Bullish On Palantir As It Is Just Beginning To Monetize Its Platforms

Invest To Retire2020-09-23

SummaryPalantir is a play on big data integration and analysis with a long growth runway ahead as multiple new industries and government agencies are just beginning to use its platforms.More advanced ...

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Discounted Cash Flow model indicates US$19 per share possible if Palantir executes well.","collect":0,"end_time":0,"defaultTopTitle":"seekingalpha.com","property":[],"viewcount":null,"language":"en","relate_stocks":{"PLTR":"Palantir Technologies Inc."},"translate_title":"看好Palantir，因为它刚刚开始将其平台货币化","themeId":null,"isJumpTheme":false,"ttsUrl":null,"symbols_score_info":{"PLTR":0.9},"content_text":"SummaryPalantir is a play on big data integration and analysis with a long growth runway ahead as multiple new industries and government agencies are just beginning to use its platforms.More advanced capabilities (at the expense of not being a ‘plug-and-play’ platform) should drive market share gains in the long-run, as data becomes larger and more complex.Revenue growth is accelerating as customers enter the monetization phase of a long sales cycle, and contribution margins have shown exponential improvement in recent quarters.US$1.2bn net cash balance sheet should be able to fund operations internally until EBIT break-even in 2023.Target price of US$12 per share based on a 15x 2021 Price-to-Sales (P/S) multiple. Discounted Cash Flow model indicates US$19 per share possible if Palantir executes well.The Offering Palantir (PLTR) is undertaking a direct listing on the New York Stock Exchange, and is expected to trade on 29 September 2020. Hence, this is not a traditional IPO with a primary share offering or an offering price. We will only get a sense of market value on the 29th of September. Palantir will have three share classes - Class A, Class B and Class F (for Founder) - and the Class A shares are the ones that will be traded in the secondary market. The difference in share classes relates only to a difference in voting power, with Class A being given one vote per share; Class B given ten votes per share; and the unique Class F having a variable voting power that ensures founders retain up to 49.999999% of voting power. In other words, this ensures founders retain major voting power over the company. Roughly 80.5% of shares, options, and restricted stock will be bound by lock-up agreements, which mostly expire on the third trading day after the release of the FY2020 full-year results (so probably some time in Feb 2021). The remaining 19.5% will be freely tradable on listing day. What does Palantir do, and how does it stack up against the competition? In layman's terms, Palantir creates big data solutions for companies and governments by combining existing internal and external sources of data and merging them into a more intuitive platform that helps i) users visualize this data better; ii) discover links between information that were previously not obvious (sometimes using AI to help with this); and iii) keep the database up to date across the organization as the data evolves. Palatir has two core products - Gotham and Foundry - which are broadly similar in purpose but used primarily by the Government and Commercial sectors respectively. In the company's earlier years they were a hybrid IT consulting/Software company, where their IT engineers spent a lot of time 'on the ground' with companies in order to figure out what was really needed and how to build this into the products being offered. But the IPO filing makes it clear that they are now positioning themselves more as a Software company (given higher valuations in the Software sector of course), and the early days of IT engineers spending a lot of time 'on the ground' is now paying off in terms of the R&D knowledge garnered from that, which enables the products to be launched at scale now.\n To be honest, I found trying to understand what Palantir really does and how it stands out against competing products quite perplexing. In Palantir's S-1 filing, they took great care to quote a myriad of case studies in which Palantir was deployed effectively (mapping 5 million Airbus A350 parts; analyzing genomic data; consolidating and connecting the relationships within information relating to terrorists or insurgents). They also give examples of the functionality of various applications within the Gotham and Foundry products (e.g. Gotham's Graph; Gaia; Dossier; Table…), which initially struck me as just being Microsoft Office on steroids. But what is the real value add here, given the wide availability of analytics platforms out there? Is it Palantir's cutting-edge AI system that parses through big data to generate insights that is the value-add? (It supposedly aided in tracking down Bin