2023-11-13 10:08:04 ET
Summary
- Palantir is facing slow growth in its government-facing business, as government agencies are diversifying and not wanting to be dependent on a single service provider.
- Increased competition from major companies like IBM and Oracle entering the AI-based enterprise solutions market poses a risk to Palantir's revenue.
- Despite the hype around AI, Palantir has seen a decline in its revenue growth rate, causing concern about its high valuation.
Thesis
Palantir Technologies (PLTR) is an American company that specializes in Big Data Analytics. It is headquartered in Denver, Colorado, and was founded by Peter Thiel, Alex Carp ((CEO)), Nathan Gettings, Joe Lonsdale, and Stephen Cohen. It started off catering to government agencies but has expanded to commercial clients across various industries. Dealing with the government, especially onboarding government agencies as clients, can be a challenging task. Of late, Palantir’s government revenue segment seems to be causing a drag on its overall revenue growth.
Catalysts
Government Revenue Growth Slowing Down
Palantir started off serving government agencies, and the United States Intelligence Community was said to be one of its earliest clients. Government agencies continue to account for a majority (~56%) of the company’s revenue. Per Palantir’s Q3 earnings presentation , the company is facing slow growth in its government-facing business, especially in the US. In my opinion, one major reason is that government agencies do not want to be dependent on a single service provider and are now diversifying, hurting Palantir’s growth rates.
One such example is earlier this year when the United States Space Force selected 17 additional vendors to provide it with space data analytics, a contract that is said to have been held solely by Palantir. The total value of this order is $900 million spread over 5 years, of which Palantir is expected to earn $110 million for a one-year extension.
Another concern has emerged for Palantir in Germany where the court(s) in Hamburg and Hesse have deemed the use of automated data analytics for policing to be unconstitutional.
If the EU follows suit, as their laws tend to be fairly similar, it could magnify the implications on Palantir’s image among government agencies to become a client of the company, as deals with Palantir could come under intense scrutiny from opposition parties and the judiciary.
Fear from Increased Competition
Palantir has been working on Artificial Intelligence solutions for close to 20 years now, but that does not make it free from fear of increased competition as major companies in the enterprise solutions, such as Oracle and IBM have recently announced that they will foray into Generative AI-based Enterprise Solutions services. IBM plans to train 10,000 consultants by the end of 2024 and has partnered with Amazon Web Services. Oracle plans to deploy Generative AI based on the Oracle Cloud Infrastructure and is partnering with Cohere to offer a complete, end-to-end solution for generative AI, with advanced security, best-in-class data management, and a comprehensive portfolio of cloud applications able to address any business problem.
Palantir’s major clients are based in the Financial, Healthcare, Energy, and Manufacturing sectors; I believe that there is undeniably a risk that the company could face increased competition from Oracle and IBM. As these contracts do not extend beyond a couple of years, the entry of larger firms poses risks to Palantir’s revenue through a higher churn rate of clients.
AI Hype not translating into Revenue growth - Higher P/S Valuations
A company’s technology might be impressive, but it doesn’t necessarily make it a good stock if its price is high compared to its growth potential or if it carries substantial risks. PLTR stock is up nearly 200% YTD , having risen from $6.40 at the start of the year to $18.85 at the time of writing in early November.
In my view, one major reason for this has been the hype around Artificial Intelligence ((AI)) since the rapid popularization of generative AI tools such as ChatGPT and Google’s Bard. The company’s stock took off starting in May and has since remained in double digits. Palantir has always been a company operating with buzzwords such as AI, ML, Big Data, etc and one would expect that the company would benefit from increasing awareness around these technologies.
However, on the contrary, Palantir has seen a decline in its revenue growth rate. Revenue grew at ~37% from 2018 to 2021. Since then, the growth rate in revenue has slowed down to ~20% if we assume 2023 Revenue as per the management’s guidance for Q4. The reason behind a slowdown in revenue growth has been highlighted in the previous catalysts.
