An analyst at Wolfe Research, named Alex Zukin, downgraded Palantir to an underperform rating this Wednesday, noting that the company may see decelerating revenue growth.
The four short reasons cited, includes that of:
- Unpredictability of contracts within Government
- Decreasing revenues
- Decreasing operating margins
- Decreasing free cash flow
Specifically I want to focus on the unpredictability of contracts within Governments, and the decreasing revenues.
Unpredictability of contracts within Government
Firstly, regarding the unpredictability of Governmental contracts, there are a few points to note in which can give investors a better outlook regarding the future of Governmental spending, and contract allocation periods.
Piper Sandler Commentary:
Piper Sandler says, “Palantir should continue to see growth in its U.S. government business as it broadens its footprint across agencies and as its largest customer (Defense) is expected to grow further”. The investment firm state how, Palantir has gained more traction with agencies beyond defence, such as VA and DOE, which will provide ongoing upside.
“Key government agencies, such as the CDC, NIH, FDA, and Air Force, as agencies rapidly adopted technology to track cases and resources during the pandemic. These initial use-cases likely acted as a catalyst for further adoption; for example, Air Force expanded its contract to include broader operations efforts.”
Piper Sandler successfully demonstrates the utility of Palantir’s software solution, and the fact that Palantir has a sticky product offering. “PLTR has maintained long-lasting relationships with government customers. PLTR has maintained relationships and contracts with the Army, Navy, U.S. Special Operations Command, CDC, ICE, and FBI for at least 10 consecutive years each. We believe these long-lasting partnerships demonstrate both the usefulness of PLTR’s platform and high switching costs once embedded.”
Piper Sandler mentions how, Palantir should continue to see strong growth in its U.S. government business as the requested discretionary budgets for the Department of Defense are expected to increase 5% in FY2022 and another 4% in FY2023.
Importantly to note, Darntons found that high DOD exposure could be very positive for Palantir. This is because, DODs requested discretionary budgets are expected to increase 5% in FY2022, and then a further 4% in FY2023.
Piper Sandler also believe that, the on-going war currently could be a major catalyst for the DOD to improve technologies for the future. Interestingly, Piper examined the budgets in depth and found that, there is a heavy emphasis on AI, LM, IT and software programs.
Piper Sandler believe that, the amounts for these requested items will continue to increase in FY22 (+27% y/y), and FY2023 (+12% y/y). Piper proclaimed that, new requests in FY2022 that weren’t included in FY2021 include ~$212M for AI and ML research and ~$83M for the Tactical Intel Targeting Access Node (TITAN) program, which PLTR has been selected to compete for.
“In 2020, PLTR’s U.S. government (USG) revenue grew 91% y/y, from $248M to $474M. However, we estimate PLTR’s revenue from the Department of Health and Human Services (HHS) grew 892% in 2020, from ~$6.4M in 2019 to ~$56.9M in 2020, and from 3% of 2019 USG revenue to 12% of 2020 USG revenue”.
There is major evidence to state that Palantir partnerships grow considerably over time. For example, within the DOD there was a recent expansion of the partnership with the Air Force. There was previously a small contract with the Air Force from 2010-2013, which consisted of four contracts wirth $226K each. However, this scaled majorly within the past few years. The data shows that in April 2020, Palantir signed a contract to license Gotham platform to the Air Force for six months, costing over $2M. Following the pilot program Palantir signed two contracts with the Air Force worth nearly $20M to provide the agency with COVID systems. “By 2021, the partnership grew to a two-year, $91.5M contract in which PLTR was to provide a data platform for the Air Force to manage resources for its COVID-19 response and coordinate decisions for joint all-domain operations.”
Concerns Regarding Lumpiness:
There are valid concerns for investors when it comes to the Palantir Governmental business, specifically the lumpiness that is apparent for Governmental agencies in terms of contract allocations. Whilst, as seen from the commentary above, Palantir & the Government clearly over the longer term, provides continued upside, there is reason to question when this revenue will be realised.
