Palantir Technologies (NYSE:PLTR) has become one of Silicon Valley’s most secretive companies. The 2020 public listing of Palantir stock promises to be one of the year’s most interesting yet.
Founded in 2003, Palantir initially began life as a software developer for the U.S. Central Intelligence Agency (CIA). Over time, however, the company expanded its reach to other government agencies and the private sector. Today, the firm employs some of the smartest minds in Silicon Valley and generates 53% of its revenues from non-government entities. Yet, few outsiders know the specifics due to its continued work in covert operations.
So how can investors value a company that often can’t disclose what it does? Here’s the summary of everything you need to know.
Palantir Stock IPO: A Direct Listing
Palantir stock begins trading on the NYSE on Tuesday, Sept. 30 under the ticker “PLTR”. The company will pursue a direct listing, rather than a traditional initial public offering (IPO).
That means PLTR won’t use an underwriter or issue new shares the same way a regular IPO does. Instead, its existing shares will simply start trading on the New York Stock Exchange.
Spotify (NYSE:SPOT) and Slack (NYSE:WORK) also pursued direct listings.
However, Palantir’s management has turned the simple process into a complicated ordeal — multiple S-1 amendments and listing delays have ensued as the company revised terms to resemble a traditional IPO. Insiders now face lockup periods designed to prevent mass-selling immediately following the listing.
Regardless of the process, however, PLTR stock will eventually trade much like its tech counterparts with multi-class stock.
Business Model: A Different Kind of Government Contractor
The U.S. government has a long history of working with independent contractors. From Ford’s World War II production of B-24 aircraft to Boeing’s modern-day Air Force One, the private sector has long helped the U.S. military and intelligence operations stay ahead of rivals.
As technological conflict moved into the digital world, the U.S. government has also adapted, enlisting companies from Booz Allen (NYSE:BAH) to Microsoft (NASDAQ:MSFT) to help. According to the Government Accountability Office, the government now spends $90 billion on information technology every year.
And Palantir Technologies sits among these critical players.
What Does Palantir Do?
Palantir Technologies was built almost as an experiment to attract top-tier talent into government service. CEO Alex Karp had a “unique ability to recognize and seduce star engineers,” according to writers at Forbes Magazine. “His colleagues were so flummoxed by his nose for technical talent that they once sent a pair of underwhelming applicants into a final interview with Karp as a test. He smelled both out immediately.” The company also names star tech investor Peter Thiel as one of its key backers.
Putting its pedigree aside, however, the firm operates as a software developer with two key platforms:
Palantir Gotham. A platform used to identify patterns within datasets. Includes features such as “Graph,” an interface for users to explore data, and “Ava,” an artificial intelligence system that scans large datasets for patterns and connections. Mostly used in government and non-profit applications.
Palantir Foundry. A data warehouse to help companies collect and analyze information. Includes “Monocle,” a graphical data interface, and “AI/Machine Learning,” a statistical package for data scientists. Marketed mainly towards the private sector.
Readers can view more details on its S-1 filings here.
Getting in the Weeds: Service vs. Product
Together, these two platforms form a base for Palantir’s more bespoke offerings. That’s important because tech contractors come in two flavors: non-scalable “Software Service” and scalable Software Product” companies.
Software Service (a model Palantir has wisely avoided) tend to work on one-off projects. A government office needing a specialized website, for example, might hire a company to build one from scratch. And because building two websites takes twice as long as making just one, these businesses can’t scale quickly.
Software Product companies, on the other hand, can use the same software to service many clients. Microsoft, for instance, can sell the same version of Windows to millions of customers with relatively little customization.
Palantir sits in between these two extremes. The company can resell its two platforms, but each deployment still requires some customization. Palantir Gotham at the U.S. Navy might look quite different from a deployment at the Health and Human Services.