Valuation - Discounted Cash Flow
In this section, we will perform a Discounted Cash Flow Analysis for Palantir.
Base Case: The company’s revenue has grown at 21% CAGR over the last couple of years, and I expect this growth rate (for the base case) to persist in the future despite issues with government contracts. The reason behind this is the launch of Palantir’s dedicated Artificial Intelligence Platform ((AIP)) and the increasing popularity and growing demand for Big Data Analytics. All operating costs have been assumed to grow at the same CAGR as the past two years to maintain consistency and reflect the improved cost efficiency. We arrived at the Free Cash Flow estimates for PLTR using their ((TTM)) Free Cash Flow Margins (22.5%) and improved upon it by 50 bps in 2026 for two years and then increased to 24% for 2028 Estimates. This gave us a fair present value for Palantir Technologies Limited of $30 Billion, translating to an intrinsic value of PLTR shares of $13.79.
Bull Case: Revenue growth was assumed to be 27% ((CAGR)) if the company can onboard commercial clients faster due to the launch of ((AIP)). For the bull case, we assumed higher ((FCF)) margins, which would arise from increased operational efficiencies. This gave us a fair value for Palantir Technologies Limited of $42.36 Billion, translating to an intrinsic value of PLTR shares of $19.70.
Bear Case: Revenue growth is assumed to lower at 16% ((CAGR)) if the company loses out on commercial clients due to increased competition and loses further ground in the government client division due to ethical issues with surveillance software and further diversification by the government clients. This gave us a fair value for Palantir Technologies Limited of $20.64 Billion, translating to an intrinsic value of PLTR shares of $9.49.
Since the company had no long-term debt, the cost of equity calculated using ((CAPM)) became its Weighted Average Cost of Capital and was used to discount future cash flows. Perpetual Cash Flow Growth was taken to 10% to capture the nascent stage at which the Big Data Analytics Industry is and the high potential for growth in the future.
My personal opinion is that the deviation from the base case is very unlikely.
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Risks
Improvement in Financials - GAAP Profitable
While, in my opinion, the stock remains over-valued due to AI Mania, the underlying business has seen improvements - particularly from a profitability standpoint. The company has now achieved GAAP Net Income profitability for the first time in its history for four consecutive quarters and is on track to achieve its first GAAP Operating and Net Income profitable financial year. This has been driven by expansion in Gross Margins and effective control of General and Administrative costs, as well as generating net positive interest/ investment income from the $3.3 billion it holds in cash/equivalents and US government securities.
If the company’s financial fundamentals improve beyond what has been estimated in the valuation, it would mean that the current market price is a closer reflection of the company’s reality than my estimates, and the fair value would need to be revised upwards.
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Possible inclusion in S&P 500
Now that the company has been GAAP profitable for 4 consecutive quarters, there is a probability of inclusion in the S&P 500, which, as per CEO Alexander Karp, would be a major milestone for the company. The implications of a possible inclusion are an increase in the stock price upon such an announcement, hundreds of millions, if not billions, of dollars in additional passive flows, as well as improved analyst coverage.
While the S&P Inclusion Effect is often short-lived and statistically insignificant after actual inclusion into the index, the passive financial flows into buying the stock may be a major support for the stock and prevent it from falling too much.
Conclusion
I’d like to conclude this report with a sell recommendation on PLTR as my base case Intrinsic Value ($13.79) estimate for the company is approximately 27% below the closing price on 7th November 2023. The company faces a major challenge due to the slow growth in government revenue. For the premium valuations that the company commands, such as ~18x Price/ FY 2023 Sales, the growth rate in revenues needs to be much higher than the prevailing 20% over the last couple of years. I opine that once the AI Mania cools down, we might see more rational valuations, and the stock would be a better buy at levels close to my intrinsic value estimates of $13.79.
For further details see:
Palantir's Valuation In Question: AI Hype Vs. Slowing Growth