Palantir: The Price Is Right

Summary

• Palantir is a great company with a stock that reflects high expectations.
• In this article, I ask myself; what would it take to make Palantir a “good” investment?
• Lastly, I assess whether it's reasonable to expect the kind of growth and profitability that justify investing in Palantir.

Frederick M. Brown/Getty Images Entertainment

Thesis Summary

Palantir Technologies Inc. (NYSE:PLTR) continues to mystify and divide investors and analysts. The stock has come down considerably since its ATH and now trades in a tight range. When it comes to Palantir, it seems most would agree that it is a good business with a solid product/service in a growing market. In this article, I take a deep dive into Palantir's margins, expenses and need for financing, to determine what the company could look like in 10 years. Profitability is moving in the right direction, but is it enough to justify the price?

What exactly would it take to make Palantir a "good" investment?

Palantir in Numbers

Looking at a 10-year horizon, what does Palantir need to achieve high returns for investors? We are going to look at existing quarterly reports to see what kind of evolution it would take to construct a bullish thesis, and then see if it can be justified. Given the early nature of the company on its growth path, we will look at a 10-year horizon. So here is what it looks like and what needs to happen.

Improve margins

Palantir's GAAP Operating Income has been negative every single quarter since its first report from March 2019. The current EBIT margin stands at -101% compared to the sector median of +8%. However, with a closer look at the evolution of these figures, I will make the case that there is already a similar margin to the sector hidden in them.

Quarter	2019-1	2019-2	2019-3	2019-4	2020-1	2020-2	2020-3	2020-4	2021-1
Revenue ($mm)	161	176	191	229	229	252	289	322	341
Cost of Revenues	-51	-57	-65	-76	-64	-68	-149	-71	-74
SG&A Expenses	-176	-181	-194	-202	-169	-196	-674	-313	-283
R&D Expenses	-77	-79	-76	-76	-66	-87	-314	-94	-99
Operating Income ($mm)	-142	-140	-144	-124	-70	-99	-848	-156	-114
Margin %	-88%	-79%	-76%	-54%	-31%	-39%	-293%	-48%	-33%

Click to enlarge

Source: Author's work based on quarterly financial statements.

If we plot the expenses with the revenue for each quarter and determine the linear relation between them, we can come up with an approximate model of fixed and variable components for each item. As revenues grow, the economies of scale will make the operating margin tend towards the variable margin. Let's have a look at these three expense items' charts:

Source: Author's work.

The relations aren't a perfect fit, but they offer a good estimate of the long-term dynamic. The equations on each graph show the fixed and variable components. In the first, for example, the variable component is 0.0991, or 9.91% of revenues, and so on. The figures are summarized in the following table:

Item	Fixed	Variable
Cost of Revenues	$42m	9.91% of revenue
SG&A Expenses	$43m	71.75% of revenue
R&D Expenses	$51m	12,88% of revenue
Total	$136m	94.54% of revenue

Click to enlarge

Source: Author's work.

As you can see, the total variable cost according to this model is 94.54% of revenue, which means the long-term operating margin, given the current performance trend, is the remaining 5.46%. This is still below the sector average EBIT rate of 7.93%, but the amount of improvement required to get on par looks a lot smaller than if we just consider the actual figure of -101%. What this means is that although we will need to see some qualitative reasons to believe that margins can improve, it also seems that revenue growth will eventually bring some profits. Further, we will make the case that this 4.46% margin needs to be close to 29%.

Keep up the growth

If margins can get up to speed with the sector, what we need to see is Palantir's growth outperforming peers consistently, or at least for the long run, as growth rates tend to slow down as the potential market gradually dries out, unless the company is constantly creating new markets.

Palantir revenue grew 47% in 2020, and almost 49% YoY in the first quarter of 2021. This is much higher than the sector median 8% growth rate. Consensus estimates have Palantir's revenues reaching $12.5bn in 2030, and in a previous article, we came to a similar conclusion based on the trend of the last nine quarters, from Q1 2019 to Q4 2021. Here is a summary of our forecasted revenue and growth rate for that period:

Year	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Revenue	1,578	2,196	2,942	3,820	4,830	5,972	7,245	8,650	10,188	11,856
Growth	44%	39%	34%	30%	26%	24%	21%	19%	18%	16%

Click to enlarge

Source: Author's work

Keep the balance sheet thin

One of Palantir's financial weaknesses as an investment is the issue of financing. Although the balance sheet's girth is largely attributable to cash, we can assume that this is necessary as this is not the only tech growth company where we see this. Given the fact that Palantir is financed almost exclusively through equity, and it is making losses, dilution is a very real and detrimental prospect for the future share value. If we look at a very summarized balance sheet for the last 5 quarters, we see growing equity and cash, where the rest combined is a diminishing net liability.

