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Peering Into Palantir's Data Market Disruption
https://www.morningstar.com/articles/1002517/article
We value the company at $28.2 billion, reinforced by a sticky customer base and positive moat trend.
Mark Cash
Sep 25, 2020
SEC filings and investor presentations have pulled back the curtain on Palantir Technologies' (PLTR) opaque operations, and we are intrigued by the company's prospects as an emerging leader in data integration, analytics, and artificial intelligence. We anticipate the company will come public on Sept. 30 via a direct listing; we value it at about $28.2 billion in equity value, or about $13 per share based on an estimate of 2.17 billion shares.
We believe Palantir has a narrow economic moat and a positive moat trend based on customer switching costs, intangible assets, and a network effect. In our view, Palantir's government and enterprise software has become mission-critical and deeply engrained with clients, the company has unique customer and market knowledge to pair with its AI acumen, and its software platforms become stronger as more users, institutions, and industries rely on its solutions. We believe these sources will strengthen, and despite a lack of profitability today, we anticipate that Palantir will generate robust operating leverage and excess returns in the long run.
Our estimated 34% five-year revenue compound annual growth rate is driven by robust growth in government and commercial sectors. Providing a holistic view of legacy data from disparate locations and various types, integrating the influx of new data, and then using AI to extract actionable insights can give organizations an advantage over peers. However, firms and governments attacking the challenge in-house can be unsurmountable. From assisting top-secret intelligence operations to extracting the optimal amount of oil out of wells to predictive maintenance on airplanes, Palantir is a disruptive force by selling commercial software platforms versus highly customized, consulting-led efforts.
We view Palantir as a land-and-expand story: After converting trial customers to its software platform, its software subscriptions proliferate in organizations and the incremental revenue outpaces associated investments required. With improvements in up-front installation costs and the cadence of subsequent software updates, we expect substantial operating margin improvement to the mid- to high 20s on an adjusted basis by 2025, up from negative 45% in 2019.
Palantir Aims to Solve Customers' Problems With Big Data
Palantir's products are aimed at first enabling institutions to integrate all their legacy and constant influx of new data, regardless of format, device, or location. The software provides a holistic view of data for testing, insight, pattern analysis, and what-if scenarios and allows technical and nontechnical users to all collaborate within the same platform. Next, its data operating system provides customers with the ability to extract insights from seemingly disparate data patterns or connections with AI. Palantir's software platforms can be deployed in any environment and buck the trend of requiring highly customized solutions. In addition to the functionality its software platforms are providing, Palantir aims to solve the historically terrible rate of success in data integration and insight-producing projects, while also not requiring customers to displace legacy investments. Its software platforms enable self-sufficient customers whereby Palantir is providing software updates, but insights can be gleaned internally.
The company sells two software platforms: Gotham, mostly targeted at government operations, and Foundry, aimed at commercial markets. Launched in 2008, Gotham's provenance was assisting U.S. counterterrorism operations to find insight from their data, and alleviating the data organizational issues and dangers of soldiers in Afghanistan and Iraq mapping insurgent networks and roadside bomb makers manually.
Over time, Palantir expanded into the commercial segment. While the stakes may be different, the challenges of integrating new and legacy data sets and gleaning insight from copious amounts of data are ubiquitous. Foundry was developed to make the integration of data sets routine in addition to gaining insights through AI. These platforms are sold across their customer segments as well, with financial institutions using Gotham for fraud investigation and Foundry being used across government divisions.
Under the hood, Palantir's Apollo platform is software that controls and updates its offerings, also enabling Gotham and Foundry to be deployed in clouds, on-premises, classified networks, edge networks, and devices. Palantir credits innovation in the Apollo platform as its way to achieve margins resembling those of software as a service instead of operating like a consulting business, all hidden to the end users of Gotham and Foundry.
Strategy Has Evolved
Starting as a company specializing in government intelligence software in 2003, Palantir's business model more likely resembled a consulting firm employed for defense contracting work. This model can require a lot of manual labor, working to build customized solutions to solve a specific problem at a point in time. Issues arise when attempting to scale that particular solution to other related challenges, whether across particular institutions or market segments.
