AI is propelling Palantir into a new growth cycle

Palantir Tech released its Q4 2023 earnings after the market closed on February 5th, Eastern Time.

The Q4 performance of Palantir Tech was somewhat surprising to the market, as the news surrounding government business last year was not favorable. However, while the government business did underperform in Q4, the commercial enterprise services experienced a rapid recovery due to the high demand for AI, with revenue growing by 32% YoY. In particular, the commercial revenue growth in the United States reached 70%, compared to the 10%-30% growth rate seen in the past year, indicating a significant rebound and surpassing market expectations for overall profitability.

The core reason for the 18% surge in after-hours trading can be attributed to the company's guidance for 2024, especially in terms of commercial market revenue, profitability, and cash flow performance.

Dolphin Research has also observed some forward-looking indicators that show a significant increase in backlog of new contracts in Q4. As the management expressed uncertainty regarding government revenue, it implies that the majority of the new demand comes from the commercial market, driven by AI-related needs such as AIP.

The recovery in commercial market growth, as well as improvements in profitability and cash flow, is the most desirable development trend for Palantir Tech in the eyes of the market. Therefore, despite Palantir Tech's valuation still being relatively high among software stocks (forward PS 14x/PE 70x), the changes brought about by AI have raised market expectations for the company's medium to long-term development.

AI drives commercial growth beyond expectations: There were signs of a recovery in Palantir Tech's commercial market revenue in the previous quarter, and with the rise in AI demand, the growth in the commercial market in Q4 once again exceeded expectations, offsetting the shortfall in government revenue and meeting the guidance given in the previous quarter and market expectations.
Growth mainly comes from the US market: The growth in the commercial market mainly comes from the United States, with a growth rate of 70% in Q4, far exceeding the 10% growth rate in the international market. At the same time, from a MoM trend perspective, there is a clear and strong recovery trend in the US market, but the international market has yet to show the same.

However, in terms of government revenue in Q4, the international market performed better than the domestic US market. But from what we can see on the US government website, the number of new contracts signed by Palantir Tech in Q4 has rebounded slightly. Therefore, although government revenue is uncertain, looking at the relatively low sensitivity of data between countries, Palantir Tech still has an advantage over its peers in the application of data analysis in sectors such as the military and healthcare. Thus, at least a relatively stable change in the amount of US government contracts can be expected.3. Better-than-expected Profit Guidance: In the fourth quarter, Palantir Tech's profitability significantly improved, with gross margin optimization of nearly 3% YoY, following the trend throughout the year. While R&D expenses increased YoY, sales and administrative expenses remained stable or continued to decline. As a result, the company achieved a GAAP operating profit of 66 million, with a profit margin of 11%, significantly exceeding market expectations.

The company's outlook for adjusted operating profit in 2024 is better than what the market anticipated, with a profit margin for the full year on par with the fourth quarter of 2023. However, the trend of quarterly improvement since the third quarter of 2022 has temporarily slowed down, possibly due to the gradual recognition of AI-related costs as revenue grows, but this is already within market expectations.

Among the expense growth, employee stock-based compensation often accounts for a significant proportion in software stocks, but it is difficult to compress it before the product technology matures in order to maintain technological advancement. The same goes for Palantir Tech, with SBC expenses accounting for 22% of revenue in the fourth quarter, even increasing by 2 percentage points MoM, mainly due to increased incentives for the R&D team, doubling YoY.

3. Significant Rebound in Forward-looking Indicators: The current revenue involves the issue of actual recognition cycle, which is difficult to track in the short term. Therefore, Dolphin Research suggests focusing on several forward-looking indicators that drive Palantir Tech's revenue growth, such as Remaining Performance Obligation (RPO), Billings, and customer count.

From the above three indicators, there is a significant rebound in the fourth quarter compared to the past three quarters, with a considerable MoM net increase. This reflects that the company's AI logic has been successfully realized in actual performance and is expected to continue driving commercial market revenue, which is the main support for its valuation.

Overall, Palantir Tech's earnings report performed well in key indicators. For example, in terms of the sustainability of commercial market growth, which Dolphin Research was most concerned about after the previous quarter's earnings report, Palantir Tech responded with AI. At the same time, there are also signs of the software scalability advantage driven by AI, which is gradually emerging in Palantir Tech.

The post-market surge in valuation also includes a short-term reward for the successful realization of Palantir Tech's AI logic in its performance. Last quarter, Dolphin Research mentioned that AI is relatively favorable for Palantir Tech's fundamentals, so it is not ruled out that the stock price will remain overbought.

However, Dolphin Research reminds that based on the implied performance expectations from the post-market valuation, the market has become more optimistic about Palantir Tech's long-term high-speed growth. The risk behind this is that if the growth rate of performance slows down or falls short of expectations, the short-term volatility caused by the market's sentiment-driven valuation compression can still be quite severe.

Although we can see some short-term trends from forward-looking indicators, it can be exhausting to monitor them when the valuation is high. Because Palantir Tech's average contract size is not small, each new partnership can visibly impact short-term performance. Therefore, investing in Palantir Tech requires not only monitoring performance but also considering the long-term prospects.It is still necessary to keep an eye on the news of short-term contract signings.

It is better to wait for opportunities when short-term contracts expire (mainly government contracts) and when the international market becomes more sensitive to data issues and international governments seek domestic alternatives to suppress valuation.

The following is a detailed analysis.

