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So much for the mission-critical defense software. Palantir (NYSE:PLTR ) lowered its Q2 guidance last week despite the steep escalation of the Russia-Ukraine war. During an odd earnings call, Alex Karp expressed frustration over governments' failure to see the world as it really is or as he puts it:

Escaping to the Metaverse or faculty lounge jargon or political structures that are clearly not solving problems

[...] Why do we describe these things as uncertainty when they are certain and are happening?

[...] We at Palantir are not fleeing to a different world, whether it's the Meta-world or a theological world or a financial version of theological world or a grad school version of theological world, which isn't even actually academic because academic presupposes interacting with the object from a theoretical perspective, differentiate from the object, not importing a theological preconceived version of the object onto the theory and reimporting that onto the object. Products don't work like that. Reality doesn't work like that.

[...] The future is to be won by people who accept the reality of what it is and not what it ought to be - PLTR Q1 Earnings Call

The good news is that many investors are failing in that regard, too, lifting shares by 7% since the earnings release selloff.

Commercial Revenue wasn't great either when excluding affiliate revenue. During the earnings call, management gave precise figures on US Commercial sales for the first time, allowing investors to extrapolate other previously aggregated segments, such as Foreign Government, Foreign Commercial, and US Government revenue, offering more insight into revenue trends. I discuss these dynamics below.

Seeking Alpha Quant Rating reflect softness in growth, compared to three and six months ago, weighted against improvements in profitability, stemming from the economics of scale and maturation of its accounts.

PTR remains overvalued despite a 54% YTD price decline. Those buying the dip most likely base their decision on technical analysis, capitalizing on stock volatility rather than the company's fundamentals. Even when incorporating a 30% growth, PLTR is still overvalued. I will discuss valuation in more detail in the coming sections. Until then, Seeking Alpha Quant Rating offers an easy-to-read valuation index.

Q1 results verify our concerns highlighted in the previous article, manifested in underestimated competitive dynamics, market position, and overvaluation. Below is an update in light of the recent market correction and an expanded analysis of PLTR's revenue trends.

What is PLTR's revenue potential? What are sales going to be like in 5 years? It is probably more than its $1.6 TTM revenue, or at least this is what the market expects.

Management states that its software has the potential of becoming the "default operating system" for government and entire industries, a goal it incorporates in its growth strategy pitched to investors during earnings calls, investment prospectuses, and news media. Investors are told that Foundry is what AWS was ten years ago, and this has been mentioned two times during earnings calls (Q4 2021 and Q1 2022) and at least once on TV.

Is Foundry the future AWS? I don't think so. But let's entertain this thought for a second. Amazon (AMZN) generated $62 billion from its AWS services last year and $18.5 billion in operating income from the same segment. Assuming a 20% tax rate and a share count of 2 billion, this translates to roughly $7 EPS. Using a price multiple of 15x translates to $105 per share. Is this the fair value of PLTR? No, because the probability that Foundry becomes AWS is uncertain. In statistics, we solve this problem using probability theory by simply multiplying the random variable ($105 per share) with the probability of achieving this figure. In this case, the likelihood of Foundry gaining as much acceptance as AWS. This could range from Zero to 100%. For example, if we say there is a 15% probability that Foundry becomes the future AWS, then the fair value of PLTR is 0.15 * $105 = $15.75 per share. For this reason, assessing growth and the validity of growth assumptions, drivers and risks lie at the heart of PLTR's valuation.

PLTR often downplays competition from other software vendors, giving an image that their product is unique to the point it warrants its own category

We are fundamentally competing with the internal software development efforts of our potential customers. IPO Prospectus

I think PLTR faces stiff competition. In 2020, the Department of Justice replaced PLTR with DataWalk (DAT.WA), a Polish microcap. Competitive bidding against other larger tech is a fundamental part of its SG&A expenses. Is Foundry fundamentally different than Azure Synapse? Well, not according to procurement managers, who consider both before making a purchase decision.

I think that the market is underestimating PLTR's competitive landscape. This is not to say that PLTR won't achieve growth. Instead, I believe that this growth will come due to operating in an expanding Enterprise Software market, capitalizing on a renewed interest in digitalization trends instead of any product superiority, whether from quality or differentiation. The competitive moat in the tech sector stems from three elements:

Let's elaborate on each factor with an example. Apple's (AAPL) moat doesn't stem from critical intellectual property "IP" shielding it from competitors wishing to build an operating system. Instead, the talent it attracts allows it to create a unique user experience. PLTR spends nearly 50% of its revenue on stock compensation to attract talent. This doesn't hurt, but engineers also look at other factors, including culture, work-life balance, and even business outlook. Glassdoor offers an excellent comparison survey, showing that although PLTR pays slightly more on average than Microsoft (MSFT), generally speaking, MSFT employees rate their company more favorably than PLTR. It is also interesting that Alex Karp has the lowest CEO approval among the FAANGs. It would be interesting to see how management will navigate between shareholders' desire for less SG&A and the stock decline shrinking its employee's total compensation.

What makes Android unique is the third-party software found in the App Store, creating an ecosystem that enriches its quality. Can you imagine your phone without the apps? This also goes for Azure and AWS. Does PLTR have this kind of ecosystem? Is it popular among engineers? Not really, but management sure is confident that someday it will, and investors seem to like the prospects.

