Palantir Stock: The Bull Thesis Keeps Getting Stronger

Nov. 16, 2021 9:30 AM ETPalantir Technologies Inc. (PLTR)43 Comments

Summary

  • Despite registering a deceleration in revenue growth in Q3, the bullish thesis for Palantir is getting stronger as commercial business momentum picks up and share-based compensation moderates.
  • Palantir's long-term growth trajectory is intact, with management guiding for 30%+ CAGR sales growth through 2025. Furthermore, Palantir is already looking like a free cash flow machine in the making.
  • The stock is undervalued at current levels, offering investors an excellent opportunity to generate long-term alpha.
  • I rate Palantir a strong buy at ~$23.
  • I do much more than just articles at Beating the Market: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »
Palantir Technologies headquarters campus exterior view in Silicon Valley. - Palo Alto, California, USA - 2019

Michael Vi/iStock Editorial via Getty Images

Introduction

Palantir's (NYSE:PLTR) latest quarterly results and forward guidance showed signs of decelerating growth. When sales growth decelerates, high-multiple growth stocks tend to come under pressure, and that's what happened with Palantir last week. In the near term, the stock market is a voting machine; however, in the long term, the market is a weighing machine. To be successful, investors must focus on the long term. Looking at Palantir's weak price action, it is easy to forget that Palantir is a truly special company with an impenetrable moat that includes superior technology, network effects (government and commercial relationships), visionary management, and a strong brand image (tied to anti-terrorism and nationalism). In my view, the latest sell-off in Palantir is a great long-term buying opportunity, and I will outline my reasoning in the following sections.

As you may know, Palantir's vision is to become the most important software company on this planet. Today, Palantir's edge AI platforms have the potential to dominate the data OS and analytics space, which happens to be a rapidly growing market. With each passing quarter, Palantir is winning new customers, and as such, the bull thesis for Palantir keeps getting stronger. Now, Palantir's Q3 report was far from perfect as the company showed signs of a growth slowdown. However, Palantir's growing business momentum in the commercial sector and signs of a long-overdue moderation in stock-based compensation expenses strengthen the bullish thesis for the company. To learn more about my bullish thesis on Palantir, I recommend you to read the following notes:

  1. Palantir Is Uncannily Similar To Tesla
  2. Palantir Is Redefining Operating Systems For The Modern World
  3. Palantir Stock: Building An Army

Before we derive the fair value and expected returns for Palantir, let's analyze Palantir's Q3 results in more detail.

Breaking Down Palantir's Q3 Results

In Q3, Palantir's revenue grew by 36% y/y to come in at $392M (ahead of management's guidance of $385M). Although Palantir beat on sales guidance, the sales growth decelerated significantly in Q3 2021 (from the 49% y/y growth seen in Q2 2021). At a time when IT spending is very healthy (as evidenced by Microsoft's stellar Q3 results), and data analytics software firms are supposed to outperform expectations as the economy returns to normalcy, why is Palantir's growth slowing down, where is the weakness coming from?

Palantir Q3 2021 Earnings

Source: Palantir Q3 2021 Earnings Presentation

After registering an impressive 60%+ y/y growth in the first half of 2021, Palantir's government business growth slowed down drastically in Q3 2021. Although Palantir's government sector revenue growth rate dropped from 66% y/y in Q2 to 34% y/y in Q3, these results are by no means poor. The slowdown could just be a result of budget management as the government fiscal year ends in September. Now, Palantir's management has always maintained that their focus is on the long-term, and we understand that Palantir's growth could be lumpy due to the nature of its contracts. On a positive note, Palantir did win some deals during this quarter, including the $900M deal with the US Army for providing Intelligence Data Fabric and Analytics solutions.

Palantir Government Revenue Growth

Source: Palantir Q3 2021 Earnings Presentation

In contrast to Palantir's government business, its commercial business is experiencing an acceleration in growth as the company moves downstream by offering its Foundry platform to select Day Zero companies (young startups) under its "Foundry for Startups" initiative. Palantir wants to become the primary data operating system provider for the next generation of tech behemoths, and this move downstream unlocks a massive market for the software provider. In Q3, Palantir's commercial revenue came in at $174M (~44% of total revenues), implying a growth rate of 37% y/y [US commercial revenue growth accelerated to 103% y/y). Hence, it is easy to see that Palantir's diversification efforts are starting to pay off. The commercial sector is a much larger market compared to the governmental sector; hence, Palantir gaining traction here outweighs its government business slowdown.

