2023-11-07 08:30:00 ET
Summary
- Today, I will review with you Palantir Technologies Inc.'s Q3 2023 earnings, as well as my thesis for the business broadly.
- Following Palantir's report, shares of the stock rallied roughly 20% within 24 hours.
- At the time, I was not immediately able to divert my attention to the report, so I wasn't sure whether this rally was justified.
- In light of the implosions of a handful of software companies recently, e.g., Paycom and Fortinet, I did not expect Palantir to report fantastic numbers that would justify such a rally.
- However, after finally getting to the report, I now fully appreciate why shares rallied to the extent that they did: Palantir's commercial business has been meaningfully accelerating through a brutal software downcycle, evidence for which can be seen in the reports of companies like Paycom and Fortinet. Today, we will review the components of Palantir's business that are accelerating. In short, I am very happy with the performance of Palantir, which was one of our highest rated/most heavily weighted businesses heading into 2023.
Acceleration
While I have been a loyal and unwavering supporter and shareholder of Palantir Technologies Inc. (PLTR) since I first purchased shares in the company at $10.25/share in late 2020, frankly, its recent share price rally seemed a bit too exuberant to me.
As I've so often highlighted to you over the last six months, software has been in a downcycle following the fastest interest rate hiking cycle in American history. Higher rates, especially dramatically higher rates created by the fastest interest rate hiking cycle ever, serve to slow economic growth, including the growth of the software industry.
Median Growth Rate For U.S. Software Businesses Through Q1 2023
X
When Palantir reported, I was preoccupied with research related to other businesses, so I was not able to investigate the quarter's report very thoroughly on the morning it was released. I'd seen the implosions of Paycom ( PAYC ), Confluent ( CFLT ), Bill.com ( BILL ), and Fortinet ( FTNT ), which were all recent casualties of the aforementioned software slowdown, so my expectations for Palantir were rather low.
To this end, I frankly believed that its share price rally was simply related to hype around the company, as opposed to fundamental improvements in the business. "In this macroeconomic environment, how could Palantir's report justify this reaction?" I thought on the morning of the earnings release.
However, as I began my review of the business in earnest over the last couple days, I came to realize that the rally was, in fact, entirely justified.
Palantir reported a simply stunning quarter, in which it accelerated growth of its commercial business substantially.
As of today, this Palantir's commercial business generates $1B in annualized sales, and, quite notably, this commercial business essentially did not exist just eight years ago!
Deal count for our U.S. commercial business is 2.4x what it was in Q3 of last year and U.S. commercial total contract value closed at $252 million, up 55% year-over-year on a dollar-weighted duration basis. We're also seeing the acceleration of larger deals and shorter times to conversion and expansion , including a multiyear deal in excess of $40 million with one of the largest home construction companies in the U.S. to start up pilot and converted all within Q3.
Ryan Taylor, Chief Revenue Officer, Q3 2023 Palantir Earnings Call (emphasis added).
And this acceleration in commercial sales resulted in Palantir's top line growth experiencing an acceleration as well, which you can see in the chart below.
Palantir's Revenue Growth Accelerates In Q3 2023
Turning to our global top line results. Third quarter revenue reaccelerated to $558 million, up 17% year-over-year and 5% sequentially, exceeding the high end of the range of our prior guidance. Excluding the impact of revenue from strategic commercial contracts, third quarter revenue grew 21% year-over-year and 6% sequentially.
Customer count grew 34% year-over-year and 8% sequentially to 453 customers as we remain focused on landing new accounts.
David Glazer, Chief Financial Officer, Q3 2023 Palantir Earnings Call (emphasis added.)
As I reviewed these metrics, I viscerally experienced excitement.
Incredibly, while software companies have imploded left and right as their growth rates slowed due to the above-mentioned fastest interest rate hiking cycle ever, Palantir's commercial sales and its business broadly have been accelerating.
Palantir Bullets
Frankly, I could not believe what I was seeing when I began to review this data! To accelerate sales to this degree in this macroeconomic environment was almost unbelievable.
While its peers have dropped like flies due rapidly decelerating growth rates due to a deteriorating macroeconomic environment, Palantir deterministically and enthusiastically has accelerated its business.
Palantir Accelerates Its Revenue Growth Sequentially
So my initial reaction to Palantir's rally was misplaced: it was not just hype around the business or a temporary pop in its shares; instead, it was the market very justifiably and logically reacting to a business that is meaningfully accelerating its sales through the worst downcycle for software since the Great Recession. Just imagine what Palantir will achieve in a better macroeconomic environment!
Palantir Sustains Elevated Customer Growth Despite A Deteriorating Macroeconomic Environment
Let's now turn to a more nuanced review of Palantir's commercial business, which is driving the acceleration in growth of its overall business. Following a review of its commercial business, we will assess its government business; then, we will conclude with a brief valuation exercise. As of today, the central point of friction for continued allocation of capital to Palantir is its elevated valuation. I will provide parameters for thinking about its valuation in the concluding portion of this review. Let's begin!
