valuation 22-q1
2 July 2022
At the time of this analysis, my valuation of the total equity in common stock for the Palantir company using base case assumptions is $10.53 billion. This translates to an estimated value per share of $5.41.
The screenshot below summarizes the DCF calculation to arrive at this valuation. The rest of this writeup will outline the base case assumptions used.
Disclosure: I hold a long position in PLTR shares at the time of publication of this post.
Revenue:
Palantir operates with 2 reportable segments: government and commercial. On a trailing 12-month basis, 57% of revenue came from customers in the government segment and 43% from customers in the commercial segment. Fundamentally Palantir sells products and services that enables organizations to effectively integrate their data, decisions, and operations at scale. Palantir has 3 principal software platforms, Palantir Gotham (“Gotham”), Palantir Foundry (“Foundry”), and Palantir Apollo (“Apollo”). Gotham and Foundry enable institutions to transform massive amounts of information into an integrated data asset that reflects their operations. Gotham was designed to service global defense agencies, the intelligence community, disaster relief organizations and other government institutions. Foundry was designed to act as a central operating system for commercial institutions and industries. Apollo is a cloud-agnostic, single control layer that coordinates ongoing delivery of new features, security updates, and platform configurations, helping to ensure the continuous operation of critical systems and allowing customers to run software in any environment.
My forecast for Palantir revenues has been designed with a 10-year high growth period, before stabilizing to a terminal growth rate. The revenue forecast has been built on the 2 revenue segments, with assumptions presented below for each:
Government: segment serves customers that are US government and non-US government agencies. Palantir only works with foreign governments that are allies of the US. The government segment has traditionally been Palantir’s foundational revenue stream, with relationships with the US government dating back nearly 10 years. The government business tends to be relatively stable with long-term contracts. That said, growth in government revenue is constrained by long sales cycles and limited growth prospects over the long term, unless there is a significant increase in software budgets by western governments. From 2019 to 2021, Palantir witnessed a 52% CAGR in revenue from this segment. For my base case assumption, I have forecasted that growth will be drastically slowed over the next year to 15% due to the macroeconomic environment, but will gradually pick up as European countries begin to increase defense spending as a result of the Ukraine war. I have tapered this growth to account for long sales cycles. The increase in growth will last 5 years, following which growth will taper towards the terminal stable growth rate.
Commercial: segment serves customers working in non-government industries. Palantir expects this segment to be the chief driver for growth in the future as organizations find current data infrastructure and platforms to be inadequate to enable their operations at the level that is expected and required for competitive advantage in a big data and AI enabled world. From 2019 to 2021, Palantir witnessed a 24% CAGR in revenue from this segment. For my base case assumption, I have forecasted that growth will be strong at 45% over the next 12 months as investments in sales pay off, however following that I have assumed a drop to 20% due to the macroeconomic environment and as companies delay investments in a recessionary environment. This will gradually pick up over the next 5 years, following which growth will taper back down towards the terminal stable growth rate.
Looking at the overall revenue growth forecast for both government and commercial, the assumptions above translate to a roughly 23% CAGR over the next 10 years. This would appear low based on historical performance but accounts for the anticipated recessionary environment we are likely to experience over the next 1-2 years as well as tapering growth towards the terminal growth rate. The big data market is estimated to be about $155 billion in 2022 and expected to grow at around 9% year-on-year towards $309 billion in 2030. Against this market estimate, Palantir’s market share in 2022 would be ~1.4%, and the base case assumptions presented above would place Palantir at a ~4.1% market share by 2030, which seems reasonable from a macro validation standpoint.
Operating margin:
Operating margin = Adjusted EBIT / Revenue. I have adjusted EBIT to capitalize R&D and operating leases. TTM operating margin is –20.16%. I have assumed operating margin gradually improves year-on-year until it reaches 25% by year 10. A terminal base case of 25% is justified comparing with other profitable software companies, specifically Microsoft with an unadjusted operating margin of ~44% for its intelligent cloud segment and Amazon at ~35% for its AWS segment. While neither Azure nor AWS are direct competitors to Palantir (they are in fact complementary in many cases), I expect that the Palantir platform, specifically Foundry, will eventually showcase network and productivity effects that today only one other company has successfully scaled – Microsoft. Given the high degree of uncertainty, I have assumed the relatively conservative operating margin of 20% at this time.
Tax rate:
Palantir is currently unprofitable, hence the effective tax rate is 0%. The US marginal tax rate is 27%. Once Palantir turns profitable, I have assumed the effective tax rate starts the second year after turning profitable (to account for tax offsets) and then to gradually trend towards the marginal rate over time ultimately reaching 27% as the base case terminal assumption.
Reinvestment rate:
Reinvestment = capital expenditures – depreciation + change in working capital. I have adjusted capital expenditures and depreciation to capitalize R&D. Given the company is unprofitable and likely to invest heavily in sales over the next few years to drive growth in the Commercial segment, I have forecasted reinvestment based on a sales reinvestment ratio. The sales to reinvestment ratio was 9.31 in 2021, 0.67 in TTM. I have assumed a sales reinvestment ratio of 1 for the next year with a gradual increase towards 1.2 as the base case terminal assumption. Reinvestment rate (RIR) = Reinvestment / EBIT*(1-t). The TTM RIR is –47.59% and the above assumptions would trend towards a terminal estimated RIR of 8.95%.
