Palantir's (PLTR 3.73%) stock has been on a roller-coaster ride over the last few years, reaching a high of $39 in 2021, then falling to below $6 in the previous 12 months, and now trading at around $17.
The reason behind such volatility in share price is the wide divergence of opinions among the bulls and the bears. The former like Palantir's business model and prospects, while the latter cringe due to the revenue concentration and the high valuation.
This article aims to delve deeper into these arguments to help investors form a more balanced view of Palantir as a potential investment.
Image source: Getty Images.
Bull case
Founded in 2003, Palantir became successful by building software that helped the U.S. government in counterterrorism operations. In the later years, it expanded into the commercial market by providing software to companies to help them make sense of their data.
There are many things to like about a software company like Palantir. First, it has a highly sticky revenue base as its software is deeply integrated into its clients' operations. In particular, Palantir tailors its software to clients' needs. So, it's very difficult (and operationally risky) for clients to change to a new provider, especially if the software functions as expected.
The enormous financial costs -- such as installation, integration, and training -- and significant time and commitment create a huge switching cost for clients. On top of that, the tech company usually enters into a long-term contract (existing contracts average another 2.8 years), further protecting its revenue's stickiness.
Palantir's sticky customer relationship also helps it grow its business with existing clients over time. For example, the average revenue for the top 20 customers during the trailing 12 months ended Dec. 31, 2022, at $49.4 million, up 13% from the previous year. This makes sense because these clients are already on Palantir's platform, so spending more money over time is just a natural consequence.
Beyond these existing customers, Palantir is well positioned to grow by adding new clients. To this end, strong tailwinds, like the increasing demand for sophisticated data analytics and artificial intelligence (AI) development, will keep the company busy for many years.
For example, Palantir launched its artificial intelligence platform (AIP) to help enterprises leverage existing machine learning technologies and large language models to gain insight into their private data. In short, it makes sense for the bulls to be excited about Palantir's long-term prospects.
Bear case
Palantir's success in helping the U.S. government helped it build a significant public sector business, reaching a high of $1.9 billion, or 56% of its 2022 revenue. Additionally, Palantir had significant revenue concentration among its top three and top 20 customers, accounting for 17% and 52% of its 2022 revenue, respectively.
Such a high concentration of revenue in the public sector (centered around its top 20 customers) poses significant risks to the company. For instance, if any of these clients reduces their engagement, terminates their contracts, or experiences financial difficulties, it could significantly impact Palantir's economic performance. Since these top customers occupy a disproportionate share of their business, they might exert their muscles and become more demanding over time, leading to a higher cost of doing business.
The silver lining here is that Palantir's software business tends to have a high switching cost, so customers usually renew their contracts so long as Palantir can continue meeting their requirements. Palantir has also slowly reduced its dependence on key customers -- the top 20 customer revenue concentrations declined from 67% in 2019 to 52% in 2022.
The other major problem the bears have with Palantir is its high valuation. The stock trades at a price-to-earnings (P/E) ratio of 290, while a well-established tech giant like Alphabet trades at a P/E ratio of 27.
While the bulls might be happy paying up for Palantir's stock, thanks to its solid business model and prospects, the bears question its risks. In particular, a considerable part of Palantir's valuation lies in investors' optimism around AI development and its potential growth.
If the AI trend turns out to be weaker than expected or Palantir fails to capitalize on it, investors may move from optimism to pessimism, sending the stock valuation down.
What it means for investors
Palantir has an appealing business model centered around software provision, ensuring a steady revenue stream. Further, the increasing prevalence of AI opens up new growth avenues, as businesses must adopt AI-based solutions to stay competitive.
Yet, the company's heavy reliance on its top 20 customers poses a notable risk, especially if these clients choose not to renew their contracts. However, the most significant risk lies in its high valuation since much of the anticipated benefits above may have been reflected in the current share price.
So, unless an investor is comfortable taking on significant risks or possesses a long-term investment horizon (say five to 10 years), purchasing the stock at today's lofty valuation may not be prudent.
