2023-11-02 08:30:00 ET
Summary
- Palantir's stock has doubled in value in 2023, driven by the AI frenzy and margin expansion.
- The company's Q3 outperformance shows continued strong market share gains, particularly in enterprise AIP deployments, which bolsters AI monetization opportunities ahead.
- Substantial improvements in its GAAP-based operating margin, which provides sustained durability to Palantir's profitability, also reinforce prospects for S&P 500 admission in the near term, which is favourable for the stock.
Palantir (PLTR) has been a key beneficiary of the AI tailwind this year, with its stock more than doubling in value through the first ten months of 2023. In addition to the AI frenzy, the stock's upsurge has also been reinforced by the underlying business' continued pace of margin expansion, enabled by disciplined spend management, the ongoing ramp of new platform deployments (particularly in AI), and substantial reductions in share-based compensation expense.
These tailwinds were further reinforced by Palantir's solid Q3 earnings performance released this morning, which underscores continued strength through the remainder of the year. Specifically, the results continue to highlight a robust ramp trajectory for AIP by leveraging Palantir's effective land and expanding business strategy across both its commercial and government segments. The land and expand flywheel critical to Palantir's growth trajectory is further supported by a consistent pace of incremental customer adds during the quarter - Palantir's grew Q3 customer count by 34% y/y, taking its total customer count in the trailing 12 months ended September 30, 2023, up 34% y/y as well.
With a strong ramp in AIP deployments across both its new and existing customers, additional clarity from management on the monetization roadmap for related opportunities would do good for the stock. While lumpy government revenue recognition and the measured, though stabilizing, commercial spending environment due to lingering macroeconomic uncertainties remain inherent business risks at Palantir, the strengthened AI spotlight observed in its Q3 results remains a net positive for the stock. Palantir's Q3 outperformance has essentially reinforced its forward outlook on capturing the TAM-expanding AI opportunities. Hence the risk-reward set-up for the stock at its current premium to the broader market is improved, which bolsters prospects for a further upsurge towards our bull case price target of $16.
AI in Government
Government revenue grew 12% y/y in Q3 to $308 million, decelerating from the pace of expansion observed in the prior quarter and in 3Q22. This continues to highlight the segment's inherent exposure to lumpiness in government contract revenue recognition, despite historical observations of a stronger back half of the year.
However, Palantir's total contract value continues to grow. Based on the USASpending.gov tracker, Palantir USG added $30.3 million in awarded contract obligations with two new awards during the September quarter, taking the total awarded amount in the TTM ended September 30 to $227.5 million. The related awards were primarily from the Department of Defense (93%) - particularly the Army and the Air Force - and the Department of State (7%).
Meanwhile, Palantir Technologies added $82.4 million in awarded contract obligations with 13 new awards during the September quarter, taking its total awarded amount in the TTM ended September 30 to $181.6 million. The related awards were primarily from the Department of Health and Human Services (35%), the Department of Veteran Affairs (15%), and the Department of the Treasury (12%), which is in line with Palantir's increased focus on expanding its government business beyond defense.
The contract awards continue to underscore the effective scale of Palantir's land and expand business strategy. In addition to the expansion of existing relationships with government agencies as observed in contract extensions during previous quarters, Palantir has also leveraged these partnerships in driving growth in its adjacent offerings - such as the latest AIP for Defense offering .
This includes the most recent $250 million three-year contract from the Army, which builds on its existing partnership with Palantir since 2018 to drive "data integration, management and AI model training" through Gotham and other combined hardware/software solutions for the Combatant Commands ("COCOMs"), Armed Services, Intelligence Community, and Special Forces. The newest contract requires the provision of additional support from Palantir to assist the said various forces of the Army in testing, utilizing and scaling its AI/ML capabilities, which likely implies the eventual deployment of AIP for Defense.
