May 21, 2022 Palantir | an ode to secrecy (or the lack of it) Gandalf: “A Palantír is a dangerous tool, Saruman.” Saruman: “Why? Why should we fear to use it?” [Saruman unveils the Palantír. It is a perfectly spherical ball, made of some sort of glass, with strange swirls in its depths.] Gandalf: “They are not all accounted for, the lost Seeing Stones. We do not know who else may be watching!” The “palantíri” or “seeing stones” allow observers to see across realms, scanning both past and future. Palantir, the company derives its name from these seeing, enigmatic and sinister stones mentioned in the Lord of the Rings. Founded by Peter Thiel, Palantir is known for its products which have been equally enigmatic and have been helping organisations to peer into the future through its data intelligence platform. Its platforms are used to ensure the readiness of more than one million military personnel and to make decisions across dozens of command structures. Its platform is also transforming how aviation industry uses data or how companies can efficiently find more oil. And unlike the movie, Palantir knows where it belongs.. We have chosen sides, says the annual report, and unlike other Silicon Valley companies, we are not in the business of selling or mining data. Palantir’s core premise is that the welfare and security of our society depend on effective software, a software that allows surveillance, security and protection. To this effect, it has not qualms if the data and platform is used to ferret out terrorists and on occasion, to kill people. In this article, we will attempt to unravel the mystery behind Palantir, a look at its business model and also review its valuation after its IPO listing. Though the forward-looking data is not publicly-available, we would go with the best estimates. So, what exactly does Palantir do? Palantir has created software platforms that are the central operating system for data. Its platform does not keep data as a static entity but its AI and ML models convert massive amount of information into knowledge by criss-crossing entities, events, relationships, decisions and consequences in context. Most importantly, data modelling, search & compute and AI & ML models unite non-technical users with technical users while bringing language as a context to the data. This enables a solider to plan a recon mission on a data platform (earlier they might have done on paper). Or enables humanitarian workers to plan disaster relief missions following tornadoes, hurricanes and other natural diseases. In the current pandemic, Palantir has been helping US government in predicting coronavirus outbreaks and in contract-tracing. Key Differentiation Palantir’s differentiated value is that it provides alpha over beta – i.e. when a company has needs that are specific (alpha) and is beyond the standardised best-practices of the the software industry or of the market (beta). It does not replace existing legacy systems, but connects it across all platforms, legacy entities and builds applications that leverage the relevant data in their source systems without any burden of systems integration. It does not sell features, tools, or one-off custom applications. When it comes to working with data, those approaches generally work only briefly, if at all. Palantir builds software platforms that become integral to the institutions they serve. By working with the intelligence community and the defence sector right at the start, it has been able to address security, stability and transparency better than its Silicon Valley peers. Palantir boasts of building the entire platform by first principles. This is also the reason that Palantir has software engineers as sales personnel who are on the front lines of the business. The software engineers learn, build and adapt the software platforms against the problems that other companies are unwilling or unable to address. Their platform is used for collaboration by the developers, analysts and non-technical users and gets better with time. Talk network effects + operational feedback look. As a consequence of going above and beyond the practice of standard software industry norms, the more complex and extensive a project is, greater are the chances of Palantir to win the project and there-in lies its biggest differentiation. How big is the TAM ? The Total Addressable Market for Palantir currently is $119 billion. Palantir divides its market into Commercial and Government. Under Commercial, the market-size is ~$56 billion which is arrived by multiplying the number of potential customers around the world — defined broadly as approximately 6,000 companies with more than $500 million in annual revenue — by an assumed annual contract value for each potential commercial customer based on organisation size and our internal data of existing customer spending. The Government sector market-size is ~63 billion which is further broken up to $26 billion in US and $37 billion in the international government sector. Palantir has also made it very clear that they are only going to work in other countries abroad whose values align with liberal democracies. They have also kept China out of the market size estimation. A quick break-up is as follows: …and the business model? The business model is straightforward in a way as the customers pay for the software platforms that they use though the pricing is based not on the cost, but the value that they provide to the customers. This approach has led to some very profitable government customers at the top. Its contribution margin from the top accounts take care of the negative contribution of the other customers and gives it the leeway to build proof-of-concept