Palantir Commercial Revenue Growth

Source: Palantir Q3 2021 Earnings Presentation

On the margin front, Palantir continues to report massive numbers. In Q3 2021, Palantir's adj. gross margin rose to 82% (up ~100 bps y/y), and the contribution margin expanded to 57% (up ~100 bps y/y). Now, Palantir is still not profitable due to a seemingly exorbitant stock-based compensation plan; however, with its margin profile, it is only a matter of time before Palantir becomes a very profitable business.

Palantir Adjusted Gross Margin vs Contribution

Source: Palantir Q3 2021 Earnings Presentation

For now, I am happy to see robust free cash flow generation from Palantir. So far in 2021, Palantir has generated $320M in adj. free cash flow (at 29% adj. FCF margin). Palantir is still in the hyper-growth phase, and so, I can see Palantir turning into an FCF machine over the 2020s - akin to today's big tech companies.

Palantir Adjust Free Cash Flow

Palantir Reconciliation of Cash Flow

Source: Palantir Q3 2021 Earnings Presentation

For Q4, Palantir's management guided for revenues of $418M (sequential growth of $26M (+6.66% q/q)). Furthermore, Palantir guided for adj. operating margins to decline to 22%; however, they guided for 22% for Q3 2021, and the actual adj. operating margins came in at 30%. So, I think there's some level of sandbagging embedded into this guidance.

Palantir Revenue Growth

Source: Palantir Q3 2021 Earnings Presentation

For 2021, Palantir is now expected to grow revenue to $1.527B (up 40% y/y) with adj. free cash flow of more than $400M. In the past, Alex Karp, Palantir's CEO, has guided for 30%+ CAGR sales growth through 2025. Hence, we can confidently expect the company to hit the $2B annual revenue milestone next year.

Since its public listing, the bearish arguments against Palantir have been centered around limited traction among commercial customers and its bloated stock-based compensation plan. However, I think Palantir is proving these arguments to be false, and Q3 was a real conviction booster.

The Bull Thesis Is Getting Stronger

In Q3 2021, Palantir added 34 net new customers, i.e., 20% q/q growth in total customers. The commercial customer count outpaced total customer growth by growing at 46% q/q, representing clear business momentum for Palantir's commercial offerings.

Palantir Commercial Customer Growth

Source: Palantir Q3 2021 Earnings Presentation

With Palantir now offering its Foundry platform to smaller companies, we can expect this commercial customer count to inflate over coming quarters and years. Many critics have labeled Palantir's SPAC investments as deals for buying revenue; however, we see these deals as strategic investments to prove the viability of Palantir's software platform across various use-cases in the commercial sector. Furthermore, Palantir's deal closure data (shared below) shows that Palantir's big investments in Sales and Marketing are paying off quite handsomely.

Palantir Deal Closure Data

Source: Palantir Q3 2021 Earnings Presentation

At the end of Q3, Palantir had $3.6B in total remaining deal value [commercial remaining deal value of $2.2B (up 101% y/y)], giving the company a strong pipeline for the next few years.

Palantir Remaining Deal Value

Source: Palantir Q3 2021 Earnings Presentation

A particularly thorny issue for Palantir's shareholders has been its bloated share-based compensation plan that makes the company look more like an employee cooperative rather than a publicly-traded for-profit corporation. Although Palantir's stock-based compensation ($184M; 47% of total revenues) remained at ultra-high levels in Q3 2021, the trend is clearly pointing towards moderation in SBC.

Palantir Stock Compensation ChartSource: YCharts

As Palantir scales up, revenues are growing rapidly, and the stock-based compensation [as a percentage of revenue] continues to decline. Hence, the bearish argument against Palantir is getting weaker with every passing quarter. Now, let's determine Palantir's fair value and expected returns to make an informed investment decision.

