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We recently described the disaster that Palantir Technologies Inc. (NYSE:NYSE:PLTR ) stock has for longs. Right now this is a trader's market and we have had a short bias the last few months at our service, with selective long-term plays only in the most quality of names. We keep hearing that that technology stocks, especially those that are potential game-changing names, are on sale, but Palantir stock, which we think is a speculative long-term buy remains expensive. But today we were taken aback at what seemed like a desperate plea for attention by CEO Alex Karp who doubled down on his view that nuclear war is about the same probability of drawing a card that is the suit of diamonds from a standard deck of playing cards. For the uninitiated, that is 25% (13/52). Alex Karp seems to think there is a 20-30% chance of nuclear war. Saying something like this, and citing your company's models and technology as a justification, seems a little desperate in our opinion.
Honestly, in that CNBC interview, it was, awkward at best. Maybe that is just the CEO's temperament. He has said many controversial things in the past. He has assailed Silicon Valley. He has said that his company is used "to kill people". He has told investors if they don't like how things are done they can invest elsewhere. Now he is out there with the nuclear war possibility. Is it to get attention to his company? Maybe. The company is known as a surveillance state's best friend, and even the New York Times has questioned whether it sees too much. Apparently they saw inflation coming, and they saw the pressure from financial institutions coming. They also saw nuclear war coming, all of this was on the Q1 call, but buried in a series of oddball comments:
You need an ability to interact with space where you solve compute and involving the reduction of data using colloquially defined AI tuned by Foundry getting that to the soldier. You need to be able to, in the context of commercial entities, rebuild the supply chain because there's war. Obviously, there's going to be food shortages. There's disruptions. You can no longer get certain resources from countries. You have to get them from others overnight. The system literally presuppose that will never happen, and therefore, fall completely apart when it does happen. There is no plan for when it doesn’t happen. This is why even though we've been completely focused product company that is only focused on these building products and we have new products coming and not as focused on actually convincing people that we're right, they still sell because the other products are not built for this world. You have a financial context. It's like we have raging inflation, we are very likely to see this will increase. The risk of a nuclear event is so much higher than it's being presented in the public world, that it’s almost surreal to watch the coverage. And yet, there's really no idea of what you would do with evaluating the quality of revenue.
So that Palantir, for example, we're a company to thrive in good times and we thrive in bad times. We are not built in the way the theologians of our financial institutions would love us to be built. So that you're built exactly like if we had listened to them, we would only be growth and no free cash flow. We're a company that throws off free cash flow. We're a company that expected inflation"
It is our opinion that this was a desperate double down on selling the company's technology. To grow, it needs more commercial customers, and it really needs government contracts. As investors know, the stock has been horrific for the last year. It has been in free fall. This is because for years, Palantir may lose money or breakeven. While they invest heavily in their growth while seeing revenues increase dramatically, in this market environment, the Street wants to only bid up stocks with growing earnings, cash flow, and return to shareholders (e.g. dividends). And as we know, Palantir is seeing revenues grow tremendously, and has some positive cash flow, but is doing the opposite of dividends and buybacks as it dilutes is shareholders. Dilution could continue so long that positive EPS becomes out of reach without future buybacks. There is a ton of stock based-compensation. This has been discussed in the past but we have to reiterate that we like that management has acknowledged that it is a problem. Still, it is ongoing, and every share that is issued waters down the ability to increase EPS. In short, shareholders could be diluted into losses. We hate to say it but frankly, it is not uncommon for stocks in seemingly innovative companies to wither away to sub $1 then eventually delist because the company failed to grow and deliver on its plans.
In our last column (linked in the opening) we stated that "we believe the stock will retest lows as the economy continues to worsen, rates are going up, and markets struggle". That is happening. Karp could have been discussing the possibility on air to drive more business. Seriously. It is not a bad strategy. Think about it. If the world is going to burn, would it not be a competitive advantage to know when and from where it could start? Makes sense to us, even if it reeks of desperation. It almost makes us want to go back on our last statement of where we would hold our nose and buy. Earlier in the month we said that "we would be both traders and investors at $7".
It is surprising to see such comments. Some may see it as the quirky type of operator that he is, but we think the comments were unnecessary, and somewhat odd given that it did not seem like business was hurting. Operationally we are seeing some positive signs. Internal metrics improve year-after-year for Palantir and we see no reason why the ongoing growth will not eventually lead to real profits, other than dilution. The company is a high growth tech but it is not bleeding out and losing money hand over first like so many others. In fact, Palantir is breaking even and making some money some quarters.
Remember, in the recently reported quarter, performance was strong on the top line and beat consensus estimates. Total revenue grew 31% year-over-year to $446 million, beating estimates by almost $3 million. One negative was that guidance was less than consensus and that hurt the stock. These comments of possible nuclear war that can be modelled comes as its operational segments are doing well. Both the government and commercial segments are seeing growth. More specifically the commercial revenue stream continues to grow rapidly, while government results are likely to get a big boost following international strife. And what better way to sell your product to governments by threatening them with the potential for nuclear war. Better be prepared right? While the war in Ukraine may or may not lead to more business the company has invested in itself to grow sales, but Karp could be out there selling the product even more especially as there are some concerns with backlog on the decline.
Deceleration of revenue growth is definitely a negative for a company like this that does not enjoy high earnings, and that is what we are seeing. Still customer count is on the rise, even if revenues only rose 16% from last year. The company added a total of 40 net new customers in the quarter, which is very positive, 3 on the government side and 37 on the commercial side.