I. AI drives business growth faster than expected

Total revenue in the fourth quarter reached $608 million, a year-on-year increase of 19.6%, and the growth rate continued to rebound from the previous quarter, which is basically in line with expectations.

Due to the high cost and customization of Palantir Tech products, it is difficult to see significant fluctuations in both "new customer conversion" and "customer churn". Therefore, the company's short-term revenue guidance is generally accurate, and the range of fluctuations is small. Therefore, the revenue is basically consistent with market expectations, and the magnitude of beat or miss can be ignored.

In terms of business segments, government revenue grew by 10.5% year-on-year, continuing to slow down. However, commercial revenue continued to improve in the fourth quarter due to the strong demand for AI, with an overall growth rate of 32%, which is better than market expectations. The US commercial market is the main driver of growth, with a year-on-year growth rate soaring to 70%. In the company's guidance for 2024, the US commercial market is expected to maintain a growth rate of 40% for the whole year.

The company disclosed that as of the end of the fourth quarter, there were approximately 465 enterprise customers worldwide participating in the testing/adoption of the AIP platform, a significant increase from the previous quarter's 300+.

In terms of regions:

(1) In the government revenue, the growth rate in the US region continued to slow down in the fourth quarter, with a year-on-year growth rate of 5%. However, due to various factors affecting revenue recognition cycles, the key is to look at changes in contract signings. In fact, Palantir Tech's advantage among US government software suppliers is relatively stable, and the actual contract signings have not declined significantly. Moreover, AI has also gained some additional demand from government clients.

For example, in December, Palantir Tech obtained a one-year contract extension for the Vantage project of the US military (originally a 4-year contract expiring in early December), as well as an additional $250 million contract for AI and ML services.

According to the official website, Palantir Tech and US government agencies still signed new contracts in the fourth quarter, and there was a slight rebound compared to the previous quarter (only listing Palantir Tech USG company). Therefore, it is expected that they will gradually confirm into future revenues.International government revenue growth of 28% is mainly contributed by government institutions such as the UK NHS. In the fourth quarter, the UK Ministry of Defense also signed a three-year contract worth £75 million ($90 million) to enhance its military's intelligence analysis and forecasting capabilities for different strategic deployments.

Business revenue has consistently been contributed by local corporate clients in the United States, with a growth rate of 70% in the US region and 11% in other regions.

Second, there is a significant rebound in contract growth.

For software companies like Palantir, future growth is the core of valuation. However, quarterly confirmed revenue is a relatively lagging indicator. Therefore, we recommend focusing on the acquisition of new contracts, mainly reflected in the remaining performance obligations (RPO), current billings, and customer count.

Remaining Performance Obligations (RPO)

In the fourth quarter, Palantir's remaining performance obligations amounted to $1.243 billion, an increase of $260 million compared to the previous quarter, showing a significant rebound. Both short-term and long-term contracts have increased, but the net increase in long-term contracts is higher, indicating a high demand from customers.

Current Billings

In the fourth quarter, billings amounted to $605 million, also showing a significant rebound.

Customer Count

Looking at the most intuitive customer count, there was a net increase of 44 customers in the fourth quarter compared to the previous quarter, which is significantly higher than the net increase in previous quarters, and all of them are additional corporate clients.Combining <1-3>, Dolphin Research believes that there is a clear rebound in leading indicators in the fourth quarter, and due to more drivers coming from "long-term contracts + enterprise customers," the growth expectations are significantly higher than the past two years.

III. Earnings Guidance Exceeds Expectations

In the fourth quarter, Palantir Tech once again achieved net profit under GAAP, and for the first time, achieved profitability for the full year. The company's earnings guidance for 2024 greatly exceeded market expectations.

In the fourth quarter, GAAP operating profit reached $65.8 million, a year-on-year increase of 470%. The operating profit margin was 10.8%, and the adjusted operating profit margin, excluding SBC, was 34%, showing a beautiful upward trend quarter by quarter.

While ensuring that R&D investment does not decrease and even increases according to industry development needs, Palantir Tech's focus in the fourth quarter was still on optimizing management expenses, while sales expenses increased slightly due to the promotion of new AI products.

In terms of R&D investment, the main increase was in employee expenses, with an increase in R&D personnel, which also increased the proportion of overall employee stock incentives to revenue by 2 percentage points compared to the previous quarter.

Although the gross margin was seasonally optimized by 2 percentage points, sales expenses returned to growth, so the company paid more attention to the contribution margin, and the improvement in the fourth quarter was not significant.

However, since revenue is fundamentally driven by the volume of signed contracts, every time a customer is successfully acquired, there will be sales expenses involved in the early stage. However, the period of customer acquisition and the actual conversion of contracts may not necessarily occur in the same quarter, which can occasionally cause short-term and drastic fluctuations in the sales expense ratio.

Although sales expenses in the fourth quarter increased year-on-year, they were still relatively restrained compared to revenue, reflecting the strength of Palantir Tech's own products.

Dolphin Research's Historical Research on "Palantir Tech":

Financial Report

November 3, 2023, Financial Report Review: "Palantir Tech: Contrary to the Trend, Growth Rebounds, and AI Plays a Key Role?"invite-code=)》

In-depth Analysis

On October 13, 2023, "Palantir Tech: What Drives its High Valuation?" was published.

On September 26, 2023, "Palantir Tech: The 'Mysterious' Military Weapons Activated by AI" was published.

Risk Disclosure and Statement for this Article: Dolphin Research Disclaimer and General Disclosure