Palantir: Risk-Reward Is Not In Your Favor For The Long Run

Summary

• In this article, I speculate on what questions you should ask yourself before buying PLTR stock.
• Even if we think of the company as a technology startup, its revenue growth does not seem to be financially healthy - follow the Rule of 40.
• PLTR's business model says we can value the company by SOTP - but even if we include revenue growth rates in our model, the stock turns out to be grossly overvalued.
• The behavior of Karp and his team suggests that Palantir is something of a "cash cow". And bulls always buy whatever management systematically dumps in the market.
• Ultimately, the risk/reward ratio is not on the side of long-term investors - so I would not recommend buying the stock as long as it is managed the way it is managed now.

Drew Angerer/Getty Images News

Introduction

Palantir's (NYSE:PLTR) 10-Q report is just around the corner and the bulls are frozen in anticipation of strong quarterly results that will finally allow the stock to come off the flat price channel and rise. I do not doubt that the results will be really strong - the company is good at inking new contracts and growing revenue at a rapid pace. I think Q3 revenue growth will be more than 30%, which is what Karp is promising/targeting.

For most long-term investors, however, it would be more important to look not just at short-term catalysts, but at the quality of the company's business model. The stock is quite expensive, and you need to be sure you are acting wisely if you are spending 30 times sales on an unprofitable company today.

In this article, I will speculate on what questions you should ask yourself before buying PLTR stock. I'll answer these questions by stating my opinion and referencing other sources, and you can answer them yourself (or in the comments for everyone to see).

Question #1: What kind of company is Palantir?

Let us approach the answer to this question in a very matter-of-fact way, without unnecessary grandstanding (as some bulls have done in the comments under my first article). Palantir was founded in 2003 (that's 18 years ago) and is a data analytics, data consulting, and software company that works primarily for various U.S. defense departments. Here is a list of the top 10 departments and contracting agencies:

Source: FPDS.gov

But beyond serving the army, the company is trying to commercialize its services - to tap a wider market, recognizing that GovTech's projected growth of 9.35% (CAGR) over the next few years will not be enough to justify the promised 30% sales growth. As Steven Fiorillo correctly noted in his recent article on PLTR, "the Amazon and IBM partnerships are just getting started." Personally, I do not doubt that Palantir will grow in its commercial side - the only question is how qualitatively and fast it's going to do it.

Even though the company is 18 years old, the bulls justify the increasing equity deficit by saying that PLTR needs to act like a startup to expand the market as much as possible. Okay, so be it. Then let us speak in the language of venture capitalists:

If you want to double your top line revenue, you need to invest twice as much in your infrastructure. So today, you’ll double your expenses but your revenue may not increase for another 24 months. Now you’re carrying the cost of growth. The trick is to balance the two. How do you invest profitability and continue to grow?

Well, venture capitalists have a simple yet consistent way to chasing growth. The Rule of 40. Here’s how you can do the same thing.

The Rule of 40 provides a high-level view of a business’ health. Put simply, if your percentages of growth rate and profit margin total at least 40 when added together, then your business is in great health and could double in valuation.

The rule simple formula is:

Rule of 40 Ratio = Growth rate + Profit

You can measure growth in different ways but the easiest one is probably just do YoY (year-over-year) on MRR (monthly recurring revenue) growth.

Most businesses will follow this rule in the early stages when they need funding. This becomes less important as you begin to scale and achieve consistent profitability.

Source: Quora, Vijar Kohli, Financier at Golden Door

Since Palantir is not yet reaching "consistent profitability", we need to look at it like an early/mid-stage startup - in which case the Rule of 40 is the best we can do to assess the quality of its business growth. Palantir has been a publicly-traded company for a little over a year, so I will measure the "Growth rate" as quarter-to-quarter (QoQ) sales growth and the "Income" as net income margins over the same period.

Source: Seeking Alpha's data, author's calculation

Even in terms of one of the key growth metrics for a fast-growing startup, Palantir is pretty weak in terms of financial health. That's why the company always feels the need for additional funding, which it gets at the expense of you, bulls (more on that later).

Yes, it is obvious that this metric has halved in 2 years (from June 2019), but the net profit margin seemed to have returned to its comfortable negative zone after the acute phase of the pandemic and will most likely remain in the same place when we look at the Q3 results.