In addition to the U.S., Palantir is also picking up pace in ramping up its government operations in Europe. Although details surrounding its anticipated contract with the UK's NHS remain limited, any near-term updates would likely reinforce confidence in Palantir's growing focus on expanding its overseas operations in allied regions, especially in Europe . This is further complemented by similar momentum in its commercial business in Europe during the third quarter, as evidenced by new industry wins in the region (further discussed in a later section).
AI in Commercial
Meanwhile, the commercial segment grew revenue by 23% y/y to $251 million during Q3. Restored acceleration in the segment's growth highlights a soft, albeit stabilizing, commercial spending environment that is being increasingly overshadowed by AIP adoption momentum.
This was already evidenced during Palantir's AIPCon 2.0 event in early September, where customers across a wide range of industries spanning financials, healthcare, transportation and logistics, manufacturing, industrial and software provided validation for the nascent technology's competency. Customers indicated time to deployment within four weeks from contract signing, with some citing as little as a week's time, which is in line with Palantir's ambitions to eventually achieve " zero to use case in five days " for AIP integration. The event also highlighted productivity gains as a key value-add for customers using AIP and Palantir's other primary offerings such as Foundry, which reinforces cross-selling opportunities over the longer term.
The success of AIP continues to build on a set of foundational strategies implemented at Palantir's commercial business, including the modularization of its platform offerings based on industry-specific needs, and further reliance on its land and expand model. This is evident in Palantir's recent partnership with PricewaterhouseCoopers ("PwC"). Specifically, PwC will leverage AIP and Foundry to help drive better value-add business impacts for its customers, servicing a wide range of industries spanning manufacturing, supply chain management, healthcare, and financials.
The company has also furthered efforts in expanding its footprint in the private sector across overseas allied regions, particularly in Europe, in recent quarters. This includes Palantir's recent partnership with Babcock , the UK-based defense firm, to deploy AIP. Specifically, the key defense and security service provider to the UK Ministry of Defence will leverage AIP "in all areas of [its] global defence business across submarines, warships, and army equipment, right through to supply chains" to optimize data-driven decisions. Palantir's partnership with Babcock marks its first with a firm in the UK's "Defense Industrial Base", or certified defense contractors under the UK's " Defense Industrial Strategy ". And considering Palantir's history of effectively scaling its land and expanding business strategy, the company's latest partnership with Babcock is expected to further its reach into UK defense opportunities across both the public and private sectors.
In addition to the UK, Palantir has also furthered its market share gains in the European private sector in Italy. The company has recently partnered with Gemelli Generator Real World Data ("Generator RWD"), a research component within the Policlinico Gemelli medical network in Italy, to deploy Foundry. Specifically, Generator RWD will leverage Foundry's AI capabilities to support clinical research related to drug and treatment discovery. The partnership again highlights another viable land and expansion opportunity for Palantir over the longer term, given Generator RWD's increasing prominence across its partner research network within Policlinico Gemelli.
Taken together, Palantir continues to demonstrate a strong ramp of its newest AIP offering, alongside deployments of its primary commercial solution, Foundry. We attribute much of this success to Palantir's ability to build and scale its land and expand its business model, as existing customer relationships branch out into adjacent opportunities and provide validation to the company's technological competency. The strategy is also bolstered by Palantir's consistent pace of growth in its customer count. As mentioned in the earlier section, Palantir has grown its customer portfolio by 34% in the trailing 12 months, maintaining an average quarterly growth of 8% over the same period.
This makes Palantir well-positioned to further capitalize on the emerging growth opportunities that have come with the advent of AI, ML, and data science - only 29% of enterprise organizations have integrated generative AI solutions into their operations to date, underscoring the massive growth opportunities ahead for Palantir. While its monetization roadmap on relevant opportunities remains unclear, Palantir's progressive market share gains in the enterprise AI segment are a value-accretive factor to the stock's long-term potential.
