Palantir: Why I Doubled Down My Position (NYSE:PLTR)

Abstract data flow background

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Investment Thesis

A year ago, investors rushed to grab Palantir Technologies Inc. (NYSE:PLTR) shares for $20 or $25 per share at a 30% projected growth. A year later, Mr. Market does not like the price at $7 or $8 per share, at a P/S multiple of around 9x and a revised growth estimate of 20-25%. I recently doubled down on my position when PLTR plunged to $6.94/share, and in today’s analysis, we explore one of the latest Palantir developments.

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Data by YCharts

Growth Headwinds Are Short-lived

Not surprisingly, the recent earnings have not pleased investors in the current fragile environment, and the economic slowdown has weighed on the company’s growth prospects. Nevertheless, the company is on track to deliver annual revenue growth of around 23% for 2022.

As growth tapers in its core government segment, Palantir needs to increase its customer base to reach a $4-$4.5 billion sales revenue goal by 2025. In other words, Palantir must stay on track for its 30% annual revenue growth to achieve its target. The growth will derive from a larger customer base and higher average revenue per customer (ARPC). In addition, partnerships with hyper-scale cloud vendors and system integrators remain critical to boosting win rates for its commercial business.

Even though Palantir has been in existence for nearly two decades, many critics of the company have justifiably criticized the company’s profitability. However, there is light at the end of the tunnel, and as Alex Karp has noted in the Q2-2022 earnings call:

That combination of radical optionality on expenses and what we perceive to be macro conditions converging with product conditions allow us to kind of see what we think will be a profitable company in 2025.

SBC Is Slowing Down

Palantir has been infamous for awarding lucrative SBC, putting a dent in the company’s operating margins. However, despite the lack of profitability, we have seen a pivot in stock-based compensation (SBC) lately, and the company is on the right track toward SBC normalization.

Undoubtedly, a disruptive company like Palantir needs to attract and retain the best talent, and SBC is an expensive way to achieve this goal. Nevertheless, SBC is slowing down. If it had excluded it from the net income, the company would have turned profitable, assuming that the savings in SBC exceeded the additional payroll cost for employees.

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Data by YCharts

Alex Karp knows that super-talented human capital is scarce. If he can hire and retain the best, he can double down on Palantir’s production capacity, moat generation, and growth. As a result, SBC is an effective way to incentivize employees and achieve alignment of shareholders’ interests over a longer term. Still, unreasonably high SBC for extended periods will hurt profitability and keep investors away. More specifically, Palantir posted a negative $62.2 million operating margin for Q3 2022, and this would have been a profit of $78.1 million, excluding the SBC of $140.3 million for the quarter.

Earnings Release

investors.palantir.com

Nevertheless, the declining trajectory provides some relief for shareholders as the company’s SBC outlay has reduced considerably from 56.8% of total revenue in Q2 of 2021 to 30.8% and 29.4% in Q2 and Q3 of 2022, respectively. Although the company refrains from providing forward guidance for SBC, I expect it to maintain its slight downward trajectory in the coming quarters, supporting its operating margins.

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Data by YCharts

Government Segment Leads The Way For Now

Sales growth has historically been driven by acquiring new clients and increasing ARPC. The latter, however, has been decreasing sequentially for the past few quarters since the customer count grew much faster than revenue growth. Regardless, this is not concerning, at least for now, since onboarding new customers is a critical part of the acquisition phase, as previously explained for Palantir’s trojan horse strategy.

Palantir has maintained a relatively high net dollar retention rate of 119% in Q3 2022 in its niche base of 337 customers, with government agencies and large defense companies as the primary users of its software. However, it still needs to expand its customer base to meet its revenue target for 2025. The customer count is far lower than most high-growth cloud software peers, including ServiceNow, which also focuses on large enterprises and has some government exposure.

Not surprisingly, amidst the geopolitical uncertainty, government agencies have expanded their contracts with the company, which is reflected in Palantir’s government segment, which grew 26% YoY, and in customer count that reached 109, surpassing the $1 billion revenue mark. Moreover, as corporations adjust their budgets for an upcoming recession, the US DoD and Western allies will keep expanding their defense budgets for the following years.

