Palantir: The AI faith ticket brings hope again

$Palantir Tech(PLTR.US) released its Q3 2024 earnings after the market close on November 4th, Eastern Time. Since the last quarter's earnings report, Palantir has risen by 50%, while the Nasdaq index has increased by less than 10% during the same period. Despite a not-so-low valuation, Palantir's significant rise can be attributed to three main factors—the expansion of its AIP customer base, inclusion in the S&P 500, and potential benefits from certain "Trump trades" (Peter Thiel, defense spending).

From the latest expectations, Palantir's valuation before the earnings release had already reached a Forward P/S of 28 times. Therefore, whether this valuation can be sustained naturally hinges on the earnings report, which becomes a critical juncture for determining whether the growth logic is temporarily "validated" or "falsified."

Key information from the earnings report:

1. Earnings stamped with "sustained growth": Similar to Q2, the biggest positive in the Q3 report is that the current profits exceeded expectations while raising the full-year growth guidance. This reflects both the sustainability of AI demand and the company's increasing profitability.

Management expects Palantir's total revenue for 2024 to be between $2.805 billion and $2.85 billion, which represents a year-on-year growth of 28% at the median, exceeding market expectations. Operating profit is also expected to increase more significantly with improved operational efficiency, with guidance set at $1.054 billion to $1.058 billion for 2024.

2. The U.S. as the "base": Although overall revenue growth is impressive, Palantir's high growth in both government and commercial revenues primarily relies on U.S. government (mainly the Department of Defense) and U.S. corporate clients. As of Q3, revenue from the U.S. region accounted for 69% of total revenue.

In contrast, the international market has seen a significant slowdown in growth, especially concerning government revenue related to sensitive information, which has been frequently mentioned by the analyst. While international corporate clients may not be as sensitive as the government, they might also be cautious due to the need for Palantir to provide a large amount of internal operational data during the customization process, particularly in Europe, where data security is a major concern.

3. The "starry sea" of commercial AI: Relying solely on government revenue makes it difficult to dispel market doubts about the sustainability of high growth. However, due to the customized and expensive nature of its products, the market is also questioning how Palantir can effectively achieve scalable product service revenue.

Since the new generation of AI transformation, Palantir has launched the AIP platform, and through the acceleration of Bootcamp, AI has quickly become a significant driver of sustained high growth in commercial revenue within a year. Therefore, the progress of AIP promotion and its actual implementation are the operational data that the market is most concerned about beyond financial metrics

1) The year-on-year growth rate of commercial revenue in the third quarter slowed down compared to the second quarter, mainly due to the drag from the international market. In the core U.S. region, the growth rate remained at 54% under a higher base, unchanged from the previous quarter.

2) Regarding the progress of AIP, this financial report did not disclose changes in the number of Bootcamp enterprises, but based on the net increase of 31 commercial clients (quarter-on-quarter), it appears to be steadily growing. At the AIPCon 5 conference in September this quarter, many deeply cooperative enterprise clients shared their successful experiences using AIP. In terms of client types, the main beneficiaries of AIP are concentrated in the traditional manufacturing sector, achieving digitalization and intelligence in various operational links, such as supply chain, inventory management, dynamic pricing, and internal decision-making.

4. Leading indicators confirm the sustainability of growth: Palantir primarily provides customized software services to clients, so revenue is relatively predictable in the short term. The company's guidance range is also quite narrow, implying a high degree of revenue certainty. Although the guidance has been continuously raised over the past two quarters, the increase has been in the range of 0-5%.

However, for this reason, to reflect Palantir's true business growth situation, the market pays more attention to indicators related to new contracts, such as TCV (Total Contract Value), RPO (Remaining Performance Obligations), number of clients (mainly commercial clients), and Billings (current billing volume).

(1) The first three involve the issue of cooperation cycles, which are more helpful for medium- to long-term growth outlook: In the third quarter, RPO continued to accelerate growth, while TCV growth slowed down, which is related to the strong promotion of AIP starting in the third quarter of last year and the higher base. However, the former includes the contract amounts that have not yet been invoiced, with a larger increase in long-term contracts, which is expected to support Palantir's medium- to long-term growth.

