Palantir: Has Cost Discipline Gone Out The Window? (NYSE:PLTR)

The All Seeing Eye?

Palantir (NYSE:PLTR), the data-analyzation & visualization company that sells AI and machine-learning platforms with names like Gotham and Foundry, derives its own name from a mythical orb from Lord of the Rings. Company co-founder Peter Thiel is a big fan of the series, and the name is quite apt: wizards can utilize the palantir–an indestructible, all-seeing orb–to see anything they wish throughout time and space.

Investors in Palantir’s 2020 IPO probably wish they could have made use of such an object.

After rocketing up more than 300% from its initial offering, holders of the stock have since been left to slowly bleed out. The stock today sits about 25% below its IPO level.

While we can’t change the past, we contend that one does not need a palantir of one’s own to see what is coming for the company’s stock. We think that poor decisions and cost controls will continue to hurt the company in the medium term and that investors should tread very cautiously with buying at these levels–or better yet, avoid it altogether.

G&A

Tucked away in a company’s operating costs is a line for general and administrative expenses. This is generally a sleepy line item, and Palantir’s explanation of it in the most recent 10-Q reads like most others in that it includes salaries and benefits for “personnel involved in our executive, finance, legal, human resources, and administrative functions”.

What stands out about this line item for Palantir, however, is how much the company spends on it.

For the quarter ending September 30, 2022, Palantir recorded revenue of $477 million. Six lines beneath that, we see that the company spent a whopping $148 million on general and administrative expenses–over 30% of top-line revenue.

This figure is a tad misleading, however, since it includes stock compensation, which is a non-cash expense. So let’s take that out.

If we remove the non-cash expense of stock comp for the G&A line item (an eye-watering $55 million for the quarter, more on that later), then we arrive at a true, cash-cost G&A expense of $92.8 million, still roughly 20% of top-line revenue.

We have to say, this is a lot. Salesforce (CRM), a client relationship software company that’s not exactly afraid to spend, had G&A expenses in the same quarter of 9% of its overall revenue including stock-based comp, and 8% when stock-based comp is excluded.

Putting this further into perspective, Salesforce has a headcount of over 73,000 (this doesn’t reflect recent layoff announcements). Palantir has an estimated 2,290 employees. (By some estimates its even a little lower.)

Including stock-based compensation (and we include it because, make no mistake, it is a real charge for shareholders), Salesforce spent about $9,000 in G&A costs for the quarter ending October 31st per employee.

Palantir spent over $49,000 per employee.

But wait, there’s more.

Don’t forget that the G&A line item only represents a portion of employee expenses. The trust cost of spend per employee is significantly higher since we haven’t accounted for the personnel expenses in the Sales & Marketing, Research & Development, and Cost of Revenue line items (Palantir includes it’s Operations & Maintenance salaries in its Cost of Revenues).

If this isn’t an example of a lack of corporate cost discipline, we don’t know what is. It is also just one building block in the story of the company’s reckless spending.

The Numbers Don’t Lie

Palantir published a slide deck in conjunction with its earnings call, which featured this slide.

A few things jump out. First, operating margins are down 13% year-over-year. The footnote on the slide specifies that these figures exclude stock-based compensation. The second thing that jumps out at us is that the slide states that “we are continuing to invest in our business”.

From this, one might reasonably conclude that the year-over-year margin compression comes from an increase in spend in one of the operating line items that, you know, grow the business–Sales & Marketing or Research & Development. We reiterate that one might conclude this from seeing–on the same slide–a decrease in operating margin with a nearby quote that the company is investing in the business.

That conclusion, however, would be wrong based upon everything else.

We’ll let management’s comments on the company’s operating margin speak for itself. Here’s Palantir CFO David Glazer, speaking about operating margin (the subject’s only mention) on the earnings conference call:

Third quarter adjusted income from operations, excluding stock-based compensation and related employer payroll taxes was $81 million, representing adjusted operating margin of 17%, 600 basis points ahead of our prior guidance. Our adjusted operating margin significantly exceeded our guidance as a result of several factors, but primarily driven by cloud and deployment efficiencies representing around $9 million of outperformance, and the elimination of certain discretionary spend across the business, particularly in G&A, representing approximately $14 million of outperformance.

Alright. So the company had guided for operating margin of 11% (17% minus the 600 basis point upside referenced by CFO David Glazer), and is trying to sell the positive that, hey, we actually achieved 17%. Given that the previous year’s operating margin was 13% higher than what was actually achieved, this doesn’t exactly seem like a win.

