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Palantir's Valuation Concerns Amidst AI-Driven Growth

Published 2024-10-18, 04:00 a/m
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Palantir (NYSE:PLTR) is an enterprise tech company that provides data analytics products, making it a direct play on artificial intelligence (AI) in today's AI-driven investment landscape. Like many AI-focused companies outside of Nvidia (NASDAQ:NVDA), Palantir saw a delayed acceleration in AI growth. However, in the most recent quarter, Palantir has distinguished itself by showing consistent strength, even as many tech peers are underperforming. This year, the stock has surged, more than doubling its value YTD to approximately $40 per share. The main driver behind this outperformance has been its impressive Q1 and Q2 FY24 earnings, where both revenue and earnings exceeded wall street's expectations. This was largely driven by the continued strength in the US Commercial segment, due to the impressive demand for its Artificial Intelligence Platform (AIP), and the subsequent raise in management's FY24 guidance.

PLTR Data by GuruFocus

Palantir is a controversial stock, with value investors debating that it is overpriced and growth investors debating that there is still untapped potential. I lean toward the former view. I believe the stock has run ahead of itself, especially when considering the future growth expectations from street expectations. While Palantir's strong operational track record and increasing demand for AIP could position the company to beat those street expectations, the stock doesn't present a good risk-reward profile at its current valuation levels if things don't go as planned. Recent developments, such as Peter Thiel's filing to sell up to $1 billion in Palantir shares, add to the growing signs that the stock is overvalued and poised for a correction.

On 9 September 2024, Palantir announced its inclusion in the S&P 500. This is undoubtedly a positive development for the stock, as it forces index funds to buy shares and thus increases the stock's liquidity. Compared to other companies like Airbnb (NASDAQ:ABNB) and Uber Technologies (NYSE:UBER), which saw increases of 7.2% and 6.2%, respectively, on the day they were added to the S&P 500, Palantir's jump of more than 14% highlights the level of hype around the stock right now. I'm not questioning the company's execution or its fundamentals, its US Commercial segment has seen impressive growth since AIP launched a year ago, and improving GAAP profitability. However, considering where the stock is currently trading, I believe there's more downside than upside in the short term. Palantir is undeniably a strong company with a competitive edge, and I'll highlight some of its positive metrics later, but the elevated valuation leads me to give the stock a Sell rating for now.

Strong Financial Performance Amid AI SurgePalantir's Q2 FY24 earnings reported total revenue growth of 27% YoY, reaching $678 million, overperforming street expectations. Government contracts made up 55% of the total revenue, growing 23% YoY. However, the star of the show was Palantir's Commercial segment, which is growing at a faster pace of 33% YoY and now accounts for a larger share of total revenue compared to last year. In particular, the US Commercial segment reported a robust 55% YoY growth, reaching $159 million. While the sequential growth rate slowed to 6%, the annual trend showed a pick-up in growth, driven by high demand for Palantir's AIP. Palantir's product offering (outlined by its AIP) has proven to be extremely valuable, allowing the company to maintain a high 3-year revenue CAGR of 23.1%. Expectations for FY24 and FY25 show revenue growth forecasts of 24% and 20.7%, respectively. Additionally, Palantir reported impressive growth in GAAP net income, growing from $28.1 million in Q2 FY23 to $134.1 million in Q2 FY24.

Growing Deal Flow and Operating EfficiencyPalantir's ability to close new deals has been improving consistently. Over the last five quarters, deals worth at least $1 billion have increased, with $10 million-plus deals showing the most growth momentum. In the latest quarter, Palantir closed 27 deals, up from 18 in the same period last year and 12 in Q3 FY23.

Source: Palantir Investor Relations

On the profitability front, Palantir remains highly profitable. Adjusted operating income grew 88% YoY to $254 million, overperforming its guidance of $209 million-$213 million, with margins expanding by 1,200bps to 37%. Furthermore, Palantir reported GAAP operating profitability for the sixth consecutive quarter, with an operating margin of 16%, up 1,400 basis points YoY. This operating efficiency is especially impressive considering that operating expenses grew just 6% YoY, showing how the company is scaling its business while expanding margins. Palantir's Rule of 40 score, a key SaaS metric, improved from 57 in Q1 to 64 in Q2, reflecting the balance of revenue growth and profitability.

Source: Palantir Investor Relations

Note - Rule of 40 refers to the sum of its revenue growth rate YoY and its adjusted operating margin for each of the periods presented

Free Cash Flow and Margin ExpansionAdjusted free cash flow (FCF), also showed strong growth. FCF grew 54.9% YoY, increasing from $96 million in Q2 FY23 to $148.7 million in Q2 FY24. The FCF margin also improved from 18% to 22% over the same period, reinforcing Palantir's ability to generate cash efficiently.