Laden) Is it simply a better version of Microsoft Office that will gain market share? After combing through the S-1 filing and watching the investor day presentation, the conclusion I have come to is that the real value add Palantir is bringing to the table is Data Integration ability. They have created a product that is somehow able to take all the legacy datasets and systems that government agencies and companies use, and merge them onto a single platform that combines them into a unified source of truth for users. This is the real value-add: the breaking up of legacy information silos, and Palantir claims to be able to do this better than competitors. I think the paragraph below best summarizes the value-add that Palantir brings to the table:  \"We believe that the integration and joining of different datasets is what matters most. Data integration also happens to be among the hardest problems to solve. We spent years investing in the development of a platform that makes the task of integrating new datasets routine so that users can focus on taking action on information.\"  Having said that, I do feel that the products being offered by competitors like Alteryx and Tableau are very similar. They all have the same functions: data ingestion, data visualization, data exploration… and so on. The goal of these products is also the same: to make data user-friendly and to extract maximum insight from available data. As I read through the websites and filings of some of these companies, I tried to understand if there was something that made Palantir stand out as a disruptor in the space. I couldn't find an obvious answer. And to me, if it is so difficult to find the answer to the question 'why is Palantir a disruptive technology?' then the likely answer is that it simply isn't.\n Of course, there are product-specific pros and cons, but my sense is Palantir is not a game-changer that is going to make all these other companies go bankrupt. What Palantir is, is a top-tier competitor with a solid product that will compete with other data science platforms out there. Palantir seems to a more heavy-duty type of platform; they refer to themselves as an 'Operating System' rather than a software or application in their S-1 filing. The platform is not as simple as plug-and-play, which results in a longer sales cycle than what you may see with other software, but it also seems to have greater functionality and ability to manipulate data than competitors. Customers who choose Palantir must commit time and effort to integrate the platform into their organization to the point it becomes like an 'Operating System', and so the adoption of Palantir will likely face internal inertia, but the rewards can be great. I think this is one reason why Palantir's customer concentration is on the high side, with three unnamed customers accounting for >10% of revenue each within some annual or semi-annual time periods over the last 2.5years, and Palantir having only 125 customers in total as of 1H20. Overall, I feel that Palantir being a heavy-duty 'Operating System' rather than a plug-and-play software will work in its favor in the longer-run, as we are only just on the cusp of the explosion in data globally. As data becomes more complex, a more advanced platform like Palantir could just be what the world needs. Total Addressable Market That the key nature of Palantir's value-add (data integration) is broad-based is important because this opens up a sizeable Total Addressable Market (or TAM) for Palantir. According to their S-1 filing, Palantir estimates their TAM to be US$119bn across the government and commercial sectors (this number includes the TAM from the governments of US allies). This is compared to US$742.6m in revenue in 2019, representing just 0.6% of the annual TAM. These TAMs should always be taken with a pinch of salt, but the rationale behind the derivation of it (talked about in the investor day video) seems reasonable, so I'll run with this for now.\n Still in early stages of growth Palantir was founded in 2003 and started off as a company focused on building intelligence software for the US Government to aid their counterterrorism efforts. Only later did it begin expanding into other government organizations and commercial organizations. You can see from the timeline below that Palantir's cross-industry expansion has only really taken off in the last 5 years or so, as they realized that the nature of data problems faced by governments and commercial companies across various industries were very similar, which the Gotham and Foundry platforms were equipped to address. There is a long growth runway ahead, as Palantir makes inroads into various new industries.  