(2) In the short term, the market mainly focuses on the growth trend reflected in Billings: In the third quarter, Billings grew by 50% year-on-year, significantly accelerating compared to the second quarter. However, deferred revenue slightly weakened, which on one hand indicates higher client usage during the current period, and on the other hand shows that the newly contracted amounts invoiced in the short term may not be high. Nevertheless, since the company has provided clear guidance for high revenue growth in the fourth quarter, to prevent seasonal effects from distorting judgments, it is recommended to continue observing changes in deferred revenue in the fourth quarter.

5. The cost control cycle has passed: In the third quarter, due to a high base last year, the year-on-year growth rate of operating profit further slowed compared to the previous quarter, with a quarter-on-quarter growth rate dropping to 7%, and the profit margin remaining basically flat quarter-on-quarter.

The increase in profitability mainly comes from the expansion of revenue realization, as cost expenses have already gone through the optimization cycle and are beginning to expand again. This quarter, the gross profit margin continued to decline by 1.2 percentage points quarter-on-quarter, reflecting some of the new investments brought about by the AI transformation. However, since Palantir's original products also involve the foundational technologies of AI, and Palantir is not competing in the general large model space, most of the investments have already been front-loaded. Therefore, the capital expenditures over the past year are not high compared to previous years, indicating that the subsequent pressure on gross profit margins and R&D expenses is relatively controllable

Among the three expenses, management expenses grew the slowest, with both year-on-year and quarter-on-quarter rates decreasing, mainly due to optimization of personnel costs.

Sales expenses and R&D expenses, which are highly linked to business growth, have both shown significant acceleration. Therefore, the pace of profit margin improvement will inevitably slow down; previously, it was about increasing revenue and cutting costs, but future momentum will rely more on "increasing revenue."

6. Performance Indicators Overview

Dolphin's Viewpoint

As of the third quarter, Palantir's fundamentals have been on a tailwind for a year. To some extent, as long as the high growth logic of AIP cannot be falsified or calculated, and there are no black swan events, it will be difficult for Palantir to have a valuation kill in the short term. This is also why Dolphin has suggested not to short Palantir easily since the second half of last year, despite not understanding the deviation in Palantir's valuation.

With the third-quarter performance landing, shareholders may also breathe a sigh of relief: the core point supporting the valuation, "sustainability of growth," has temporarily been guaranteed. Although the short-term improvement in profit margins will significantly slow down, it is not the primary concern in the current trading growth attribute; continued attention is warranted. Palantir's current round of capital expenditure has not significantly increased, so even if the pace of improvement slows down, maintaining the current level may not be difficult.

Although there are no concerns about Palantir's short-term fundamentals and competitive advantages, Dolphin believes that Palantir's fundamentals and valuation must be viewed separately. For investors who have not yet taken positions, we still believe that caution is warranted from a potential risk-reward perspective.

On the one hand, the current valuation has some non-fundamental factors, such as inclusion in the S&P 500 and the Trump trade.

On the other hand, while PLTR's long-term focus is on AI, the current strong revenue is also contributed by a short-term surge in demand from the U.S. government. Additionally, the AI market is vast, but due to Palantir's customized product specificity, it is actually difficult to make accurate predictions about PLTR's medium to long-term growth potential. The market can basically only follow the company's guidance and assess the likelihood of performance beats by comparing the marginal changes in AIP's Bootcamp.

However, the current valuation levels of EV/Rev=30x (post-market capitalization of 105 billion, with 2025 revenue expectations raised by 5% to 3.5 billion) or EV/FCF=70x theoretically imply a significant growth expectation. For existing shareholders, since there are no clear signals of marginal weakening, they can continue to enjoy short-term emotional premiums. But for investors who have not yet entered, this risk-reward ratio is indeed not reassuring.

The following is a detailed analysis

1. Continuous AI Demand, Accelerating Revenue

In the third quarter, total revenue reached $726 million, a year-on-year increase of 30%, exceeding market expectations (~$704 million), with growth continuing to accelerate compared to the previous quarter

Palantir primarily provides customized software services to clients, so its revenue is relatively predictable in the short term, and the company's guidance range is also quite narrow, implying a high degree of revenue certainty.

