Palantir — Understanding the operational structure of a high growth company

Palantir (NYSE:PLTR)

Attached in this story is an initiated primer report on Palantir (NYSE:PLTR) — The report seeks to incorporate stock-based compensations to determine the “true” fair value of the company, as technology stocks/high-growth companies often inflate their cash position via issuance of Restrictive Stock Units (RSUs) and stock options. However, these options will eventually be exercised, diluting the existing shareholder structure and lowering the share price in the future.

In this report, I include:

1. FY21 Q3 Financials Overview
2. Financial Analysis
3. Valuation
4. Dilution via Stock-based Compensations
5. Probable Bull Case Revenue Growth
6. Financial Model

Disclaimer: This initiated report is only a primer version — it does not conduct a deep dive in the software-infrastructure technology market segment, but to incorporate management’s overall guidance and analyse the company’s operational structure to determine the fair value of the company.

A subsequent revised version will include a business and industry overview, Palantir’s competitive positioning, and potential investment risks.

1. FY21 Q3 Overview

Palantir announced its financial results for FY21 Q3 including the following:

(1) 34 net new customers in Q3, closing 54 deals of >US$1M, 33 deals of >US$5M, and 18 deals of >US$10M

(2) Total revenue growth of 36% y-o-y to US$392M for FY21 Q3

(3) Positive free cash flow of US$119M, representing a 30% margin

Further, CEO Alex Karp posited a 40% revenue growth for FY21 and a sustained 30% y-o-y growth up to FY25. Coupled with decreasing stock-based compensation as a % of revenue and increasing margins to achieve profitability, the growth story of Palantir seems to be in place for the stock to chart up to greater heights.

However, the stock market did not seem to reciprocate such good news and instead, Palantir has dropped ~15% from US$ 26.75 to US$22.83 as of 15th Nov 2021. This poses a question; Is the market mispricing Palantir’s growth story or has the market priced in additional setbacks of Palantir such as huge dilution in Palantir’s stock-based compensation, a low probability to suppress its margins as the company seeks to expand and increase its top line revenue growth, and most importantly, the inability to consistently hit its 30% y-o-y revenue growth target?

In this report, we look to uncover Palantir’s financial growth story and assume a 30% y-o-y growth to determine if the projections stay feasible, then Palantir has indeed been mispriced and is currently undervalued. Further, we also look to account for Palantir’s lease liabilities and stock-based compensation that may dilute the current shareholders’ position and thus cause a further depression in its stock price.

2. Financial Analysis

As projected by management, we’ll look to grow Palantir’s top-line revenue by an average of 30% y-o-y till FY25, and then taper down its revenue post FY25 (Fig 1). Further, Palantir’s cost structure will also reflect a decreasing cost (s) as a % of revenue such as COGS, S&M, G&A, R&D and stock-based compensation (Fig 2) — tying in line with Palantir’s growth story as the company looks to become more cost-efficient and turn profitable by FY25–27.

Following which, we can identify that Palantir will be growing at a 32.9% CAGR from US$1.5B in FY21 to US$8.4B in FY27 (hitting the target of US$5B at FY25 too). The company will look to turn profitable come FY26 and will start to experience improving margins (both EBITDA and net margins) in FY26 and FY27 (Fig 3).

From Palantir’s current financials and its projections at FY21, we can conclude that the company’s future growth story for the next 3–6months is crucial to determine if the stock can experience a surge in price, since its current operating structures in FY21 has experienced a huge improvement with respect to its top line revenue growth. Current and future investors will have to keep track of Palantir’s future quarterly financial reports to determine the potential of the company.

3. Valuation

DCF Valuation

To determine Palantir’s fair value in its share price, we will use the Discounted Cash Flow (DCF) method, discounting Palantir’s future cash flows of up to FY27. The DCF valuation employs the Free Cash Flow to the Firm (FCFF) methodology to arrive at the intrinsic value of the company. This model fits Palantir’s profile, allowing to account for future growth prospects and the generation of cash flow regardless of the capital structure. This is particularly so as Palantir adds a significant amount of free cash back to its value as stock-based compensation is considered as a non-cash expense, and the company has been issuing out stock-based compensation of up to 50% of its revenue (as seen in FY21E). Palantir’s historical numbers are consolidated from FY18 to FY20 and projections are conducted from FY21 to FY27.

Weighted Average Cost of Capital (WACC)

WACC (Fig 4) is estimated at 8.5% for Palantir. Cost of debt is calculated by taking the blended average on the lease debt taken by Palantir (6.35%) and credit facilities (2.75%) and adding the 10-year risk free rate. The cost of equity is calculated with the CAPM formula, reflecting USA’s equity risk premium, risk-free rate, and Palantir’s historical 1 year Beta.

