PLTR - Will AIP Drive Enough Demand Growth To Justify Palantir's Valuation?

2023-07-12 08:00:00 ET

Summary

• PLTR stock has soared due to the AI bonanza and guidance for sustained GAAP profitability moving forward.
• Palantir's growth rate has been decelerating, with its international business declining and its U.S. business finding it challenging to sustain high growth rates, suggesting a need for a major boost from its U.S. AI business.
• We look at how much of a boost will be needed to justify the current valuation.

In a recent interview with Bloomberg, Palantir Technologies ( PLTR ) CEO Alex Karp touted his company's Artificial Intelligence Platform (i.e., "AIP") and highlighted it as a major growth engine for the company.

Mr. Market clearly buys the company's narrative, sending the stock soaring into the stratosphere in the wake of the ChatGPT and Nvidia ( NVDA ) driven A.I. market bonanza this year:

On top of that, PLTR's Q1 results showed that it has been GAAP profitable for two quarters in a row and expects :

to continue to deliver GAAP profitability on a consistent basis.

This guidance - combined with steady declines in stock-based compensation and NVDA's blowout earnings report and guidance in late May - have accounted for much of its year-to-date rise. With the stock trading at such bloated levels, can the company's A.I. exposure deliver enough to growth to warrant this valuation? In this article, we will share why we believe it likely will not and PLTR therefore warrants a Sell rating.

PLTR's AIP Growth Outlook

If PLTR and its CEO Alex Karp are good at one thing, it is using buzzwords to feed retail investor hype in the power of its products. Granted, PLTR does produce quality software products that are used by many of the leading public and private organizations in the world and are enabling them to accomplish tasks better and more efficiently. Many - including PLTR's leadership - even credit their products for Ukraine's outperformance against Russia in the ongoing war there.

However, the company has used buzzwords and pulled attention-gaining stunts in the past, playing to the Bitcoin ( BTC-USD ) crowd by saying that it was considering holding it on its balance sheet back in early 2021 when the cryptocurrency was red hot. It also bought $50 million of gold bars ( GLD ) for $50.9 million, only to recently sell the holding less than two years later at a very slight $0.2 million gain. Now, A.I. is red-hot and PLTR is hyping up its A.I. street cred like never before. As Edwin Dorsey recently pointed out:

Palantir management has done nothing to temper recent investor enthusiasm. In fact, "AI" was mentioned 68 times on the company's Q1 May 2023 conference call, up from 17 mentions on the Q4 February 2023 call and just six mentions on the Q1 call in 2022.

What does this mean? It means that just because PLTR and its eclectic CEO make a big claim about an aspect of their business (remember their repeated emphasis on their ability to conservatively achieve $4 billion in revenue in 2025 that they are no longer talking about?), it is not even remotely automatically believable.

When we look at PLTR's AIP, we get the following comments from Mr. Karp in the aforementioned recent Bloomberg interview:

Our customer base is large and - usually we have to go to find people - now we have customers, especially the U.S., just calling us everyday...we have been getting the number of inbound calls that we usually get in a year, in like a month. Then when we are at a conference, there are customers showing potential customers how to use our products.

This sounds extremely bullish for the growth rate and implies that it most certainly will accelerate from current levels. However, beyond the tidbit about the number of inbound calls, it is nothing more than anecdotes with nothing quantifiable to justify it.

How Much Will Growth Need To Accelerate To Justify PLTR's Valuation?

While it is certainly possible, even probable, that PLTR will benefit from an upswing in A.I. related demand in the United States, there are a couple of interesting factors that temper our enthusiasm about A.I. as a tailwind for PLTR.

First is the fact that Mr. Karp included in his remarks the phrase "especially the U.S." This is significant because PLTR has had no issues with generating growth in the U.S. thus far. Where it has been struggling is internationally. As management stated on the Q1 earnings call:

We have a tale of two cities here. We have America, which is growing around 28%, it is now 64% of our business. Four years ago it was 37% of our business. We are absolutely disrupting in the U.S. of A. International is growing around 10% and that is becoming obviously a smaller part of our business.