Source: Seeking Alpha's data, author's calculation

This should give pause for thought to those who consider Palantir a startup (albeit so old). However, I propose to return to the discussion on the main question - what kind of company is Palantir. Is it an IT defense consulting company, a data analytics company, or a combination of both?

You probably replied that it was a combination of both - that is logical because it follows from the last quarterly report and revenue breakdown:

Source: PLTR's 2Q report, author's calculations

Then we know how to value the company - through the growth and structure of its revenue. The Sum-Of-The-Parts (SOTP) valuation model suits here perfectly - Palantir in this case has plenty of peers for comparison.

Government =		61.83%
Company name	P/S (TTM)	Sales growth, last quarter, YoY
Booz Allen Hamilton (BAH)	1.51	4.30%
Science Applications International Corp. (SAIC)	0.72	4.08%
Leidos Holdings (LDOS)	1.07	18.33%
Average	1.10	8.90%
Commercial =		38.17%
Company name	P/S (TTM)	Sales growth, last quarter, YoY
Tyler Technologies (TYL)	15.31	60.97%
Verint Systems Inc. (VRNT)	2.35	5.14%
Splunk Inc. (SPLK)	11.10	23.18%
Cognizant Technology Solutions Corp.	2.30	11.81%
Alteryx (AYX)	9.22	24.84%
Median	9.22	23.18%
Gov's P/S per 1% sales growth	12.36
Com's P/S per 1% sales growth	39.77
Palantir's Gov growth, 2Q, YoY	66.31%
Palantir's Com growth, 2Q, YoY	27.78%
implied PLTR's TTM P/S	9.28
vs. current P/S (TTM)	-70.20%

Click to enlarge

Source: Author's calculation (based on SA's data)

Of course, the SOTP results have proven to be overly conservative, primarily because some peers are at a completely different stage in their business development (particularly in the "Government" segment). However, this gives us an understanding of how overvalued the company is - even with the promised growth of >30% over the long term, the current multiples are too high. The company is valued as if it will definitely realize itself in the "Commercial" segment - even though it is obvious that it has someone to rival it in terms of growth in this segment.

What is my preliminary conclusion from the above? I answer the question posed as follows: Palantir is a fast-growing company, but with vague prospects of breaking even (in terms of net earnings) - even if we think of the company as a technology startup, its revenue growth does not bring any value to shareholders since it's non-qualitative. The company's business model suggests that it can be valued by SOTP - but even if we include revenue growth rates in the valuation model, the stock turns out to be grossly overvalued - no synergy between the two segments or continuation of "low-grade" revenue growth can justify this.

Question #2: How much do Mr. Karp and others deserve?

According to Bloomberg, Alexander Karp was among the top-10 highest-paid CEOs and executives in 2020:

Source: Bloomberg.com

I suggest that we look at how "qualitatively" these companies have grown over the last 12 months (TTM or 2021 vs. 2020). Since individual representatives of the sample are unprofitable (like Palantir itself), I will use the same metric as in the analysis above - the Rule of 40.

Source: Bloomberg's and SA's data, author's calculations

Author's note: Sales growth rates are calculated based on the last quarterly data available. But even if PLTR shows 40-45% YoY sales growth in Q3, the company will be an outsider in terms of this particular metric.

Do not get me wrong - I do not object to a CEO/founder of a company making a lot of money - that's the company's raison d'être. But I am against it constantly being done at the expense of the shareholders - they have already paid you money for your company, why make them pay even more if what they paid for is not going to be profitable anytime soon?

Yes, Karp does not receive a salary, but he instantly sells everything he receives, splitting up and selling his options in different tranches to get the most favorable average selling price. I honestly do not understand the current compensation policy. In my opinion, the CEO, the founder of the company, should be trying with all his might to bring his company to the top - all I can see today is the constant dilution and the lack of profitability over the 18 years of the company's existence.

But the bulls, apparently do not care - anyway, now and then I read the excuses as to why Karp makes nearly $370 million a year while the net profit margin is more than 95% (of revenues), only with minus sign in from of it.

Without straying too far off-topic, I propose to investigate how much and how often Karp sold his options off the market. I collected this data from the official SEC's "Forms 4" and tried to visualize it.