1. Business Segment Analysis

(1) Government revenue remains the highest contributor: In Q3, government revenue grew by 32.5% year-on-year, continuing to recover, mainly driven by demand from the U.S. government. With the global situation heating up and the demand for data modernization in the Department of Defense, Palantir has secured multiple government contracts this year, and this trend is expected to continue in the second half. Among the new contracts in the third quarter, a relatively large one is a 5-year, $100 million contract from the DEVCOM U.S. Army Research Laboratory.

The two large contracts mentioned by Dolphin in the previous two quarters (a 2-year, $178 million contract with the Army; an initial order of $153 million from the Department of Defense's Digital and AI Office, with potential additional contracts of up to $480 million over 5 years) have also started to be recognized in the performance cycle since Q3.

As of November 3 (Eastern Time), the scale of new performance contracts confirmed in Q4 has already exceeded half of that in Q3, which to some extent reflects the sustainability of Palantir's revenue growth on the government side. From the current contract scale and the distribution of awarding agencies, the Department of Defense is the largest agency for Palantir's orders from the U.S. government, accounting for about 90% of the total amount.

At the same time, U.S. government revenue accounts for 75% of total government revenue (2Q24) and 41% of total revenue. This means that regardless of how grand Palantir's AI business dreams may be, at least for the current and foreseeable short-term cycle, the importance of the U.S. Department of Defense in supporting Palantir's growth is crucial.

Clearly, this depends on the government's budget for the Department of Defense. Currently, we are in the final critical period of election voting, and in previous in-depth research covering Palantir, Dolphin mentioned that different political parties have different attitudes towards defense spending budgets during their governance periods. In simple terms, the Republican Party tends to be more aggressive, while the Democratic Party is more cautious. Therefore, if the Republican representative Trump can take office, in addition to the speculative sentiment reasons regarding Peter Thiel's concept mentioned earlier, from a fundamental perspective, Trump's administration would be more "friendly" to Palantir than Harris.**

(2) The vast ocean of commercial AI: In the third quarter, commercial revenue grew by 26% year-on-year, a decline compared to the second quarter, mainly due to the drag from international markets. The incremental commercial revenue primarily comes from customer demand driven by AIP. (This financial report did not disclose the number of customers participating in testing through Bootcamp, but this metric is crucial for assessing AIP's demand, so it is recommended to pay attention to the upcoming conference call.)

Although enterprise customers participating in Bootcamp may not necessarily become actual customers of Palantir, AIP's use of the Bootcamp strategy has successfully compressed the overall customer conversion time (to 1-3 months), which somewhat compensates for Palantir's scaling disadvantages.

Palantir held AIPcon 5 (the fifth conference) in September this year, revealing the current progress of AIP. From the experiences shared by participating enterprise customers, the main application stage of AIP is to provide deep data analysis capabilities for traditional manufacturing enterprises. Enterprises can achieve digitization and intelligence in different operational links through AIP, such as supply chain, inventory management, dynamic pricing, and internal decision-making.

2. Contract Situation: More Growth in Long-term Contracts

For software companies, future growth potential is the core of valuation. However, the revenue confirmed each quarter is a relatively lagging indicator, so we recommend focusing on the acquisition of new contracts, primarily reflected in contract status (RPO, TCV), current billing flow, and the increase in customer numbers.

(1) Remaining irrevocable unfulfilled contracts (RPO)

In the third quarter, Palantir's remaining contract amount was $1.57 billion, an increase of $200 million quarter-on-quarter. Like the second quarter, the third quarter also saw a significant net increase in long-term contracts, which truly reflects growth. (The increase in short-term contracts may come from long-term contracts expiring and converting to short-term, rather than being driven by external demand.)

