Palantir IPO: Listing gains are likely to be capped by reputational concerns around an otherwise enviable product stack
Palantir is a US-based software company specializing in big data analytics. Founded in 2003 to support US government efforts to counter terrorism through the use of data mining, its data integration platform provides the tools necessary for organizations to draw inferences from complex sets of random data through machine assisted analysis.
Palantir earned 67% of its revenue from 20 clients in 2019. Government contracts accounted for 53% of its revenue share in H1 2020. In a recent press release, Palantir now projects as much as 43% sales growth in 2020. We believe that Palantir might continue to make winning bids for government contracts and maintain/increase its revenue share. However, future growth and share price will be driven by Palantir’s ability to acquire and grow large corporate customers, and not govt. contracts.
The problem also lies in the low margins from govt. contracts. Growing revenues have not translated into increased profits. In fact, Palantir has not seen a single year of profits since inception 17 years ago. It is not clear to us how this situation will change in the coming year.
Palantir pivoted to Enterprise SaaS via its product- Foundry. They’ve spent $1.2 Bn in R&D since 2008. We firmly believe that their data mining software is industry leading. But we’re not convinced that this alone is enough for widespread corporate consumption.
Their increasing marketing and sales spend tell the same story. They call it consulting, we call it poor operational efficiency. As Palantir expands, its cost of revenue will increase as a percentage of revenue. Palantir continually needs to improve its operational efficiency to remain competitive and scale profitably.
Palantir, as of now, holds a 3% market share in the ever-increasing Data Analytics market. We believe that Palantir has the first-mover advantage to offer specialised, customer-specific, use-case data analytics software. It needs to become price competitive to capture market share. High initial investments in software platforms imply stickiness to the chosen services by prospective clients.
Palantir has ambitious plans of expanding into markets where they have limited operating experience. The average age of top 20 customers is 6.6 years. However, they need to increase the number of customers to ensure security of future revenue streams. Its dependence on third party cloud service providers has increased. The Company has spent heavily on making its platform future-ready and created a niche for itself in a highly competitive landscape.
“Growth Investors have been parking their money in the tech sector at much higher valuations than they command at present. However, not everything that shines is gold.”
The main cause of our worry is continuous governance and reputation risks. They face a lot of scrutiny owing to the nature of their business and their association with ICE. There are several governance issues as well. Post IPO, the three founders will continue to hold 50% voting rights.
Given the negative public image and governance concerns, we don’t think Palantir would repeat the success of a Snowflake or Unity. Listing gains maybe limited, long term investors may want to back the company.
Upbeat Market Sentiments driving Lofty Valuations
NASDAQ-100 Technology Sector has given a 47% return in the last 6 months. There is a lot of merit in tech being the growth sector, but the froth has certainly built up. Palantir is likely to be a beneficiary of the hype in recent tech valuations.
Palantir’s post-money valuation stands at $20.33 Bn- as per the last funding round in 2016. It has grown over 2,900 times since its inception from a modest $7 Mn. Our estimates and the estimates of a few other analyst firms do not peg Palantir’s valuation beyond $10Bn. But then you look at Snowflake’s market cap of $ 75 Bn and know anything’s possible.
The Company’s fair valuation, using revenue multiple of peers stands at $8.8 Bn, according to Pitchbook. The valuation has been calculated using different multiples for government revenue and commercial revenue, according to Palantir’s revenue share in these segments. This valuation translates to $4.055 per share. It is consistent with the industry price-to-sales ratio multiple of 9.04x, considering revenue at the current revenue run rate for 2020- $963Mn.
In a secondary market transaction, Torre Capital and others invested in the range of $7-$8 per share. This amounts to a $14- $16 Bn valuation, based on Palantir’s current total diluted common stock.
These inflated valuation numbers are just an indicator of how markets have been defying the previously used pricing benchmarks in the past few months and a number of stocks are trading at a much higher price than what their fair price as per valuations should be.
Many tech giants are entering the U.S. stock market before the United States presidential election on November 3. While Snowflake’s IPO was a huge success, we doubt whether that same success will be replicated by Palantir owing to our qualms about its public perception.
Despite privacy-controlled platforms, it has attracted negative press in the market for invading data privacy of civilians by helping Law Enforcement agencies in carrying out such activities.
The Company, in its S1-filing, has differentiated itself from other tech-companies by stating that they are not in the business of collecting, mining or selling customer’s data, unlike some of the largest tech companies who have built their entire business doing just that”
This debate is more perception and less fact, and likely to continually be a headwind for Palantir’s share price.
Is Palantir prepared to handle competition?
Palantir provides the software combined with consultancy. It has established a distinguished space in the industry servicing the white space that existed. However, it is exposed to a wide range of competition from the big and small players alike.
Where stickiness and high installation costs ensure a consistent revenue stream, the space has known to become extremely crowded and commoditized with an increasing PE-VC funding in startups in the tech space. There is indirect competition from large sized incumbents like Microsoft, IBM, Amazon to Google and Facebook.
With more than 1500 players in the Big Data space in U.S. alone, identifying direct and indirect competitors can get tricky from investor perspective.
Like Palantir, all of these companies are not profitable yet (net profit). According to the rule of 40 previously used by Tech Investors, the sum of revenue growth and profit margins should exceed 40% for a software business to be considered in good shape. Although, even though these companies do not make the cut as per the rule, the industry attractiveness and scope has led to high volumes of private investment in this space. What we may be looking at is a big bubble assigning absurd valuations.
“Where stickiness to the platform and high installation costs ensure a consistent revenue stream, space is known to become extremely crowded and commoditized”
Investment Recommendation: The success of Foundry- Palantir’s enterprise SaaS platform will be the primary driver of its growth. However, in the near term, it will be out shadowed by its negative public perception and unethical use of private data. The stock is likely to underperform, at least compared to more straightforward SaaS companies.
This article has been co-authored by Prerna Singla and Anurag Somani, who are in the Research and Insights team of Torre Capital.
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