Palantir's Incredible Commercial Business Performance
Now moving to our commercial segment. Third quarter commercial revenue grew 23% year-over-year and 8% sequentially to $251 million. I'd like to congratulate the entire commercial org for reaching a $1 billion annualized run rate milestone this quarter. It's quite an achievement.
Excluding the impact from strategic commercial contracts, commercial revenue grew 34% year-over-year and 11% sequentially.
David Glazer, Chief Financial Officer, Q3 2023 Palantir Earnings Call (emphasis added).
Considering Palantir's commercial business essentially did not exist just eight years ago, the above-illustrated metrics, including Palantir's achievement of a $1B annualized commercial business run rate, are simply incredible.
As I've noted already, though it certainly bears repeating, the acceleration of Palantir's commercial business, even in a good economic environment, would be noteworthy and highly laudable. But to accelerate in this macroeconomic environment, where its software peers are experiencing growth rate implosions left and right, is almost unbelievable.
Palantir's Software Peers Selloff Violently As The Macroeconomic Environment Further Deteriorates
Palantir's Commercial Business Customers
On Palantir's earnings call, Palantir attributed the acceleration to three primary factors:
- A renewed Go To Market motion predicated on brief AIP (a new Palantir product inspired by the LLM revolution) boot camps that prospects love
- Excitement within its culture, creating momentum for the entire business
- And its differentiated vision for software, which is the central reason I originally purchased Palantir in late 2020.
Palantir's U.S. Commercial Revenue Growth Accelerated In Q3 2023
In the third quarter, U.S. commercial revenue reaccelerated to $116 million, up 33% year-over-year and 13% sequentially. Excluding revenue from strategic commercial contracts, U.S. commercial revenue grew 52% year-over-year and 19% sequentially.
We continue to see the impact of our intense focus on AIP on our commercial business , both through the adoption of new customers and the expansion of opportunities at existing customers.
David Glazer, Chief Financial Officer, Q3 2023 Palantir Earnings Call (emphasis added).
When I first purchased Palantir at $10.25/share in 2020, I was primarily betting on Palantir's culture.
It was largely a philosophical investment in the sense that I was betting on the company's ability to create a differentiated vision of the future, in which Palantir sold software based on this differentiated vision, and executed with relentless tenacity and focus.
- Note that I did not buy it at $30/share or $40/share in late 2020 and early 2021, and, in fact, called that price action ridiculous/excessively exuberant as the underlying quantitative metrics did not justify such a valuation. We will focus on Palantir's quantitative attributes later in this review.
My bet on Palantir was that they would not allow exogenous factors, such as competitive considerations impact their evolution. My bet was that Palantir would self-deterministically build software without any consideration for what their peers were doing, which, in my mind represents weak mindset: a scarcity mindset. That is, an excessive focus on competition represents an inability to confidently and faithfully assert one's own vision of the world into the marketplace. Please feel free to engage with me in the comments about this, and I will elaborate further.
My bet was that Palantir would self-deterministically create a vision of the future and build software for that vision. My bet was that Palantir would not allow the macroeconomic environment to influence its behavior to an excessive degree.
My bet was that Palantir would have faith through the process of executing its vision and would ultimately prevail.
Today, as the business experiences a material acceleration of its commercial business, in the midst of a terrible macroeconomic environment, I believe these bets have been validated.
Palantir's culture of self-determinism and differentiation is on full-display for the world to see.
Palantir Accelerates The Growth Of Its Commercial Customer Count
Our U.S. commercial customer count grew to 181 customers, reflecting 37% growth year-over-year and 12% sequentially, benefiting from the increase in velocity of our AIP go-to-market motion. This represents a ten-fold increase in U.S. commercial customer count from when we went public just 3 years ago.
Ryan Taylor, Chief Revenue Officer, Q3 2023 Palantir Earnings Call (emphasis added).
This customer growth has translated into the $1B in annualized commercial revenue that we can see below:
Palantir's Commercial Business Achieves A $1B Annualized Run Rate For The First Time
As I noted earlier, considering this business essentially did not exist in 2015, a $1B annualized run rate scale is exceptionally impressive.
Next, let's turn to a consideration of Palantir's government revenue growth.
Government Revenue Slowed Substantially
While Palantir reported a fantastic quarter for its commercial business, its government business performed rather poorly in the quarter.
Shifting to our Government segment. Third quarter government revenue grew 12% year-over-year and 2% sequentially to $308 million. U.S. government revenue grew 10% year-over-year and 2% sequentially to $229 million. While it's hard to predict exactly when our government revenue will reconverge at historically high CAGRs, as Shyam mentioned, our products, PG, GAIA, MetaConstellation and AIP are needed in battlefields across the world and even more so in the current geopolitical landscape. International government revenue grew 21% year-over-year and 2% sequentially to $78 million, bolstered by our continued work in health care and defense.
David Glazer, Chief Financial Officer, Q3 2023 Palantir Earnings Call (emphasis added).
Palantir's "historically high CAGRs" mentioned in the quote were about 35%, which is the rate at which Palantir's government business grew annually during the 10 years prior to 2022.
