rate of dilution, then issuing additional shares isn’t as impactful.
For being a SaaS company, Palantir is really a people business. Each aspect of its operation (and each expense on its income statement) includes people and their compensation expenses, from personnel for Operations and Maintenance (O&M; flows into Cost of revenue) to the salespeople who execute on pilots and customer growth activities (flows into Sales and marketing) and software developers (flows into R&D).
Glassdoor reviews should always be taken with a grain of salt, but just look at these compensation estimates for FDEs. Does Palantir need a writer?
Beyond a comfortable base pay, take a look at the cash bonus and stock bonus. Palantir pays its employees well — and it shows in its financial statements.
Palantir gets its foot in the door early
In July, Palantir launched Foundry for Builders to target startups and help them develop their operating systems from the get-go. It’s clear that the company wants to get involved early, but this new initiative only scratches the surface.
In its quarterly report, Palantir shared that it had invested in a lengthy list of companies, including SPACs:
In essence, Palantir bet on a diverse selection of industries like air taxis (Lilium), digital health (Babylon), and biotech (Celularity). But Palantir also benefits through longer-term partnerships with these companies — they entered into commercial contracts with Palantir, ranging from three to ten years. According to the company’s 10-Q, the maximum potential revenue from the highlighted commercial contracts is $428 million, including options.
While those investments are intriguing, they weren’t the most...unusual. Palantir also bought $50.7 million worth of 100-ounce gold bars. Is Palantir predicting doomsday?
Probably not. More likely, they’re simply prepping for economic uncertainty surrounding the pandemic.
Based on traditional valuation metrics, Palantir is expensive at $26.51 per share. Since it isn’t profitable, we have to shift to price-to-sales and price-to-book ratios. PLTR’s P/S of 31.93 and P/B of 24.97 are quite high relative to peers. For reference, Salesforce’s respective ratios are 10.58 and 4.66; Alteryx’s are 9.58 and 11.68. Of course, these metrics aren’t perfect. At the end of the day, it boils down to what investors are willing to pay.
Note: P/S essentially calculates the amount investors are willing to pay for $1 of a company’s sales. This is a common valuation metric for unprofitable companies to compare to peers and broader industry and index benchmarks.
Note: P/B compares a company’s market value to its book value — the net assets of a company (i.e. if a company liquidated its assets and paid off all of its debt, the remainder would be book value).
The High-Level Finances
Palantir’s customer growth rate has directly translated to higher revenue, which grew 47.2% from FY19 to FY20 after growing 24.7% from FY18 to FY19.
Through two quarters of 2021, revenue is up 49% year over year. Relative to last year, management expects FY21 revenue to increase by approximately 30%, which would ballpark to around $1.42 billion.
Despite the growth, Palantir operations have generated significant losses — thus, the concern about scalability and profitability. During the first half of FY21, the company’s operations incurred a net loss of $260 million.
Palantir’s expenses tell two notable stories. First, the company is beefing up its sales staff, which contributed to the sizable increase in clients (and revenue). Second, Palantir invests in its employees, who ultimately sell, design, deliver, and maintain the end-user’s product. We’ll expand on this more below in the “Adjusted Finances” section
Balance Sheet & Cash Flow Highlights:
As of June 30, Palantir had $2.3 billion of cash and equivalents, which absolutely dwarf its total liabilities of $1 billion.
Speaking of liabilities, Palantir had no outstanding debt as of June 30 — although it does have an undrawn $400 million revolving credit facility.
Palantir’s operations generated $139.6 million of cash flow — a welcome sign that, despite the losses, the company’s business is generating cash. See the advantage of stock-based comp?
In Palantir’s case, I think it’s helpful to view their operations without their stock-based compensation expense. While you can’t just get rid of this expense (since it does impact the business in the form of additional shares), excluding it sheds more light on the company’s progress toward operating profitability.
For instance, Palantir went public last fall, which naturally leads to an outrageously high expense for share-based compensation — in PLTR’s case, $1.2 billion. If you remove this expense, Palantir’s operating income has improved each of the last three years — and actually turned positive last year.
In the following table, I’ve removed stock-based compensation from each expense item, which is summarized in the second table by line item.
Assuming the company can reach its revenue expectations, profitability doesn’t seem like a farfetched concept.
Palantir’s EPS results are likely to remain unimpressive and unappealing, at least for the foreseeable future. Palantir’s staggering number of outstanding shares is the culprit. The company would need to generate huge profits and/or institute a share-buyback program — the odds of that are low considering the company is in growth mode and prioritizing R&D.
The Primary Strengths
Commercial growth. Targeting the private sector (i.e. not solely government agencies) is a gamechanger for Palantir’s growth potential. Even IBM, a competitor in this space, is leveraging Foundry. Management expects revenue to increase at an annual rate of 30% over the next five years (including FY21).
Market positioning. Foundry is the company’s path to additional scale, but let’s not forget about Palantir’s bread-and-butter strength: it’s the undisputed leader in the government space for its services. It has unique government access thanks to its long history with government agencies (highest access among commercial companies).
Financial health. Palantir has no outstanding debt and it’s sitting on more than $2 billion of cash. The company generates solid levels of adjusted free cash flow. Tack on the stock-based compensation approach, and you've got a cash-flushed business — hence the ability to make sizable investments in other budding industries.
The Primary Risks
Hefty personnel expenses. Ultimately, this is what’s responsible for Palantir’s inability to generate a profit. It puts a lot of resources into outfitting its customers with the right data platform, which is expensive and calls into question the ability to scale.
Customer concentration. Although Palantir has increased its customer base over the last few years, its top three customers still account for a significant percentage of total revenue — 25% as of FY20. That figure is down slightly from 28% in FY19. Palantir’s customer growth initiatives have helped reduce its customer concentration so far in FY21, as its top three customers represented 19% of its total revenue through six months — compared to 29% in the first half of 2019.
Diluted value. While this isn’t an operational risk, it is something investors have to consider. If Palantir’s outstanding share total outpaces its earnings growth, its share price will suffer from downward price pressures.
The Street’s Opinion
PLTR registers an “Underweight” consensus rating, indicating that analysts think the company is overvalued. PLTR’s average price target implies an 8.7% downside, while the lowest price target suggests an even steeper fall of 25.7%.
Bullish or Bearish?
There are a lot of reasons to like Palantir, the company, even as a finance-minded person (as opposed to a software developer).
Revenue growth from both a historical and future perspective
Unique positioning with government agencies
A cash-flushed balance sheet with improving operating results
Profitability seems feasible
Clearly values its employees and compensates them with plenty of shares, which should aid talent acquisition and retention
However, Palantir, the stock, muddies the waters with its extremely high share count and ties to meme traders. So, it’s much harder to set a price target.
For that, we’re bullish about PLTR from a long-term perspective (3-5+ years), but we’re hesitant at its current share price for any shorter of an investment timeline.