Palantir’s Business Model: A Hybrid of Service & Platform
The firm’s hybrid model makes the company incredibly tricky to value. Like Microsoft, Palantir needs massive outlays to develop and maintain its core product. But like general contractors, they also have expenses associated with each deployment.
In other words, the company always faces an unclear profit/loss calculation on each sale. Price too low, and you’re not guaranteed to cover R&D overhead. Price too high, and risk losing the entire contract.
The company’s S-1 filings show that management has struggled with this balance. In 2019, the firm generated just a 6.7% contribution margin in 2019 (gross profit minus selling expenses). (Note: this includes all corporate stock options as a real expense to provide a better apples-to-apples comparison). That was lower than SAP (NYSE:SAP), for instance, which had a contribution margin 5.7 times higher. Alarmingly, even many Software Service companies like Booz Allen (at 10%) out-earns.
As Palantir prepared to go public, however, its contribution margin shot up to 30.6% in H2 2020. Even with the coronavirus pandemic as a catalyst, that’s an unusually large jump for a 17-year old company. So what does that mean?
PLTR: From Startup to Grown Up
The company has explained these improvements in a wall of jargon. Here’s an excerpt from its S-1 filings:
“The improvements are generally due to increases in revenue recognized in each period. In addition to a continued decrease in the number of software engineers and related costs required to install, deploy, and manage our software platforms, as well as increases in the efficiency of our sales and marketing function from the investment in a direct sales force.”
Investors should view this muddled explanation with suspicion: significant swings often signal undisciplined pricing. Indeed, employees have often complained about the company’s inexperienced management. And the problem is particularly acute in sales, an area that Palantir’s management has traditionally disparaged.
It’s a shared experience with other engineering-first companies, including Slack, GitHub and Dropbox, said Mark Cranney, a former operating partner for venture firm Andreessen Horowitz. “All went through similar phases of this anti-sales culture.”
Yet the company stands to reap massive rewards if it can mature. Tractica, a market research company, estimates the AI software industry to grow at a 44% CAGR through 2025. Gartner, another research firm, has highlighted how the industry generates trillions of dollars in business value. Can Palantir bring a management and sales teams to take advantage of a rising tide?
Corporate Governance Issues
Outside investors, unfortunately, won’t have much of a say. Palantir’s stock listing comes with unusual rules that give its three founders indefinite control over the company.
At first glance, these rules might seem normal. From Facebook (NASDAQ:FB) to Under Armour (NYSE:UA), other companies have often used multi-class shares to keep founders in control. Facebook CEO Mark Zuckerburg, for instance, commands around 60% of his company’s voting shares.
Palantir, however, takes the concept to the next level. By issuing special “Class F” shares to themselves, the company’s three founders’ voting power will never drop below 49.999999%. That’s true even if they sell shares or retire.
“We have never seen anything like this before with a startup IPO,” TechCrunch writer Danny Crichton wrote in a blog post. And it’s true: Palantir’s ownership structure looks much more like a Limited Liability Partnership (LLP), where outside investors (limited partners) have no control over management (general partners), board composition, or compensation.
If investors can stomach that, then Palantir could be the right investment. But there’s more.
No Stranger to Controversy
In July, the federal government surprised the medical community by suddenly announcing a new set of coronavirus reporting guidelines. Rather than report infection data to the CDC, hospitals would send data to a newly formed system at the Department of Health and Human Services (HHS). Chaos ensued as medical staff struggled to switch systems in the middle of a pandemic.
“The transition has been a disaster,” said Jeffrey Engel, senior adviser to the Council of State and Territorial Epidemiologists, an association that represents state public-health officials. “What HHS said was that the CDC was not nimble enough and couldn’t handle new data elements, and that’s simply not true.”
Why the sudden change? Thank Palantir.
