Palantir: Will Rising Rates Keep Compressing Its Valuation?

Palantir (PLTR) has been very popular with the retail crowd, being one of the most purchased stocks by retail investors in 2021. Palantir is a data analytics company providing analytical software for both government bodies and individual companies. I am neutral on the stock.

The company’s Gotham platform is mostly used by intelligence agencies and defense, where Palantir’s software helps users identify key patterns among different data clusters. Palantir also offers Foundry, which enterprise software companies can use to see how existing operations can be improved by analyzing operational data.

If operations can be further streamlined to increase efficiency, companies can save money, adding additional profit to the bottom line. Although Palantir has a range of commercial clients, most revenue comes from government bodies.

Palantir is one of the best at developing analytical-based software and has a history demonstrating that it can win contracts with both governments and individual companies. Palantir went public via a direct listing in 2020, which is typically done to provide existing shareholders with much better liquidity if they want to sell their shares instead of selling shares privately off the market.

However, although the company is delivering increased revenues and cash flow, its stock is down to $16, with an implied market capitalization of $33 billion. In January 2021, Palantir stock was as high as $39. One year later, the stock is down 60%. This is more a result of a valuation adjustment rather than deteriorating fundamentals.

Growth Strategy

Management is confident enough in PLTR’s software that they bear the initial cost of a pilot program for new potential clients. Palantir is sure that a big portion of pilot programs will be successful due to the appeal of its software.

Once this is successful, Palantir further refines and integrates its software based on the organization’s needs, but now with payment from the customer. Palantir aims to repeat this as much as possible to scale up the business, which should help grow its free cash flow in the long term.

The cost of running multiple pilots is very expensive, with SG&A (including Sales & Marketing) expenses typically costing more than Palantir’s total revenue. Therefore, progressing past this phase over time is crucial. Ideally, management would want to get to a point where they have a large client base after having exhausted years of pilot programs.

Pilot programs will not go away, but rather, it is expected that over time there will be an inflection point where revenues from existing clients dwarf the annual cost of running new pilots. This strategy for customer acquisition is already successful, with management adding 34 net new customers in Q3.

Scalable Software

The question many investors have is exactly how scalable is Foundry? If a software engineer or team is constantly developing existing software to serve the changing needs of the organization, then how scalable is the software as it has a degree of labor? Once Palantir reaches the expansion phase with the client, how much total labor time is required per client?

This is another question investors want to know as it helps gain an understanding of Foundry’s scalability. This would give insight into the true pace of Palantir’s potential growth.

Revenue has grown from $595 million in 2018 to an estimated $1.52 billion for the full year of 2021. Additionally, Palantir is guided to report its first year of positive free cash flow at $359 million for Fiscal Year 2021.

There is a consensus among analysts that revenue and profit growth will remain in the double-digit range for most, if not all, forecasted years on their models. Palantir is a market leader in data analytics and has won contracts over Google/Alphabet (GOOG) and Microsoft (MSFT) several times – particularly with government bodies.

Palantir has demonstrated leadership in its sub-sector; therefore, many growth investors are excited to see how Palantir grows over the next five to 10 years.

Valuation Adjustment

Early in 2021, when a number of technologies companies peaked, Palantir reached a forward EV/EBITDA multiple of 264x. This forward multiple has decreased to 56x, which is still high. However, management is confidently guiding strong double-digit growth with roughly 30% revenue growth expected in 2022.

The expectation for rate hikes increased through 2021 and into 2022, leading to a sell-off in highly valued technology companies as transitory inflation proved false.

As rates increase, so does the weighted average cost of capital (WACC), which is used to discount potential future cash flows in order to find a company’s true intrinsic value. WACC decreases when interest rates are low, meaning valuations are expected to increase as future potential cash flows are worth more.

Growth companies, in particular, with large future cash flow potential tend to be the companies that benefit the most in equities markets when interest rates are low. However, as rates increase or as the expectation for higher rates grows due to pivoting fiscal policy or central bank signaling, growth companies tend to see the biggest valuation adjustments.

Therefore, the fundamentals for Palantir’s last year largely remain unchanged, but valuations are appropriately adjusting in anticipation of liquidity tightening. Investors have also been heavily critical of the significant amounts of stock-based compensation employees are receiving, which dilutes existing shareholders, lowering their future earnings per share.

In 2020, management paid over $1.27 billion in stock-based compensation to employees and over $853 million in the last 12 months. This is treated as a non-cash item; therefore, stock-based compensation is added back when calculating free cash flow.

Net income, however, is adjusted for stock-based compensation which is why Palantir’s net income is negative. On a positive note, stock-based compensation is a popular benefit among highly skilled software engineers. Therefore SBC not only helps retain talent but also helps align employees with the long-term goals of the company.

Wall Street’s Take

Turning to Wall Street, Palantir has a Moderate Sell consensus rating based on one Buy, three Holds, and four Sells assigned in the past three months. Despite this, the average Palantir price target of $22.14 implies 38.3% upside potential.

Analyst price targets range from a high of $25 to a low of $18.

Conclusion

Palantir has no debt and a cash position of ~$2.5 billion based on Q3 results. With a quick ratio of 4x, Palantir has the flexibility to run pilots and heavily reinvest back into the company in order to support long-term growth.

Although the valuation is still high after the 12-month sell-off, if management can maintain strong double-digit growth over the next 10 years, then Palantir could offer impressive cash flow numbers in the billions towards the end of the 2020s.

As Palantir doesn’t have the cash flow to support its current valuation, in the short term, the price movement will be determined by interest rates, inflation, and signaling from the Federal Reserve.

Download the TipRanks mobile app now

To find good ideas for stocks trading at attractive valuations, visit TipRanks’ Best Stocks to Buy, a newly launched tool that unites all of TipRanks’ equity insights.