solutions for its new customers. Its average revenue per customer is also very high. Its top 25% of customers provide ~65% of contribution margin. In 2019, the average revenue per customer was $5.6 million, and the average revenue per customer for the top twenty customers was $24.8 million. Their business model is divided into three phases: Acquire – initial pilots with customers to prove value, generally operating at a loss and without a guarantee of future returns. Revenue per customer for a financial year is $100,000. Success of Acquire stage is measured by the revenue generated through that account in the following year. It is key to note that profits is not a consideration at this stage, only revenue is. Expand – Deepen relationships, understand principal challenges faced by customers and solve them through software. Any account with a revenue more than $100,000 and a negative contribution margin in the preceding year. In this phase too, Palantir operates at a loss, as measured by contribution margin, in order to drive future revenue growth and margin expansion. Scale – As the accounts mature, investment costs relative to revenue decreases. Customers become more self-sufficient to use the software. Palantir charges for software and only Operations and maintenance services while customers use the software themselves. Scale customers have a revenue more than $100,000 wiht a positive contribution margin. It is in the Scale phase that the contribution margin on specific accounts improve thereby leading to a better margins. Over the long term, Palantir would want to move all of the customers to Scale phase and its contribution margin per customer would also increase. The top 25% of customers in the Scale phase in 2019 had an overall contribution margin of 89% in H1 2020. As mentioned earlier, these Scale accounts are from the US government and the defence sector. Palantir had earlier sued the US army over their procurement strategy and has now won the contract of $756 million (over 10 years) to provide just that. Below is a quick chart on how its government contracts are poised to grow in this year. Flywheel of Growth Beauty does not come from decorative effects but from structural coherence – Pier Luigi Nervi To build their own virtuous flywheel, Palantir and Peter Thiel knew that they need to tread in an area where the competition is least. Palantir picked up those projects, putting the layer of AI and ML to solve the deeper problems and invested in R&D. As they worked on each accounts, their platform had extended capabilities with higher technical performance while they embedded themselves deep into the heart of the organisation with Data as the Central Operating System. Moving on the strength of the software, they train their clients to use their platform themselves. With just a thin layer of manpower to maintain the product, the users become increasingly dependent on Palantir. This allows their model with a great mix of Products and Services company, while also increasing their capabilities in developing industry solutions. With Airbus, for example, Palantir was initially focused on the production of the A350 aircraft. The deployment of its software soon grew into Skywise, the aviation platform that has become the central operating system of the airline industry. Skywise now connects more than 9,000 aircraft across more than 100 airlines. Decision-makers at each of these institutions use Skywise to more efficiently design, manufacture, service, operate, and maintain their global fleets. This forms a virtuous loop as the high installation costs, high failure risks, complexity of data environments, and the long sales cycles associated with these opportunities raise the barriers to entry for competition. The larger, more complex, and more technologically demanding the problem, the more likely is Palantir to succeed. Financials A quick look at Palantir’s financials show that most of its growth has come in the last couple of years. In 2018, they changed their stance on sales and employed sales personnel to acquire customers. This has led to a growth of 25% in 2019 and a 50% growth over H1 2019. The gross margins of Palantir are higher than a Services firm. While it is yet to become profitable, it uses Contribution margin as a metric to measure profitability per account and overall. Contribution margin is defined as revenue less our cost of revenue and sales and marketing expenses, excluding stock-based compensation, divided by revenue. Valuation As Palantir went through an IPO last month through a direct listing, its shares listed at $10 per share. This gives the firm a valuation of $22 billion. Since its listing on Sep 30, the share price has appreciated by 30%. For the current year, the company is expecting revenues of $1.06 billion with a non-GAAP Operating Income between a range of $116 million to $126 million. This suggests during direct listing, the company was valued at 22x times it 2020 revenues. That multiple is higher than software companies like Salesforce.com, Microsoft but also below the other software companies that IPO’d this year e.g. Snowflake which was valued at 100x sales and Zoom which is valued at 60x sales. Palantir is a blend of product and services companies and the multiple it has fetched in the direct listing reflects the same. Its shares have moved up by 50% since the time of its listing which augurs well for the company. As the quarterly results came out last week, Palantir has reported revenue growth by 52% and also raised its guidance for the full year. In the current scenario of political and economic uncertainty along with a global pandemic, the demand for their software is only going to grow.