Palantir: Growth And Profitability Achieved, Wait For The Right Price (NYSE:PLTR)

Investment Thesis

When I sat down to analyse Palantir (NYSE:PLTR) I was expecting to find the same old story of a young cash-burning ultra overvalued software company selling its world-disrupting vision to hopeless investors attracted by buzzwords like bees to honey, while in reality, it was nothing but empty talk.

Well, I couldn’t be more wrong.

To be honest, I was right on the overvalued part of the story because, based on my analysis, Palantir’s current market price is 43% higher than its intrinsic value, but this was not always the case.

In the last two months, Palantir’s stocks climbed more than 120%, reaching a $34 billion market capitalization, however, after the big price correction happened in late 2021 and early 2022, the company traded around its intrinsic value of $20 billion for roughly one year – from May 2022 to May 2023 – before skyrocketing as soon as Q1 results came out.

I think Palantir is a perfect example of how stock markets can be inefficient in the short term and how being a patient investor – who waits to buy a great company only when it trades below its intrinsic value – can pay off in the long run.

The fear of missing out is a terrible enemy for investors. Those who bought Palantir at the peak of the 2021 bubble are still suffering tremendous losses, while those who patiently waited for a price correction had more than an opportunity to jump in when the company was trading below its fair value and now are sitting on terrific gains.

Palantir seems on the verge of delivering tremendous growth and profits – as we will see later – however, my investment thesis is to be patient and wait for any sort of price correction catalyst – from missing exaggerated EPS expectations to the FED’s further raising interest rates – which would give investors the chance to buy the company around its intrinsic value.

Business Model

Palantir develops data-driven operation and decision-making software, and before I completely lose your attention, let’s break down this agglomerate of buzzwords.

Investors, among others, should easily understand the utility of Palantir’s products as the investment industry has always been well aware of the importance of data to make informed decisions, even before the term Big Data was first coined.

Put in simple words, Palantir has developed a set of software solutions which organizations – whether governmental or commercial – can use to interpret the enormous amount of data produced to improve the likelihood of reaching their operational goals whether they are to eliminate potential threats or achieve greater efficiency and market shares.

Currently, Palantir offers four different software solutions referred to as platforms or operating systems:

• Gotham, a platform dedicated to the government sector.
• Foundry, a platform dedicated to the commercial sector.
• Apollo, a platform to safely deploy and update other software solutions.
• AIP, the latest arrived, which powers the existing platforms with large language models (LLM) facilitating the interaction between humans and machines thanks to generative AI.

Company MOAT

Over the past two decades, rather than creating commoditized software solutions – which can be implemented easily and quickly by thousands of organizations – Palantir developed customizable software solutions actively seeking to solve complex and capital-intensive problems which the majority of its competitors were refusing to solve due to the high risks involved.

Given the high costs to implement Palantir’s solutions – $50.9 million on average for its top 20 customers and $2 million for the others – its 391 clients account for the largest organizations in the world like major Western governments and enterprises from the Fortune Global 500 list.

While the strategy chosen by Palantir forced the company to face many issues in the past – slowing down scalability along with the ability to absorb costs and reach profitability – now that the importance of data-driven decision-making software solutions, or vulgarly AI, has been widely recognized, Palantir has a tremendous advantage over its competitors which will require years, and billions invested in R&D, before closing the gap.

Despite Palantir’s products are not highly scalable in terms of implementation – as organizations require trained consultants to fully understand the platform capabilities before using it – its solutions are highly scalable in terms of what they can do.

Whether the goal is to detect the movements of military convoys, help aerospace companies manufacture aircraft, or win a Formula 1 Grand Prix, organizations can use Palantir solutions to seek patterns in data and increase the likelihood of success.

But is not just the wide potential of its solutions which will grant Palantir a significant moat, the market in which the company operate is characterized by higher barriers to entry if compared to the broader software industry.

Governments – given the classified nature of their operations – only rely on trusted contractors and Palantir itself struggled for many years before being acknowledged among the few of them. Enterprises on the other hand – given the high costs and chances of failure – are not willing to bet on risky solutions, which might or might not work, preferring to stick with products that already proved to be able to deliver results.

Having been on the market for over two decades and being a pioneer in the AI software application industry, Palantir has already gained the trust of many governments and enterprises and now that the world has seen what AI technologies are capable of, Palantir is ready to capitalize on these opportunities while its competitors are still catching up.

Revenues Projection

What unites Palantir’s customers is the capacity to afford customized software solutions – which requires plenty of capital resources – and being able to actually benefit from its solutions, usually mature companies seeking to improve their efficiency and market shares.

Government institutions aside, only the largest enterprises in the world can fit this description.

Using revenues to determine the size of enterprises, I gathered a sample of the 500 largest global enterprises – excluding Chinese and Russian ones as Palantir doesn’t operate there – representing Palantir’s potential customers.

Collective, these companies generated revenues of $30 trillion in 2022. Using the US 10 Year Treasury Bond yield of 3.78% as a proxy for future growth rate – as it incorporates the expected inflation and growth for USD-denominated assets – revenues generated by the top 500 companies in the world are expected to be around $43.5 trillion by 2032.

