Palantir: Look Closer, The Seeds Are Sprouting
- The article takes on Palantir's business model, highlighting the exponential levers that drive growth across time.
- I present historical data that points to how Palantir has grown, drawing insights into future growth potential, even in this tricky macro environment.
- The 30% YoY annualized sales guidance is likely to be beaten and surpassed. All the granular indicators and trends point towards this possibility.
- At an NTM EV/S of 9.8x, I expect robust long-term compounding potential from the ~$10 price. Now is the time to take a position.
- I do much more than just articles at The Abstract Portfolio: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »
Palantir (NYSE:PLTR) does not function the same way as many other software companies, and due to the nature of its products, the company's business model is particularly unique. In this article, I discuss this unique business model and draw on some data, inferring whether we're due for some outperformance in coming quarters. Macro adjusted, if we have some semblance of outperforming growth and earnings, the stock will eventually trend in the upward direction on fundamentals, building alpha over the sector or the rest of the high-growth space. I think this is probable, not just possible. I'm long PLTR.
My previous article on Palantir discussed what makes the company's software different in a rather abstract and philosophical sense. Whereas most publicly listed software companies are building "apps", Palantir was in the business of building highly customizable "operating systems" that can adapt, integrate, and evolve with its customers' organizations - whether government or commercial. Such software is inherently harder to sell, but once integrated, becomes remarkably sticky. Interoperability of a platform like Foundry means that users get to define the problems they want to solve, the context in which they wish to solve them in, and use their specific knowledge and experience to work with the software to morph it into solving any data-driven issue.
So a manufacturing engineer can use Foundry to speed up the supply chain of a vehicle assembly plant by allocating resources, machines, manpower, and labour while optimizing costs. Or a military strategist can understand threat levels in a remote part of the world and get assets moving with clarity via Gotham. There is no pre-packaged app, that solves such problems, so Palantir created customizable, broad-based platforms (Gotham, Foundry etc) that can be understood and used by domain experts to solve issues on the fly amidst complexity.
The stock has unquestionably been a loser over the past several months, amidst one of the worst tech drawdowns many of us have experienced for several years and with broader questions being raised on inflation, true profitability, and the excesses of Silicon Valley folks on paying themselves big with not enough alignment towards shareholders. Certainly in Palantir's case, the questions of excessive SBC (stock-based comps) have been warranted - and management has repeatedly settled on the lines of talent needing to be paid to produce exceptional results over the long term.
Palantir's business model works in three phases - the three phases can be used to describe almost any contractual relationship with a singular customer or enterprise. I think this is key in understanding how Palantir grows and what's involved when the top line posts 35% YoY etc. Once this is established, making some predictions on immediate and long term growth becomes an easier exercise. The three phases are:
- Palantir runs a small pilot program to show what the software can do in a smaller sense for a new customer.
- Customers are defined as "Acquire" customers if they generate <$100k annual revenue in the given year.
- Get bigger by understanding the principal challenges a customer faces; Palantir invests a lot to deeply understand a customer's problem, and to build, train, or deploy a solution.
- Palantir loses money, tracked by the Contribution Profit, as they invest in the relationship and the software doesn't bring in the dough until it scales, is used well, and people know what to do with it in an enterprise
- Customers are defined as "Expand" customers if they bring in >$100k in revenue AND a negative contribution margin during the year in review.
- The software does what it's supposed to, and is scaled big for the entire organization; now employees of the enterprise build, tweak and evolve it by using apps on top of the existing solution to keep improving it while making use of ongoing support
- Customers are categorized in "Scale" if they generate >$100k and have a positive contribution margin during the year in review.
The success of a customer relationship means that a customer cycles through all three phases, getting re-categorized as the relationship expands, along with exponentially growing revenue and eventually contribution profit.
Now one must note, that going from Acquire to Scale can occur in different timelines depending on the enterprise and the problems they wish to solve. However, none of it is straightforward since this isn't easy "out of the box" software. One, however, might presume that if we have the data on these cohorts and the dollar values they're bringing in, we would have some loose leading indicators on future revenue growth. I'll try to string together some of these ideas in the next section. Firstly, I'd like to summarize a few key inferences from the business model:
- Customers and dollar values from the customer are typically captured across long periods of time - could be months to over a year until a relationship is profitable for Palantir;
- Revenues are therefore a lagging indicator vs. the number of customers and the dollar values attributed to the Acquire and Expand phases
- Palantir mostly loses money during Acquire and Expand; they only have profitable accounts when customers reach Scale mode - this is understandable since neither the customer nor Palantir fully understands the ROI or value of the software until it is deployed en mass.
- Revenue from a customer comes in slow during Acquire and Expand, and then rapidly at an exponential level in Scale.
- Profits significantly lag on new customer contracts.
Bits of Data
Palantir has a habit of shooting out several numbers during earnings, on customers, growth rates, contract values, and a load of other KPIs that may not be too coherent when seen at first glance. They all matter, of course, but it's worth starting with the Acquire, Expand, and Scale data.
