Palantir (NYSE:PLTR$Palantir Technologies Inc.(PLTR)$ ) exited its tough operating environment in 2022 with a few key takeaways that included an ambitious guide from management (nothing new here) for both its top- and bottom-line.
Specifically, the company anticipates GAAP-based net income achieved in thefourth quarter to sustain through the current year and beyond - a milestone realized two years earlier than Palantir's "original goal of GAAP profitability in 2025". The guidance on anticipated sales was equally as ambitious, with management expecting full year 2023 revenue between $2.18 billion and $2.23 billion, which would represent y/y growth of as much as 17%. Although the target deviates far from Palantir's previous aspirations to achieve 30%+ annual growth on a multi-year basis, management expects the 17% y/y expansion in 2023 to be buoyed primarily by hopes for U.S. commercial revenue growth at more than 40% y/y (commercial revenue exited 2022 with mere 11% y/y growth, or approximately "33% ex-SPACs") despite an operating environment blighted bymacroeconomic uncertainties that will likely be complicating the picture further.
The following analysis will look into details surrounding management's ambitious guide for the current quarter and full year 2023 - including the step acquisition of the Palantir Japan joint venture, the strategic investment program, and developments regarding "disciplined spend management" such as recently announced job cuts and moderating stock-based compensation - and gauge their respective impacts on Palantir's fundamental prospects, and implications for the stock's near-term outlook. We believe the company's underwhelming fourth quarter results and lingering macroeconomic uncertainties make a complex set-up for management's ambitious guide.
This accordingly makes elevated execution risks ahead at Palantir, which is corroborated by the rapid evaporation of post-earnings gains in the stock during mid-February back to the start-of-year $8-range. The lack of fundamental support observed for management's ambitious 2023 guidance could also drive the stock towards greater vulnerability to declines in tandem with near-term market volatility amid an evolving macro backdrop, which we view would then create an improved risk-reward opportunity to participate in Palantir's otherwise still-impressive double-digit growth prospects buoyed by secular demand for cloud-based digitization technologies over the longer term.
GAAP Profitability
While GAAP-based net income is typically a positive milestone worthy of praise in tech - especially under the current market climate where profits are preferred over growth at all costs - the first thing that comes into question upon Palantir's announcement of the achievement during its fourth quarter earnings call is whether it will be sustainable. Specifically, management expects to maintain GAAP profitability through 2023 and beyond - which is two years ahead of its business plan.
Although the announcement has taken many by surprise, a closer look would reveal that Palantir stock's operating margins remain negative (though substantially improved, thanks to lower SBC expenses and disciplined opex). Much of the company's fourth quarter GAAP-based net income was driven by "below-the-line items" - primarily, the one-time $44 million gain on its step acquisition of the Palantir Japan JV.
For context, thePalantir Japan JVwas created in2019when Palantir entered into a partnership with insurer Sompo Holdings, Inc. (OTCPK:SMPNY/OTCPK:NHOLF) to deploy Foundry tailored to industry-specific use cases across the Japanese market:
In addition, in November 2019, we created a jointly controlled entity in Japan with SOMPO Holdings, Inc., in which we subsequently obtained a controlling interest in November 2022… On November 8, 2022, the company gained the right to majority representation on the board of directors of Palantir Japan, thereby obtaining a controlling interest. Prior to obtaining a controlling interest, the Company [Palantir] accounted for its 50% ownership in Palantir Japan as an equity method investment, which was created to distribute Palantir platforms to the Japanese market… The fair value of Palantir Japan on the acquisition date totalled $149.0 million, which included the Company's equity interest immediately prior to the acquisition of $74.5 million and the noncontrolling interest of $74.5 million.
Source:Palantir 2022 10-K
Upon acquiring additional interest in Palantir Japan that allowed Palantir a controlling interest in the Japanese subsidiary, the company recorded a one-time $44.3 million gain, which offset all of the operating losses, interest expenses, and losses on marketable securities, among other below-the-line items, to drive GAAP-based net income of $33.5 million in the fourth quarter. Other less impactful drivers of Palantir's fourth quarter GAAP profitability also include continued declines in SBC, as well as "disciplined spend management" that included cost savings realized from ongoing R&D efforts.
In other means, to gauge the sustainability of Palantir's GAAP profitability observed in the fourth quarter would be to determine whether the underlying drivers of operating income - namely, growth with added contributions from Palantir Japan, and operating cost efficiencies - are well supported in the absence of one-time below-the-line items:
1. Palantir Japan
As discussed earlier, the $44 million baked into fourth quarter other income (expense), net represents a one-time gain recorded on Palantir's step acquisition of its Palantir Japan JV in November 2022. Given Palantir's 2022 10K alludes to the subsidiary's contributions to its consolidated fundamentals post-step-acquisition as "immaterial", it is unlikely that there will be sufficient growth impact from the transaction alone to put the company on the map for sustained GAAP profitability going forward.