Alphabet's (GOOG) Google Search is only competitive because of the massive amounts of data it collects from users, allowing it to tweak and hone its search algorithms. This is why MSFT is paying people to use Bing more than ad revenue. PLTR's engineers spend a lot of time on customers' sites, tweaking and editing algorithms as they respond responding to customers' complaints and feedback. These expenses are recorded as SG&A and R&D, and at current levels, these accounts are more than one would be comfortable with from a SaaS company. Disappointing EPS also contributed to the ticker's selloff last week. Historically, the more clients remain with PLTR, the more profitable they become. This is why PLTR divides its clients into three categories (Acquire, Expand, and Scale).

Soft Q1 mirrors challenges facing PLTR to deliver on growth expectations and cast doubt over its market position and competitive edge. One might ask, how is 31% revenue growth a disappointment? The much-touted "gravity-defying growth" experienced in 2021 resulted from an initial spike in marketing resources and moat from going public, in addition to a low revenue base, making incremental revenue additions translate to large growth percentages. The 31% growth is the lowest since going public, verifying these dynamics, and contributing to the recent selloff.

Moreover, there are signs of weakness in core segments. For example, the government segment increased only by 16%, despite a rise in geopolitical tensions, which theoretically ought to increase demand for Gotham, and foreign governments seem hesitant to try PLTR. The International Government segment posted $53 million in sales, mostly from the UK's National Health Service's Covid-response program.

Speaking of the global market, Europe lags behind the US in terms of digital transformation (business process automation), so this is a challenge and opportunity at the same time. Unit now, we're not seeing momentum in Foreign revenue, neither from the commercial nor public sectors. Many are talking about the 136% growth in US commercial segment. This is an impressive figure until one finds out that Q1 US commercial revenue stood at $35 million last year, and this year it is $84 million, which, in my book, doesn't constitute a "momentum," given the size of the US market. Moreover, this figure includes revenue from PLTR's affiliates, who received significant equity investments from PLTR in recent quarters. Excluding these affiliates, total commercial revenue growth is closer to 25%. Again, these figures would be okay if it wasn't for the price.

During the earnings call, management revealed US Commercial revenue figures separately for the first time, allowing us to extrapolate other revenue segments beyond the traditional breakdown between Government vs. Commercial and US vs. International.

Source: Author's estimates based on company data

Interestingly, Foreign Commercial is higher than US Commercial, despite the recent surge and the contribution of PLTR's affiliate acquisitions. Is this a sign of a maturing US digital transformation market? No one can really tell. US government remains the cornerstone of PLTR, and it is frustrating to see International Segment lagging as it is.

YTD, PLTR price declined 60%, bringing PLTR closer to its fair value. However, by no means is it cheap. PLTR trades at 60 times its operating cash flow. Its enterprise value to sales is 11.2x, almost four times the IT sector's average. For PLTR to reach a similar multiple to MSFT, it must double its operating cash flows and maintain a 20% - 25% growth rate. This is the bare minimum to justify its current price of $8.3 per share. This also ignores the different market position, product portfolio, and a competitive moat between the two companies, which tilt in MSFT's favor. In my view, any price beyond $10 pushes PLTR's valuations/growth expectations into a state of unreasonableness. Some commentators say that if you wait for enough time, PLTR shares will increase. Sure, if not for anything but inflation, assuming it maintains its market position. But if you're not looking for Alpha, you are better off buying the S&P 500 (SPY) index. From my experience, you find Alpha in underestimated tickers, and PLTR is anything but underestimated, given its hefty valuation and lackluster growth.

What about the PE ratio? At this point, PLTR spends a lot of money on R&D and marketing, mirroring the cost it incurs in installing and tweaking software algorithms to customers' liking, which, to a certain extent, underestimates its long-term profitability margins.

We would like to see growth prices (manifested in R&D and marketing expenses) go down from a valuation perspective. Other companies are achieving more growth with fewer costs.

To PLTR's credit, the software business is characterized by scalability and high-profit margins. By definition, the bigger a SaaS company gets, the higher its net income margins. If you look at its peer group, you'll find different net income margins. For example, MSFT's 5-year average net income margin is 28% from a $147 billion 5-year average revenue. Salesforce (CRM), on the other hand, had a 7.5% net income margin from a $19 billion 5-year average revenue.

I think PLTR falls at the lower end of the profitability scale, given its small size ($1.6 billion TTM revenue). Assuming it generates a similar profitability ratio as Salesforce (CRM) (7.5% 5-year average margin), PLTR will need to quadruple its revenue by next year to achieve a comparable PE ratio to its peers, based on the current price of $8.3.

Despite the recent selloff, PLTR shares remain overvalued, even when incorporating a 30% growth scenario pitched by management during earnings calls. It seems PLTR's "mission-critical" software is not as critical as many think. The inability to penetrate the foreign public sector is a source of concern. Maybe it is just that the products are not as appealing or revolutionary as management would hope. Perhaps the European market is not ready. In a best-case scenario, disappointing results mirror a longer sales cycle than expected, meaning it will take more time for PLTR to achieve its revenue target.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of MSFT, AAPL, SPY either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.