For the cohorts ending 2020, the following dollar values were pegged for the year:
- Acquire: $0.3m revenue, -$36.8m contribution loss
- Expand: $20.3m, -159% contribution margin
- Scale: $1.1b, 63% contribution margin
The same cohorts pegged in 2020, recorded the following results in 2021:
- Acquire: $45.1m revenue, $7.2m contribution profit
- Expand: $83.3m, 45% contribution margin
- Scale: $1.3b, 63% contribution margin
Data from the latest Annual Filing (10K).
Palantir also mentioned that new customer revenue from 2021, came in at $83.9m in 2021, which is more than 3x of the Acquire + Expand cohorts by 2020 end.
Interestingly, tracking the newer cohorts over a one-year period has historically led to some exponential stuff. Acquire and Expand businesses grew several times over and built in an incrementally positive contribution margin to the total bottom line - the one that's been expanding towards GAAP Profitability quickly.
Unfortunately, we don't have the latest cohort numbers broken down pegged for the end of 2021 yet. Palantir will likely include this in the next earnings release. But that $83.9m of fresh customer sales is likely to multiply 2-3x at the very least, one would assume. A 3x is $168m in extra sales right there, ignoring new customers and most Scale cohorts in 2022. Such data points to fat growth ahead.
To step into data elsewhere, the Q4 earnings presentation had a lot to draw upon. Let's break the growth dynamics down into Commercial and Government.
Commercial Revenue Growth
- Customer count increased 200%
- US Commercial net dollar retention was 150%
- International Commercial net dollar retention was 103%
Specifically, for the US cohort, growth has been on an exponential trend upward; the following data was shared in the latest presentation:
If a fresh $19m cohort (2019) scaled to $69m in a year, and the $6m cohort (2020) scaled to $18m, then what can we expect from the latest $53m cohort for US Commercial Revenue?
Going by recent history, one would expect at least a $100m from this cohort just in FY21? This isn't an unreasonable expectation to me. Factor in some natural expansion of previous cohorts and you have another $70-80m? Add some new commercial contracts and another $20m? For Palantir which has $1.5B in annual sales, one can find ~15 pts (or half) of their next year's excess guided growth (30pts) right here from the US arm of their Commercial vertical. This trend is further realized when you put the rapidly expanding salesforce to work.
FY20, a tough macro environment with the pandemic shock, did not impede the growth of the FY19 cohort - though it did stop a sizeable new cohort from forming. This could once again be the case in FY22. Macro cyclicality has a tendency to be ironed out over consecutive annual revenue records when it comes to Palantir's business.
Government Revenue Growth
Any weakness in Palantir's last 2-3 quarters has been attributed to the lower rate of government segment growth. Dollar retention has been more than strong (it's been excellent), however, it seems like governments didn't initiate new contracts all that much in the year 2021 - just about $8m.
- US Gov Retention Rate of 141%
- International Gov Retention Rate of 161%
- Customer count unchanged at 90
Regardless of the tiny cohort in 2021 to add to incremental revenues, retention rates have been substantial enough to drive strong organic growth. Whether it's Defense in the US or Healthcare in the UK, etc - government bodies have shown a tendency to renew and expand contracts for higher effective revenue contributions over time. Every year has seen some expansion and even if it's a little low next year, the flywheel will drive the growth of the previous cohorts.
Then finally, if one were to think in years, Palantir isn't constrained by any market opportunity per se but more by their sales and deployment execution.
The aim of Foundry is seemingly to become the modern enterprise's core operating system. With the data points, variety of problems, and internal connections within an enterprise it touches, that's not an unreasonable ambition.
We haven't even discussed Apollo, which is in the early stages of its potential. It automates the software needing to be deployed in any enterprise and does it continuously. Sounds like another massive, all-industry and all-enterprise kind of problem to solve.
High Probability Of Sustaining 30% YoY Growth Or More.
Guidance has always been simple for Palantir: 30% compounding on sales annually until 2025. So far, it has kept steadily above that, recording ~34% last quarter.
I suppose bears would cite the macro environment as a reason for customers to shy away from spending on Palantir. History has shown that when Palantir has its foot in the door, it drives value from new cohorts at an exponential rate. 2020, a tough macro year for big IT spending, still saw the expansion of 2019 commercial customers, and it's likely that 2022 will as well. In all probabilities, it appears that Palantir will meet its 30% sales compounding guide as revenues appear to record at a significant lag to new customers. New customers on count and contract value, especially in the commercial segment, have skyrocketed heading into 2022 and I'd urge investors to reconsider the business model as a likely indicator of exponential trajectories to come under the GAAP Revenue surface.
On the government side, there's an argument to be made that the Biden administration government may not have been the most Palantir friendly - however, the natural net dollar retention points to organic revenue growth even from existing government relationships that are significant enough at this stock price. There might eventually be some change in this regard given the global geopolitical situation and the Defense Department's choices. An important point I think will hold true is that government spending on software is less impacted by the macro cyclicality - the same cyclicality that shall impact Palantir's commercial customers a little more. There's some inherent diversification of revenue streams through this.