Specifically, Palantir had disclosed in its latest 10K filing that Palantir Japan had contributed 0.4% of 2022 consolidated revenues, or $7.6 million, from November 8th to December 31st. Extrapolating that for the year would total approximately $53 million. Based on management's guide for full year 2023 revenue between $2.18 billion and $2.23 billion, or growth of 14% to 17% y/y, taking out consideration of anticipated annualized contributions from Palantir Japan (under a conservative scenario of no growth at $53 million) would indicate organic growth at Palantir of just between 12% and 14% for full year 2023. This accordingly puts higher risk over the achievability of management's ambitious guidance for sustained net income going forward.
2. SBC
On the SBC front, the figure has been on a consistent decline - both on an absolute basis and relative to a revenue basis - over the last three years. Reductions in SBC related to G&A were most significant in the fourth quarter, despite improvements across the board.
Palantir Historical Stock-Based Compensation Trends (Palantir)
Yet, at 30% of revenue in 2022, the figure remains high among its software peers, especially given the growth that has decelerated rapidly to the teens. This potentially explains Palantir's recent decision to opt forjob cuts- an endeavour that CEO Alex Karp had previouslyshut down- over a mere slowdown in hiring to improve productivity and unit economics at the company and better align with its GAAP profitability goals for 2023 and beyond. Even so, the recent reduction of its workforce by 2% is unlikely to drive sufficient impact on SBC in 2023 to make meaningful contributions towards operating income, and inadvertently, GAAP profitability due to timing, which potentially means more disciplined spend management in other areas of opex.
3. Disciplined Spend Management
Management had also alluded to continued "disciplined spend management" in the fourth quarter, which drove operating margin improvements that added to achieving GAAP profitability. Related cost-efficiencies were observed in reduced spending across all opex categories (ex-SBC), with the exception of G&A, and in particular, savings in R&D (4Q22: 12.8% of revenue, ex-SBC; 3Q22: 15.9% of revenue, ex-SBC; 4Q21: 13.1% of revenue, ex-SBC).
While adjusted operating margins currently stand at an impressive 22%, which is about 600 bps ahead of management's prior guidance to indicate continued cost discipline, GAAP operating profit continues to be weighed down by significant - though reduced - SBC as discussed in the earlier section. To achieve a positive GAAP operating margin, which would be critical to sustaining GAAP profitability in the current year, Palantir would likely need to continue the rate of spending deceleration observed in the fourth quarter (discussed further in below sections), a difficult task even with consideration of already lower costs of acquiring incremental sales thanks to its effectiveland-and-expandbusiness strategy, all the while without compromising on its ambitious growth estimate.
Strategic Investment Program Woes
Another headwind that is driving incremental caution over management's optimism on sustained GAAP profitability is Palantir's struggling strategic investment program. Specifically, Palantir had invested into a handful of SPACs as part of its aspirations to grow Foundry application with "day zero" companies. But macroeconomic conditions have taken a turn for the worse over the past two years, making the strategic investment program an incremental burden on Palantir's financials instead in recent quarters.
In the latest development, Palantir has guided commercial revenue contributions from its strategic investment contracts at $15 million to $17 million in the first quarter, down from $20 million in the fourth quarter and $39 million in 1Q22. The company has also written down $262 million in total remaining deal value attributable to the strategic investment program, which is consistent with growing signs of turmoil in pre-revenue and/or unprofitable start-ups due to deteriorating macroeconomic conditions - Fast Radius (FSRWQ), a SPAC that had entered into a6-year $45 million dealwith Palantir in May 2021 as part of the strategic investment program, filed forChapter 11 bankruptcyin November.
There are also growing signs across industry that the remaining commercial deal value attributable to the strategic investment program is slated for continued churn in the near term as challenging macroeconomic conditions dry the funding taps that pre-revenue/unprofitable start-ups have been relying on:
In the fourth quarter of 2022, U.S. commercial revenue grew 12% year-over-year to $77 million but was down sequentially as we saw headwinds from catch-up revenue in the prior quarter as well as a decline of revenue from customers in our strategic investment program given the outsized impact of the macro environment on these customers.