We think that it is positive to see the customer growth. However, even with the increase in revenues and customers, the stock is actually still expensive, like so many other growth tech names. Even at 8 to 9X sales, the stock is much cheaper than it has ever been, but it is still not "cheap". In Q1 Palantir lost $39 million in the quarter operationally, but adjusted income from operations was $117 million. One positive is that the company is still free cash flow positive. Adjusted free cash flow was $30 million for the quarter and was profitable at a $0.02 adjusted EPS bottom line figure. While Palantir continues to see 30% annual revenue growth through 2025, its near term outlook was cloudy.
So given that we are looking at a situation where our view is being somewhat altered based on the brash comments made, our hypothesis is that it could be done to improve government business. It seems much of the growth has been commercial, with the company just signing a deal with automaker Stellantis. We decided to take a further look deeper into the some of the need for Palantir to expand its government contracts. Again, in the last quarter, 3 new government contracts were put into place. We believe the company is trying to make a move for more business on this front.
For this investigation and analysis we consulted heavily the 10-Q. Generally speaking Palantir's customers pay them to use the software platforms Palantir has created. Palantir offers contract terms of "one to five years in length", but customers "sometimes enter into shorter-term contracts". From these contracts the company's reported revenue is generally realized over the contract term. It is important to note that many customer contracts contain "termination for convenience provisions." This could end contracts early.
As we got deeper into the filings we learned that Palantir invoices the government separately. For example in large government agencies, like when an agency has several divisions, or offices, or units, whenever any of these subdivisions enter into a separate contract they are treated as a separate entity and counted as a separate customer. This is vital to understand.
For example, the FDA, the CDC, and the National Institutes of Health actually are all part of the U.S. Department of Health and Human Services. However, any contract with them is counted as a separate customer, even though it is the same broader agency.
One item to note is that Palantir's average revenue its best 20 customers over the last year was $44.6 million. We think this is an important point that investors should be aware of. This average contract revenue value grew 24% from an average of $36.1 million in revenue from the top twenty customers in the comparable one-year period from 2021.
It is interesting that both commercial and government sectors face similar issues when it comes to managing and analyzing data. Palantir has a statement in the 10-Q that "we intend to expand our reach in both markets moving forward". Perhaps we are on to something with this threat of nuclear war? While the commercial sector is rapidly adding new customers and growing, the pace of government growth has slowed. This is undeniable. Yet, most of the revenue is still government based. At the end of Q1 2022, 54% of revenue came from government agencies and 46% came from commercial customers. The company is also looking to expand to international customers, including governments. More and more revenue is international. About 39% of revenue is non-U.S. based now.
Expanding to governments outside the U.S. is important for Palantir. This is especially true as Palantir often may not get the full value of its U.S. government contracts. This is because the U.S. federal government is prohibited from exercising contract options more than one year in advance. From the 10-Q:
We historically have not realized all of the revenue from the full deal value of our customer contracts, and we may not do so in the future. This is because the actual timing and amount of revenue under contracts included are subject to various contingencies, including exercise of contractual options, customers not terminating their contracts, and renegotiation of contracts. In addition, delays in the completion of the U.S. government’s budgeting process, the use of continuing resolutions, and a potential lapse in appropriations, or similar events in other jurisdictions, could adversely affect our ability to timely recognize revenue under certain government contracts.
Another item that lends evidence to our hypothesis of using scare tactics to drive business is that Palantir recognizes that increased government spending on technology aimed at national defense, financial or policy regulation, cybersecurity, or healthcare mandates drives demands. Wouldn't the threat of nuclear war being likely suggest that governments might want to invest in analyzing this potential further?
Again on the conference call Karp alluded to this. "[At] Palantir, we are playing a critical, crucial and much bigger role than we're allowed to mention or would ever discuss in public and current events." Now, the company does not enter into relationships with governments that do not support western democracies. They do not do business with China, or other regimes that conflict directly with western values. However, they are expanding into new markets in emerging nations:
Our successes to date have primarily come from customers in relatively stable and developed countries, but we are in the process of entering new and emerging markets in non-U.S. countries, including with COVID-19 response efforts and defense, law enforcement, national security, and other government agencies, as part of our growth strategy. These new and emerging markets may involve uncertain business, technology, and economic risks and may be difficult or impossible for us to penetrate, even if we were to commit significant resources to do so.
While this is a risk disclosure it offers important clues as to what the company is up to. They are moving and spreading internationally and not just to Europe for example.
It is our opinion that the company must expand internationally. What better way to get new sales than to start fires and be the person to sell the smoke detectors? That is what Palantir's software does, assess and analyze data for threats. It is a loose analogy but fitting. But why is Palantir in such desperate need of expansion to new governments and industries? It is because the only thing keeping the stock going is the revenue growth rate which has been so strong. The company has incurred losses every year of operation. It expects operating expenses to increase. With stock based compensation, Palantir may never be EPS positive consistently, or be able to grow its meager earnings. The only way it can do so is by expanding its reach.
Are we reading too much into the CEO's commentary? Maybe. He is no stranger to controversy. But the threat of nuclear war is basically the threat of the end of the world. That is it. Nuclear war will wipe out most of humanity and destroy the Earth along with most wildlife. It is a major statement to liken to drawing diamond from the deck of cards. We think it is not only a scary prospect, but to insinuate that your company's tech can model it, and you have the answers, seemed desperate. It comes as the operations grow and there is no debt and nice positive free cash flow.
The stock has been a disaster, but there is strong upside potential. This is why we believe the company is on the verge of making a major push for international business, particularly on the government side of things. The evidence is there in our analysis of the 10-Q, the earnings, the conference call, and the interview the CEO gave. We see it as sadly bullish for investors, because Palantir's software can help detect and predict threats. But would it really matter if the CEO is correct and we draw that card?
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