Palantir Techologies' (PLTR 3.73%) stock is on fire of late, delivering a remarkable 175% to investors in 2023.
The general optimism around artificial intelligence (AI) companies and Palantir's recent turnaround in losses are some of the catalysts that drove the share price.
While existing investors have benefited, potential investors are considering jumping in to the company to ride the AI tailwind. Still, investors should know these two significant risks about Palantir before buying the stock.
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Palantir has a significant revenue concentration
In its early days, Palantir, which was founded in 2003, built software that helped the U.S. government in counterterrorism investigations and operations. Over the years, it expanded to cover other parts of government functions, overseas markets, and the commercial segment, touching more than 60 industries worldwide.
Palantir's early success in helping the U.S. government helped it build a massive public sector business, accounting for 56% of its 2022 revenue of $1.9 billion. The downside is that the software company is highly dependent on the public sector. While there's nothing wrong with generating high revenue from the government, it limits Palantir's ability to grow in the future. After all, there are only so many governments in the world, many of which Palantir will never be able to deal with due to national security issues.
Besides, Palantir's top three and top 20 customers accounted for 17% and 52% of its revenue in 2022. While these relationships are generally sticky due to high software switching costs, having too much revenue concentration in top customers may lead to future problems. For instance, if Palantir fails to renew these contracts, it could significantly impact revenue and profitability. For perspective, the dollar-weighted average contract duration was 2.8 years in 2022, meaning that Palantir must try to retain these customers every three years.
Of course, the software company has been working hard to reduce its revenue concentration. For instance, while the top 20 customer revenue concentration was high at 52% in 2022, it declined from 67% in 2019 as Palantir grew its client base. Besides, the development of artificial intelligence (AI) could help Palantir build a more substantial commercial business, reducing its dependence on government contracts.
Still, investors must get comfortable with Palantir's revenue concentration risks before buying the stock since any diversification efforts -- like expanding the commercial revenue -- will take years to materialize.
Palantir's stock is priced for perfection
Palantir achieved a new milestone when it reported its first operating income under generally accepted accounting principles (GAAP) in the first quarter of 2023, giving investors more confidence in the viability of its business model. On top of that, it predicted that 2023 revenue would reach $2.2 billion, a double-digit growth from the previous year, and a GAAP net income.
And as investors expect growth to remain robust thanks to the AI tailwind, Palantir's stock price rose to levels not seen since 2021. While existing investors gain, new investors must pay a high price tag to buy the stock. For perspective, the stock trades at price-to-sales (/PS) and price-to-earnings (P/E) ratios of 18.7 and 303, respectively. Comparatively, Alphabet trades at P/S and P/E of 6.2 and 25.3, respectively.
The bulls may argue that such a valuation is reasonable, considering that Palantir is well positioned to benefit from increased AI demand. It could grow its revenue by increasing customers' wallet share or acquiring new customers.
But for conservative investors, buying a stock at such a high valuation provides no margin of safety, even though the company has good prospects ahead. Any hiccup -- such as a change in prospects or missed earnings -- could send the stock price spiraling down.
In other words, while there's no rule saying that a company cannot maintain its high valuation -- and some growth companies have maintained their high valuation for a long time -- investors will need a gut of steel to invest in the stock at today's valuation.