Return on capital:
Return on capital (ROC) = EBIT*(1-t) / (Debt + Equity). The TTM calculated ROC is 17.62%. Implied ROC = EBIT*(1-t) growth rate / RIR. Given EBIT is forecasted to continue to be negative for the next few years, this measure is not insightful in the short term. That said, looking at the terminal assumption, the implied ROC is 22.34% given the aforementioned EBIT and reinvestment assumptions. This is reasonable for a mature software company. For comparison, Microsoft ROC is 22.43%.
WACC:
Risk-free rate: has been determined noting Palantir is a US based company that has USD as its primary reporting and operational currency. Assuming USD as our currency of choice, US Government Treasury bonds in local currency (USD) is generally considered as stable and certainly (relatively) risk-free given the current our current geopolitical macro environment. I will use the US 10-year Treasury bond rate. The US 10-year Treasury bond rate at the time of this analysis is 2.89%. With rising interest rates, I have assumed a higher rate for the next 2 years of 4%, following which the rate gradually reduces until a terminal base assumption of 2%.
Equity risk premium: calculation is based on Palantir’s operations. I start with the implied equity risk premium for the S&P 500 by forecasting the expected growth in cash payouts of earnings for the next 5 years, based on aggregate analyst estimates, and subsequently forecast the risk-free rate of growth in perpetuity post the 5 years. Given Palantir’s global operations, the equity risk premium needs to be adjusted with relevant country risk premiums. I’ve used revenue by market as the key driver for country risk. I have calculated the country risk premiums by referencing the country default spread and comparing the variance against the US default spread. ~26% of Palantir revenue is classified under “rest of world”, and for this I have applied a GDP weighted risk premium for Western European countries, making the assumption that these constitute the major of the component markets. he Palantir operations and geography adjusted equity risk premium at the time of this analysis is 6.06%, and I have assumed it to remain constant as base case assumption.
Equity beta: is a weighted levered beta based on the company’s operations by industry. Palantir operates in 1 industry – software. Industry betas are calculated using a simple average across firms’ beta, taken as a weighted average of 2-year and 5-year weekly return regression betas, with 2-year betas weighted 2/3rds. Industry unlevered betas are calculated with the formula = Beta / (1+ (1-tax rate) (D/E)), where D = Total debt, including lease debt, and E = market value of equity. Both debt and equity are aggregated across firms in an industry to calculate D/E. I apply Palantir’s D/E ratio to the unlevered industry beta to calculate the levered beta. Applying the business exposure weights, we arrive at the enterprise beta. The Palantir business operations driven bottom-up beta at the time of this analysis is 1.10. I have assumed this to gradually increase over time to 1.24 terminal base case, accounting for an increased debt ratio of 15% in the future.
Interest coverage default spread: is estimated by comparing Tesla’s interest coverage ratio the average default spread for similar companies, mapped to their average company rating. With an interest coverage ratio of -27.53, Palantir has the lowest rating (D2/D), mapping to a default spread of 14.34%. I have assumed this to gradually move towards the default spread for a B2/B rated company as profitability increases.
Debt to capital ratio: for Palantir is currently low at 1.36%. This is positive in the current macroeconomic climate, with anticipated interest rate hikes. However, over time I assume Tesla will gradually move towards a terminal debt ratio of 15% as my base case assumption. Note: I have used market values of debt and equity to calculate the debt to capital ratio.
WACC: is currently calculated at 9.64%, with a cost of equity of 9.53% and cost of debt of 14.34%. WACC is estimated to increase to 10.75% in the next 12 months, primarily driven by a rise in the risk-free rate, following which I assume a gradual decline to a terminal WACC of 8.72%, driven by a stable risk-free rate of 2% and an increased debt ratio of 15%.
Terminal growth rate:
I’ve assumed terminal growth rate in FCF to match the risk-free terminal rate, anticipated to be 2%.
Equity options:
Palantir has stock-based compensation that includes stock options and restricted stock units (RSUs). Utilizing the Black-Scholes pricing model, I have estimated the value of all outstanding options for each category of stock-based compensation separately, which at the time of this analysis amounted to a total value of all outstanding options of $3.56 billion. The tax adjusted value of these options is $2.60 billion.
Minority Interests:
Palantir entered into a number of agreements to purchase shares of various companies in exchange for these companies signing up to commercial contracts for access to Palantir’s products and services. The terms of these contracts range from three to ten years. As of 31 March 2022, Palantir had minority interest ownership in 22 public and private entities with a total book value investment of $415.50 million as a result of these investment agreements. The ownership in each of these entities ranges from 0.40% to 4.07%. I should individually value each of these entities separately and accordingly adjust the valuation based on Palantir ownership, however in full transparency, I have not had the time to do this yet. Most of the companies are very early-stage growth companies so I do not believe an in-depth analysis of each company would result in a material impact to the Palantir valuation at this stage. For now, I have assumed a sales revenue multiple ranging from 0 to 5 to estimate each entity value. At the time of this analysis, the estimate of minority interest value is $32.20 million, which is almost certainly overly conservative. That said, I do plan to separately value at least some of the major holdings and will periodically update this analysis.
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