Quarter	2020-1	2020-2	2020-3	2020-4	2021-1
Cash ($mm)	1,079	1,498	1,800	2,011	2,339
Equity ($mm)	146.6	729	1,252	1,523	1,806
Rest of Net Assets ($mm)	-933	-768	-548	-489	-534

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Source: Author's work based on quarterly financial reports.

The good news is there is more cash than equity (in book value) at all times, so the operations are not generating any financial urgency to keep diluting the stock. We can assume that keeping an appropriate cash balance and stock-based compensation to executives look more significant now at a stage where revenues are still very small. If you took a linear approach to the relation between this balance sheet and operations, it would appear that equity keeps growing faster than revenues, but we are going to suggest an approach where the required equity slows down as revenue grows higher, as you can see in the following chart:

Source: Author's work

With this model and the revenue we forecasted, the need for equity would only reach a little over $10bn in 2030. I have added to the table below the earnings forecast as per the margins we discussed before (with the variable margin growing gradually to the 29% we mentioned in the previous section), and the additional funding required to maintain the equity book value on the desired level. Note that we have approximated the Operating Income to Net income, as so far, the company doesn't seem to have a clearly non-zero average tax rate or a significant interest expense.

Year	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Revenue	1,578	2,196	2,942	3,820	4,830	5,972	7,245	8,650	10,188	11,856
Earnings	-25	73	216	414	678	1017	1440	1958	2580	3315
Equity	2,391	3,695	4,849	5,880	6,805	7,642	8,404	9,104	9,749	10,347
Additional Funding	894	1,231	938	616	247	-180	-678	-1,259	-1,934	-2,717

Click to enlarge

Source: Author's work

As you can see there will probably be some more dilution, but the required additional funding would be moderate, and the company would theoretically even be able to reduce the stock after a few years (or return value to shareholders in some other way). How many shares this means depends on the price at each given time, but we could reach an estimate if we increase the current share price by 20% each year, which is a reasonable expected return for a growth stock with an uncertain future.

Year	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Initial nº Shares	1,822	1,862	1,908	1,937	1,952	1,958	1,955	1,944	1,929	1,909
Share Price	22.49	26.99	32.39	38.86	46.64	55.96	67.15	80.59	96.70	116.04
Additional funding	894	1,231	938	616	247	-180	-678	-1,259	-1,934	-2,717
New shares	40	46	29	16	5	-3	-10	-16	-20	-23
Final nº shares	1,862	1,908	1,937	1,952	1,958	1,955	1,944	1,929	1,909	1,885

Click to enlarge

Source: Author's work

So, what would this scenario look like in terms of over or undervaluation? Let's look at the earnings per share and the price to earnings ratio. If we assume that in the long run, earnings growth is approximately equal to sales growth, and that the 8% sector average holds, then with Palantir's growth at 16%, and applying the price to earnings growth logic, you could justify Palantir's PE ratio to be twice as much as the sector PE ratio. If the sector PE was still 33 at that time, Palantir could trade at a PE of 66. As you can see, the 29% margin we calculated earlier was not arbitrary, since all other assumptions equal it is the number that makes the forecasted 2020 PE ratio 66.

Year	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Share Price	22.49	26.99	32.39	38.86	46.64	55.96	67.15	80.59	96.70	116.04
EPS	-0.01	0.04	0.11	0.21	0.35	0.52	0.74	1.02	1.35	1.76
PE ratio	-1690	709	291	183	135	108	91	79	72	66

Click to enlarge

Source: Author's work

Is this realistic?

The calculations above would make a compelling case for investing in Palantir. A price target of $116.04 is a yearly return of just over 20%, which should be enough to entice investors. However, is this scenario realistic? The analysis laid out above relies on three key variables; growth, profitability and PE ratio.

