Can Peter Thiel pull a rabbit from his hat with Palantir?

By Rohit Kulkarni, SharesPost

Palantir is more than one of the world’s most valuable enterprise software unicorns. It could be one of the largest enterprise IPOs of a generation.

Because of its success, the involvement of [Founders Fund investor] Peter Thiel and the nature of its secret work, it has become a fascination and darling of the venture ecosystem. That’s why all eyes are on the company and its potential public offering.

As a business, Palantir develops data analytics software that addresses fraud prevention, counter- terrorism, and other business intelligence tasks. The company’s roots can be traced back to the anti-fraud work done by Thiel at . In the wake of the 9/11 attacks, PayPal co-founders thought their platform could be used to look for terrorists. Eventually, they co-founded the company and named it after a magical, all-seeing crystal ball from “The Lord of the Rings.”

Fast forward, 10 plus years. Palantir has grown to an estimated $3.5 billion in gross bookings this year, with almost 50 percent of those coming from government contracts. We believe investors have become marginally positive on Palantir’s prospects during the Trump presidency, given the close relationship between Thiel and Trump, and a greater likelihood of rising defense spending over the years to come.

Despite such a positive backdrop, investors have plenty of reasons to be cautious about Palantir, including a lack of information and transparency, the intense competition from well-capitalized and entrenched software vendors, its profitability potential, and, most importantly, the valuation. Even Peter Thiel’s fund marked Palantir’s valuation at roughly $13 billion in late 2015.

All of these concerns raise three obvious questions:

1. How would institutional public equity investors value Palantir’s IPO?;
2. What are key reasons to be bullish about Palantir?; and
3. What could go wrong for Palantir?

How would public equity investors value Palantir IPO?

If Palantir pursues an IPO, and if Palantir goes public in 2019 (roughly 18–24 months from today), potential public investors will likely calculate the company’s Enterprise Value based on a blended average of 2019 and 2020 financial estimates. We realize there are a lot of “ifs” in this scenario. However, based on publicly available information and the application of reasonable growth rates to Palantir’s bookings and net revenue ratio, we’d expect Palantir’s revenue to grow to between $2.2 billion in 2019 and $3.0 billion in 2020, expanding at 25 percent pace year-on-year. Based on our revenue estimates and a 6-7x EV multiple estimate, we believe Palantir could be valued at $20 billion, in line with the current private valuation. And, it has the potential to go higher if it continues to improve its bookings-to-revenue conversion coupled with an ongoing mix shift from government services revenue to a more enterprise SaaS revenue model.

What are the key reasons to be bullish about Palantir?

As we evaluate the investment opportunity with Palantir, there are some key trends to consider, in addition to a large and growing market opportunity for big-data-analytics software vendors and secular trends, such as data growth and cloud computing. Included are:

• A unique, user-friendly customer proposition: Palantir’s first-generation product roadmap was largely driven by government use cases and emphasized ease-of-use and actionable dashboards for non-technical end users. We believe that Palantir’s in-house intellectual property, which was built upon early government contracts, has allowed the company to reduce friction around big data analytics. Enterprise companies can now focus on drawing actionable business conclusions, rather than implementing data cleanup, parsing, and other input-related activities.
• High-profile customer sales increases and marketing leverage: Palantir’s technology has been associated with prominent global events in disaster relief (Hurricane Sandy), fraud detection (the Bernie Madoff ponzi scheme), and anti-terrorist activities (the capture of Osama bin Laden). While its peer SaaS companies spend up to 50 percent of their net revenues on sales and marketing, we believe Palantir benefits from the media coverage of highly visible events as well as customer stories. This publicity likely leads to significant savings on sales and marketing expenses and moves the company a step closer to profitability by the end of 2017.
• Attractive revenue mix-shift from government to commercial: We believe Palantir has diversified its customer base by growing its commercial revenues from an estimated 0 percent of revenue in 2008 to roughly 50 percent in 2017. Investors will view this shift positively. It will increase reporting transparency and mitigate investor concerns about Palantir’s reported conflict with certain government agencies.
• Continued significant growth potential in government IT spend: U.S. federal, state and local IT spending is expected to exceed $200 billion in 2017, with roughly 30 percent to 35 percent of this amount dedicated to IT in defense, public safety and justice departments. Palantir’s predominant focus on these verticals, coupled with its custom offerings for specific government use cases, gives us greater conviction that Palantir has a pathway to long-term growth by virtue of its work for the government.

What could go wrong for Palantir?

There are downside risks to monitor. Although there are several great things going on for Palantir, we would caution investors on the following potential downside risks for the company:

• Unclear long-term profitability potential: We are encouraged by recent media reports that Palantir remains on track to become profitable by the end of 2017. However, the long-term cost structure of comparable big data analytics and business intelligence companies remains unproven and debatable. Over the longer-term, as Palantir shifts from a services-and-consulting-driven sales cycle to a traditional SaaS sales cycle, we expect longer sales cycles, which will likely lead to a structurally higher spend compared to today’s levels.
• Opaque pricing strategy: Unlike some of its peers, Palantir does not publicly disclose its pricing strategy. This lack of transparency leads to an unclear understanding of its offerings and how they compare with the offerings of its peers. Media reports regarding Palantir’s price sheets indicate that Palantir’s solutions may be more expensive than its peers. That could lead to a lack of pricing leverage or to increasing customer acquisition costs.
• Challenge of converting bookings into net revenues: In 2015, Palantir’s customer bookings exceeded an estimated $1.7 billion. However, it is unclear how much of that money translated into revenues for the company. We believe that typical Palantir customers sign three-year contracts, implying a 33 percent current fiscal year book-to-cash conversion. Investors would view a growing cash conversion ratio as a sign of long-term healthy performance.
• Rising private shareholder activism potential: Palantir’s early investors have been fairly patient for a liquidity event. It will be almost 10 years since Palantir first raised institutional capital. Over the past year or so, the company has been embroiled in a two-way legal battle over information access with an early investor, KT4 Partners. Such legal battles highlight the contentious relationships between startup investors and companies that want to maintain tight control of stockholders. As evidenced with recent events at Uber, we would closely monitor the ongoing lawsuit with KT4 partners, and any such other related events.

Rohit Kulkarni is a managing director and head of research at SharesPost. This article is an excerpt from the 78-page report “Palantir Redefining Analytics, Augmenting Intelligence & Unlocking Secrets.”

Photo of rabbit being pulled out of a topper hat courtesy of Gutzemberg/iStock/Getty Images