CA - Palantir: Fundamentally Challenged Business Model

Summary

• 2022 was a painful year for tech investors, and especially so for Palantir investors.
• Ceding control to the founders seems nice, altruistic even. I like it when those in management are shareholders too, it can help to align interests.
• But in the case of Palantir, the F Class shares go too far. I want founders to influence the company, but total unchecked control? No. Definitely not.
• Despite the PR boost stemming from the war in Ukraine, I don’t believe they overcome a fundamentally challenged business model.

Introduction

Happy New Year! As we start 2023 many investors look forward to what the new year will bring for the stocks in their portfolios. Perhaps no investor class is more eager to close the books on 2022 than the high growth/momentum investors are. 2022 was a painful year for tech investors, and especially so for Palantir ( PLTR ) investors.

In my last article, I highlighted my concerns with Palantir’s governance structure and its margin profile. I noted how the governance structure (or lack thereof) leaves investors with little/no ability to hold management accountable. And how their margin profile is weaker compared to other software companies. Finally, I made my argument that even after the recent stock correction that shares were still not a good deal.

As we begin 2023, I now ponder the question, will Palantir’s share price see a repeat of 22 or 2020... or perhaps something else entirely?

2022 Recap

Before we dive into the financials, I think it’s prudent to understand how one of the largest events of the past few decades, the War in Ukraine, could massively impact Palantir.

There are decades where nothing happens, and there are weeks where decades happen – Vladimir Ilyich Lenin

Because Palantir sells so much software with potential military applications, it’s important to consider the political climate and how it may or may not affect Palantir’s performance as a business and an investment. Besides the defense contractors ( ITA ) I can think of few companies so closely tied to the US government besides Palantir.

After decades of relative stability and an increasingly globalized, liberal, and democratic world 2022 marked a stark shift from the post-WW2 rules-based world order.

In February of this year Russia, a nuclear-armed totalitarian regime, invaded a free democratic country (Ukraine) in an act of pure conquest, totally stomping on the rules-based order established in the post-WW2 order.

And then, shocking everyone, Ukraine persevered.

Powered by NATO weaponry and technology Ukraine held its ground and has now begun to push back the Russian invaders.

While a number of its exact applications are secret, in this author's view, it’s nearly certain that Palantir’s software is being employed to aid Ukraine on the battlefield. To support my claim, an interesting analysis of the impact algorithms are having in Ukraine can be found here in this article in the Washington Post where the writer highlights the use of Palantir’s MetaConstellation technology on the battlefield.

As great as that is, how does this help investors?

…Well, it's at least a spectacular PR boost.

After all, what stronger vote of confidence can someone bestow on a company than to trust it with the safety of their citizens' lives? Talk about trust. And when you look at how well the Ukrainians are performing despite them being undermanned and underequipped, it seems to me that software like Palantir’s is helping to balance things out.

It’s not a stretch of the imagination to suggest that a corporate decision-maker might think “Well if Ukraine can trust the lives of their nation to this software, then maybe I can trust my supply chain operations to them too”. It doesn’t get more “mission critical” than saving lives.

Palantir is clearly capitalizing on this as evidenced by its ad in the Wall Street Journal.

To assess whether this positive PR is having the expected result let’s first shift our attention to Palantir’s revenue growth. For growth companies, like Palantir, revenue growth is an especially important metric because growth investors make a choice, conscious or otherwise, to pay a higher price today for expected growth in the future. If that growth fails to materialize stocks re-trade meaningfully downward.

In the short run, the market is a voting machine but in the long run, it is a weighing machine. ? Benjamin Graham

Revenue

As you can see in the chart above, Palantir’s revenue growth is less than stellar. In any other industry, 22% growth would be quite an accomplishment, but when compared to the 35% growth that was achieved just a few quarters earlier investors are right to be concerned.

As companies slow IT investment given the overall macro climate, I am unsure what positive catalyst could move the needle in a meaningful way to drive revenue growth for Palantir.

Dilution

22% revenue growth is even more disappointing when paired with the knowledge of how much dilution has occurred.

As you can see in the chart above, Palantir’s share count has skyrocketed since its direct listing leaving shareholders owning a smaller portion of the company each year.

Compare that dilution and revenue growth to my largest personal investment, Constellation Software ( OTCPK:CNSWF ), which is growing faster and has had ZERO dilution.

Margins

Well if revenue growth is slowing is Palantir making up for it with stronger margins? Perhaps their revenue mix tilts more towards software and away from professional services.

I’ll give credit where credit is due, Palantir should earn some measured praise for the improvements made concerning their operating margins. While -11% is still negative, it’s moving in the right direction. If this trend continues in the next few earnings reports I could be convinced to speak more positively about Palantir. For now, I am still skeptical. One year is just too small of a sample to draw any strong conclusion from.

If operating margins continue to improve I would suggest a useful data point to investors would be to compare the operating margins of Palantir versus that of Accenture’s ( ACN ) ~15%. Accenture has lower gross margins than Palantir, at just 32% versus Palantir’s 79%, it’s more difficult to compare their gross margins due to Palantir’s preference to charge certain expenses as R&D.

Risks

In my last article, I highlighted a few risks facing Palantir. As a refresher, the largest risk, in my view, is its poor governance structure. Palantir’s F-Class shares give its founder rights and privileges that are almost unheard of in the industry, allowing them to retain control even as they sell shares. Some have complained that these F-Class shares make some of its early founders “Emperors for Life” a title rebuked by the founders.

Ceding control to the founders seems nice, altruistic even. I like it when those in management are shareholders too, it can help to align interests. But in the case of Palantir, the F Class shares go too far, I want founders to influence the company, but total unchecked control? No. Definitely not.

The F-class shares remove accountability from decision-makers which, over time, may lead to a decoupling of the interests between management and shareholders.

In my opinion that decoupling has already begun.

Just look at their stock-based compensation, which countless articles have mentioned here on Seeking Alpha. Even if you are bullish on Palantir, you must admit there has been a large number of complaints concerning SBC. Sadly, due to the F-Class shares, retail investors must simply “take it”, as they have no recourse to cut back on the dilution that is hurting them so badly because their votes mean very little.

Well, they do have one remedy, they could sell.

...If I were a shareholder, that’s what I would do

Price Target and Conclusion

Given Palantir’s slowing growth and poor governance I rate Palantir a sell. Despite the PR boost stemming from the war in Ukraine, I don’t believe they overcome a fundamentally challenged business model. Without improved governance, there is little opportunity for investors to voice their disdain.

As far as a price target goes, I would suggest using Accenture’s valuation as a reference. Palantir claims it’s not a consulting business, they claim to be a software business but the margins don’t reflect that. Accenture trades at price to sales of ~2.8x according to Yahoo Finance, since Palantir is growing much faster than Accenture I believe a premium is warranted. But by how much? Using the lofty PS target of 5.6 (2x of Accenture) Palantir’s shares could trade for as much as $5.3 a share.

I believe the risk is to the downside, not the upside, slowing revenue growth and poor governance make Palantir a sell. My 1-year price target is $5.3 a share.

Thank You, Reader!

Thank you for taking the time out of your day to read my article on Palantir. I try to engage with all of my readers so if something sparked your interest or you have any questions please let me know in the comments below. Wishing you all a prosperous and healthy new year.

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