Due to the fact that Governments innately are incredibly inefficient, often revenue realisation, and contract timings can vary, and thus can result within delays. This translates into misleading revenue decelerations for the Governmental sector due to the fact that the contracts can take time to sign, and complete.
Dr Alex Karp mentioned coherently within an array of earnings calls that Palantir will not experience further deceleration within the Governments, however in fact – there is potential for higher upside. Congress were operating under a CR, or continuing resolution, as a temporary measure to fund Government activities for a limited amount of time. Overall, and per the words of CEO Alex Karp, it seems evident to assume that this delay within spending, due to the innate bureaucratic nature of Governments has resulted in a major delay within spending and contract allocation.
Within recent times, the Department of the Air Forces have been very vocal in terms of issues caused by the use of continuing resolutions to fund the federal Government. Interestingly, and to ease concerns of Palantir investors, Air Force Secretary made the case that a CR in the upcoming 2023 fiscal year would have a majorly “negative effect”.
Kendall explained how operating over a CR keeps spending levels frozen from the previous year’s level in which limits the DOD’s ability to adjust for impacts of inflation and other increases within budgets.
“The thing that’s unique about this year is that inflation is occurring and is somewhat unpredictable, and a CR locks you into a previous year’s level of funding when prices are increasing. So you need to get to a point where you can make some adjustments because of that,” Kendall said.
The Space Force is projected to gain a 36% increase over 2022 within budgets for 2023. Any more CRs would majorly delay these funds, in which can deter the growth of the service, indirectly also creating volatility in terms of contracts for companies like Palantir.
COO Sankar also noted his concerns and commentary regarding the lumpiness of contract allocations:
This lumpiness comes down to contract timing and events occurring. “We will not deprive customers with software – just because the paper work is not there.” The COO concluded that there would be meaningful upside within Governments in the next few quarters.
Shyam Sankar stated in an exclusive call last month, that the Government business growth rate within 2018 was extraordinary. However, to explain the recent deceleration, there is often a drag that existing resolutions create as they prevent new starts from occurring. “Things that are new, they are delayed” said the COO. Sankar concluded, within the call with analysts from Morgan Stanley, that there are often complicated dynamics with budgets. This therefore can create volatility for upside, as projects can get caught up in blitz to get money out the door.
As noted previously, there may be temporary decreasing realised revenues within the Governmental sector, based on the complexities and often drag created for contract allocations, and specific revenue allocations too.
However, as concluded, this revenue realisation within the Governmental sector is a temporary feat, in which over the longer term, translates into an outstanding CAGR for Palantir.
Regarding the commercial space, there are some points in which investors must battle with.
Morgan Stanley optimistically noted recently that:
Cost pressures should make companies accelerate investments in automation and productivity-enhancing technologies. Many of these technologies are inherently deflationary. Within this note, we provide a shopping list of “deflation enablers.”
Persistent inflation in areas such as labor, supply chain/procurement, and energy give rise to transformational investment across industries. While cyclical forces tend to deter investment in an uncertain macro environment, we believe structural changes in demographics, energy policy and security, and an aging capital base make technologies focused on cost reductions and productivity more valuable.
Software is a “Deflationary Technology in an Inflationary World”.
“The case for digital transformation has never been more urgent or more clear. Digital technology is a deflationary force in an inflationary economy. Businesses, small and large, can improve productivity and the affordability of their products and services by building tech intensity.
The Microsoft Cloud delivers the end to-end platforms and tools organizations need to navigate this time of transition and change.”— Satya Nadella, CEO of Microsoft.
The fundamental purpose of software is to optimize business and consumer processes, automating them to be more efficient and effective. So in a larger sense, one can make the argument the entirety of the enterprise software industry serves the purpose of driving efficiencies within business to fight inflation (as Satya Nadella noted above).
