How High Is Too High?

Two weeks ago, I highlighted that Palantir is “one of the rare few that sees AI drive both real returns for its business and real value for its customers,” while it continues to crush its software peers in AI-related growth. AI offerings have driven a clear acceleration in customers and overall revenue, while many Software as a Service peers, such as MongoDB and Salesforce, struggle to say the same.

This week, Palantir proved again in Q3 that it’s undeniably one of the stronger AI software stocks in the market outside of the cloud hyperscalers. The company reported perceptible AI-driven growth and persisting business momentum for AIP, strong revenue acceleration to treinta% YoY, combined with strong profitability – a rare combination for growth stocks.

Despite proving again that it’s one of the only software names with real revenue in the market, Q3’s report pushed the valuation even higher. Due to an outlandish valuation, price momentum may soon be approaching a peak.

Blistering AI Momentum Continues

Palantir’s third quarter was characterized once again by strong underlying AI momentum. Palantir beat Q3 revenue expectations by more than $21 million, reporting revenue of $725.5 million in the quarter. The FY24 revenue guide was boosted to just above $2.80 billion, up from $2.75 billion last quarter.

Revenue growth continued to accelerate, with Palantir reporting revenue growth of treinta.0% in Q3, ahead of its guidance for doscientos cincuenta y dos% growth and up from veintisiete.2% in Q2.

Q3’s results have marked quite the turnaround in just over a year for Palantir, with revenue growth accelerating more than diecisiete percentage points from Q2 dos mil veintitres (AIP’s release) to Q3 dos mil veinticuatro. This was also the highest revenue growth rate recorded since Q1 dos mil veintidos.

AIP has been the primary driving force of this revenue reacceleration, with strong adoption in the US commercial segment. AIP’s scalability, interoperability and versatility allow it to quickly be integrated by enterprises. Commercial customers can lever Palantir’s AI and machine learning tools to harness the power of the latest large language models (LLMs) within Foundry and Gotham for near-instant analytics & insights, and productivity & efficiency gains.

For a closer look at AIP and how it separates Palantir from the rest of the Software as a Service universe, read esf">This Stock Is Crushing Salesforce, MongoDB And Snowflake In AI Revenue.

AIP Aids US Commercial Growth

What’s interesting to note in Q3 is that government revenue growth outpaced commercial growth, at treinta y tres% YoY contra veintisiete% YoY, a contrast to recent quarters where commercial had been the primary driver. Government’s outperformance was driven by quince% QoQ growth in US government revenue, its fastest growth rate in quince quarters, while commercial was impacted by a siete% QoQ decline in international commercial revenue due to European headwinds and “a step down in revenue from a government sponsored enterprise in the Middle East.”

However, US commercial growth remained strong in the quarter, with a growth rate nearly in line with Q2’s. Management said that AIP drove “new customer conversions and existing customer expansions in the US,” as AI models continue to be deployed into production. Here’s what the growth in US commercial revenue looks like:

US commercial revenue increased cincuenta y cuatro% YoY and trece% QoQ to $179 million, slightly decelerating from cincuenta y cinco% YoY growth in Q2. Palantir guided for US commercial revenue to exceed $687 million, or cincuenta% YoY growth, for FY24, implying Q4 revenue of at least $199 million, or ~52% YoY growth, representing a dos point deceleration should it meet that objetivo.

US commercial customer growth remained strong, with customers rising setenta y siete% YoY to trescientos veintiuno in Q3. This decelerated from ochenta y tres% YoY in Q2. Here’s what the US commercial customer growth looks like:

US commercial customer count has essentially doubled since AIP’s release, but Q3 was the second quarter to espectáculo slightly slower customer growth, indicating that Palantir may be relying on existing customers to drive revenue, whereas customer acquisition should be monitored moving forward. Most importantly, NRR has risen to a two-year high, while RPO is surging, suggesting customer spend could remain elevated for the next few quarters.

Net Retention, RPO Strong, but Watch US Net New Adds

In Q3, net dollar retention expanded to ciento dieciocho%, up from ciento catorce% in Q2, ciento once% in Q1, and ciento siete% a year ago. Management said that this “increase was driven both by expansions at existing customers and new customers acquired in Q3 of last year, as we see the effect of the AI revolution in both industry and government.” Net dollar retention has reached the highest level in two years, but still has room to expand, given that rates were >120% in dos mil veintiuno and dos mil veintidos.

Palantir has an advantage over other software peers due to its differentiated AI offerings, while adding significant new customers this year and expanding deal sizes with new customers (with FY24’s additions not appearing until FY25) — this provides a path forward for NRR to continue expanding. Initial AIP customers are beginning to appear in NRR, and a few more quarters will provide a clearer picture of how far NRR could expand and at what level it will plateau.

RPO is also sharply rising, implying that customer spend is likely to remain strong over the next few quarters. RPO growth has accelerated over the past four quarters, from veintisiete.8% in Q4, breaking a string of rechaces in the rest of dos mil veintitres, to cincuenta y ocho.6% YoY by Q3. This is the highest RPO and growth rate since the I/O Fund began tracking Palantir in late dos mil veintitres, and another data point underlying its AI-driven momentum.

