2023-11-07 16:15:47 ET
Summary
- Palantir's Q3 earnings beat expectations, leading to a 20% increase in the company's share price.
- The company's commercial segment is experiencing strong growth, outpacing the government sector.
- Palantir achieved its fourth consecutive quarter of GAAP profitability and raised its top-line guidance.
- The firm's free cash flow margin expanded to 25% in the third quarter.
- Shares are now too expensive, trading 65% above the 1-year average P/S ratio. Investors may be overreacting to Palantir's guidance raise.
Palantir ( PLTR ) submitted a better than expected earnings card for Q3 last week that led to a more than 20% jump in the software company’s share price. Palantir saw its fourth consecutive quarter of GAAP profitability and a significant expansion in its free cash flow margin in the third-quarter. The company also made considerable progress in terms of monetization and the commercial business continued on its upward trajectory as well. However, given the massive increase in price lately, I believe that investors may want to wait for a drop before engaging. While Palantir's AIP has a lot of potential in both the commercial and government markets, I believe investors have become too exuberant. This is the time to be careful!
Previous rating
I recently discussed the potential impact of the Cisco-Splunk deal that made major waves in the market for AI stocks. Cisco took over data analytics company Splunk in a major $28B deal recently that caused me to speculate about the takeover potential of a company like Palantir as well: Spunk Deal And Implications Of $28B Deal For Palantir . My last rating on Palantir was Buy.
Although Palantir is making progress in building its AI capabilities, the firm is now solidly profitable on a free cash flow basis and the commercial segment is seeing considerable growth momentum, I am downgrading Palantir to hold after the company’s shares have surged after the Q3’23 earnings card. Shares seems fairly priced now and I would consider re-engaging at the $16-17 price level.
Palantir beats EPS and top-line estimates
Palantir beat third-quarter earnings estimates with adjusted EPS of $0.07 per-share by $0.01 per-share. The data analytics company reported revenues of $558.2M compared to a consensus of $555.9M.
The commercial segment is on fire
The commercial market remains a uniquely attractive growth opportunity for Palantir, in large part because this segment is a counterweight to the government business on which Palantir has historically relied.
In the third-quarter, Palantir achieved total revenues of $558.2M, showing a year over year growth rate of 17%. Although consolidated top line growth has been moderating lately, Palantir's revenue base keeps growing at a respectable pace.
Palantir’s commercial business generated $250.6M in revenues in Q3’23 compared to $307.6M in the government business. Government revenues were $307.6M and the government segment had a total top line share of 55% while commercial clients contributed 45% of revenues in the third-quarter.
But commercial revenues are now growing about twice as fast as revenues in the government sector. Palantir’s Q3’23 commercial revenues increased 23% year over year, driven by strong product adoption specifically in the U.S. commercial market, while government revenues advanced at a more steady 12% rate year over year. U.S. commercial, Palantir’s growth driver, is crushing it and the segment saw a 33% year over year top line increase to $116M.
Too many investors are overly focused on Palantir’s top line growth, in my opinion… which is important, no doubt, but it is not as important as other metrics such as customer monetization and net customer acquisition rates. These figures show whether or not Palantir’s Foundry software platforms are finding new adopters, especially in the promising commercial market.
Palantir had 453 paying customers using its software and analytics products in the third-quarter, showing 34% year over year growth. Growth was especially pronounced in the commercial segment where the firm added 28 new customers since the end of June (total customers increased 32 Q/Q). This expansion in the (commercial) customer base comes on top of Palantir improving its customer monetization as retained clients typically increase their spending on the firm’s software products over time. In the September quarter, Palantir’s average top 20 client spent a massive $54M on the Palantir’s platform, showing growth of 13% year over year.
AIP adoption set to grow
Looking into the future, Palantir's artificial intelligence platform AIP is set to see growing adoption as more companies invest in AI capabilities to drive corporate efficiencies, cut waste, automate customer service functions (as an example) and provide high-quality business or government data insights. For Palantir this creates potentially a prolonged earnings tailwind as governments as well as companies have unique needs that AI promises to solve (that is, sifting through large amounts of data and making sense of it).
AIP can help companies and governments model different operating environments, support scenario analyses and support decision-making and AIP can also be integrated into Palantir's Foundry platform to help customers utilize the strength of AI to analyze data. The U.S. military, as an example, recently awarded a new contract (worth up to $250M) to Palantir as it seeks to scale its AI and machine learning capabilities. Going forward, I expect Palantir to aggressively roll out AI product solutions for which, according to the CEO, there is plenty of demand .