For the purposes of this note, we’ve tried to narrow the focus to vendors whose software targets a specific inflationary cost pressure being seen in the market today.
C3, Palantir, Snowflake – Enabling More Efficient Supply Chains and Logistics with Better Use of Data. Consolidating multiple data sources and making it usable to solve some of the most difficult problems facing organizations and governments is the core functionality of all these vendors. In the context of this report, all three have talked to a significant use case within their customer base of driving logistics and supply chain efficiencies with their software.
To focus on one vendor in particular, Palantir’s core Foundry data platform accelerates the integration of data, allows simulations against that data, enables real-time alerting for any potential disruptions in the data which allows customers to optimize and find efficiencies in supply chains and logistics.
In other words, in consideration of the higher cost of capital, and labour, companies are going to be investing within deflationary technologies and software to gain competitive advantages and to increase efficiencies.
And whilst this sounds idealistic, and perhaps a best case scenario, for Palantir, there is reason to assume that this adoption will not occur as fluently within the commercial space. There are three specific reasons for this:
- Invasive software solution
- Not developer friendly
In consideration of the complex economic environment, it can be reasonably assumed that companies are going to cut costs. Within an idealistic world, software adoption increases, in an attempt for these organisations to become more efficient, and thus save time and cost.
However, currently there is still a lot of friction associated with adoption of the Palantir software solution. This is characterised by the invasive pressure, in conjunction with the sales force issues.
In comparison to other software solutions, Palantir is far more invasive, and acts as the foundational cardiovascular system for ones organisation. This is in comparison to Snowflake, in which instead is a sole one off solution for a company.
Palantir is far more invasive in comparison to other tools. This technical superiority, and invasive nature, comes with trade offs, including that of a higher expense. This may dissuade usage and adoption of Palantir.
To ease concerns, Palantir is aware of this, and have recently moved towards a new pricing model, in which will allow for easier adoption of the solution:
Palantir is now focusing on consumption-based pricing. This allows folks to start with no commit. Instead, companies can start with issues they want to start focusing on, and over time slowly start to consume more. This therefore allows for a lower barrier to entry, however also potential for the customer to move towards Palantir full stack eventually.”
Interestingly, C3AI’s CEO recently introduced consumption-based-pricing models too. He mentioned in a quote:
“I’m pleased to announce that C3 AI is transitioning from a subscription model to a consumption-based pricing model, bringing us in line with what is becoming the standard among enterprise SaaS companies,” said CEO Thomas M. Siebel. “We have implemented a new pricing model, a new sales model, a new partner model, and new applications to accelerate sales cycles, accelerate product adoption, increase market share, and increase revenue growth and profitability in the medium and long-term.”
Mr Siebel also mentioned that, “The economic downturn is real. Our customers are scrutinizing big deals as never before, which also makes this a smart time to launch consumption pricing.”
In other words, a consumption–based pricing model is a service provision and payment scheme in which the customer pays according to the resources used. This is in comparison to the previous pricing model that was based on “all-you-can-eat”, namely providing everything all at once for organisations.
Another issue that could dissuade adoption for the invasive software solution is the fact that Palantir is yet to achieve a developmental community, or test trial, for their software. Unlike other successful tools, Palantir is unique in the sense that developers can not use the program within a “freemium” tier model.
This may reduce the understanding of Palantir from an organisational point of view, and thus may dissuade the incentive to purchase the complex software.
Usually innovation thrives within times of chaos, and there is evidence to back this claim up. However, specifically for the commercial sector, Palantir must reduce the friction associated with adoption of the platform, in order to ensure that Palantir can thrive in this complex macroeconomic period.
This can be achieved via:
- Freemium tier
- Consumption based pricing model
- Faster ramping of sales force
Palantir must act fast to ensure that adoption of their products occurs whilst companies are within this challenging macroeconomic period. Software is deflationary, however Palantir must reduce the friction associated with adoption in order to allow for hyper growth.