I started a short position in Palantir Technologies Inc. (NYSE: PLTR) using put options, and I expect the stock to fall to my fair value estimate of $2.50.
In light of recent earnings, I am lowering Palantir’s previous $5.00 price target at $2.50. My main concern with Palantir is the slowdown in government business, which still accounts for the majority of the company’s revenue. Consistently high sales and marketing spend also undermines Palantir’s business model scalability argument.
Government business is losing ground
One of the most frustrating aspects of Palantir’s 1Q-22 was the company’s government affairs, which had long been considered its most valuable asset.
Palantir’s government business has long been cited as a reason to buy Palantir stock, due to the lucrative contracts awarded to Palantir by the government. Additionally, Palantir has longstanding relationships with government officials, which could translate into significant long-term revenue potential for Palantir, the argument goes.
I think the market is overestimating Palantir’s growth potential and focusing solely on accelerating the company’s commercial revenue.
Palantir’s government segment generated $241.8 million in revenue in the first quarter, compared to $204.6 million in the commercial segment. What worries me, and was a driving factor in my decision to finally initiate a short position, is that Palantir’s government revenue growth slowed to just 16% in 1Q-22. Palantir’s government revenue growth in the prior year quarter was 76%.
So we’re seeing a significant slowdown in Palantir’s largest operating segment. Government contracts accounted for about 54% of revenue, and the slowing growth of the company’s largest business is, sadly, rarely talked about.
As commercial revenue increases, a key part of the bullish thesis is that Palantir has a reliable government revenue stream to fall back on if times get tough. If the economy goes into a recession and the US government decides to cut spending, Palantir, which is just a government contractor, could see its revenue base shrink.
Government revenue per customer increases, reaching $10 million in 1Q-22. While this is an encouraging development, I think the slowdown in Palantir’s growth is more important.
The problem with Palantir’s cost structure, persistent scalability challenges
I’m not going to go into the details of Palantir’s stock-based compensation because others have already, and it’s not news that Palantir is issuing a lot of stock and diluting shareholders.
Instead, I like to point out that Palantir consistently only achieves profitability at the fit level, as well as Palantir’s cost structure. Palantir adjusted EBITDA in 1Q-22 was $121.7 million, representing a margin of 27%. At first glance, this seems like a fantastic opportunity, but the company just doesn’t seem to be able to turn a profit in terms of net profit. First-quarter losses totaled $101.4 million.
Net losses are recorded in the “accumulated deficit”, which can be found on the balance sheet and totaled $5.6 billion in 1Q-22. If Palantir continues to generate about $100 million in quarterly losses for the rest of the year, the accumulated deficit could reach $6.0 billion by year-end.
One of the issues I have with Palantir, and the second reason why I started a short position, is the unsustainable level of operating expenses that take a large chunk out of profits every quarter.
Please see the table below for Palantir’s revenue, sales and marketing expenses, and total operating expenses for the past four quarters, both in dollars and as a percentage of quarterly sales. The total operating expense ratio exceeded 100% in two of the last four quarters (in 3Q-21 and 2Q-21). A ratio of 100% indicates that the company’s operating expenses, before interest and taxes, are equal to the amount of its sales.
A ratio above 100% is disastrous and indicates that the company is losing money on sales. A business that consistently has operating expenses that exceed its revenue will either close down or continue to post further net losses in its accumulated deficit unless shareholders intervene. Palantir’s operating expense to sales ratio has improved over the past two quarters, but remains far too high to justify the current valuation.
Another issue in the chart above that I haven’t mentioned yet is the exorbitant sales and marketing costs that are incurred to generate sales. Over the past four quarters, Palantir has spent an average of 39 cents of every dollar in sales just to generate sales, and the company spent an average of about $160 million per quarter the year before. Additionally, Palantir’s sales and marketing spend as a percentage of sales has remained consistently high over the past four quarters, fluctuating between 36% and 43%.
Due to the high ratio, Palantir doesn’t seem to have a scalability advantage. Selling predictive analytics software and solutions to customers is a time-consuming business, and I don’t see any scalability advantage for Palantir based on the company’s cost structure.
Palantir’s cost items are at least partially inflated by stock-based compensation expense, which is allocated to different expense groups each quarter. Palantize allocated $149.3 million in SBC expenditures to various expense groups in 1Q-22, which shareholders actually paid. I promised not to go into too much detail here, so I’ll include the following table just for the sake of completeness.
Fair value of $2.50 (if you are generous)
I initiated a short position in Palantir with a strike price of $6.00 and an expiration date in January due to slowing sales growth in the largest business segment and a change clear attitude towards unprofitable multiple stocks.
Even though Palantir is in a downtrend and its stock price has fallen more than 54% in 2022, investors continue to ignore the many red flags.
Palantir’s slow government business is just one issue that continues to be overlooked, but the company, like all good shorts, has more than one problem.
Palantir’s inability to generate a profit on an unadjusted basis, along with its still-high selling and marketing expense ratio, are two compelling reasons to anticipate further decline. These are the reasons why I lower my Palantir price target from $5.00 to $2.50.
Palantir would still be valued at 3.0 times sales at a price of $2.50. After discussing the various factors that support my short decision, the current P/S ratio is around 9x, which I consider completely indefensible.
If Palantir’s stock price were to rise significantly by the time my put options expire, those put options will likely be worthless when they expire. On the other hand, if Palantir’s stock price were indeed to fall as expected, I could potentially double my investment. To keep risk low, I only invest a small portion of my assets.
Why Palantir Stock Could Rise
Palantir could change its fortunes in the government sector if it wins new contracts. Palantir still has a lucrative client in government, and if the government decides to go on a spending spree to combat recession risks, Palantir could take advantage. Acquiring new business customers can lead to a lower sales to marketing ratio. However, I have serious doubts that new contracts will translate into real trading profits.
Given Palantir’s Q1’22 trade update, I’m reconsidering my $5.00 price target. While everyone seems focused on Palantir’s business acceleration, the deceleration in government business appears to be a blind spot for investors.
Additionally, the unfavorable cost structure simply does not support the idea that Palantir has or will soon achieve scalability. Because fewer and fewer investors are willing to pay exorbitant sell multiples for Palantir’s business, I lower my price target to $2.50 and increase my conviction by selling the company short by the through put options.