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Never Meet Your Heroes

Put yourselves in our shoes for a moment. Our comfy old-folks-slippers. We run an investment research business focused on two sectors – software, and space. We say space, but that’s really defense, because from Sputnik onwards, the whole point of impressive deeds in the heavens has been to demonstrate national military and industrial strength back on Earth. So, along comes the direct listing for Palantir (PLTR) – thought to take effect on September 23 – and we get all excited. This company has been around for a long time and it has had all the ripples of hype you would expect from a Peter Thiel-backed startup consuming billions of dollars of invested capital and counting many national governments as customers. It’s a software company, selling into the defense and national security market. Perfect for us. Two growth sectors in one.

Our enthusiasm waned as we watched the presentations in the Investor Day video posted in the run-up to the planned direct listing. You can see that presentation here. We’ve met an awful lot of software and services companies over the years and by and large when you are being sold to this relentlessly, you should worry.

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We turned to the S-1. The typical profile of an enterprise software company about to go public is high levels of revenue growth and quarterly losses beginning to reduce, giving the impression that profitability is just around the corner.

The best of today’s young cloud software companies have worked out how to generate plentiful cashflows even at modest scale; they do this by paying staff in stock or stock derivatives, freeing up cash to flow to the bottom line. The cost to you, the investor, is dilution, but for high growth software companies the market has long gotten used to this and prices it in without query. A key focus of ours is the degree to which deferred revenue is growing, relative to recognized revenue. Deferred revenue is, oddly given the name, a balance sheet liability item. It’s the offsetting liability matching the cash inflow from customers when they pre-pay for service yet to be delivered. As the company delivers the service (the cloud software) over the following twelve months, that liability is reduced each month by the amount of revenue recognized in that month. Pre-paid contracts are a wonderful thing in cloud software; they deliver a bow wave of cash ahead of revenue and profits. In our top cloud picks – like CrowdStrike (OTC:CRWD) – you can count on virtually all of last year’s revenue being recognized this year. The balance sheet tells you this; and it means that all the sales staff have to do is to go win new business each year to keep the growth rates up.

Palantir (PLTR) however now has deferred revenue working against it. Here’s the summary financials from the S-1.

Source: Palantir S-1, Cestrian Analysis.

If you watch that Investor Day presentation linked above, the company tells you that earlier in its life it charged customers upfront for multi-year deployment contracts. This is to be applauded; customer prepayment is the very cheapest form of funding – better than debt or equity. Just ask Warren Buffett – prepaid software contracts are an awful lot like insurance premia in that regard.

But for this to be a long-run benefit, you have to keep the flywheel spinning. Keep that upfront cash coming in ahead of revenue, keep paying your staff in stock, keep the stock moving up. That’s how you run a cash generative, high growth software company where execs are making big money, investors are making good returns, everyone happy. The core of this is having a repeatable product – the more cookie cutter the product, the higher the cashflow margins, all other things being equal.

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But here’s what’s happening at PLTR.

First, the products will inevitably require a great deal of customization. We rather suspect from the presentation that there is quite a degree of bespoke build in each customer environment. That’s true for all enterprise software companies with complex products; but when PLTR talks about building a “full stack” for its customers that suggests to us that every customer is rather different to the last. We can’t prove this. But again, in our many years on this planet we’ve seen a lot of software companies and a lot of services companies – and in particular a lot of services companies saying they are software companies, but aren’t. And PLTR has many echoes of the latter in the way it pitches itself.

Second, the business model has changed. Customers are no longer paying upfront for multi-year contracts. PLTR is recognizing the revenue from those older contracts, where they were paid some time back; that’s resulting in revenue and profit growth, but heavily negative cashflows. You can see that in the table above. In FY12/2018 and FY12/2019, there’s an inflow of cash into working capital. That will be a result of increases in deferred revenue (meaning increases in cash). But in the first half of 2020 there is a very significant outflow of working capital, which the S-1 tells you is due to the reduction in deferred revenue as it’s recognized during the period. Since the company is no longer charging customers upfront, there’s no new deferred revenue (cash) flowing into the business ahead of newly-recognized revenue. So you have revenue up, EBITDA up; but cashflow down.

The resulting cash burn is significant. $230m of unlevered pre-tax free cash outflows in the six months ending 30 June 2020, as a function of $1.2bn of net cash at the same date, indicates that the company has to either (a) start charging some customers upfront again, and/or (b) raise new money whilst the market is hot and equity pricing is high. Now, the direct listing seems to not include any primary capital raise, instead being an opportunity for existing shareholders to achieve liquidity. We think the corollary of that is that before too long we would expect to see PLTR tap the public markets for capital. And if it does so in a market tougher than today, that can hurt the stock price.

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These are the fundamentals of the business and they are not strong. We prefer to remain at Neutral and stay on the sidelines as a result. This is not to say the stock cannot shoot to the Moon – we are old enough to know that stock prices and fundamentals do sometimes coincide, but not often – but we don’t want to buy in at this stage in case the market turns sour, since we cannot find support for any likely near-term PLTR valuation (we’re in a cloud boom!) on the basis of fundamentals.

We will be covering PLTR going forward and we hope to see the company resolve this cashflow issue and then move forward with revenue, earnings and cashflow in balance; should it do so we expect the stock would benefit. But for now, we’re at Neutral and on the sidelines.

Cestrian Capital Research, Inc – 17 September 2020.

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Disclosure: I am/we are long CRWD. Business relationship disclosure: See disclaimer text at the top of this note.

Additional disclosure: Cestrian Capital Research, Inc staff hold personal long account position(s) in CRWD.

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