US Defense Budget, statista, Palantir, PLTR

US DoD Defense Outlays (www.statista.com)

In the past decade, the US DoD defense outlays were relatively muted in terms of growth, but the reversal trend that started in 2018 will maintain its rising addition trajectory through 2027. In addition, it is no surprise that PLTR’s government customer base has risen by 17% since the Russia-Ukraine war, and global tensions will maintain this momentum. Lastly, the US government is the primary value driver accounting for nearly 76% of the total executed contract value in Q3, as the US military has deployed AI and ML capabilities to enhance its military position.

Palantir, PLTR, customers, government, commercial, segments

Customer Count (Yiazou Capital Research)

However, the shift towards the commercial segment is already happening through a more sophisticated and coherent commercial offering, which can now be deployed to new customers within minutes. In a recent letter, Alex Karp noted:

In the past, the time and effort required to build relationships with and deliver our software to customers weighed on our ability to expand at a pace commensurate with demand in the market.

System Integrators Key To Com Ramp-up

Palantir’s partnerships with system integrators, including IBM and Fujitsu, will be critical to maintaining growth in its commercial sector. The addressable market is projected to be larger than its core government segment. Palantir has opened up its platform to allow third-party developers to build custom applications quickly, and it could help expand uses for its software in areas such as compliance and risk management.

In addition, the company’s alliance with IBM might be beneficial for expansion to healthcare and financial-services customers, where Palantir could displace analytics offerings from rivals such as SAP, Oracle, and Microstrategy. In the last quarter, the commercial segment accounted for approximately 43% of Palantir’s sales, suggesting plenty of room to grow, given the enormous market potential for analytics software.

Despite the strong growth in the government segment, Palantir’s future relies on commercial customers, and as long as the company grows its commercial base and diversifies its revenue, I expect a higher degree of predictability in the top-line growth figures.

Palantir, PLTR, customers, government, commercial, segments

Com Vs. Gov (Yiazou Capital Research)

Palantir’s sales in the US are smaller than those of other high-growth enterprise software providers, but US revenue growth remains resilient. Thus, strategic partnerships with hyper-scale will likely make the US key to the company’s customer expansion and shorter sales cycle in its commercial segment.

Palantir, PLTR, customers, government, commercial, segments

10-Q (seekingalpha.com)

In other news, Palantir’s contribution margin of 52% in its latest fiscal quarter is a stark improvement from pre-Covid-19 levels of around 20%. Moreover, Palantir did not disclose the revenue contribution from its cloud product, which could still be a small portion of sales. Professional services are a much greater revenue contributor than software peers, which use system integrators for implementation work, with services accounting for about 5-7% of PLTR’s total sales.

Palantir’s TAM Is Expanding

Palantir’s Foundry and Apollo products are expanding its total addressable market (TAM) beyond specialized uses for defense, terrorism threats, cybersecurity, and fraud detection. In addition, Palantir’s leading role in geospatial data and pattern recognition should continue to help differentiate it compared to analytics software from companies such as Microsoft, Qlik, and Salesforce.com.

Palantir had less than 2% exposure to the $83 billion global big-data and analytics software market in 2021. The market is expected to grow at a CAGR of 9.96% to over $146 billion by 2027. Palantir’s data-visualization capabilities and speed at finding patterns within data sets are helping expand its use more broadly as an analytics product in a market projected to grow at a CAGR of 5.6% to over $35 billion by 2028.

Palantir, PLTR, customers, government, commercial, segments

TAM (investors.palantir.com)

Concluding Thoughts

PLTR has fallen almost 70% from its 52-week high and trades at multiples lower than peers, many of which have declined amid a pullback in valuations of high-growth data-analytics companies. At the current price levels, the stock has priced in the margin deterioration in the next few quarters amidst a macro slowdown, and I see a limited downside. Any surprises on the upside would be a catalyst for a positive re-iteration of the stock multiple.

Mark The Date: 11/22/22

On November 22, I am launching Yiazou Capital Research, my research platform on Seeking Alpha Marketplace, where we provide our best-in-class in-depth equity research and top investment ideas in this bear market. After the launch and for a limited time, the first members joining our community can lock in for a special legacy price forever.

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