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Palantir Earnings Review - Pullback & Market Froth

1 John Chapter 3 verse 11 states, "For this is the message you heard from the beginning: we should love one another."


The Bible teaches that from the beginning, God's intent has been for us to love one another. This is always easier said than done. It makes me think about the pressures I face daily, notably dealing with multi-tasking between work and family and all the responsibilities that are involved. Or it makes me think of others I know dealing with much more dire circumstances whether jobs or loved ones have been lost. It is during the daily interactions of these moments, that find I so easily forget God's message to love one another, seeing myself easily driven by emotions instead.


For investing, this can relate to the dialogue I enter into in providing information on a point that I have, as well as the discussions I become involved with. The goal for all investors is the same, build wealth/generate returns through the successful execution of strategies and management. Getting caught up in the moment or emotions, can lead to poor execution.


Today, Palantir Technologies (PLTR) witnessed a nearly 13% pullback. As I updated my financial model for the company, a reoccurring theme has begun to play out. Earnings season is upon us and I am finding more so than not, that many companies that I own are looking quite frothy moving forward. When I say moving forward, I don't mean the next year or so, I mean over the course of the next five-year period.


To provide an illustration of this, I'll use Palantir's results today as an example.


Palantir

Palantir has built two principal software platforms, Palantir Gotham (“Gotham”) and Palantir Foundry (“Foundry”). Gotham, the company's first software platform, was constructed for analysts at defense and intelligence agencies. They were hunting for needles not in one, but in thousands of haystacks. And they did not have the software they needed to do their jobs. In Afghanistan and Iraq, soldiers were mapping networks of insurgents and makers of roadside bombs by hand.


Gotham enables users to identify patterns hidden deep within datasets, ranging from signals intelligence sources to reports from confidential informants, and helps U.S. and allied military personnel find what they are looking for. Palantir later found that the challenges faced by commercial institutions when it came to working with data were fundamentally similar. Companies routinely struggle to manage let alone make sense of the data involved in large projects. Foundry was built for them. The platform transforms the ways in which organizations interact with information by creating a central operating system for their data.


Gotham’s use has now extended beyond intelligence analysis into defense operations and mission planning. And Foundry is becoming the central operating system not only for individual institutions but for entire industries.


Palantir's key financial metrics as of today's filing and on a Last Twelve-Month, LTM, period are as follows:

  • Net Cash Position: $1.9 billion

  • Revenues: $1.1 billion

  • Gross Margin, GM: 68%

  • Operating Cash Flow, OCF / Margin: ($297) million / (27%)

  • Free Cash Flow, FCF / Margin: ($10) million / (1%)

  • Shares Outstanding: 1.8 billion

Palantir generated a very solid year-end quarter with 2020 full-year Revenue growing 47% from the previous year to $1.1 billion. Analysts were expecting a small gain for the quarter from Net Income, and to their surprise, Palantir generated a loss. For me, I'm not as concerned with this point, as the market sold off on the news, but I did see some Cash Flow issues that look like Palantir will be depending on 2021 as its year of Cash Flow inflection.


We'll get further details once the 10-K is filed, but new contracts in the fourth quarter were split between government and private sector customers including Rio Tinto, PG&E, bp, U.S. Army, U.S. Air Force, FDA, and NHS.


Palantir estimated first quarter 2021 Revenue to be 45% above last year, and total annual Revenue for 2021 to be greater than 30%. The guidance for 2021 is consistent with what was provided earlier, suggesting strong sustained growth early in the year, and deceleration throughout. Adjusted Operating Income as provided at 23% for the first quarter, but not for the entire year.


As I stated, I wasn't really concerned with earnings miss. However, I did see some interesting Cash Flow elements that investors should be paying attention to. First, the good news was that Palantir's adjustments to reconcile Net Income accounted for nearly $160 million in Cash Flow. The bad news was that working capital was highly negative for all of 2020, led by declines in Accounts Payable, Deferred Revenue, and Customer Deposits.


The two years prior (2019 and 2018), working capital had consistently been the positive driver for Cash Flow, although a downtrend was prevalent. During Palantir's pre-IPO time period, I was modeling Cash Flow inflection beginning in 2020. This was on track after the Q3 earnings report, but it now looks like inflection will be occurring in 2021.


Key updated valuation metrics for Palantir include:

  • Enterprise Value, EV: $47.5 billion

  • EV/Revenues: 43.5 times

  • Net Debt/OCF: N/A

  • Stock Price, SP/OCF per Share: N/A

It's still very early, but William Blair has already downgraded Palantir. I suspect tomorrow they'll be much more information on analyst actions. Today, Palantir is trading with a strong premium at nearly 44 times EV/Revenue, with OCF/FCF now being negative.

I am leaving my assumptions in place for Palantir to track towards a 20% OCF margin through 2022, with Revenue just below $2 billion. I have an 18-month PT set at just below $36 per share, reflecting just below 30% upside. In addition to the OCF margin, the PT assumes a 30 times EV/Revenue and an OCF/share multiple towards 150 times.


As we are now entering 2021, I felt it prudent to look out a little further towards 2025. Palantir is estimated to generate around $1.5 billion in Revenue for 2021. Assuming that they can average a little below an annualized 24% growth rate, and by 2025, Revenue would be expected to achieve $3.5 billion. Assuming very modest share dilution and an expanding OCF margin towards 27%, to get towards a $60 SP, Palantir still needs to trade with an EV/Revenue multiple at 30 times, and 100 times OCF per share to get towards $55 per share. Even at these premium multiples, Palantir would generate an annualized return from 17-20%.


This gives me cause for concern, with respect to managing the position. Palantir right now, is the 10th largest holding in the portfolio with a 2.7% weighting. I have an average purchase price at $9.30 per share. Based on this, with no further action, my annualized return would be at 40% by 2025 in the above scenario. I am looking for 25-30% annualized return in the portfolio overall, so I won't be considering adding to the Palantir position unless it falls below $25 and/or closer towards the $20 per share level.


So far in 2021, I've had 13 companies report including Palantir. After earnings results, only four of are at SP levels that would merit consideration to add to existing positions. From last year's portfolio inception, nearly every holding has a strong chance at returning 20% or greater over a five-year annualized period (2020-2025). However, the much slower expected performance from today's SP levels through 2025 are a clear indication that today's multiples for those that have already announced, are at a steep premium suggesting overvaluation.


Like Palantir, many solid companies are simply trading much too high, and would likely benefit from a pullback. Palantir, even with today's 13% percent drop is no where near the radar to trigger any consideration, let alone action. Anything below $25 will garner interest, and I'm not sure the market is yet ready to head to a level that low. But in time, we may see our opportunity.




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