Palantir: Focus Is On Government Business And Profitability (NYSE:PLTR)

Palantir Technologies headquarters campus exterior view in Silicon Valley. - Palo Alto, California, USA - 2020

Michael Vi

Elevator Pitch

I downgrade my investment rating for Palantir Technologies Inc.’s (NYSE:PLTR) stock from a Buy previously to a Hold now.

In my earlier July 26, 2022 update for Palantir Technologies, I rated PLTR as a Buy because I took the view that the company’s “2H 2022 revenue should beat market expectations.”

I have less confidence in Palantir Technologies’ short-term financial performance now, and this has prompted me to rate PLTR as a Hold (rather than a Buy now). My key concerns lie with the timing of contracts for the company’s government business and its intention to continue growing its salesforce. Also, Palantir Technologies’ current valuations seem to be fair, which further supports my Hold rating for PLTR.

Spotlight Is On Short-Term Weakness Relating To PLTR’s Government Business

In the past three months, Wall Street analysts have been slashing their respective financial projections for PLTR in an aggressive manner. During this period, the vast majority or 12 of the 14 sell-side analysts covering Palantir Technologies’ stock reduced both their topline and bottom line estimates for the company. Specifically, the market’s fiscal 2022 consensus revenue and normalized earnings per share or EPS for Palantir Technologies were cut by -4% and -69%, respectively, in the last three months.

This series of revenue and earnings downgrades for Palantir Technologies came about, as the company’s FY 2022 revenue guidance of $1.900-$1.902 billion as indicated in its Q2 2022 results media release came in below the consensus forecast of $1.98 billion.

It is also relevant to note a key difference in PLTR’s Q1 2022 and Q2 2022 earnings press releases. In Palantir Technologies’ first quarter earnings release, the company emphasized that it expects “annual revenue growth of 30% or greater through 2025” as “per long-term guidance policy, as provided by our Chief Executive Officer, Alex Karp.” Surprisingly, there was no reference made to PLTR’s long-term topline expansion target in the company’s second-quarter media release. This might suggest that the sales recovery for Palantir Technologies’ government business might take a longer time than what investors are expecting.

The weakness associated with Palantir Technologies’ government business is the key factor contributing to the company’s lower-than-expected full-year 2022 revenue guidance and its omission of the 2025 revenue goal in its most recent quarterly earnings press release.

At its earnings call for the second quarter of 2022, Palantir Technologies noted that “the USG (U.S. government) has some of our largest contracts, and they have been pushed out” and highlighted that its FY 2022 “guidance excludes any new major U.S. government awards.”

It is also noteworthy that PLTR mentioned at the recent quarterly results briefing that its “U.S. (government) business has a (historical revenue) CAGR over a decade or more of 35%” which “included a number of years where it was flat or even negative.” This implies that sales for Palantir Technologies’ government business have been lumpy in the past, and there could be prolonged periods where this business delivers disappointing growth due to the uncertainty relating to new contract timing.

As such, it is possible that the revenue growth deceleration for Palantir Technologies’ government business and the company as a whole extends beyond 2022. According to consensus data obtained from S&P Capital IQ, analysts are taking the view that PLTR’s YoY topline expansion slows from +30.8% for Q1 2022 and +25.9% for Q2 2022 to +21.1% and +17.0% for Q3 2022 and Q4 2022, respectively.

However, the sell-side expects Palantir Technologies’ revenue growth to accelerate to +20.4% YoY, +21.4% YoY, and +24.7% YoY, for Q1 2023, Q2 2023 and Q3 2023, respectively. In other words, there could be room for disappointment again, assuming that there is a further delay in the timing of new government deals.

On the flip side, I am still confident about the growth prospects of PLTR’s government business in the long run.

In my late-July 2022 article, I emphasized that Palantir Technologies will benefit from the fact that “geopolitical tensions and conflicts are expected to drive an increase in the amount of money that governments around the world spend on defense.” This is a view shared by company management as well.

PLTR’s CEO stressed at the company’s Q2 2022 results call that “the next 10 years” are “clearly more dangerous” in terms of geopolitics and “America’s engaged on multiple fronts.” In that respect, Palantir Technologies emphasized that its government business has “the product market fit and access to the market”, and indicated that the performance of this business “will be at least as good in the future as it was in the past.”

All Eyes On Profitability And Investments

The most recent Q2 2022 was a good quarter for Palantir Technologies in terms of profitability, but this is unlikely to be sustained.

PLTR’s actual second-quarter non-GAAP adjusted operating profit margin was 23%. This was much better than the Wall Street analysts’ consensus estimate of 21% according to S&P Capital IQ data, and also higher than the company’s earlier 30% operating margin guidance. However, there are signs that Palantir Technologies’ current pace of investments will be a drag on the company’s future profitability.

In its Q2 2022 10-Q filing, PLTR revealed that it has “3,269 full-time employees as of June 30, 2022.” This implies that Palantir Technologies had added 212 net new employees in the second quarter of 2022 and grew its staff strength by approximately +26% YoY in the recent quarter. PLTR commented at its Q2 2022 earnings briefing that “the expansion of our sales operations” to support the growth in its commercial business “does continue.”

In other words, Palantir Technologies doesn’t appear to be pulling back on its investments (especially in sales) anytime soon even though it is facing revenue growth deceleration in the near term.

Based on the mid-point of its management guidance, Palantir Technologies is guiding for non-GAAP adjusted operating margins of 11.5% and 18.0% for Q3 2022 and full-year 2022, respectively. These are inferior as compared to what the company achieved in Q2 2022 (23%). Also, PLTR only expects to become profitable on a GAAP basis in 2025 as per management comments at the Q2 call, and this is aligned with the sell-side’s consensus financial projections.

Valuations Are Reasonable But Compelling

The market values Palantir Technologies at a consensus forward next twelve months’ Enterprise Value-to-Revenue multiple of 7.3 times now, according to S&P Capital IQ’s valuation data.

PLTR’s current valuations are quite reasonable. A September 14, 2022 Financial Times article quoted fund manager Ben Rogoff from asset management firm Polar Capital highlighting that “the (average) forward valuation of a software stock has gone from 25-times sales to 10-times sales.”

Some form of valuation discount relating to size is warranted given that Palantir Technologies isn’t exactly the largest of software stocks boasting a market capitalization of $17 billion. A high single-digit forward Enterprise Value-to-Revenue valuation ratio for PLTR seems just about right, so I won’t describe Palantir Technologies’ valuations as compelling.

A potential positive re-rating of Palantir Technologies’ valuations sometime in the future is dependent on both company-specific and market-specific factors. The economic environment needs to be better before investor sentiment towards the software sector improves. Separately, PLTR’s government business has to show signs of growth acceleration, and the company as a whole needs to prove that it is making progress towards achieving GAAP profitability in the intermediate term.

Closing Thoughts

My rating for PLTR’s shares is now a Hold. I have considered the outlook for the company’s government business, expectations of its future profitability, and the stock’s valuations in deciding that a Hold is the most appropriate rating for Palantir Technologies.

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