Source: Palantir S-1 filing A dive into Palantir's Financials: operating leverage shines through The first thing to point out is that Palantir's revenue growth is actually accelerating, not decelerating (unlike most growth companies). Total revenues in 2019 were up 24.7% y-o-y but in 1H20 revenues were up 49.1% y-o-y. And this is despite COVID-19, which has reduced face-time between Palantir's software engineers and its customers. In my view this is not a one-off window-dressing event, but rather it is the nature of Palantir's business model wherein customer spending rises exponentially as they mature in terms of time spent integrating Palantir into the organization (explained more in a subsequent paragraph). Given that Palantir is still in the early stages of breaking into multiple industries in the Commercial sector, I think this dynamic will continue to drive acceleration in revenues in the near-to-medium term. We have also seen operating and net margins improve significantly as revenues grow, reflecting the operating leverage inherent in the business of selling software. Diving a bit deeper into the details, while the reported 1H20 costs are a bit understated as there were significant travel cost savings totaling c.US$31.6m (according to the S-1 filing) in 1H20, even adjusting for this, Palantir's operating margin has improved to -41.8% in 1H20, compared to -88.3% in 1H19 and -69.4% in 2H19. If this trend continues, I think it's possible that we see positive operating margins by late-2022.\n  Source: Palantir S-1 filing Palantir also reports what it calls Contribution Margin, which is defined as \"revenue less our cost of revenue and sales and marketing expenses, excluding stock-based compensation, divided by revenue\". I don't find this metric particularly meaningful, given that it excludes important and significant expenses namely Research & Development, General & Administrative, and Stock-Based Compensation costs which were 32%/34%/33% as a percentage of revenues in 2019 respectively. On stock-based compensation, many companies choose non-GAAP measures that exclude this expense as it is non-cash, but given the dilution to shareholders down the road from exercise of stock warrants, this is a very real expense in my view, and excluding it makes little sense. Nonetheless, despite the flaws of the metric, because Palantir has disclosed its Contribution Margin in terms of quarters since 1Q19 (whereas for other financial metrics only Annual/Semi-Annuals are disclosed), it is useful in getting an even better sense of the trends in margins. In this respect, the numbers tell a positive story, with contribution margins rising sharply and consistently every quarter, from 15% in 3Q19 to 55% in 2Q20 as customers reach a more mature stage.  Source: Palantir S-1 filing Indeed, we can derive more color on this from Palantir's S-1 filing where they detail their 'land and expand' strategy. Basically, customers are classified into three buckets called 'Acquire', 'Expand' and 'Scale'. Customers in the Acquire and Expand buckets are loss-making because Palantir spends on pilot projects with them and deploys personnel to educate the customers on how to use the platform, as well as figure out customer needs, with little revenue in return; these stages are essentially where profitability is sacrificed in order to drive customer acquisition.\n In the Acquire stage for example, only US$0.6m of revenue was earned from these customers in 2019 vs. a contribution loss of US$65.4m. In the Expand stage, in 2019 customers spent c.US$176m with a contribution margin of -43% (or a contribution loss of about US$76m). In comparison, customers in the 'Scale' stage generated US$565.7m in revenue in 2019 at a contribution margin of +55%. On top of this, Palantir also compares how the same customer cohort in 2019 has done in 2020 as projects move further along the curve, and the numbers are very encouraging. Across all three buckets, the same customer cohorts showed large increases in revenues and sharp improvements in contribution margins. This is summarized in the table below:  Source: Palantir S-1 filing So we can see that getting customers to the Scale stage is the key here, and once Palantir is able to do that, we see margins improve exponentially. Has it been able to do that? Well, the numbers don't lie - as we saw in the quarterly contribution margin chart, over the last year or so margins have more than tripled, which speaks to the maturing of Palantir's customer profile. And in the longer-term, I believe there is much more room for contribution margins to rise. If you look at the top 25% of Palantir's customers in the Scale phase by contribution margin, they had a contribution margin of 87%/89% in 2019/1H20, and I see no reason that other customers cannot achieve similar margins over time. In terms of the balance sheet, Palantir had US$1.497bn in unrestricted cash vs. US$297m in debt as of 30 June 2020 - or a net cash balance of US$1.2bn. Looking