Source: Palantir 4Q22 Earnings Call Transcript
Similar observations have also been echoed by Palantir's peers:
Clearly, some of the newer technology companies, we've seen a slowdown in some of those ones, which we had highlighted last year. And I do think you're definitely going to see a slowdown in a lot of the venture [backed] companies that may have been growing very quickly.
Source: Snowflake F4Q23 Earnings Call
Looming macroeconomic uncertainties are likely to drive a broader wave of conservatism over enterprise IT spend in the near term, which is consistent with signs of a significant slowdown in Palantir's organic commercial revenue growth in the current year as discussed in the earlier section. This accordingly puts incremental weight on Palantir's cost-savings initiatives in order for it to achieve GAAP profitability in the current year. However, the company's continued efforts in helping customers achieve more with less by building Foundry on the concept of "ontology", and rolling out Apollo to improve costs of new technology development and deployment continues to bode favourably with growing demands for cloud optimization across the enterprise IT spending segment. Hence, Palantir's technology edge could potentially be a partial offset to near-term risks of a tighter IT spending environment amidevolving macroeconomic uncertaintiesahead.
Down to the Fundamentals
Drawing on the foregoing analysis, Palantir's guide for sustained GAAP profitability in 2023 - which will be dependent on substantial cost reductions and outsized growth - appears to be in a stark disconnect from its current operating environment. This is further corroborated by deterioration in key performance indicators in the fourth quarter, including flat billings y/y, deceleration in remaining performance obligations to 12% y/y, decline in total deal value by 23% y/y (or -8% y/y ex-SPACs), as well as a sequential drop in net dollar retention from 119% to 115%. With macro conditions likely to worsen before it gets better - considering still stubbornly elevated inflation, a tight labour market, and interest rates on the rise - there is little visibility into what might be structurally supportive of GAAP profitability at Palantir in 2023.
Updating our fundamental forecast for Palantir with actual fourth quarter results and considerations of the company's current operating environment discussed in the foregoing analysis, we find little support for GAAP profitability in full year 2023, though prospects may improve in 2024 buoyed by nominal operating income.
Palantir Base Case Financial Forecast (Author)
Paired with key valuation assumptions including a 10% WACC consistent with Palantir's cost structure and risk profile, as well as a 3.5% perpetual growth expectation (implied terminal value multiple of 9.7x) considering economic expansion in its core operating regions counting the U.S., Europe (primarily, the U.K.), and APAC (primarily, Japan and Korea), we remain hold-rated at an estimated base case intrinsic value in the $8 to $9 range. This is consistent with the stock's current levels, which trades more in line with the average among peers with a similar growth and profitability profile, and reflective of investors' lack of confidence in management's ambitious forward guidance.
Palantir Base Case Valuation Analysis (Author)
Palantir Base Case Valuation Assumptions (Author)
Palantir Base Case Valuation Sensitivity (Author)
In the bull case event where Palantir does eke out GAAP profitability in 2023, which will be primarily driven by substantial cost discipline - all without compromising double-digit growth - the stock could potentially reach prices in the teens, representing upside potential of more than 50% from the shares' last traded price of $8.40 at the time of writing (March 7).
Palantir Bull Case Financial Forecast (Author)
Palantir Bull Case Valuation Analysis (Author)
Palantir Bull Case Valuation Assumptions (Author)
Palantir Bull Case Valuation Sensitivity (Author)
But with difficulty finding support for the bull case, risks are likely skewed to the downside at Palantir over the near term. Another lacklustre quarter in hard-to-predict government revenues and macro-sensitive commercial sales - which is likely to fall short of management's optimism - would easily dial up the stock's exposure to ongoing market volatility in anticipation of further economic turmoil, and potentially push it towards our bear case PT at$5 per share.
Final Thoughts
While Palantir's double-digit growth amid mounting macroeconomic uncertainties remains an impressive feat, and cost discipline recently observed via job cuts, conservative R&D spend, and continued SBC reduction are bright spots, management's ambitious growth guidance could potentially backfire by not having sufficiently de-risked for conditions over its immediate- and near-term operating environment. Although on the valuation front, Palantir's debt-free balance sheet alleviates some of the headwinds from rising borrowing costs (recall from ourrecent macro commentarythat valuation multiples are primarily driven by the cost-return on capital spread), its near-term fundamentals (i.e., the "return on capital" leg of valuation) remain vulnerable to the looming downturn. We believe the current macro set-up and management's ambitious guide leaves room for significant execution risks ahead at Palantir, which could drive the stock lower, though the underlying business remains sufficiently robust to support a compelling buy opportunity in the event of a share price pullback to capitalize on longer-term value accrual potential.
Source: seeking alpha
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