With its foray into the commercial markets, Palantir was also initially operating a consulting model upon releasing Foundry in 2016. The following year, the company migrated commercial customers to a software platform instead of bespoke applications. While the firm may have lost customers during this process, we believe having a commercialized platform is the correct strategic play in the long run. Palantir has evolved toward a SaaS company, with all its customers using its software platforms.
Palantir's development team rotates into the field to understand customer- and industry-specific challenges firsthand, and then updates its platforms to meet the tasks. The company retains the intellectual property gained through these improvements. It typically provides its solutions at no cost for a trial period. Importantly, Palantir is coming to companies with a solution from the get-go, instead of a plan of integrating data before tackling the analytics implementation. These loss-leading efforts turn into customers as Palantir supports prospects with engineers for installation and software training. Palantir's engineers return from the field as customers become self-sufficient with the software.
Palantir's revenue streams are more globally and sector diversified than most investors may suspect, in our view. The company sells its platforms to the United States and allies on the government side and into a variety of commercial industries, in total 36 industries across 150 countries. While we expect U.S. government customers to remain a cornerstone of Palantir's business, 53% of revenue was commercial-based and 60% of revenue was derived outside the U.S. at the end of 2019.
The impact of these strategic changes is accelerating revenue streams alongside an improved operating profile. Margin expansion comes from lower deployment costs, proliferation of its platforms throughout existing client organizations, and properly pricing its software platform to maximize the value that customers receive.
Moat Is Underpinned by High Customer Switching Costs
We assign Palantir a narrow economic moat rating, primarily based on customer switching costs and secondarily strengthened with a network effect and intangible assets. Despite a lack of profitability today, we anticipate that Palantir will rely on these moat sources to generate robust operating leverage and excess returns in the long run.
Data proliferation is only accelerating as organizations further interconnect disparate systems across on-premises, private clouds, public clouds, edge locations, and personnel and devices. We believe the explosion of data and the management of data in a variety of formats presents a confounding issue for organizations.
Palantir sells software solutions aimed at solving the issues of data integration without requiring organizations to start from scratch and provides a centralized view to gain insight from the data through AI supporting manual operations. We believe that Palantir's software platforms have become mission-critical for governments and enterprises and cultivate high customer switching costs. The company targets large-scale data operations in global enterprises and governments and further focuses on complex situations that have high installation costs and elevated stakes upon failure. Implementation and integration of software and associated data can create large barriers to changing from software that is providing a crucial function for business operations. As particular software platforms become more widely spread within organizations, the higher the cost of changing vendors, in our view.
Palantir's sales motion is predicated on acquiring, expanding, and scaling accounts. The acquire phase typically provides customers with short-term pilot deployments of Palantir's software at little to no cost for the customer. Palantir ramps up its investment in the expand stage to understand the particular issues faced by the customer and its industry. This strategy aims to ensure that the software provides appreciable value in an attempt to lock the customer into the ecosystem. Scaling is when revenue outpaces incremental investments, margins improve, and Palantir's platform starts to proliferate within organizations. Palantir has historically operated at a loss, which we expect to continue on a GAAP basis until later in the 2020-29 decade as it ramps up sales, marketing, and infrastructure investments to seize its market opportunity. Nonetheless, we believe that profound improvements in margins through decreasing the time and number of engineers required to install, deploy, and manage the software platforms, alongside scaling the customer cohort, will lead to sustainable excess returns on invested capital in the long run.
In our view, Palantir is a beneficiary of high customer switching costs. It does not require organizations to completely overhaul their existing technology and infrastructure investments. Its software platforms integrate with customers' historical systems, and new data sources and methodologies can be added to the data operating system. We think this integration will make it especially difficult for customers to quickly switch to alternate vendors, and we believe that this gives Palantir flexibility to address many use cases while becoming critical to operations.
Palantir Also Benefits From Network Effects and Intangible Assets
Palantir's platforms are intended to be collaborative across entire organizations: Developers and data scientists can write custom applications on top of the platforms in their chosen coding language while nontechnical individuals can use the platforms and make actionable decisions. By transforming data into common vernacular and views that are easily comprehensible, we believe a network effect exists within organizations as well. Each additional user brings a unique viewpoint and the platforms can spread across an institution. With data constantly being ingested and analyzed, Palantir's platforms can uncover new insight and notify appropriate individuals that may have not been privy to the new information, making the platforms more powerful as more users participate. Going further, Palantir has been able to establish its platforms as the data operating system within government operations and the airline industry, with partnership plans intended for the healthcare and financial services industries as well.