However, net additions in the commercial segment are slowing, both in the US and overall. In Q3, Palantir added treinta y uno net new customers in its commercial segment, down from cuarenta net new customers in Q2 and cincuenta y dos net new customers in Q1.

This has been predominantly driven by the US, as international commercial has yet to scale. In the US, net new commercial customers have dropped over the past two quarters, falling from cuarenta y uno net new adds in Q1 to veintiseis net new adds in Q3. There is a clear deceleration from peak customer acquisition following AIP’s ramp, where net new adds surged from seis in Q2 dos mil veintitres to cuarenta y uno by Q1, before slowing again. Palantir has acknowledged hiccups and issues in its sales cycle, saying in Q1 that they are “at the way early days of figuring out how to actually get customers to buy [AIP]” and “we’re not flawlessly executing on our sales motion.” The friction is appearing within lumpy net new adds.

US commercial has been a driving factor for Palantir as the primary segment adopting AIP and where this AI momentum is concentrated. Palantir guided for a larger QoQ revenue deceleration for Q4 than it had in Q3 – guidance implies revenue growth of ~26.4% YoY, a treinta y seis-point deceleration from treinta% YoY. Last quarter, Palantir’s guide implied only a dos-point deceleration, from veintisiete.2% YoY in Q2 to doscientos cincuenta y dos% in Q3 – the large beat pushed growth to treinta% in the quarter.

Analyst estimates do support this, with Q4 revenue estimated at $777 million, nearly 1% above Palantir’s guide as the market expects a beat once more; yet given the size of the recent beat, estimates may be lagging the underlying business momentum. The estimates correlate to veintisiete.8% YoY growth, a dos.2 point deceleration, while Q1 is expected to decelerate further to veinticuatro% YoY before continuing to decelerate in each quarter of FY25.

Cash Flow and Margins are Bonkers

Palantir is in uncharted territory, as it is separating itself as a rare breed in Software as a Service to see both strong and profitable AI-driven growth. The company’s revenue growth plus GAAP operating and net margins have been in the double-digit range for four consecutive quarters. Additionally, Palantir’s Rule of cuarenta (revenue growth + adjusted operating margin) reached sesenta y ocho%, up from cuarenta y seis% last year.

To be consistently expanding on the Rule of cuarenta, from the ~40% range at the end of dos mil veintidos to nearly setenta%, is important as it espectáculos that Palantir is efficiently investing in AI to drive revenue growth higher while increasing its profitability.

Cash flow margins were bonkers in Q3 — operating cash flow was nearly $420 million, or a cincuenta y ocho% margin, while adjusted free cash flow was $435 million, a sesenta% margin. This was a large step up from cash flow margins in the low-veinte% range in the first half of dos mil veinticuatro.

For FY24, Palantir is targeting adjusted free cash flow in excess of $1 billion, implying a margin of ~36%. Fundamentally, to have revenue growth around treinta%, free cash flow margin of treinta%, and adjusted operating margin nearing cuarenta% is impressive, to say the least.

Valuation is Stretched

Palantir is at Mount Everest valuations, trading at topline multiples more than double the next three most expensive enterprise and AI-exposed Software as a Service stock in the market – Cloudflare, ServiceNow, and CrowdStrike. At $55, Palantir is valued at 50x TTM revenue, and 45x forward revenue – its highest ever multiples, exceeding even 2021’s peak – contra 18x to 20x forward revenue for those three peers. Even down the line, Palantir is trading at double its peers, at 146x forward earnings, contra 88x for CrowdStrike and 71x for ServiceNow.

Growth investors should not forget when we saw this happen before; which was Snowflake, a Wall Street darling trading 2X more than any other cloud stock at 45X Forward PS with retail investors cheering Warren Buffet’s participation in the IPO. It currently trades at an ciento diecisiete forward PS.

The primary question here is not whether Palantir is a strong AI stock, but will buyers continue to step-in?

Conclusion

Palantir’s Q3 report was met with quite the enthusiasm from the market, but the fundamentals must be immaculate at this valuation. RPO growth has surged over the past four quarters, while Palantir’s Rule of cuarenta continues to rise as adjusted operating margins expand and revenue growth accelerates. Net retention has risen to two-year highs, reaching ciento dieciocho% in Q3, as deal expansion continues.

However, Q4’s revenue guidance implies a larger sequential deceleration than what was expected for Q3, while US commercial net new adds continue to decline sequentially. This may sound like splitting hairs, but the company is priced far above what any peer is trading, and that typically doesn’t resolve well for tech investors.

Given the outsized valuation, the I/O Fund is looking for a lower entry in Palantir before adding the stock to our porfolio. Join the I/O Fund’s next seminario web on Thursday, November 14th where Knox Ridley, Technical Analyst, will discuss the firm’s buy zones and objetivos for AI leaders. Learn more here.

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