Kevin Dietsch
Introduction & Investment Thesis
Palantir Technologies (NYSE:PLTR) has been one of the most controversial stocks on the market since going public in 2020. However, after reporting strong Q3 2023 earnings results, it’s clear that this underdog stock offers tremendous upside potential for investors. Their strong revenue and EPS beat, coupled with a guidance bump and more durable profitability means this firm is set up for sustainable growth. It’s an exciting story I think that should be a part of anyone’s portfolio.
While, in my last report, I focused on how Palantir was winning new key corporate clients, I think this quarter emphasized the staying power and still massive untapped market potential that government contracts hold, something that I missed before. With conflicts continuing to brew with militant groups in the Middle East and the war in Ukraine in desperate need of a breakthrough, companies like Palantir can provide the information edge. Information is the new secret weapon in winning wars.
With government contracts being a place where growth can likely accelerate going forward and the firm now reporting durable operating profits (net of interest on cash), I am upgrading my rating to a strong buy from a buy.
Q3 Earnings Report
On November 2nd, Palantir reported Q3 revenue of $558 million, up 17% year-over-year and exceeding expectations of $556 million (Q3 earnings call). GAAP EPS came in at $0.03 and non GAAP adjusted income at $0.07/share, beating estimates by $0.01. This marked Palantir’s fourth consecutive quarter of GAAP profitability and third consecutive quarter of GAAP operating profitability, showing the company’s clear path to sustained profitability.
For me, operating profitability is really important. Like I mentioned before, I was previously skeptical of how profitability would pan out net of the interest the firm had on its idle cash. Second quarter’s operating profitability was just $10mm (Q3 Investor Presentation). Operating profit has grown 4x in the third quarter. That’s amazing- I don’t know how many other firms saw their operating profit 4x quarter over quarter. Operating profits now represent over 50% of this quarter’s net income too, a crucial milestone. With this, I now feel far more confident the firm has a fair shot of being included in the S&P 500. With indexes allocating billions of dollars to the firm, this will increase upward pressure on the stock.
Palantir GAAP Operating Income (Q3 Earnings Presentation )
In addition to beating top and bottom line estimates, Palantir saw robust customer growth. Total customer count grew 34% year-over-year to 453 customers. Interestingly, U.S. commercial customer count expanded 37% to 181 customers, representing massive share gains in Palantir’s most critical market, the United States.
Palantir’s government revenue also showed resilience, growing 12% year-over-year to $308 million. While government revenue growth slowed, Palantir is poised to regain share as global allies increase defense spending amid rising geopolitical tensions (Q3 Earnings Call). In fact, international allied government revenue is growing at twice the speed of 21%. The world is getting more chaotic, not less. Palantir benefits from this.
Forward Outlook
For Q4 2023, Palantir expects revenue of $599-603 million, ahead of consensus estimates of $591 million. The company also predicts Q4 adjusted operating income of $184-188 million, demonstrating continued operating leverage.
For the full year 2023, Palantir raised guidance to expect revenue of $2.216-2.220 billion and adjusted operating income of $607-611 million. Hitting the midpoints, this guidance implies 16% annual revenue growth from 2022.
These forecasts show Palantir’s growth story is far from over. With revenue highly visible and highly sticky, Palantir has clear visibility to deliver on its aggressive 2023 outlook. The company is firmly on track to hit its goal of strong revenue growth and $4 billion in revenue by 2025, implying a revenue CAGR of 30% from 2021.
My Biggest Earnings Takeaway: Massive Government TAM
While Palantir’s commercial business grabbed headlines this quarter, I was more fascinated by the growth and excitement of the government business which offers arguably greater long-term upside. For me, this is a change from my last report before earnings, I now truly understand the government TAM (Total Addressable Market).
Palantir’s core platform offers what appears to be a best in class surveillance system for foreign allied governments. There’s a really solid piece on the work Palantir software did for the US government and Afghanistan government before the US removed support in 2021. In our modern era, intelligence and information means more than ever in fighting terrorism and foreign wars. This is the only way we can have a one-up on China and Russia.
Changing war dynamics means changing war spending priorities. Total NATO defense spending is worth $1.26 Trillion this year alone. This number will likely go up more as chaos ensues.
Yet Palantir’s Total Government revenue (defense and non defense) is about $1.2 billion annually based on 3Q’s ARR. This represents ~0.1% of the spend of the NATO defense industry. In allied governments (mainly NATO countries) collectively allocated 1% of their budgets to intelligence software like Palantir, this opportunity could multiply their government business by billions of dollars.
