Peering into Palantir's Data Market Disruption

SEC filings and investor presentations have pulled back the curtain on Palantir Technologies' (PLTR) opaque operations, and we are intrigued by the company’s prospects as an emerging leader in data integration, analytics, and artificial intelligence. We value it at about USUS$28.2 billion in equity value or about USUS$13 per share based on an estimate of 2.17 billion shares.

We believe Palantir has a narrow economic moat and a positive moat trend based on customer switching costs, intangible assets, and a network effect. In our view, Palantir’s government and enterprise software has become mission-critical and deeply engrained with clients, the company has unique customer and market knowledge to pair with its AI acumen, and its software platforms become stronger as more users, institutions, and industries rely on its solutions. We believe these sources will strengthen, and despite a lack of profitability today, we anticipate that Palantir will generate robust operating leverage and excess returns in the long run.

Our estimated 34% five-year revenue compound annual growth rate is driven by robust growth in government and commercial sectors. Providing a holistic view of legacy data from disparate locations and various types, integrating the influx of new data, and then using AI to extract actionable insights can give organizations an advantage over peers. However, firms and governments attacking the challenge in-house can be unsurmountable. From assisting top-secret intelligence operations to extracting the optimal amount of oil out of wells to predictive maintenance on airplanes, Palantir is a disruptive force by selling commercial software platforms versus highly customized, consulting-led efforts.

We view Palantir as a land-and-expand story: After converting trial customers to its software platform, its software subscriptions proliferate in organizations and the incremental revenue outpaces associated investments required. With improvements in up-front installation costs and the cadence of subsequent software updates, we expect substantial operating margin improvement to the mid to high 20s on an adjusted basis by 2025, up from negative 45% in 2019.

Palantir Aims to Solve Customers’ Problems with Big Data
Palantir aims to solve the historically terrible rate of success in data integration and insight-producing projects, while also not requiring customers to displace legacy investments. Its software platforms enable self-sufficient customers whereby Palantir is providing software updates, but insights can be gleaned internally.

The company sells two software platforms: Gotham, mostly targeted at government operations, and Foundry, aimed at commercial markets. Launched in 2008, Gotham’s provenance was assisting U.S. counterterrorism operations to find insight from their data, and alleviating the data organizational issues and dangers of soldiers in Afghanistan and Iraq mapping insurgent networks and roadside bomb makers manually.

Over time, Palantir expanded into the commercial segment. While the stakes may be different, the challenges of integrating new and legacy data sets and gleaning insight from copious amounts of data are ubiquitous. Foundry was developed to make the integration of data sets routine in addition to gaining insights through AI. These platforms are sold across their customer segments as well, with financial institutions using Gotham for fraud investigation and Foundry being used across government divisions.

Under the hood, Palantir’s Apollo platform is software that controls and updates its offerings, also enabling Gotham and Foundry to be deployed in clouds, on-premises, classified networks, edge networks, and devices. Palantir credits innovation in the Apollo platform as its way to achieve margins resembling those of software as a service instead of operating like a consulting business, all hidden to the end-users of Gotham and Foundry.

Strategy Has Evolved
Starting as a company specializing in government intelligence software in 2003, Palantir’s business model more likely resembled a consulting firm employed for defence contracting work. This model can require a lot of manual labour, working to build customized solutions to solve a specific problem at a point in time. Issues arise when attempting to scale that particular solution to other related challenges, whether across particular institutions or market segments.

With its foray into the commercial markets, Palantir was also initially operating a consulting model upon releasing Foundry in 2016. The following year, the company migrated commercial customers to a software platform instead of bespoke applications. While the firm may have lost customers during this process, we believe having a commercialized platform is the correct strategic play in the long run. Palantir has evolved toward a SaaS company, with all its customers using its software platforms.

Palantir’s revenue streams are more globally and sector diversified than most investors may suspect, in our view. The company sells its platforms to the United States and allies on the government side and into a variety of commercial industries, in total 36 industries across 150 countries. While we expect U.S. government customers to remain a cornerstone of Palantir’s business, 53% of revenue was commercial-based and 60% of revenue was derived outside the U.S. at the end of 2019.