at the statement of cash flows, one key point to note (this was mentioned in the investor day presentation) is that prior to 2020, Palantir often billed customers upfront for multi-year contracts, resulting in lumpy cash inflows into customer deposits/deferred revenue accounts and that cash would be gradually drawn down over the life of the contract. But since 2020, as customers have matured, Palantir is looking to shorten this billing cycle and cash flows should match the income statement more closely. Hence, in 1H20 although we see a pretty large quantum of operating cash outflows, this is likely due to the transition phase between billing cycles. Meanwhile, capex on property, plant and equipment is low and non-significant, so Free Cash Flow largely mirrors Operating Cash Flow. From the start of 2018-1H20 (2.5 year period), Palantir had a cumulative negative Free Cash Flow of US$463m. Doing the math, at this run-rate, Palantir's cash balance would last about 6.5 years. That is a pretty decent cash burn runway for a fast growing company in my view. At worst, any worries about cash balances won't really surface in a big way until 2-3 years later. At best - and this in my view is more likely - given the operating leverage highlighted earlier, we should see Free Cash Flow improve significantly over the next few years, and my bet is Palantir's balance sheet will be able to last it until the company turns Free Cash Flow positive.\n  Source: Palantir S-1 filing Valuation As with other loss making but fast-growing tech companies, I prefer to include a Discounted Cash Flow model in the analysis, as this accounts for the level of profitability expected to be achieved in the longer-term. I also use a peer multiples comparison as a second method of valuation. Discounted Cash Flow First, let me talk about the Discounted Cash Flow model. I have done a 20-year Discounted Cash Flow model for Palantir, and the key assumptions behind it are as follows:  Over the 20 year forecast, revenue grows from US$742m in 2019 to US$33.5bn in 2039, representing a 45x growth. While that seems quite optimistic at first glance, consider that the TAM for Palantir is estimated at US$119bn currently; if I assume that the TAM doubles in 10 years and triples in 20 years (i.e. hitting almost US$360bn in 2039), then under my assumptions Palantir would have about a 9.4% market share of the market by 2039 vs. less than 1% at the moment. I think this is a reasonable assumption especially since demand for Palantir's product over the competition should grow as data becomes more complex. In the nearer-term, for the 2019-2027 period, I am modelling revenue growth of c.40% CAGR. This compares against a projection by Verified Market Research for the Global Data Prep market to grow at a CAGR of 25.65% from 2020-2027. Again, I feel this is defensible given that Palantir is in the expansion/grabbing of market share stage. On margins, I assume contribution margins gradually trend upwards (from 55% as of 2Q2020), and mange to reach 70% in steady state. Remember, this is compared to Palantir's top 25% of customers in the Scale phase who have contribution margins in the high 80%s. This flows down to operating (EBIT) margins, which improve with greater economies of scale, from an adjusted -41.8% in 1H20 to -0.8% in 2022 before breaking even in 2023. They then improve gradually before hitting a steady-state margin of ~30% in 2030. A 30% margin is comparable to best-in-class software peers like Adobe. I am using the fully diluted share count of c.2.17bn shares, which includes all the RSUs, options, warrants, growth units and stock appreciation rights regardless of whether they have vested or not. My sense from reading the S-1 filing is that the vast majority of these will vest or be exercised given that the listing itself is an important criteria for vesting while the weighted average option exercise price is pretty low at about $3.55. Hence, it is probably prudent to assume all of these are converted to common equity over the next few years. I use a WACC of 10% to discount future cash flows. I find this is a good rule of thumb to use as a discount rate for riskier companies from my experience. Oil & Gas companies use a 10% discount rate on their future production and that level of risk seems somewhat commensurate with the level of risk we are looking at with regard to the limited visibility on Palantir's revenue and margin outlook. In any case, better to be conservative than not. \n Here is a snapshot of the model:  Source: author's calculations and estimates The discounted cash flow model derives a US$19 per share target price, or an equity value of US$41bn for Palantir. This seems high versus where Palantir's shares had traded in the private market, but I am baking in reasonably aggressive revenue and margin assumptions. Peer Comparison