We also aren’t sure why the company would post a slide for investors about investing in the business when, in the words of the CFO, the 17% operating margin vs. the expected 11% that management guided to was completely due to “efficiencies” and cost-cutting of $14 million predominantly from the G&A line item.

Posing these savings from cost-cutting as “[investing] in our business to position the company and our customers to win” feels, well, not equivalent. For context, few homeowners would equate cutting costs on subscription streaming with investing in a new roof.

It feels almost feels like a slap in the face to shareholders for management to not only post an 13% loss of operating margin year-over-year, but to claim this as a win by stating that “the elimination of certain discretionary spend across the business, particularly in G&A” qualifies as “outperformance”.

Despite management taking a victory lap for cutting costs in their bloated G&A expenses, our guess is that there still is much more that could be put on the chopping block.

What The SPAC?

Palantir’s two main business segments are Government and Commercial. In the company’s early days, the primary Commercial sales strategy was to bring in large-scale enterprise clients who could incorporate Palantir’s massive data platforms into their existing structure (the average annual customer spend was $8.1 million at one point.)

It soon became clear to management that the pool of companies with the resources and willingness to do that was smaller than anticipated, so the company shifted strategy. This involved hiring salespeople, focusing on smaller businesses, and investing in SPACs.

Wait. What?

In Business 101 textbooks, hiring sales people and expanding into new customer demographics are traditional ways to grow revenue. Investing in SPACs, however, is strangely absent.

Palantir invested in several SPAC startups with wide-ranging focuses, from robotics (Sarcos) to telehealth (Babylon) to vehicle data gathering ((WeJo)), and others, including flying-taxi company Lilium. The companies that received funding Palantir all found that it was worth their while to utilize Palantir’s products themselves.

In all, Palantir spent over $400 million investing in these companies, a not insignificant amount considering that the company only had a little over $2 billion in cash on hand during the investment spree.

What follows, of course, is history.

SPACs collapsed last year, with several of Palantir’s investments falling to zero and declaring bankruptcy, leaving Palantir’s stakes effectively worthless.

While we cannot fault management for an idea that fails–most business ideas do–we can, however, state with a high degree of confidence that investing 20% of your available cash in questionable scooter and flying taxi companies in exchange for use of your software seems… unwise.

Stock-Based Comp

Much has been written about the issues with stock-based compensation at Palantir, but we think readers would benefit with the perspective of just how much stock-based comp Palantir distributes on a per-employee basis.

Investors are often unaware of the dilutive threat posed to their holdings by egregious levels of stock-based compensation. If you aren’t sure why you, as a shareholder, should care, then let’s frame it in simple terms: stock-based comp has the exact opposite effect of share buybacks, which increase the value of a shareholder’s equity by reducing the shares available for purchase. Stock-based compensation adds to the share count available, which proportionally reduces the value of existing shareholder’s equity stakes.

In Silicon Valley, stock-based compensation rules the roost. In 2022, Palantir is expected to have provided a little over $600 million in stock-based compensation (that’s $200,000 per employee, if you were wondering).

While this is a non-cash charge to the company, it certainly doesn’t feel that way to shareholders. Add to this that Palantir has also been a net issuer of stock each year ($500 million in 2021, $100 million estimated in 2022), and it becomes pretty clear that shareholders are swimming upstream in the search for value.

Palantir currently has about 2,000,000,000 outstanding shares, up from its IPO level of 1,650,000,000. This means that investors have seen their equity diluted since the IPO by 26%–and that’s not even factoring in how the stock has performed price-wise.

The Bottom Line

We believe that investors in Palantir–despite its attractive and revolutionary business–have been done a disservice by management.

1. The company appears to lack cost discipline, spending inordinate amounts of money on General and Administrative expenses.
2. Investors have experienced a tidal wave of dilution with the company’s liberal stock compensation plan.
3. Management has made extremely questionable capital allocation decisions, notably through large investments in high-risk SPACs, many of which are now worthless.

For these reasons, we believe that investors would do well to avoid Palantir, at least until the company and its executives establish that they can run a cost-efficient business.

The company is currently valued at 45x NTM earnings, an absurd valuation in our opinion. Other software firms like Salesforce or DocuSign (DOCU) currently trade in the mid to high 20s. If we assign a valuation of 25 times–still elevated, in our opinion–next year’s estimated earnings of $0.16 per share, we arrive at a price target of $4 per share, a significant downside from the current price of $6.73.

We should also note that this price does not reflect the further dilution that shareholders will incur if stock-based compensation does not slow dramatically.

For these reasons, we believe that Palantir has a long way to go before it can regain the trust of investors.