Taking a sample of the major software companies in the world instead – which usually generate revenues by selling their software solutions to other enterprises – we obtain that, on a median value, their software solutions account for 0.015% of the revenues generated by the top 500 companies in the world. Looking for the top-performing software companies, the 80^th percentile accounted for 0.043%.

But now you might be thinking “Why are you giving us this information?” “Why should I care what percentage of revenues large enterprises spend on software solutions?”

Well, in my narrative I see Palantir becoming one of the top-performing software companies in the world selling its products to the major enterprises out there, and by knowing what percentage of revenues those enterprises spend on software solutions – along with assuming Palantir’s solutions impact – I can reasonably forecast Palantir’s future revenues.

Currently, Palantir’s commercial revenues of $834 million account for 0.003%, but assuming Palantir reaches the level of the top performing software companies, accounting for 0.043%, by 2032 commercial revenues would be equal to $18.5 billion, a whopping 36.4% CAGR.

In 2022, commercial revenues represented 44% of total revenues – equal to $1.9 billion – while government revenues accounted for 56%.

By 2032, I expect commercial revenues to outweigh government ones as more and more enterprises will understand the benefits that Palantir’s products can have on their bottom lines and also because government contracts usually take longer to be finalized due to strict bureaucratic procedures.

Assuming the commercial segment will account for 65%, the government line will generate an additional $10 billion with Palantir’s total revenues achieving a nearly 15x return by 2032, growing at a CAGR of 32.9% and sitting around $28 billion.

Efficiency & Profitability

Moving on to efficiency and profitability, in Q1 Palantir finally reached operational profitability with an operating income of $4.12 million, while if we capitalize R&D expenses – rather than treating them as operating expenses – already in 2022, the company managed to turn its business model profitable achieving an operating income of $4.7 million.

The management expects to continue achieving profitability for the rest of the year, and in a recent interview Alexander Karp – Palantir CEO – confessed that the number of monthly calls they are receiving from customers now is equal to the same amount of calls they used to receive in an entire year in the past and that Palantir’s customers itself are promoting its solutions to their own customers as a proof of how effective they are.

With that said, in the coming years, I reasonably see Palantir ramping up profitability very quickly and achieving an operating margin of 26%, again, on par with the top-performing software companies out there.

However, such tremendous growth will require substantial reinvestments to be supported. In 2022, Palantir reinvested 18% of its revenues, and I expect the reinvestment margins to remain around this level in the foreseeable future, to then slowly come down until reaching the industry median value of 10.25% as the company enters a more mature phase.

With these assumptions, Palantir will achieve a return on invested capital (ROIC) of nearly 48%, slightly higher than the 3^rd quartile industry value of 44%, continuing my narrative of Palantir establishing itself as a top-tier software company.

Cash Flows Projection

Combining operational profitability increasing and reinvestment needs declining over time as Palantir gets bigger, we can expect the company to start delivering consistent free cash flows to the firm (FCFF) to its shareholders.

Despite FCFF being expected to remain negative in the next couple of years – as the reinvestments will erode the initial profits generated by the company – by 2025 we can likely see Palantir start delivering positive FCFF of around $200 million while ten years from now, given my assumptions, FCFF are expected to sit around $2.7 billion, achieving a 12x return in 8 years.

Valuation

Applying a discount rate of 10.99%, calculated using the WACC, we obtain that the present value of these cash flows is equal to $19.7 billion or $9.3 per share.

Compared to the current prices, Palantir’s stocks result overvalued by 43.12%.

Risks

Even though I assumed tremendous growth and high profitability levels, at today’s price, Palantir still results overvalued, but as said in the introduction, this was not always the case.

Investing in Palantir right now, after the stock surged more than 120% in only two months and while AI stocks are victims of market euphoria, would expose investors to enormous risks when the “AI bubble” will eventually burst as the AI hype fades away as it happened with cryptos or EV stocks.

My investment thesis is to wait for any potential catalyst – not related to a worsening of the company’s fundamentals – that would trigger a price correction. It can take the form of missing analysts’ expectations – the market tends to overestimate the potential of young growing firms and any results even slightly below the consensus might generate significant drawdowns – or a negative development in macroeconomic factors.

Over the long term, these sentiment-induced market fluctuations are irrelevant, but in the short term can create attractive entry points to take a long position in the company and, over the entire life span of the investment, are crucial for its overall success or failure.

Conclusion

So to conclude, Palantir is a great company but at the current prices doesn’t represent a great investment opportunity. Don’t be influenced by the fear of missing out on potential short-term gains and be a patient investor waiting for the right opportunity to jump in.

Editor’s Note: This article was submitted as part of Seeking Alpha’s Best AI Ideas investment competition, which runs through August 15. With cash prizes, this competition — open to all contributors — is one you don’t want to miss. If you are interested in becoming a contributor and taking part in the competition, click here to find out more and submit your article today!