Fundamental and Valuation Considerations
Adjusting our previous fundamental forecast for Palantir's actual Q3 results and its forward outlook based on the foregoing analysis, we expect the company's revenue to grow by 16% y/y to $2.2 billion for the full year 2023. Specifically, government revenue is expected to expand by 19% y/y to $349.0 million in the calendar fourth quarter, resulting in full-year sales of $1.2 billion (+16% y/y), in line with expectations for backend-loaded strength in public sector spending during the first three months of its fiscal year. Meanwhile, commercial revenue is expected to grow by 26% y/y to $250.2 million during the fourth quarter. Our assumption anticipates continued strength in the ramp of AIP deployments alongside expanding adoption of Foundry, which will be partially offset by a $14 million to $16 million headwind from Palantir's strategic commercial contracts in the fourth quarter, resulting in full-year commercial sales of $969.1 million (+16% y/y).
On the cost front, continued SBC reduction and disciplined spending management remain evident in Palantir's pace of margin expansion observed in Q3. Specifically, GAAP gross and operating margins expanded by 70 bps and 530 bps to 80.7% and 7.2%, respectively, in the third quarter. Meanwhile, the non-GAAP equivalent of said profitability metrics expanded at a more prominent pace, indicating substantial progress in Palantir's efforts to reduce its lofty SBC spend to a reasonable level that is comparable to its industry peer average in the 20% range . The results already consider Palantir's previous warnings of potentially higher SBC spend in Q3, considering the incoming class of new graduate hires, which implies improvements on this cost aspect that has historically had investors concerned.
This accordingly puts Palantir on track to full-year profitability, with expanding operating margin underscoring the durability of this achievement supported by scale over the longer term .
Having achieved four consecutive quarters of GAAP profitability, Palantir effectively satisfies the eligibility requirements for admission to the S&P 500, underscoring a potential boost to its share performance in the near term driven by incremental investors' demand. Taken together with the valuation premium attributable to its AI prospects, which has been reinforced by impressive results in Q3, we are maintaining our base case price target for the stock at $14.
The base case price target is computed under the discounted cash flow approach, which considers projections taken in conjunction with the base case fundamental analysis discussed in the earlier section. A WACC of 10.0% is applied, which considers Palantir's capital structure and risk profile relative to expectations for a higher normalized risk-free Treasury benchmark going forward. This elevated discount rate is compensated by the company's improving fundamental prospects, driven by TAM-expanding opportunities through AIP and margin expansion at scale. Given its debt-free balance sheet and expanding cash flows reinforced by sustained GAAP-based profitability, Palantir is also well-positioned to take advantage of the elevated interest rate environment. This essentially mitigates its exposure to the impact of rising capital costs, with self-sufficient funding for longer-term growth initiatives - particularly in AI developments. These factors taken together help us maintain the base case price target at $14 for the Palantir stock. An implied perpetual growth rate of 3.5% is applied to terminal cash flows over the forecast period in the DCF analysis, in line with the projected pace of economic expansion across Palantir's core operating regions.
Final Thoughts
While inherent business risks - spanning lumpiness in government revenue recognition and a macro-sensitive commercial spending environment - persist, Palantir's continued ramp of AIP to capitalize on emerging secular tailwinds remains a bright spot for the stock. Meanwhile, profitability and cash flow expansion, supported by an effective land and expand business strategy and a consistent pace of new customer additions, also mitigates its exposures to the impacts of an elevated normalized rate environment in the near term. Taken together, we believe the Palantir stock's risk-reward set-up at current levels has improved coming out of the underlying business' solid Q3 performance, with its forward outlook reinforced by the continued ramp of AIP share gains and a stabilizing commercial spending environment. Although the stock now trades close to our base case price target, we believe the latest results reinforce investors' confidence in Palantir's AI opportunities over the longer term, which could buoy a further upsurge towards the bull case price of $16 within the near term.
For further details see:
Why Is Palantir Up 12% Post Q3'2023 Earnings? Our Price Target And Analysis