Palantir's U.S. Government Revenue Growth
Palantir's Government Revenue Growth
While Palantir's government revenue growth has been disappointing, I believe three ideas should be noted:
- Palantir's revenue growth is tracking roughly with the performance of virtually all software businesses in the U.S. economy presently, meaning that it is having a hard time growing, just like the average software business in the U.S.
- No business will grow linearly.
- Palantir's ability to create new lines of business reduce its dependence on any single line of business in a given period, making it a more durable business in both good economic times and bad. Notably, good economic times for software will come again in the future, and Palantir's entire business will likely even further accelerate beyond the degree to which it has recently accelerated.
As Warren Buffett has said,
Businesses do not meet expectations quarter after quarter & year after year. It just isn't in the nature of running businesses. And, in our view, people that predict precisely what the future will be are either kidding investors, kidding themselves, or both."
- Warren Buffett.
In short, I expect that Palantir's government business will once again accelerate in the years ahead.
And, once it does, Palantir will be experiencing 15-30% annualized growth from both its commercial and government businesses, which I believe will propel its revenues into the realm of $10B+ in the years and decades ahead.
Valuing Palantir
With these ideas as our platform, let's now turn to a consideration of Palantir's valuation.
As of today, I am entirely content with the core business of Palantir; however, I am hesitant about its valuation. This exercise will create parameters for me, and you, as to where I will once again resume buying Palantir.
Notably, Palantir is now profitable, so our assumptions around long term margins are far less reaching than they were when we first bought the business at ~$10/share and when we bought the business in the single digits in late 2022/early 2023.
We beat the high end of our guidance range on both top line and bottom line and increased our Rule of 40 score 800 basis points quarter-over-quarter to 46, while simultaneously delivering our fourth consecutive quarter of GAAP profitability, the first time ever that we are GAAP profitable on a trailing 12-month basis. We also delivered our third consecutive quarter of GAAP operating profit and over $0.5 billion in adjusted free cash flow over the last four quarters.
David Glazer, Chief Financial Officer, Q3 2023 Palantir Earnings Call (emphasis added).
In order to qualify the following assumptions, I believe it's worth briefly reviewing Palantir's gross and operating margins:
As we can see, Palantir generates 80% gross margins, which generally suggests a software business can generate 25% to 40%+ free cash flow margins. Further, we can see that Palantir does have the capacity to expand its margins at will, as evidenced by the expansion of its GAAP Net Income.
Understanding Palantir's economic moats is a key component of projecting long run margins; however, for the sake of brevity, I will do so in a future review of the business instead of today.
Let's now begin our valuation exercise.
Assumptions
TTM revenue [A] | $2.2 billion |
Potential Free Cash Flow Margin [B] | 35% |
Average diluted shares outstanding [C] | ~2.326 billion |
Free cash flow per share [ D = (A * B) / C ] | $.33 |
Free cash flow per share growth rate (reasonable) | 17.5% |
Terminal growth rate | 3% |
Years of elevated growth | 10 |
Total years to stimulate | 100 |
Discount Rate (Our "Next Best Alternative") | 9.8% |
And here are the results of the valuation exercise:
With respect to my dilution assumption presented above, I projected that Palantir would dilute shareholders by 15% over the next 10 years.
In Palantir's most recent quarter, its dilution rate ran at about 5.9% in annualized dilution.
It's notable the Palantir is still building from the ground up its new commercial software platform, which has been the source of the incredible dilution we've experienced as shareholders over the last three years.
However, with Palantir's exceptional free cash flow generation and with the company having built out its commercial business to a large degree, I expect dilution to continue to slow rapidly, as it has in recent quarters.
Palantir Bullets on X
Turning to total projected returns based on the above assumptions:
I would say that I did not use overly optimistic nor overly pessimistic assumptions.
17.5% annualized growth, in light of Palantir's commercial sales growth of 52% ex SPACs, is reasonable. Perhaps, it's conservative.
15% dilution is probably about reasonable in light of Palantir's cash hoard and free cash flow generation, which we will discuss in a moment.
A 35% long run free cash flow margin is probably about accurate.
And a 30x exit multiple, or a 3.33% FCF yield, is fair for a utility-like software business embedded into earth's most vital institutions, such as the Royal Navy and the CIA/FBI.
And, as of today, we're getting a projected return of 8.56%, which I think makes sense.
We've been largely avoiding Palantir at these levels, with the bulk of our buys in the single digits and low 10s.
Based on the above assumptions, I plan to wait for sub $15/share to resume accumulating.
Concluding Thoughts: Hulking Cash Hoard
As I noted above, I believe Palantir can achieve a robust free cash flow margin over the long run via which it will add to its truly hulking cash hoard depicted below.
Like the majority our companies, Palantir has a genuinely hulking cash hoard alongside no debt, and this allows the company to operate from a position of incredible strength during this period.
In future reviews of Palantir, I will discuss with you how the company fits within our four foundational investment frameworks and what economic moats Palantir possesses.
Thank you for reading, and have a great day.
For further details see:
It's Not Just Palantir's Stock That Is Accelerating