Beware of Palantir's rally -- it may not be sustainable

This year's market rally has been driven by the AI craze that's creating FOMO among investors. Both high and low-quality stocks have benefited from the market rebound, and data analytics company Palantir ($PLTR) is somewhere in the middle. The stock has nearly doubled this year on AI optimism and solid Q1 earnings results. While the company beat Q1 revenue and earnings estimates, the outperformance was driven by special events that will not repeat in the coming quarters.

Now PLTR stock trades at a nosebleed valuation even though growth rates are expected to slow significantly in the coming quarters. In fact, the company's expected annual growth of under 20% is well below the management's estimates for annual growth of at least 30% for the foreseeable future. Let's see what the future holds for this controversial company.

A Tech Contractor For Governments & Big Corps

A few years ago, Palantir was an unknown company to the general public. It didn't want to attract attention due to its close relationship with intelligence agencies and the US Army. But it became very popular when it went public in late 2020, during the market boom. The support from celebrity fund manager Cathie Wood also helped the stock soar nearly 300% in just four months before collapsing and losing up to 80% of its value.

The listing in late 2020 was a strategic decision as during that time, Palantir's software was in very high demand due to the Covid pandemic. Its platform was being used by governments around the world for the disease monitoring and then for COVID-19 vaccine distribution.

Now the pandemic is over and most governments have terminated their contracts, creating a huge headwind for Palantir's growth. Keep in mind that gov contracts account for 55% of Palantir's revenue, so these terminations are severely impacting the company's top line. As you can see below, the company's growth has been slowing quarter after quarter. In just three years, growth has fallen from over 50% to the high teens.

This is because Palantir is a tech contractor for Western governments and very large enterprises. In Q1, the average contract value of the top 20 customers was $51 million. In other words, PLTR is not your typical SaaS firm. Having such large customers is not a great thing for several reasons. First, it creates significant concentration risk as a single contract termination can severely impact revenues. On top of that, it makes financials lumpy as it’s not easy to find companies that will sign multimillion $ contracts.

Smaller deals won't move the needle as Palantir's current annual revenue run rate is around $2 billion. And when it comes to smaller deals, Palantir faces stiff competition from other big data companies. Alteryx ($AYX) is an important player in the space and with annual revenues of over $850 million, it essentially goes head-to-head with Palantir in the commercial side of the business.

Palantir can grow nicely in the coming years thanks to the growing demand for big data analytics platforms. Yet, relying on multimillion $ deals is not necessarily a good thing due to the high concentration risk and the difficulty of finding a lot of such deals that can drive sustainable long-term growth.

Revenue Growth Not As Strong As It May Seem

Palantir's Q1 revenue grew 18% y/y to $525 million and easily beat estimates. However, if we see what caused this revenue outperformance during the quarter, the reason is not very encouraging. During the SPAC craze two years ago, Palantir invested in several SPAC deals in return for future contracts for its data-crunching platform.

Now these SPAC-listed companies are filing for bankruptcy en masse and before ceasing operations they have to meet their contractual obligations with past vendors and Palantir is one of them. During the quarter, Palantir's US commercial business saw a $33 million revenue bump as a result of SPAC bankruptcies. In Q2, prepayments will fall to between $17 and $19 million and drop off further in the coming quarters.

In Q1, Palantir essentially beat revenue estimates due to the collapse of several of its old customers, meaning that revenue growth will slow down dramatically in the coming quarters. Q2 guidance suggests y/y growth of just 12%, which is below analyst estimates. Yet, the stock rallied after Q1 earnings and guidance thanks to the strong performance on the bottom line and management’s guidance for continued profitability through the end of the year.

It's true that Palantir is showing some financial discipline. In Q1, sales and marketing expenses increased 16.6% y/y, trailing revenue growth. Overall, total operating expenses increased by only 5.6% y/y in Q1. Equally important, stock-based comp fell 23% y/y in Q1, but it was still sizeable and caused a y/y dilution of 8.3%.

Dilution is a silent shareholder value destroyer as most investors don't pay much attention. In this case, the 8.3% dilution means that revenue per share increased by only 8% y/y in Q1, much slower than the headline growth of 18%. If stock-based comp doesn’t fall further in the coming quarters, the combination of dilution and slowing growth will result in negative revenue growth per share.  

What About Valuation

Palantir is no longer a high-growth name as its growth is not expected to exceed the 20% threshold for the foreseeable future. In fact, in the near term, its growth is expected to fall in the low teens, which is not very encouraging. Yet $PLTR has soared this year, due to the AI craze and the positive net income. At current prices of around $12.6 per share, $PLTR trades at a nosebleed valuation of 13.5x sales. The current multiple is ridiculously high and can't be justified by the current and expected growth rates, meaning that the downside risk is now significant.

What Else

Palantir has made great progress on the profitability front and investors are rewarding it for that. In Q1, it delivered its second straight quarter of positive net income as well as a very high Free Cash Flow of $182 million. However, the growth is slowing dangerously.

The current stock price suggests that growth will accelerate dramatically in the coming years, which is quite a risky assumption given the stiff competition, and the already large revenue base. $PLTR stock is too expensive given the current and expected financial performance in the midterm.  

I've no positions in the stocks mentioned.

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