All in all, that 30% growth for years to come is a reasonable target that ought to be surpassed regardless of this macro environment. Software spending is seen as crucial, and not just "nice to have" as data becomes the new oil, and making sense of it is vital for any competitive company. Palantir operates in spaces where it's extremely hard to do that in the face of complexity, making it a rare kind of company with a moat built on differentiation.
Meanwhile, margins have kept up with sales, and profitability ex. SBC has expanded to some very healthy levels. Operating margins, and Free Cash Flow margins in the 20% range show signs of an effectively operated business that's controlled and rather disciplined in its business execution.
The bottom chart above shows the breakdown of the much-criticized stock-based compensation. It has flattened out over the last quarter and is normalizing on an absolute basis, while the rest of the business keeps growing bigger. As a result, the percentage value that eats into the financials attributed to SBC will eventually trend to much more palatable levels. This is precisely what Alex Karp has pointed out, stating that the margins will become normal. With the monumental effort involved in solving the hardest problems in data domains, comes a need for serious talent. Great engineers have always been in short supply, so it does seem reasonable that the company is taking its resources to drive R&D. Now that these platforms are scalable and chasing go-to-market opportunities that are huge, the rest of the business should make up for the years of product development spending. We are at that time to ramp up considering the company's lifecycle and recent trends.
A Period Of Low Valuations For Disruptive Growth
Unprofitable high growth businesses are undoubtedly going to have to tighten up operations given this macro environment. The markets don't have much patience for issuing capital, and if anything, the private markets are following suit noting that their exits won't give them the sort of returns that they saw in 2020. Cash is no longer cheap, wherever a newer enterprise is in its lifecycle.
This creates a game of corporate finance strategy that fulfils the market's desires. Unprofitable businesses have to clean up and not spend on growth at all costs. This will hamper growth, and slow down the rosy future and market capture ambitions they had. While moderately cash flow generative businesses can keep compounding and executing to their natural rhythm. Palantir is one such business. Ignore the largely skewed GAAP earnings, and note Free Cash Flow. Palantir does not have a cash problem as they're generating enough of it from contracts and whatnot. This wasn't true in FY20 or FY19, but it is true now. With this fact, Palantir has an expanding salesforce that's set to deploy their product to more enterprises, and faster, which should result in controlled growth.
With the mega drawdown in tech, PLTR is now trading at 9.8x NTM EV/S. For a company that's offering a uniquely differentiated set of products, that's inherently high gross margin, and free cash flow generative - an investment really isn't asking for much at these prices when some long-term potential is established.
A large swath of emerging software companies are trading on multiples that are in the same ranges as many mature, and much larger peers - Salesforce, ServiceNow, Adobe, Atlassian, and the like. There ought to be a premium for such businesses like Palantir that indeed have unbounded long growth runways; as it stands in current markets, there isn't. That presents an opportunity for investors.
Palantir can do the bare minimum on their own guidance here - compound at 30% annually on sales until 2025, and you have a chance at some strong returns over the next few years. While the stock heading lower is surely possible, I don't find it likely that multiples will contract from the 10x levels they're at over a long-term period. Time and sales growth will take care of it. PLTR thus offers robust compounding potential, with a good chance for some positive catalysts that have been brewing in 2021 to take effect in 2022.
- Growth decelerates to the 30% rate or below, this would lead to multiple compression and would render my assumptions wrong
- The macro-environment causes a dry up in additional software and data analytics spending that impacts Palantir more so than expected
- Competition from cheaper, different, custom software contractors
- The government business under-expands or gets rid of existing contracts
- More immediate term valuation compression - it's a low-profit stock so is subject to extreme drawdowns and volatility - especially in recessionary bear markets like these.
Getting granular with the business model is key to understanding what drives Palantir's growth. Data so far showing business expansion has trended in the right direction. Several seeds have been planted on the US Commercial front, and if contract scaling goes as expected, those seeds will sprout to drive exponential revenue from the latest batch of customers in 2022. The Government vertical, which hasn't seen much new business, still drives organically higher sales/earnings as the use of Palantir through older scalable contracts. Both verticals combined indicate that there are likely big sales ahead in 2022 to be realised, even with adverse macro conditions.
Logically following the company's guide and extrapolating cohort data growth, Palantir is positioned to deliver on their 30%+ guide on sales and perhaps a lot more for years to come. With a now self-funded balance sheet, the company doesn't need fresh market capital that so many emerging tech businesses had and have relied on. This drastically reduces financial risks and business execution can move forward as planned, with a healthy cash reserve just in case.
Lastly, on valuation, Palantir isn't the cheapest software company but then again it shouldn't be. At least for the next few years, it has an unconstrained TAM, and its success depends on selling and habituating enterprises and governments to their one of a kind platforms. This, as explained, is a time-consuming process given the complexity of the problems they solve. Amidst this market opportunity, 9.8x NTM EV/S is very reasonable for a differentiated leader with a long growth runway. I expect little multiple compression over the long term and some good upside to come for patient investors from the ~$10+ price as Palantir scales up further.
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Analyst’s Disclosure: I/we have a beneficial long position in the shares of PLTR either through stock ownership, options, or other derivatives. 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.
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