Palantir Technologies Inc. (NASDAQ: PLTR) is being mislabeled as a fancy defense contractor by the Bears; instead, it is a growth story for the next bull run that is starting to gain critical mass in selling software solutions for the data-driven world, after more than a decade of development.
We are Bullish on the name, own it in our portfolio and the stock was part of the recent weekly list of top ideas. The long-term thesis boils down to few key points, the company is a leader and one of the pure-plays on advanced data analytics software. Data is growing, data is getting complex, and the need for data intelligence is ubiquitous, among large enterprises today and medium-small enterprises down the road.
But the muted response to the stock so far suggests the enthusiasm hasn’t caught on yet. Yes, 25% higher than the reference price may be muted given the potential; more on this later in the note.
Misunderstood name, ill-informed opinions, and agenda
As a direct listing, investors didn’t get a chance to learn about the story. Usually, institutional investors get plenty of time to understand the story when the company hits the roadshow during a normal IPO process.
Aside from lack of history with investors due to direct listing, the stock is suffering due to misinformation related to the name, either due to limited understanding of strategic advantages of a large data analytics software company or agenda to build opinions in an election year, things bad for stock in the short-term but opportunities for investors who aren’t shy to read through 10Ks and ready to do a little digging.
Is it worth a closer look? Yes, the opportunity to find a high growth story at a price better than Snowflakes of the current market and one that might turn profitable sooner than the industry. Not to forget that a re-rating from a defense contractor to a software company comes with huge trading multiple.
Concerns surrounding the name
Most of the concerns surrounding the name boil down to:
- Fancy defense contractor: using mostly innuendos and conjectures, almost all negative notes and research about the company try to paint the company as a fancy defense contractor. Indeed, this is one concern that has stuck with new investors, mainly because it has a bearing on the trading multiple. Software and SaaS companies are priced at 10-20x the trading multiple of a defense IT services contractor.
- Secretive is another word that is associated with the company, which should ideally be read as a bit complex to understand. Realty is the Street and media used to social media and consumer SaaS businesses are finding it hard to get their arms around a data-analytics business. Yes, welcome to the world of Big-Data, AI, and Machine learning tools; the trend is just starting.
- Valuation: If Buffett has changed, so should you. Yes, not cheap, but nothing is and when will things turn cheap is beyond the scope of this article. There are numerous studies out linking low-interest rates and their impact on growth stocks.
- Personality and politics: Another Bear thesis revolves around the personality of founders and politics, things we believe do not capture investor attention over the long run, even though create great reading materials and click-baits for the media.
It’s not a defense contractor and here’s why
Yes, the company started by selling software solutions to the defense agencies and draws almost 50% of the revenue from them, but still should not be labeled as a defense contractor in investor parlance.
Defense IT services vendors usually bid for projects, hire people, and execute the work assigned. The business carries relatively low margins and there is low operating leverage in the business model, i.e. expenses more or less move in sync with revenues.
Palantir, on the other hand, offers platform-based software solutions – Gotham, Foundry, and Apollo right now that can be further customized according to customer needs. Gotham is designed for defense services.
Instead of a long installation process that some detractors talk about, an average installation takes 14 days and in some cases just a few hours. Almost 41,000 upgrades can be managed in a week, double the rate of last years.
Yes, the company refined its products catering to the defense sector, an environment with a large set of data, but now that 50% of the business is coming from the enterprise sector and demand for complex data analytics growing across the board, it is truly a Big-Data company.
|Software/ SaaS||Revenue 2019||Growth 1H 2020||Gross Margins||Revenue/ Employee||P/ Sales|
Revenue/ employee based on revenue annualized using 1H growth for each company.
Another way to highlight ignorance on the part of some Bear thesis is by comparing the business fundamentals with other software/ SaaS and defense IT services businesses.