The company’s co-founder, Peter Thiel, has always had a cozy relationship with the Trump administration, even acting as part of the President’s transition team. The HHS system was developed, in part, so that Palantir could analyze the data. Democratic U.S. Senators swiftly decried the $25 million deal on matters of serious privacy concerns. “Neither HHS nor Palantir has publicly detailed what it plans to do with this PHI, or what privacy safeguards have been put in place, if any …”
It’s not the first time the firm has hit the media spotlight. In 2019, the Washington Post wrote an extensive article on how the company worked with ICE to identify undocumented immigrants, a project that Google rejected. And controversies will likely keep on coming.
What’s Palantir Stock Worth?
Investors who can stomach the company’s rigid structure and mercenary nature still need to value its shares. But that poses yet another problem: Palantir stock faces an unusually broad range of potential outcomes.
Conservative estimates will point to a company more interested in technological mastery than shareholder profits. Using a 3-stage DCF model with a 30% growth rate decreasing to 18% by 2027 shows a fair value of around $4.0 per share, roughly where its shares privately traded in July.
More aggressive estimates might push growth to 45% in 2020, 35% in 2027, and increase its EBIT margins to 35%. In that case, the software firm values closer to $35 per share or a $77 billion market capitalization. That’s more in-line with its $20 billion price tag that investors placed on the company five years ago. (Since then, the company has almost tripled its revenues)
The most aggressive analysts might even see the software developer as the next IBM (NYSE:IBM) or Microsoft. It’s one of the best-positioned companies to succeed in creating a unified AI and data analytics platform. That could push its valuation well beyond $200 billion.
Three key issues prevent investors from creating a clear-cut valuation.
First: The company still runs a bespoke service. Unlike consumer-goods companies like Tesla (NASDAQ:TSLA) and Apple (NASDAQ:AAPL), Palantir doesn’t produce widgets for mass-market sale. Instead, each deal needs constant tailoring, much like custom cars or wedding dresses. That means each sale is dependent on the company’s ability to hire and maintain talent, something far harder to judge.
Second: Palantir has a hugely unpredictable working capital need. In 2019, the company generated $203 million in self-reported working capital on just $742 million in sales. (That happens when firms receive up-front payments for long-dated contracts). However, in the first half of 2020, Palantir reversed course, consuming $591 in additional funds to support just $481 million revenue*. Even if the company eventually collects the cash, the higher capital investment pushes down the return on invested assets (ROIC) and lowers a company’s fair value.
Third: There’s the secrecy around the firm’s operations. Is the firm working with the U.S. government on developing the next generation of war machines? Or a system to constantly track the location of every American? We may never know until the product gets declassified, which could happen decades in the future.
What Should Investors Do About Palantir Stock?
Investors looking to buy Palantir stock will be in for a bumpy ride. The company is rapidly transforming from an engineering-led firm into a more traditional sales-based one, and few people know what will happen. Its direct listing will also create volatility; without investment bankers to help value the IPO, investors will need to value the company for themselves. Slack has slumped 30% since its 2019 direct listing. Spotify, on the other hand, has soared 62% since its debut.
Here’s my recommendation: if PLTR trades for less than $10 on its opening day, back up the truck and load up. Few companies in the Western world attract data science and programming talent the way Palantir can. And the firm’s push into private sector deals will unlock a massive market that’s hungry for top-tier machine learning and data analytics talent.
But if PLTR stock jumps to $50 and beyond, then it’s better to put away the elephant gun and wait for a better target. The company may grow into the next IBM, once valued at over $200 billion. But as IBM’s shrunken $107 billion value shows, it’s hard to remain #1 in a tech service industry forever.
Buyers get ready. Palantir stock won’t fail to surprise.
* Palantir’s cash flow should alarm any would-be investors. The sudden reversal in working capital (however arcane it seems) points to weakening credit terms. In other words, management could have achieved its massive 45% H1 growth 2020 partially by offering better terms to customers. (i.e., “We’ve raised prices by 20%, but don’t worry, you don’t have to pay us for five years…”) Or it might have just forgotten to pick up the check in the mail.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.