Defending the growth story is perhaps the easiest out of these three. Palantir is currently growing revenues at a rate of 40%, gaining market share, and making itself ever more indispensable to public institutions. As we laid out in this article, Palantir has a compelling business and moat, which puts it head and shoulder ahead of the competition. On top of that, it's also easy to argue that, as a whole, the data analytics industry should grow even faster over the next 10 years. By some estimates, the global analytics market will grow at a CAGR of 25% in the 2021-2030 period. This is in fact very much in line with our forecasted CAGR for Palantir in those 10 years, which comes out to 26.92%. Ultimately, I believe this growth forecast is quite conservative.

On the other hand, profitability is something more of a wild card, but there are key factors that prove, to an extent, that Palantir can easily be profitable. It's clear by looking at the numbers that Palantir's rate of dilution will slow down, or at least can slow down. In reality, the company doesn't need to dilute that much, since it actually has plenty of cash. Dilution is happening mostly as a result of Palantir issuing stock options to reward their employees, which are arguably the company's most valued asset. Of course, the company may choose to continue to do this, but, ultimately, this is something Palantir controls and can decide based on a calculated cost-benefit analysis.

Moving on to the operations themselves, there's also reason to believe that Palantir can improve its margins. This is exactly what we have seen happen in the last few quarters, with Palantir decreasing deployment times and increasing revenue per customer and gross margins. I believe there's a reason for this, and it has to do with the nature of what Palantir offers. What the company does, ultimately, is give its clients a platform, which relies on both infrastructure, Palantir's software/AI, and resources, which are Palantir's employees, who act almost as consultants to the client.

This Platform, powered by both humans and machines, is what delivers value to clients, and in the long run, it is to be expected that this Platform will be able to deliver more value. Firstly, because Palantir's AI will keep improving, but also because Palantir's engineers will get even better and more familiar with the process. On top of that, as it becomes increasingly clear just how useful data is, companies will collect more of it, which is another input that will allow Palantir to offer more value. In short, more value equals more money, which means higher profitability for Palantir.

The forecast above predicts that Palantir can achieve a 29% operating margin by 2030. It's hard to predict this with complete accuracy, but I do believe that Palantir can approach this level of profitability in the long run. A more mature competitor, for example, Cognizant Technology Solutions Corporation (CTSH), has an EBIT margin of 14.6%. A 21% margin for Palantir is an ambitious target, but wouldn't a market leader also have market-leading profitability?

Last, and certainly not least, in order to justify an investment in Palantir, the company will have to keep its above-average valuation multiples. Many investors will simply refuse to invest in companies with such high PE ratios because they are "too high" and "hard to justify". However, this is an arbitrary judgement, and more importantly, an investing dogma that would have prevented you from investing in some of the best-performing stocks of the last few years.

The valuation above uses a PE of 66, which is twice that of the industry. A PE of 66, out of context sounds like a lot, but this is justifiable if you believe that the company will continue to be a market leader. It stands to reason that a company that is growing earnings twice as fast as its peers, should have double the PE. There are many other factors that go into determining a PE, such as profitability, market conditions and historical performance, but Palantir seems to check all the boxes. The company is thriving in a growing industry, and investors today are rewarding it with a higher valuation. Looking forward and because of the reasons laid out above, improving growth and profitability, a PE of twice the industry makes sense. It accounts for both the fact that as Palantir matures, the PE will come down, but also for the fact that the company still deserves a premium valuation.

Takeaway

I started this article with a simple question. What would Palantir need to do in the next 10 years to justify an investment today? Palantir is priced for success, but I believe the "targets" that today's price imply are mostly achievable. I'd say the most problematic variable would be profitability, but there's plenty to support the idea that Palantir should be considerably more profitable in the future. Ultimately, as long as Palantir shows that it is moving in the right direction and it preserves its market leadership, this should be enough to sustain high multiples and a higher share price in the future. Furthermore, there are other "paths" that could take Palantir's share price much higher. The company could pursue growth only and forget about profitability. As long as investors see this as a good move, the shares could still trade much higher in the coming years. Ultimately, "success" is measured by the market in different ways, and I believe that Palantir has what it takes to be seen as a successful company in the future, which will be reflected in its share price.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.