We also believe that Palantir has valuable intangible assets associated with specific customer and industry acumen. In an approach to alleviate the issues with these complex projects that can rely on a patchwork of solutions, Palantir rotates its software engineers between field and development efforts to gain insight about customer and industry-specific challenges that can strengthen its platforms' capabilities. We believe that this unique customer and industry acumen creates intangible assets for Palantir's platforms, while also fortifying a network effect.
As of December 2019, Palantir had 475 U.S. patents and over 500 patents outside the U.S., as well as 800 patents pending in total. Its software is built with stringent security, auditing, and compliance capabilities while still enabling functionality and collaboration.
Moat Trend Is Positive
We believe that Palantir's narrow moat is strengthening. Most important, in our view, customer switching costs are increasing as the company's platforms experience strong business expansion within customer cohorts. We also think the network effect is strengthening from expanding use cases across a wider gamut of market verticals and deeper penetration within existing customers. Similarly, intangible assets are increasing as more industry-specific acumen is learned and deployed within its software platform. Supporting these traits are a critical legal ruling in favor of the company and streamlined operations simplifying and hastening software deployment while positively effecting margins. Additionally, the secular trend of massive data proliferation and interconnectivity should drive increased demand for seeking insights from data generated and stored, in our view. We believe Big Data analytics and successfully using AI to uncover insights are in the early stages of adoption, and being able to provide standardized commercial solutions could be the disruptive force across customer markets.
As Palantir continues its expansion and customer acceptance into various industry verticals, we believe the company gains unique industry knowledge that strengthens its products and creates a more robust ecosystem of customers utilizing its data operating systems. The company's customer switching costs increase as its software platforms propagate throughout various teams and divisions within organizations after initial acceptance within a subsegment. While we expect Palantir's government vertical to remain critical to growth, the expansion into commercial verticals helps diversify its revenue stream and increases the chances of becoming the de facto data operating system for industries.
Our Fair Value Estimate is $13 per Share
We value Palantir at $13 per share, which approximates to a $28.2 billion market capitalization based on an estimate of 2.17 billion shares. Our fair value estimate is consistent with a 2020 enterprise value/sales multiple of 23 times and free cash flow yield of 1%. While we recognize these multiples are high, we also foresee rapidly growing and operating leverage for Palantir in the years ahead.
We forecast a 34% five-year revenue CAGR driven by Palantir expanding its government and commercial operations. By segment, we model the government sector growing quicker in the near term, with a 37% five-year revenue CAGR, while the commercial segment has a 31% five-year revenue CAGR. Looking further out, we expect the revenue contribution from the commercial segment to surpass the government sector late in the 2020-29 decade.
In the government sector, we believe Palantir's successful lawsuit regarding U.S. government agencies considering commercially available options before custom alternatives should propel robust growth, and having incumbency should help the company become the data operating system standard. Our forecast for revenue growth from the government is not materially contingent on the outcome of the 2020 U.S. presidential election or any other geopolitical risks in the years ahead, such as further U.S.-China trade tensions or military conflicts with other regions.
For the commercial segment, we expect strong growth as more companies and industries strive to understand actionable insights from their data stores and new data generated. We believe the company has opportunities, as it has done within aviation, to become the de facto data operating system that various clients feed data streams into within the commercial sector.
Led by the company requiring fewer resources to deploy its platforms, higher-margin commercial contracts, expansion of government deals, and economies of scale for hosting its software, we model gross margins expanding into the low 80s through the 2020s versus 67% in 2019. We believe that after it wins accounts, Palantir can proliferate its software through organizations as firms look to extract insights by further stitching disparate data sources together. With higher gross margins and less incremental investment required for sales and development per customer, we expect operating margin expansion per customer over time. We model the GAAP operating margin expanding to the low double digits in 2025, from negative 78% in 2019, and the adjusted operating margin expanding into the mid- to high 20s in 2025, compared with negative 45% in 2019.