Another accomplishment: the fourth consecutive quarter of GAAP profitability
I believe it is safe to say that Palantir has achieved critical scale. While the software analytics company generated losses for many years as it tried to figure out its business model, the company is now solidly profitable, not only on an operating income basis, but also on a GAAP basis. Palantir generated $71.5M in GAAP earnings in Q3’23… which was the fourth consecutive quarter GAAP profitability for the company. In total, Palantir generated $147.3M in GAAP profits in the last four quarters.
Will there be a dividend?
I believe there is a slight chance that Palantir will introduce a small dividend at some point in the near future in order to allow shareholders to share in its success through a regular cash contribution. This is speculation, of course, but with consistent GAAP profitability now being established, I would not be surprised to see the introduction of a dividend for Palantir.
Raised guidance
Palantir raised its top line guidance from $2.212B to $2.216-2.220B which was the second increase in the company’s outlook in FY 2023. The increase in guidance was only 0.3%, however, and didn't justify the large jump in Palantir's valuation, in my opinion.
Growing free cash flow profitability
Palantir generated a considerable amount of adjusted free cash flow in the third-quarter and free cash flow margins are expanding, indicating that the software analytics company has reached an inflection point.
In Q3’23, Palantir generated total adjusted free cash flow of $140.8M on $558.2M in revenues which calculates to a massive 25% free cash flow margin… indicating that Palantir’s business is not only expanding rapidly, but now also quite profitable on a free cash flow basis. The trajectory of Palantir’s free cash flow margins since Q3’22 is displayed in the table below.
Palantir | Q3'22 | Q4'22 | Q1'23 | Q2'23 | Q3'23 | Growth Y/Y |
Revenues () | $477.9 | $508.6 | $525.2 | $533.3 | $558.2 | 17% |
Operating Cash Flow () | $47.1 | $78.8 | $187.4 | $90.2 | $133.4 | 183% |
Adjusted Free Cash Flow () | $36.6 | $75.8 | $188.9 | $96.0 | $140.8 | 285% |
FCF Margin | 8% | 15% | 36% | 18% | 25% | 17 PP |
(Source: Author)
Palantir’s valuation vs. other software analytics/AI companies
Palantir is not a bargain... it never was and likely won’t be in the near future. The company is expected to generate around ~20% annual top line growth in the next two years and although I like Palantir’s business proposition, especially AIP, for customers and investment proposition for investors, I believe shares are now on the expensive side.
Palantir’s business is now valued at price-to-revenue ratio of 15.6X which is significantly above the company’s 1-year average P/S ratio of 9.5X... implying a premium of 65%. Last time I covered Palantir, shares were trading at 12.1X revenues and since then the multiplier factor has expanded by almost 30%... although Palantir only raised its guidance by a relatively small amount of 0.3%.
Other AI stocks, such as Splunk ( SPLK ) and C3.ai ( AI ), are trading at lower revenue multipliers, but they also are expensive with P/S ratio of 5.6X and 9.2X. The valuations currently are stretched and I would wait for a drop to $14 (a support level that was confirmed multiple times) before re-engaging with Palantir.
I like Palantir's long term value proposition, especially in the AI market, but only at the right price, and preferably when shares are not overbought. I also believe that Palantir's guidance raise, which was relatively small, didn't justify such a large valuation increase following the Q3'23 report. I see a ~$15 price level as an attractive entry price region which implies a P/S ratio of ~12X.
Risks with Palantir
The biggest risk, as far as I see it, is a slowdown in the commercial enterprise market which would likely translate to slowing top line growth as well. Commercial is lifting Palantir’s entire business, although the government business still makes the largest revenue contribution. Lower free cash flow margins and disappointing adoption of AIP going forward would likely get me to reevaluate Palantir and potentially consider a sell rating.
Final thoughts
The third-quarter showed crucial progress in a number of key metrics, but especially customer monetization and free cash flow margin expansion. Palantir’s business is moving in the right direction which resulted in a fourth consecutive GAAP profit for the software analytics company as well as an impressive free cash flow margin of 25%. Given that Palantir raised its guidance only by a small amount, I believe shares of Palantir are now overvalued (they are trading 65% above the 1-year average P/S ratio) and I see limited upside potential following the Q3-earnings related spike. The risk profile, following Palantir’s Q3’23 earnings report is now neutral, in my opinion!
For further details see:
Palantir Q3: Be Careful When Investors Are Greedy (Rating Downgrade)