Next, looking at peer valuations, while the average Price-to-Sales multiple for my comparison set is only at 6x, this is because the average is dragged down by companies who either i) don't have as great an ability to scale, such as Booz Allen and Globant due to their consulting-type business model or ii) have lower sales growth such as Altair or MicroStrategy. In my opinion, Alteryx is the most relevant peer here and Alteryx is being valued at 14x P/S. Interestingly, Alteryx shares have sold off in recent weeks because of disappointing numbers through 1H20 as COVID-19 has impacted their sales cycle. On the other hand, we saw Palantir record a stellar 1H20 with revenue accelerating to 49% y-o-y (vs. 24.7% in 2019). Some of the strength in Palantir's numbers is probably due to the lagged effect from a longer sales cycle, but nonetheless seeing customers willing to ramp up spend significantly during a period of stress shows that Palantir's platform is a 'must have', whereas competitors like Alteryx may be more of a 'good to have'. Having said that, Alteryx is already profitable on an EBIT level and should be awarded a valuation premium for that whereas Palantir is still not profitable. On a net basis, I am pegging Palantir at 15x 2021 P/S, which is just slightly above Alteryx. This yields a US$12 per share target price. \n Source: Palantir S-1 filing, company filings, author's calculations The final piece of information we have with regard to valuation is Palantir's privately traded share prices. From the S-1 filing, we can see that from Jan 2019-July 2020, Palantir's common shares traded at a pretty tight range around US$5 per share. However in August, the weighted average share price shot up to US$7.31, but the range of trade prices was very wide, at US$4.17-11.50 per share. I would ignore the September number given that it only represents one day in September. Putting all these valuation insights together:  Source: Palantir S-1 filing, author's calculations The verdict: Target price of US$12 per share. I am basing my target price for Palantir on the 15x 2021 P/S valuation, which represents a middle ground between the various valuation data points. I would view the DCF-derived target price of US$19 per share as the potential for Palantir's shares if they execute well. Key Risks Geopolitical risk - could Palantir become the Huawei of the West? The US has sanctioned Huawei, a privately owned company, on the basis of national security concerns. Many US allies have followed suit (e.g. not using Huawei components in their 5G network buildouts). The US has also disallowed any company using US manufacturing equipment to supply Huawei's subsidiary HiSilicon with components for its semiconductors. These unilateral moves show that there are many creative ways in which the US and China can make 'economic attacks' on each other. Is it possible that China makes a tit-for-tat move, and declines to do business with companies using Palantir? The answer is yes, this is a real possibility in my view - in fact, just as I was done writing this, it was reported in the news that China is debating adding US Tech companies to its 'unreliable entity list', which is the blacklist that was initially announced in May 2019 in retaliation to the Huawei sanctions. While I think it is likely that higher-profile names will be added to China's blacklist first, this is something that bears watching over time, as Palantir might fit the bill of a 'foreign entity' with great access to corporate data. The risk here is not that of Palantir not being able to sell to Chinese firms - we already know Palantir has chosen sides and is not selling to non-US allies. The risk here would be the Chinese refusing to do business with, or reducing business with, firms that use Palantir, as these firms might input data on the Chinese into Palantir and, justifiably or unjustifiably, result in 'national security concerns'.\n Revenue concentration. Palantir's top 20 customers accounted for 67% of total revenue in 2019, at an average of US$15m per top 20 customer in 2019. While customers historically have signed on to longer-term contracts, with Palantir's existing contracts lasting another 3.5 years on average as of 30 June 2020, these contracts usually contain a termination for convenience clause, which basically means that customers can cancel or walk away at any time. Palantir losing some of its top 20 customers would be negative for growth and the share price. Inability to generate economies of scale. If the deployment of Gotham and Foundry to new customers proves to be more labor-intensive than anticipated, then Palantir would start to be valued as an IT consulting/systems integrator rather than a software company.\nDisclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. 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