2023-11-20 06:53:12 ET
Summary
- Palantir Technologies sells software for database management and decision making, with a refocus on AI applications and expertise this year.
- Palantir's stock price has experienced a significant increase during 2023, but there are doubts about whether this jump is sustainable and if the current valuation is justified.
- I rate shares a Sell until operating business growth rates accelerate above the current 20% analyst estimate, or price declines back toward $15.
- Valuations on earnings and sales are too high, roughly double the level of application software industry peers.
This is my first article on Palantir Technologies ( PLTR ), a hot IPO from 2020 that is just now turning the corner to operating profitability. The company is a technology concern, selling software to parse through tons of database information to find patterns and glean results from specified queries. It's main purpose is to help the intelligence community in the United States spy on people, reworded to the politically-correct terminology as assisting in counterterrorism investigations and operations. For sure, this is a vital industry in today's brave new online computer world. But is it really a growth industry, and is Palantir really a growth stock? These are issues I have struggled to understand since it began public trading.
The 2023 claim to fame and future fortunes is the company's remolding of its image with investors - as a top AI choice (artificial intelligence) for database management, analytics and decision making. I will say marketing the company as an AI winner is definitely sexier than saying we are the world's spy leader, plus the market opportunity is materially larger.
And, Palantir has become a top investment gainer during 2023 on the AI excitement visiting Wall Street (will it stay or will it go?), with a year-to-date jump of +220%! The question for new investors revolves around whether or not this dramatic change in business worth is sustainable. Do growth rates in underlying metrics this year and next actually support the share valuation?
My simple answer is I doubt it. The valuation today is amazingly stretched, while the share quote looks quite susceptible to disappointment in 2024.
So, if a bear market in Big Tech is approaching (like I have been explaining since the summertime in other names), Palantir will almost surely participate on the downside. My view is the immediate downside risk of a -30% to -40% price decline far outweighs potential upside of +10% to +25% by the end of 2024. My conclusion is hot-money traders and novice, easily excitable investors have piled into PLTR during 2023, and pushed the valuation way ahead of operating results. A 6-month to 12-month period of cooling in the share quote is my expectation. As such, I rate the company a Sell and Avoid for the time being.
The Overvaluation Problem
As an investor you have to not only dream of what upside is coming, but also understand what you are paying for the privilege. A complete investment-process review includes weighing both potential rewards and risks, if you will.
At $20+ a share, the total equity capitalization of Palantir is $43 billion. The good news is the balance sheet is very strong, with nearly $3.3 billion held at the end of September vs. $922 million in total liabilities. However, revenues for this year are projected at just $2.2 billion with $520 million in non-GAAP cash earnings. Meanwhile, analyst projected business growth rates around 20% annually for 2024-25 would be nicely above average vs. other U.S. firms, although not incredible.
Even worse news, $520 million in adjusted cash earnings and $475 million in "free" cash flow over the last 12 months were basically a function of employee compensation through stock options and awards of $472 million. I will say that's how Silicon Valley and Big Tech generally run businesses today, with oversized payments in stock for work, not the usual cash payments for labor. For sure, when you strip out stock compensation to workers, the whole sector appears far more overvalued than you would guess using GAAP accounting metrics.
Anyway, using $520 million in cash-adjusted earnings (instead of GAAP accounting nearer breakeven for income), the share price valuation still represents a sky-high ratio of 82x annual 2023 income estimates. The S&P 500 blue-chip index is in the low-20s for a comparable P/E multiple. When pricing 12 months of future expected growth, Palantir has moved from a valuation pick in the same area as peers a year ago to the most overvalued position in big-data analytics and application software currently. The projected 1-year forward P/E of almost 70x is exceptionally rich. In comparison, most peers are trading under 30x.
After adjusting company values to cash on hand and zeroed out debt, the enterprise value calculation on 2024 sales is also quite stretched. To make any sense, business growth has to take off soon to catch up to the rocketing share quote. The 15x EV multiple on future revenue expectations is a rough 70% premium to the industry average of 9x. If there's a silver lining, the strong balance sheet flush with cash and solid business growth prospects do pull the regular price to "trailing" sales multiple of 20x, down to an EV to sales ratio of 15x.
Seeking Alpha's computer ranking system gives Palantir an "F" Valuation Grade overall, compared to a list of sector-average fundamental ratios and several 5-year looks at past PLTR operating results.
Final Thoughts
Investors contemplating adding Palantir shares need to think long and hard if the premium valuation is worth buying, especially if growth rates decelerate in a recession next year (instead of accelerating on AI growth).
My Sell rating on Palantir is for a strict 12-month outlook. It's entirely possible the organization's AI push will lead to exciting growth for the operating business and shareholders. Yet, in a bear market on Wall Street next year (which is my baseline projection outlined in previous articles) a drop in PLTR's price back to $15 or even $12 cannot be ruled out. At that stage, we might experience an incredibly smart entry for a 5-year holding period. My summary view is the AI craze for investors will subside, and better valuations will appear sooner or later for Palantir.
How could I be wrong? Of course, if operating results start to spike beyond current analyst projections, a $25 or $30 price remains an outlier possibility in 2024. I would say a zigzag pattern to $30 in the first half and correction back to $25 (not far above today's quote) by the end of 2024 would be my most bullish outlook scenario.
Another scenario with a minor probability is Palantir becomes the target of a takeover by a larger fish wanting exposure to the AI story. The likes of Microsoft ( MSFT ), Oracle ( ORCL ), or International Business Machines ( IBM ) might be interested in a hookup at some point. My issue is today's high valuation may mean only a slight share price premium is offered in the low to mid-$20s. I do believe the odds of an offer could improve by next summer, given a far lower stock quote under $15, and an acquisition price around $20 with a transaction closing date in early 2025. Such would allow the business to grow into the offering price paid. Unfortunately, if you buy your PLTR shares above $20 today, there wouldn't be any upside captured in the end.
If you are interested in the AI future of Palantir, the stock could be one to watch closely, with the battle plan of buying on weakness. I would use a cost-average approach over the next 3-6 months. You could purchase a small position under $18, add to it in the $15-16 range, while getting more aggressive under $14 (if this price level reappears in 2024).
Again, underlying business growth rates of 20% do not support a trailing P/E well above 70x or a multiple on sales close to 20x. I would prefer half that valuation, all else being equal. Waiting to purchase Palantir closer to 35x EPS and 10x sales would give you far better odds of making money years down the road. (I personally cannot remember many breakeven GAAP income plays with 20% growth rates selling for price to revenue numbers well above 10x, over my 36+ years of trading, excluding the late-1990s Dotcom bubble era.)
So, either company growth has to pick up to a rate above 30%, or the stock quote needs to fall back to rebalance with its moderate projected path of earnings and sales expansion. No emotions or overoptimism, just the math.
Without the exaggerated AI hype since the spring, I figure Palantir would still be trading around $11-$12 per share. Let's say the hype fades next year, while base company metrics rise another 20%. That would give us a "fair value" target in 12 months of $14.50 to $15 a share, down roughly -25% from today.
That's my take on Palantir in November 2023. Hopefully, this article will add value to your research and decision process.
Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.
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Palantir Is Too Expensive; Avoid Until Growth Rates Expand