Financially Strong and Improving
We believe that Palantir is in a solid financial position that is on a positive trajectory. The company has historically operated at a loss while producing negative operating cash flow; however, we expect these results to improve throughout the 2020s. We believe rapid revenue growth alongside an improving margin profile will help generate bottom-line improvements alongside positive free cash flow. The company's existing customer base generates the bulk of revenue, which we believe gives high visibility and an opportunity to expand customer margins. Although we suspect that Palantir can generate positive free cash flow and become profitable on an adjusted basis in the next few years after adding back copious amounts of stock-based compensation, we believe that GAAP profitability may not come until the middle to latter half of the 2020s. We expect expansion into the commercial market, proliferation across government sectors, and decreasing the expenses required to initially deploy its software platforms will drive Palantir's operating profile and cash flow improvements.
As of the end of June, Palantir had an accumulated deficit of $4 billion, $300 million of outstanding debt due in 2023, and $1.5 billion of cash and cash equivalents, excluding restricted cash. The company chose to use a direct listing to join the public markets, so no cash will be raised during the initial public offering. According to PitchBook data, Palantir's Series K funding round in 2016 provided a post-money valuation of around $20.3 billion. The company received subsequent funding from private sources and strategic partnerships, but using its S-1 volume-weighted stock price for August 2020 and the pro forma share count after going public implies its market capitalization may have dropped substantially. However, we believe that strategic initiatives to expand its enterprise software subscription business, alongside sticky government deals, could reward investors over the long run.
Some Notable Risks
We assign Palantir a high fair value uncertainty rating.
The integration of disparate data sources and uncovering actionable insights with the assistance of AI is challenging and may not be a widespread problem that customers require to be solved. While Palantir may be able to execute on this task, a big enough market may not exist, pushing the company into a niche.
Palantir's top 20 customers represented 67% of revenue in 2019. As of its IPO filing, Palantir had a small customer base of 125 institutions, so losing any key government or commercial customers, which have flexibility not to expand contracts with the firm, could be overly damaging. Palantir has also stated its intention to not enter contracts with organizations that it considers inconsistent with its mission to support Western liberal democracy and its strategic allies, including the Chinese market. This limits overall market size and could increase cyberattacks, and working with military operations could cause potential investors to avoid the name.
A differentiated selling point is the commercial aspect of Palantir's software platforms; however, customers may choose to keep their historical method of employing consultants and system integrators to assist in-house developments for data projects. Alternatively, large established firms may attempt to copy its commercial approach and limit any premium Palantir can demand. Without strong revenue growth and an improving operating profile, Palantir may not achieve profitability. The company went through many rounds of funding before announcing its direct listing, and investors may not be willing to support a long-term, arduous journey to profitability and possible shareholder returns.
Palantir has three share classes. Class A has one vote per share and Class B has 10 votes per share and is convertible to one share of Class A. Class F has a variable number of votes and provides the founders with the ability to control nearly 50% of total voting power. As long as 20 million shares of convertible stock remain outstanding from Palantir's Series C, D, and E rounds, the holders of these shares, voting as a single entity, can elect one board member out of the six (at the time of the S-1 filing). Holders of Class A and B shares, voting as a single entity, elect two board members. The combined holders of outstanding convertible preferred stock and common stock elect the remaining board members. With this structure, we believe that Class A investors have to be comfortable with trusting the founders' strategic imperatives and use of capital.
Investors also must be comfortable with Palantir's beliefs and ideals. The company will forgo opportunities, however lucrative, if it believes they do not match its culture, knowing that these contracts will go to competitors. With the voting power concentration, we believe investors must be comfortable with Palantir not taking part in deals that are not aligned with its vision to support Western liberal democracy and its strategic allies. In our view, Palantir is making the best long-term strategic decision for its business, and not wavering from that stance could be fruitful in winning future government deals with the U.S. and its allies. We also believe the expansion into commercial markets and previous investments to improve installation costs are moves in the correct direction for the entire business.
The company has been criticized in the U.S. for how its software may be used to infringe upon civil liberties and data privacy concerns. Palantir believes it has purposely developed its software to safeguard such concerns; it also employs a privacy and civil liberties team to help customers use its technology responsibly. Palantir does not mine, purchase, or monetize data, and the data is owned by its customers.
We do not expect any shareholder returns through common dividends. Share repurchases may occur as the company's presence in the public market matures, but we believe investments in development and sales would be the best use of capital during the rapid-growth stage.
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