Furthermore, despite having major government relationships with the U.S. Army, Air Force, Marines, and Navy, Palantir has barely scratched the surface of its total addressable market (TAM) in the US government either. The U.S. defense budget alone stands at nearly $800 billion, providing Palantir a vast growth runway inside this NATO spend figure.
With global defense spending rising amid escalating geopolitical tensions, Palantir finds itself in the right place at the right time. In fact, The U.S. Army recently awarded Palantir a new $250 million contract for advanced AI capabilities, showing the urgency of Palantir’s mission. In my opinion, This massive government opportunity remains misunderstood and under-appreciated. This single line of business could multiply over the next few years.
This discussion doesn’t even take into account their new Government Web Services platform to power the US defense tech ecosystem. I am not going to try to price in the fair value of this because it’s so new, but its promising. Here’s an excerpt of it from the call:
In September, we also launched Palantir Government Web Services to expand Palantir’s mission by supporting and growing today’s nascent but inspiring defense tech ecosystem. Through Palantir GWS, we’re providing emerging and existing companies in the defense industrial base with the enabling software to quickly operationalize their mission-critical capabilities at scale, all aimed at minimizing the value of death and bringing the best of America’s greatest advantage software to the fight. -Q3 Earnings Call
The US defense industrial base is over $800 billion annually. This is a massive market they are tapping into through GWS. It will be exciting to watch this market opportunity crystallize over the coming quarters.
Shareholder Value
In addition to investing aggressively for growth, Palantir offers shareholders direct value creation through buybacks. In August 2023, Palantir’s Board of Directors authorized up to $1 billion to repurchase the company’s stock over a two-year period.
By repurchasing shares at depressed valuations, Palantir can boost EPS and create substantial long-term value for remaining shareholders. Palantir also has a strong balance sheet, ending Q3 with $3.3 billion in cash to fund growth initiatives and buybacks.
Risks
Of course, Palantir faces risks worth acknowledging. The company relies heavily on government customers, with 54% of Q3 revenue coming from government deals. A loss of key government contracts could negatively impact Palantir’s growth trajectory. And with previous data leaks being a concern, just one data breach could seriously undermine the company.
Palantir also faces intense competition from defense contractors and enterprise software vendors. Larger companies like Microsoft (MSFT), Amazon (AMZN), and Google (GOOG) (GOOGL) have far greater resources than Palantir. If these tech giants target Palantir’s core markets, it could disrupt the company’s strong momentum. Big Tech already has a big presence in the defense department, with major cloud providers getting billions in spend from them.
Palantir is different, however, focusing on delivering the critical software that front line troops and defense analysts use directly every day in order to support them in their jobs. This is a high trust space. This trust (while it can be broken) is one of Palantir’s current biggest moats.
Valuation
Even after rallying over 25% since reporting earnings, I believe the stock is undervalued. If the firm can capture even just an additional 0.4% of total defense spending globally from NATO, this could unlock upwards of $5 billion in annual government contracts. Given the critical nature of these contracts churn would be low meaning revenue. I believe this deserves at least the median industry price to sales multiple.
If this marginal revenue opportunity is given an industry average price to sales multiple of 2.39, this would add ~12 billion onto the company’s valuation representing a 30% increase in the current market cap from $40 billion and a 30% increase in share price. Keep in mind even with this 30% increase in share price the stock still trades below its all-time high back in 2021.
Why I think these contracts are not priced in
Palantir’s PEG (Price to Earnings Growth) multiple (forward) is currently 1.06. The sector Median is 1.74. This means the market is viewing the stock with a lower growth outlook than the sector median. I find it hard to believe that the median stock in the sector has such a powerful market opportunity and TAM in front of them as Palantir does.
Conclusion
Palantir’s Q3 earnings show this battle-tested company has turned the corner to profitable growth. With secular tailwinds in both its commercial and government divisions, Palantir has a visible runway for over high double digit annual growth through 2025. Despite these strengths, risks remain (as they will for any business that has highly concentrated revenue and is highly dependent on customer trust). But Alex Karp and management is careful, and for long-term investors, I believe Palantir offers one of the most compelling risk/reward setups in the market today. According to NYU mathematician & philosopher Nassim Taleb, the way to gain in a modern environment is to be convex to chaos and change. This is exactly what Palantir is doing.