Key Risks to an Otherwise Appealing InvestmentInternational RevenueWhile Palantir's US Commercial segment has been performing exceptionally well, investors should be mindful that over 35% of its revenue comes from outside the US, where growth is slower. International revenue saw only a 15% YoY increase and even a 1% sequential decline, largely due to headwinds in Europe. Management has indicated that international commercial revenue will remain under pressure in Q3 FY24, raising concerns about the company's ability to maintain its overall growth momentum.

S&P Inclusion HypeAnother factor that could affect investor interest in Palantir is the fleeting nature of the S&P 500 boost. While inclusion in the index is a milestone, Palantir's 14% surge following the announcement may already account for much of the short-term gains. Historical data shows that newly added companies tend to outperform the index in the first three months as portfolio managers rebalance, but the S&P Effect usually fades afterward.

Valuation ConcernsThe key factor in my bearish outlook for Palantir is its valuation, which I find to be relatively overextended, despite Palantir's strong fundamentals and potential benefits from its AIP. While bullish investors may argue that Palantir is trading below its historical average price-earnings and forward price-earnings ratios, this argument doesn't hold much weight given the stock's short trading history and consistently high multiples. Palantir has spent much of its short trading history at extremely high valuation multiples, making it susceptible to being overvalued for extended periods. This, combined with the hype surrounding the company, leads me to believe that the stock is priced beyond what its fundamentals and potential growth justify right now.

In my view, the stock's overextended valuation significantly limits its upside potential, particularly when compared to other opportunities in the SaaS sector. Palantir is currently trading at a forward P/E ratio that is nearly double the average multiple of its peers. For example, the closest peer in terms of valuation, Crowdstrike, trades at a forward P/E of 68.5x, while Palantir is priced significantly higher as shown below. This valuation gap exists at a time when the overall SaaS industry has been under significant pressure, with multiples contracting across the board. Despite this broader trend, Palantir's stock continues to trade at a premium, as a result of the hype surrounding its AI capabilities and the S&P500 inclusion. While some may argue that Palantir deserves this higher premium due to its strong fundamentals and AIP potential, I believe that its current valuation makes the stock vulnerable to a potential correction. When comparing Palantir's earnings multiples to other SaaS companies such as Crowdstrike, Salesforce, and Adobe (NASDAQ:ADBE), which also have strong forward earnings growth rates, the significant valuation gap becomes even more questionable. The current environment is no longer the tech-bubble era of 2021, when stocks across the board traded at inflated multiples. Most software companies have seen their multiples adjust, but Palantir remains one of the few companies that still command a 2021-like premium.

PLTR Data by GuruFocus

Given this environment, I expect Palantir's valuation multiple to compress. Based on current market conditions, I expect that Palantir could trade at a forward P/E of around 65xsimilar to that of Crowdstrike's multiple. This implies a downside risk of approximately 32%, bringing the stock price closer to $27 per share. Companies like Crowdstrike and Salesforce are growing at above-market rates while trading at much more reasonable multiples, so they offer similar AI-driven growth narratives without the overextended valuation risk that Palantir currently carries.

I'm also using a discounted cash flow (DCF) model to gain better insights into whether the stock is under- or overvalued. For this analysis, I'm using the most recent reported number of diluted shares outstanding, which stands at 2,415 million, alongside a 10% discount rate. A reasonable foundation for the calculation is the company's upper-end guidance for FCF at $1 billion. I also assume a perpetual growth rate of 4%, which seems like a fair long-term projection. Based on these inputs, Palantir would need to grow its free cash flow by 29% annually over the next decade to be fairly valued at its current stock price. Some may argue that this is achievable, especially considering that the company has shown higher growth rates in recent quarters. However, when we contextualize these numbers, the picture becomes more complicated.

First, Palantir continues to dilute its shares. In Q2 FY23, the company reported 2,278 million diluted shares outstanding, which grew to 2,415 million by Q2 FY24a 6% YoYincrease. Taking this dilution into account, Palantir would need to grow at an annualized rate of 35% over the next ten years just to offset the effects of dilution, assuming this rate of dilution persists. Second, much of this growth must come from the top line. Currently, 28% of Palantir's revenue is already being converted to free cash flow, and I am skeptical about the company's ability to expand that margin further. This means that the 35% growth rate would have to come from revenue growth alone, a tall order given that Palantir has not consistently achieved such growth in recent periods. Since early 2022, top-line growth has decelerated, and I find it difficult to believe that the company will be able to sustain such aggressive growth rates over the next decade.

Final ThoughtsPalantir has certainly proven skeptics wrong by demonstrating how its AIP can generate real value, and the company is gaining significant traction with its customers as a result. I expect its growth to continue, and possibly even accelerate given the right industry landscape and improved macro environment. However, this doesn't change the fact that the stock price has surged ahead of the company's fundamentals. I'm not questioning the underlying business, which remains strong, but the stock's recent run-up has elevated expectations to a point where the downside risks outweigh the potential upside, with the possibility of a 32% correction in the near term. However, for long-term investors, there may be a more favorable entry point if the stock experiences a pullback.

This content was originally published on Gurufocus.com

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