Palantir (PLTR 0.44%) is a leader in artificial intelligence (AI) software. While AI has been all the rage and many companies are launching their own versions, Palantir has been in the field for much longer. This experience is paying off during the AI arms race, and Palantir's products are seeing strong demand.
This makes Palantir a very intriguing stock to own, but there is one thing that holds me back: I don't think the stock can live up to expectations.
Palantir's products are incredibly useful for all industries
Palantir started off as a company making software for government agencies. While the U.S. government was its primary customer, it also sold its AI software to allies around the globe. Its AI software takes in loads of information, processes it, and then gives its users actionable insights on what they should do next. Whether that is deployed by militaries or for financial auditing purposes, Palantir's software can be tailored to fit many needs.
After capturing a ton of government business, Palantir opened up its software to the commercial side. The premise of Palantir's software is data in, insights out -- so there's a huge use case no matter what industry you're in.
While Palantir's software succeeded in the commercial market, its latest launch, Artificial Intelligence Platform (AIP), has been an absolute game-changer. AIP goes beyond standalone software that analyzes data. It allows its users to integrate AI across all business areas. It can automate workflows and then execute without intervention or pause to have a human review before executing. It also allows generative AI model integration in a business, a key part of any AI offering.
AIP is incredibly popular, especially among U.S. commercial customers. For multiple quarters in a row, management described the demand AIP is generating as "unprecedented," which gives you an idea of the hype behind the product.
In the first quarter, U.S. commercial revenue rose 40% year over year to $150 million. However, that is only 24% of Palantir's total revenue, as government customers have been slow to adopt AIP. With government contracts still making up 53% of total revenue, they remain the most important clients. While this cohort hasn't yet adopted AIP, management is confident that this change will happen soon.
All of this adds up to a fantastic investment thesis for Palantir. However, the stock has become so expensive due to the high expectations that even if it excels, it may not respond.
Palantir's stock has a lot of expectations built into it
Right now, Palantir stock trades at a sky-high 24 times sales.
PLTR PS Ratio data by YCharts
The price-to-sales (P/S) ratio is necessary because Palantir hasn't achieved full profitability. Although its profit margins are improving, it has a long way to go to reach industry-leading software margins, which are typically around 30%.
If Palantir could snap its fingers and instantly achieve a 30% profit margin, the stock would trade for an expensive 80.7 times earnings. Now, it's common for software companies to get higher multiples attached to their stock due to their strong margins. So, if we say Palantir should be worth 30 times earnings, then it must grow its revenue by 169% and achieve industry-leading 30% profit margins.
That is an incredibly high expectation, especially considering that Palantir's Q1 profit margin was 17% and its growth rate was 21%. Should Palantir maintain its 21% growth rate, achieving the required growth would take two years and three quarters. So essentially, you'd have to sit and wait on the stock for three years before it would arrive at the threshold discussed here.
Now, the market is dynamic, and if Palantir continues to succeed, it will likely bid the stock up. However, because the market is pricing in three years of strong growth, I'm hesitant to purchase, as many companies don't have the same expectations built in and are growing at a similar (or faster) rate. As a result, I will pass on Palantir stock, even though I think the business will succeed.