In fact, the international commercial business actually declined by 7% sequentially and the international government business did even worse, declining by 13% quarter-over-quarter.

Meanwhile, in the U.S., PLTR has been around ~28% and it now makes up 64% of its total business. What this means that PLTR is having to lean increasingly heavily on its U.S. business to drive growth, which is fine, but it also restricts the length of its growth runway somewhat. This is because PLTR has already picked a lot of the low-hanging fruit in the United States - especially in its government business - as it has been around for two decades now.

On top of that, its growth rate has been decelerating meaningfully of late as its international business has floundered and its U.S. business is finding it increasingly challenging to sustain its previously high growth rates as its size has ballooned:

As a result, PLTR is going to need a major jolt from its U.S. AI business to reverse its growth deceleration trend, never mind to justify its lofty current valuation.

At the moment, Wall Street analysts are projecting that PLTR will reaccelerate revenue growth from the expected 15.9% in 2023 to 23.7% moving forward through 2027. This seems quite reasonable to us, as we do expect some tailwinds in the U.S. government business due to geopolitical competition around the globe heating up and we also expect a tailwind to the commercial business - as management has already alluded to - from the current A.I. bonanza. However, until there are signs of life in the international business, it is hard to imagine them returning to the 30-50% topline CAGRs of the recent past.

If PLTR can deliver on current analyst estimates, which see it expanding EBITDA margins from ~25% this year to nearly 40% in 2027 (a pretty tall task for a company that is pretty labor-intensive for a software firm), it will generate about $2 billion in EBITDA in 2027 and - according to analyst estimates - a $0.50 normalized earnings per share in 2027 as well. The earnings per share growth rate is expected to come in at 21.3% in 2027.

When it comes to assigning a fair value multiple to PLTR, we can look at Roper Technologies ( ROP ). It also operates in the software industry but has much more stable cash flows and a much longer and more proven track record of compounding shareholder wealth than PLTR does, though it also has far less innovative spark and little to no exposure to AI. It is expected to grow revenue and earnings per share at nearly the same CAGR through 2027 (especially when including the dividend that it pays out), and currently is valued at a 29x forward P/E ratio.

As a result, we can assume that by 2027 PLTR will likely have proven itself to be a consistent profit generator and have a more stable cash flow and growth profile ahead of it. Assuming that its AI and data analytics businesses continue to grow with the broader industry, it will likely have a similar (high teens revenue and earnings per share CAGR) outlook to ROP's by the beginning of 2027. Therefore, we assign PLTR a fair value multiple estimate of 32x (giving it a 10% premium to ROP to account for the innovation strength of PLTR which is partially offset by ROP's proven track record and competitive positioning). Based on this, we see a fair value of $16 for PLTR stock at the end of 2026. With the current stock price at $16.49 as of this writing, that means that PLTR is set to deliver basically nothing in the way of total returns over the next 3.5 years assuming that current analyst estimates hold.

In order to deliver at least an 8% CAGR given these assumptions, PLTR will need to grow earnings per share at a ~40% CAGR between now and the end of 2026. Even if we assign a higher multiple of 40x forward earnings for entering 2027, it will need to slightly outperform current analyst estimates.

Investor Takeaway

PLTR stock has been on a tremendous run lately, fueled by the AI bonanza and management's guidance for sustained consistent GAAP profitability moving forward. While we expect the AI wave to provide a strong tailwind to PLTR's growth moving forward, it will take a lot for it to boost growth enough to justify its current valuation. We think a low 30s price to forward earnings multiple will be warranted on PLTR's stock once it hits the end of 2026 if it perfectly hits analyst's current targets. If it can significantly outperform those targets and earn a higher valuation multiple in the process, it can still deliver satisfactory returns. However, the odds of that are pretty tough given that analyst projections are already counting on a ~50% acceleration in the current revenue growth rate over the next 4.5 years.

As a result, we rate PLTR stock a sell and only the most speculative of buys for investors who have wildly bullish expectations for AI-driven growth and PLTR's business in particular.

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