The impact of these strategic changes is accelerating revenue streams alongside an improved operating profile. Margin expansion comes from lower deployment costs, proliferation of its platforms throughout existing client organizations, and properly pricing its software platform to maximize the value that customers receive.

Moat Is Underpinned by High Customer Switching Costs
We assign Palantir a narrow economic moat rating, primarily based on customer switching costs and secondarily strengthened with a network effect and intangible assets. Despite a lack of profitability today, we anticipate that Palantir will rely on these moat sources to generate robust operating leverage and excess returns in the long run.

Data proliferation is only accelerating as organizations further interconnect disparate systems across on-premises, private clouds, public clouds, edge locations, and personnel and devices. We believe the explosion of data and the management of data in a variety of formats presents a confounding issue for organizations.

In our view, Palantir is a beneficiary of high customer switching costs. It does not require organizations to completely overhaul their existing technology and infrastructure investments. Its software platforms integrate with customers’ historical systems, and new data sources and methodologies can be added to the data operating system. We think this integration will make it especially difficult for customers to quickly switch to alternate vendors, and we believe that this gives Palantir flexibility to address many use cases while becoming critical to operations.

Our Fair Value Estimate is US$13 per Share
We value Palantir at US$13 per share, which approximates to a US$28.2 billion market capitalization based on an estimate of 2.17 billion shares. Our fair value estimate is consistent with a 2020 enterprise value/sales multiple of 23 times and free cash flow yield of 1%. While we recognize these multiples are high, we also foresee rapidly growing and operating leverage for Palantir in the years ahead.

We forecast a 34% five-year revenue CAGR driven by Palantir expanding its government and commercial operations. By segment, we model the government sector growing quicker in the near term, with a 37% five-year revenue CAGR, while the commercial segment has a 31% five-year revenue CAGR. Looking further out, we expect the revenue contribution from the commercial segment to surpass the government sector late in the 2020-29 decade.

Financially Strong and Improving
We believe that Palantir is in a solid financial position that is on a positive trajectory. The company has historically operated at a loss while producing negative operating cash flow; however, we expect these results to improve throughout the 2020s. We believe rapid revenue growth alongside an improving margin profile will help generate bottom-line improvements alongside positive free cash flow. The company’s existing customer base generates the bulk of revenue, which we believe gives high visibility and an opportunity to expand customer margins. Although we suspect that Palantir can generate positive free cash flow and become profitable on an adjusted basis in the next few years after adding back copious amounts of stock-based compensation, we believe that GAAP profitability may not come until the middle to latter half of the 2020s. We expect expansion into the commercial market, proliferation across government sectors, and decreasing the expenses required to initially deploy its software platforms will drive Palantir’s operating profile and cash flow improvements.

Some Notable Risks
We assign Palantir a high fair value uncertainty rating.

The integration of disparate data sources and uncovering actionable insights with the assistance of AI is challenging and may not be a widespread problem that customers require to be solved. While Palantir may be able to execute on this task, a big enough market may not exist, pushing the company into a niche.

Palantir’s top 20 customers represented 67% of revenue in 2019. As of its IPO filing, Palantir had a small customer base of 125 institutions, so losing any key government or commercial customers, which have flexibility not to expand contracts with the firm, could be overly damaging. Palantir has also stated its intention to not enter contracts with organizations that it considers inconsistent with its mission to support Western liberal democracy and its strategic allies, including the Chinese market. This limits overall market size and could increase cyberattacks, and working with military operations could cause potential investors to avoid the name.

A differentiated selling point is the commercial aspect of Palantir’s software platforms; however, customers may choose to keep their historical method of employing consultants and system integrators to assist in-house developments for data projects. Alternatively, large established firms may attempt to copy its commercial approach and limit any premium Palantir can demand. Without strong revenue growth and an improving operating profile, Palantir may not achieve profitability. The company went through many rounds of funding before announcing its direct listing, and investors may not be willing to support a long-term, arduous journey to profitability and possible shareholder returns.

The company has been criticized in the U.S. for how its software may be used to infringe upon civil liberties and data privacy concerns. Palantir believes it has purposely developed its software to safeguard such concerns; it also employs a privacy and civil liberties team to help customers use its technology responsibly. Palantir does not mine, purchase, or monetize data, and the data is owned by its customers.