As the chart above shows, Palantir is growing at better or sometimes better than the fast-growing SaaS/ software stories. The difference is even more prominent if you consider the scale of absolute revenues, i.e. Palantir is generating close to 2-3x the revenues of other high-profile growth stories. Indeed, the fully funded backlog of government business grew 74% over the last eighteen months.
Palantir’s gross margins are significantly higher than most high-growth SaaS stories, the chart above. Indeed, non-GAAP gross margins for the most recent quarter would position the company as the highest gross margin business among fast-growing SssS/ software businesses above.
In the meantime, one can see how defense IT services businesses usually carry 10-15% type of gross margins.
Revenue per employee
Another good metric to measure the quality of business and ability to create value for the shareholders is employee productivity, as measured by revenue per employee.
Here again, Palantir is at the top of the chart, as shown above. Indeed, the market’s much-loved names like Snowflake and MangoDB suffer on this count due to the large size of sales teams on their rolls. Please note the data is based on annualized revenue for the current year.
Here again, criticism is misinformed. As the chart above shows, Palantir stock is trading at a 50-80% discount to high growth software/ SaaS names, even though the company is delivering operating metrics that are significantly better than those peers.
Margin leverage, profitability, and value generation
Yes, relatively better is not always a great thesis to look for new investments and that’s why the real story, financially, is about the company’s ability to drive profitable growth as the revenues grow.
|Palantir Technologies Inc.|
|As % of revenue||2018||2019||1H 2020|
|Sales and marketing||61.8%||49.9%||29.7%|
|Research and development||35.8%||32.0%||20.7%|
|General and administrative||40.8%||34.2%||24.8%|
Excludes stock-based compensation
There are endless stories about the business and how it is making losses even after 17 years of operations, what those detractors fail to acknowledge is the operating leverage in the business model, ability to measure the business’ ability to generate profitability. As the chart above shows, excluding stock-based compensation, the company generated operating profitability during the first half.
In simpler terms, Palantir is growing revenue fast, but operating expenses continue to decline as a portion of the total revenue pie.
More importantly, Palantir was able to grow revenue by 49% without any major increase in operating expenses, a feat that none of the high-flying SaaS stories mentioned above have achieved. We know that because we have detailed models on all these names in our earnings database, along with 1250 other listed companies.
|Palantir Technologies Inc.|
|$ Millions||2018||2019||1H 2020 Annualized|
|Sales and marketing||$368||$371||$286|
|Research and development||$213||$238||$199|
|General and administrative||$243||$254||$239|
Excludes stock-based compensation.
Indeed, the picture gets much clearer on an absolute dollar basis. As the chart above shows, on an annualized basis, operating expenses declined during the first half when revenue grew 49% during the same time frame.
Most readers won’t need to be reminded of the positive impact of additional revenue on the bottom line if the operating expense line is held back.
|Palantir Technologies Inc.|
|As % of revenue||2018||2019||1H 2020||Q2 2020|
One of the major reasons so many stories have misunderstood the name is because they have failed to understand the importance and improvement in the contribution margins of the business.
Contribution margin = (revenue – cost of revenue – sales and marketing expenses + stock-based compensation) / revenue.
This is a perfect metric to measure Palantir’s ability to generate profits as revenues grow. Initially, new clients carry negative contribution margins due to startup and related expenses, but as revenues grow, contribution margins starting growing because those expenses are capped.
During the initial phase, it was understandable for the business to make negative contribution margins since the negative contribution margin of new business would have overshadowed improving the contribution of businesses entering into the second year of operation.
Now that Palantir is making positive contribution margins, and healthy ones too, there is reason to feel optimistic that profits and cash flows should see positive trends from here onwards.
Ignore the click baits and do your research. As mentioned earlier, we own the stock.
DISCLOSURE: We are Long Palantir stock. Before writing a note, we usually ask (via Twitter and Stocktwits) for things readers would like us to cover in the note, please do share your views for our next note. This is purely an academic exercise for our internal use and you should NOT invest based on this note.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.