EV/EBITDA and Terminal Growth

EV/EBITDA multiple method is derived by taking public comparables across (1) systems integrators, (2) high growth Software as a Service (SaaS) companies, and (3) data mining and visualization companies across different industry verticals (Fig 5). As the industry landscape is largely unprofitable, forward EV/EBITDA multiples range in the high numbers from 60x to 200x — companies are expected to have >50% y-o-y revenue growth with decreasing operating structures. Due to how sensitive the multiples are, I’ll estimate a range of multiples as:

(1) 40x — 20–30% y-o-y growth (a 30% cut from its current multiple as there are no current peer comparables in this segment. The next target multiple will be 10–20x, comprising of large systems integrators and enterprise AI companies such as IBM, Cognizant, etc)

(2) 60x — 30–40% y-o-y growth (where Palantir is currently priced at)

(3) 100x →50% y-o-y growth (evidenced by how DocuSign and Datadog are valued as they experience such high growth rates)

These multiples will be carried forward to our sensitivity analysis. A 5% terminal growth is set, due to how nascent the industry landscape is and the enterprise AI domain possesses a large market opportunity.

Fair Value per Share

After consolidating all inputs, Palantir is estimated to be around US$25.22 per share via EBITDA multiple method and US$24.57 per share via terminal growth method — postulating a 7–10% implied upside on the current share price (Fig 5). Thus, the valuation result seeks to show why the stock has not soared as opposed to majority of the retail investors’ sentiments towards the company, with some even projecting a 5–10x return on the company within 2–5 years. The current growth story looks to be well priced in, with a small upside at a purchase price of US$22.83 as of 15th Nov 21.

4. Future Dilution?

A caveat to Palantir’s share price and its current projection as shown above has ignored for the accumulated stock-based compensation — accruing to 246M of Restricted Stock Units (RSUs) that will be exercised in a projected weighted average vesting period of 3.2 years (166M current, 80M projected from 2022–2025). When employees start to exercise these rights, (1) future dilution and (2) decreased free cash flow will occur, slashing the fair value per share to a lower price. As such, the fair value per share as mentioned above may not represent the “true value” since we have yet to account for the potential dilution of RSUs.

Option Value Conversion

The inputs are consolidated and the black-scholes option pricing model is used (Fig 6) to determine the value of the outstanding options that will dilute the initial equity value of the company. Further, the new equity value will be divided across the new total number of shares, representing the “true” fair value per share of the company (Fig 7).

With the dilution effect accounted for (representing over US$3B in dilution across 246M shares), Palantir’s true fair value per share will be priced at US$20.75 via EBITDA multiple method and US$20.18 via terminal growth method. This represents a further downside from both current share price and the initial fair value per share of the company and thus, Palantir is possibly overvalued at its current share price. Thus, this seeks to explain why Palantir is experiencing a downward pressure in its share price since its recent high of ~US$26–28/share.

Sensitivity Analysis

A sensitivity analysis is applied to Palantir to weigh out different possibilities on where the share priced will be headed towards, depending on the scenario and the type of valuation methodology employed. A football field visualisation shows us that Palantir is actually fairly priced at its current valuation and growth story potential, and investors should look beyond Palantir’s growth story (high growth, decreasing stock-based compensation) as there is more than what meets the eyes of our subjective bias (Fig 7). Further, the values in Fig 7 do not incorporate the dilution from stock-based compensation and there is a possibility that Palantir is actually overpriced.

Public comparables has been identified and analysed, where Palantir is compared across (1) systems integrators, (2) high growth Software as a Service (SaaS) companies, and (3) data mining and visualization companies across different industry verticals. Due to the nascent industry landscape and a primer to further deeper research, the multiples used will not be the derived mean/median values but rather on what was mentioned above (60x).

5. Bull Case as a Catalyst?

Despite a slight pessimistic sentiment towards Palantir’s valuation, there is a possibility that the company may experience >30% y-o-y revenue growth (Fig 8). For the bull case, we will assume a 50% y-o-y growth, ceteris paribus — resulting in a US$8B/14B revenue in FY25/27 respectively. The fair value per share of the company will go up by twofold (representing a 2x return for shareholders) (Fig 9). Despite Palantir’s strong competitive positioning, I opine that the proposed scenario may not be likely — since B2B/B2G sales cycles undergo a long duration (as experienced from my current job) and a 2x revenue growth from FY25(US$8B) to FY27(US$14B) will indicate Palantir to experience:

(1) A 2x growth in customers and/or contract value

(2) Close to 70–90% retention rate, as the company mentioned that the usual customer lifetime value is only 5 years

(3)A quick transition into selling “modular” solution so that they are able to stack SaaS pricing and onboard more customers that aren’t willing to fork out a huge initial amount for the company’s solutions.

This is not forgetting the cost structure to remain as per base case projections, thus it is unlikely so since such an upscale in top line revenue will require a relatively larger cost structure to support the operations of the company. Hence, projecting such valuations does not seem realistic and the base case’s outcome is recommended.

6. Personal Take

Palantir’s share price has undergone loads of controversy in terms of the forecasted direction and the possibility of a huge potential upside. Ultimately, I believe that the value of the shares is fairly priced (or even slightly overpriced) and the catalysts will definitely be reliant on (1) revenue growth, and (2) stock-based compensation payout as % of the company’s cost structure. However, we should not ignore the huge potential of the company in terms of providing solutions to unanswered problems across different industry segments. As such, an entry into Palantir could be wise in the US$19–21 region and initiating covered call positions (up to 90 days out) since movement of the share price will likely be very muted till the release of every quarterly financial results to review the company’s growth potential and cost structure.

Disclaimer

The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decision by a person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security.