(2) Current Billing Flow

The billing flow for the third quarter was $823 million, a year-on-year increase of 50%, continuing to accelerate compared to the previous quarter. The contracts billed during the period mainly reflect fluctuations in short-term demand (including the portion of revenue already recognized). Although, considering historical circumstances, Dolphin believes that the fluctuations in a single season do not indicate significant issues from the perspective of product competitiveness. However, due to the relatively high valuation, the market will naturally be more stringent on performance, thus paying close attention to this metric.

Deferred revenue slightly weakened in the third quarter, also indicating that the new contract amount for invoiced collections may not be high. However, since the company has provided clear revenue guidance for the fourth quarter (short-term growth is guaranteed), to prevent seasonal effects from distorting judgment, Dolphin suggests continuing to observe the changes in deferred revenue for the fourth quarter.

(3) Total Contract Value (TCV)

The total contract value recorded for new contracts in the third quarter was $1.1 billion, a year-on-year increase of 33%, continuing to slow down quarter-on-quarter. The slowdown is mainly due to the significant deceleration of U.S. commercial contract amounts to a growth rate of 10% because of a high base, which Dolphin mentioned in last quarter's data regarding the potential for slowdown, and the third quarter's data just confirms this judgment expectation.

The statistical difference between RPO and TCV mainly lies in whether customers have clear invoicing and payment. The increase in RPO while TCV slows down may further reflect the expectation that new long-term contracts account for a large portion. However, the changes in new short-term contracts are still worth monitoring, as this will undoubtedly increase the proximity of the inflection point for the slowdown in short-term revenue growth.

(4) Customer Growth

From the most intuitive customer count, which is also a medium to long-term indicator, there was a net increase of 36 customers in the third quarter, of which 31 were from commercial clients and 5 were from government agencies.

Combining <1-4>, Dolphin believes that the forward-looking indicators overall continue to reflect Palantir's medium to long-term robust growth trend, but there may be signs of further marginal slowdown in the short term. Whether this is seasonal fluctuation or a sustained trend is worth continued attention.**

3. The cost control period has passed, and the pace of profit margin improvement has slowed down

In the third quarter, Palantir's operating profit grew to $113 million, a year-on-year increase of 183%, as it approached the end of its profit turnaround phase, with growth rates significantly slowing due to a higher base.

The increase in profitability mainly comes from the expansion of revenue realization, while cost expenses have already gone through the optimization cycle and are starting to expand again. This quarter, the gross profit margin continued to decline by 1.2 percentage points quarter-on-quarter, reflecting some of the new investments brought about by the AI transformation. However, since Palantir's original products also involve the foundational technologies of AI, and Palantir is not competing in the general large model space, most of the investments have already been front-loaded. Therefore, the capital expenditures over the past year are not high compared to previous years, indicating that the subsequent pressure on gross profit margin and R&D expenses is relatively controllable. This also led to free cash flow, under the booming profits, not being dragged down by Capex, and rising rapidly.

Among the three expenses, management expenses grew the slowest, with both year-on-year and quarter-on-quarter rates decreasing, primarily due to personnel optimization reflected in the changes in SBC expenses.

However, both sales expenses and R&D expenses, which are highly linked to business growth, have shown significant acceleration, meaning that the pace of profit margin improvement will inevitably slow down. Last quarter, management had already issued a warning during the conference call—expenses in the second half of the year will need to accelerate growth, but will ensure that the growth rate of expenses is lower than that of revenue. This means that the original dual-effect improvement of "increasing revenue + cost reduction" will need to rely more on "increasing revenue" on the income side for future momentum.

Finally, in the indicator reflecting the company's product competitiveness, the contribution margin = Non-GAAP gross profit - Non-GAAP sales expenses, this indicator is generally used for companies with high customer acquisition costs to measure the extent to which revenue covers fixed costs, excluding operating costs and promotional expenses. It can also reflect the revenue performance of the product itself after excluding the effects of promotional marketing

In the third quarter, the confirmation of incremental costs related to AI may have led to a sequential decline in gross margin, which in turn affected the upward trend of marginal profit margin, resulting in a decrease of 1 percentage point to 59.7%, rather than due to a deterioration in product strength or excessively high sales expenses (Q3 sales expense ratio remained flat sequentially).