Source: Data from Openinsider.com, author's calculations & visuals

As we can see, Karp slowed down sometime after the IPO and the stock price went up. When it fell sharply (March 2021), he sold even less. Since then, the price has hovered between $26 and $23 per share. Throughout this time, Karp has been selling regularly and in almost identical amounts to whatever price he gets from the market - otherwise, the options expire. That makes sense, but why are there so many options (more than from November 2020 to March 2021)? The volume of selling now is about the same as we saw in October 2020 - when the average realized price was $9.41/share - 63.64% below the current price, which is about the "fair price" we saw when calculating the SOTP. Interestingly, David A. Glazer (CFO and Treasurer) and Ryan D. Taylor (Chief Legal and Business Affairs Officer) also sold systematically, and when the share was worth significantly lower than it is now. The President and Secretary of Palantir, Stephen Andrew Cohen, always sells whatever he gets - every single time.

Many bulls hope that SBC will be discontinued once the company can cover its costs through operating activities. But exactly when that will happen, no one can say. And the signs do not suggest that it will happen soon. Until then, enjoy the dilution and the price that will most likely return to the flat channel a few days after the November 11 report release.

Question #3: Is competition really going to be fierce in the foreseeable future?

Yes, it is. We must realize that the company will not long grow solely on budgetary money - hence the commercialization of the business is inevitable. Then Palantir will face (already faces) a fierce battle for a place in the sun. The competition's pressure is evident even from the growth of the company's revenue in the "Commercial" segment - an increase of just 28% although the whole company is valued at 36 times EV/revenue (TTM).

In my earlier articles on PLTR, I talked about the difficulties the company faces when it wants to bring its product to the broader market. I do not think even partnering with AWS will change things significantly - the ETL processes the company is helping to set up are not anything innovative that anyone but PLTR can do.

If Palantir is targeting data consulting, then a logical question arises: "Why should I pay a tech company to solve my company's problem when there are some well-known consulting firms (the Big 3) whose business experience will help me more?" (BCG, for example, has a separate division dedicated to analyzing data and running all kinds of machine/statistical learning models in production - this division is called BCG Gamma). I believe customization will be a major pain point for Palantir for the foreseeable future.

It seems that the effects of competition combined with the constant dilution of share ownership are not just worrying me - the hedge funds' faith in the company has also begun to wane:

Source: Yahoo Finance

Bottom Line

The company's quarterly report is just around the corner, and many have high hopes for it. I am not saying the report will be weak - if you are a bull, you'll find in it what excites you first - good revenue growth, maybe 40-45%, who knows. That may undoubtedly drive prices up for a while and catapult the stock out of its current flat price channel.

However, this will not change the whole picture. Bulls say that bears are complaining about the same things (SBC, competition, etc.) - yes, but to all questions, bears receive either emotional outbursts about how the company will change the world (due to innovation, which simply does not exist) or naive ideas as separately taken problems can be solved just by themselves.

At the moment, the position of the bears is closer to me. I am not questioning the company's product - yes, it may be really good. But it's hardly much better than what's already on the market (specifically in the "Commercial" segment). Management is not doing enough, in my opinion, to make the company profitable and stop shareholder dilution - that's the most important warning sign for any long-term investor. The behavior of Karp and his team suggests that Palantir is something of a "cash cow" - more specifically, its shareholders, who tirelessly justify everything that happens with the "above-30%-long-term-growth" promises (even the hulking IT giants showed much greater revenue growth compared to Palantir).

In the short term, the stock is likely to respond with a strong upward move on the back of justified earnings forecasts. However, recent insider trades suggest that net profit margins (or more accurately, losses) will not significantly improve - again, revenue growth will not do any good. Such an expansion strategy carries serious risks - if the company falters at some point, the market will not forgive it, given how long shareholders have endured "the value erosion".

In the long run, I believe that unless SBC stops, the stock will remain in its flat state, as I showed in my previous article with other tech companies with "promising prospects". Ultimately, the risk/reward ratio is not on the side of long-term investors - at the very least, you need to wait for clear action from management to bring the company to profitability (it would be high time, after 18 years of existence).

You may, of course, think otherwise. If I were tasked with expanding my audience, I would only ever write good things about PLTR, because even among Seeking Alpha users, most people only expect positive things from the company (therefore, they are looking for confirmation of their belief in different articles). However, I have decided to periodically remind you of the risks you take when buying PLTR in light of everything that is going on around the company. In my opinion, diversity of opinion and awareness of all risks is the key to rational investment decisions in the stock market.

Happy investing and stay healthy!

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.