Palantir's Fair Value And Expected Return

To find Palantir's fair value, we will employ our proprietary valuation model. Here's what it entails:

  • In step 1, we use a traditional DCF model with free cash flow discounted by our (shareholders) cost of capital.

  • In step 2, the model accounts for the effects of the change in shares outstanding (buybacks/dilutions).

  • In step 3, we normalize valuation for future growth prospects at the end of the ten years. Then, we arrive at a CAGR using today's share price and the projected share price at the end of 10 years. If this beats the market by enough of a margin, we invest. If not, we wait for a better entry point.

Assumptions:

Forward 12-month revenue [A]

$2 billion

Potential Free Cash Flow Margin [B]

40%

Average diluted shares outstanding [C]

~2 billion

Free cash flow per share [ D = (A * B) / C ]

$0.4

Free cash flow per share growth rate

27.5%

Terminal growth rate

3%

Years of elevated growth

10

Total years to stimulate

100

Discount Rate (Our "Next Best Alternative")

9.8%

Results:

Palantir L.A. Stevens Valuation Model

Source: L.A. Stevens Valuation Model

According to our model, Palantir is worth ~$31 per share, i.e., it is currently undervalued by ~27%. Hence, Palantir seems like a good buy here. However, we must also assess the expected returns for the stock to make an informed investment decision.

To calculate the total expected return for the next decade, we grow the above free cash flow per share at our conservative growth rate, then assign a conservative Price-to-FCF multiple, i.e., 35x, to it for year ten. Thereby, we create a conservative intrinsic value projection (2031 price target), by which we determine the 10-yr expected CAGR returns. If these returns cross our hurdle rate of 15%, we buy, else we wait for a better buying opportunity.

Here are the expected returns for Palantir:

Palantir Expected Returns

Source: L.A. Stevens Valuation Model

As per the results above, Palantir's stock is projected to grow from ~$23 to ~$132 at a CAGR of ~19% by 2031. Since these expected returns are higher than our investment hurdle rate of 15%, I rate Palantir a strong buy at ~$23.

Looking At The Technical Picture

In late September, I highlighted the following risks for Palantir:

  • Palantir's management is focused on the long-term, and the company is expected to invest aggressively in the hunt for future sales growth, which in other words means Palantir will remain unprofitable in the near term. With rising inflation and growing bond yields, loss-making equities trading at big multiples (e.g., Palantir currently trades at ~35x P/S) could be in for a deep correction. Therefore, Palantir's stock could remain volatile over the next few months.
  • As discussed today, Palantir now sits at crucial support around its 50-SMA and 200-SMA ($25), and a breakdown could open further downside move here towards the $20 mark. Hence, I prefer buying through a dollar-cost averaging plan over the next few months.

Source: Palantir Stock: Building An Army

Since then, Palantir's breakout from an inverse head and shoulders pattern proved to be a head fake, and the stock has broken down below its 200-DMA trendline after a death cross in early October. Due to an inflationary environment, the market sentiment is pretty bearish towards growth stocks (barring a few market darlings), and so, Palantir could yet have more downside in the short term. The $17.5 to $20 zone should serve as strong support for Palantir.

Palantir Stock ChartSource: YCharts

Concluding Thoughts

From a long-term perspective, I continue to think of Palantir as a next-gen big tech company that could very well command a market cap of trillions of dollars down the road. With growing momentum in the commercial sector and a monopolistic market share in the governmental defense software space, Palantir is one of the strongest long-term growth stories for the next decade. Although Palantir is not yet profitable, the company already generates massive amounts of free cash flow ($400M in 2021). Furthermore, Palantir's stock-based compensation is showing signs of moderation. Additionally, the valuation multiple (P/S of 23x based on 2022E revenue of $2B) has contracted significantly over the last ten months or so. With near-term volatility here to stay, I continue to recommend the use of a dollar-cost averaging plan to build a position in Palantir (up to 3-4% of portfolio). At $23 per share, Palantir is a strong buy.

Key Takeaway: I rate Palantir a strong buy at $23

Thanks for reading, and happy investing. Please feel free to share your thoughts, questions, and/or concerns in the comments section below.

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This article was written by

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