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Should Palantir spin-off its Commercial business?
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Palantir's stock price has been under pressure for many months and this creates discomfort for many investors. In this article, we will provide an articulated answer to the heavily discussed question:
Should Palantir spin-off its Commercial business?
Sharp edge for whatever time
Palantir’s structure is set to benefit from an operational standpoint from whatever happens in the world:
Bad Times: the Government needs to keep spending or even increase spending to deal with sudden problems like hurricanes, pandemics and even wars.
Good Times: the Commercial business could benefit from CEOs’ confidence in expanding their digital transformation journeys.
This integration between Commercial and Government is a core element of my investment thesis.
I would even say the idea of leveraging the tech developed in the Government sector to attack the Commercial side was brilliant and constitutes a factor that makes Palantir unique, as there is no other software company offering such integration, as shown by the lack of direct Palantir comparable company (Sum-Of-The-Parts Valuation). Actually, we have evidence that commercial companies like Servicenow, Microsoft and AWS are becoming more and more interested in working with the government.
However 27% of the people who answered my poll, support the view that the Commercial business should be split from the Government business.
Proponents of the spin-off idea suggest that a separation would:
increase the focus of the management team to scale faster;
improve Palantir’s public image by distancing from “spy,” and “controversial,” labels;
unlock more shareholder value resulting in a higher stock price.
Is it really the case?
How a “split” could be performed?
Currently, Palantir’s Government and Commercial businesses operate under the same parent company “Palantir Technologies.” There is only one operating company selling both software to government and commercial clients. The split we see in the financials is to help investors assess the developments.
A split between Commercial and Government would mean performing a “spin-off” operation to “extract” the Commercial business from the Parent company.
This could be done in two ways:
The Commercial business could exist as a subsidiary of the parent company. Subsidiaries operate under the direction of the parent company.
Alternatively, the spun-off company could become a completely independent company, therefore free to pursue its own interests.
To better understand the potential benefits and disadvantages, we will focus on the more extreme case of a complete spin-off.
Splits are not “all roses”
Before assessing Palantir’s specific case, there are some considerations worth mentioning:
Spin-offs are costly: they require substantial work from lawyers and investment bankers. One recent example is Kyndryl, which has been spun off by IBM. The related spin-off cost was $634mn against a valuation of ~$7bn market cap in the first day of trading. Now Kyndryl trades at a $2.5bn market cap, not really what I would call a “success.”
Splits typically generate significant value when the spun-off company is already independent and financially stable. A relevant example of this is eBay spinning off PayPal in 2015. When eBay decided to spin off PayPal, the latter was already mostly independent with only 24% of transaction volume coming from eBay vs. 71%, 10 years before. In addition, PayPal was financially stable with a 16% Net Profit Margin.
Spin-offs could be extremely risky for operations. The creation of a new brand can disorient customers and employees and create internal tensions when there are products sold by both entities. For instance, Palantir Apollo sits exactly in between Government and Commercial. How do decide which business unit should be in charge of it? In addition, to attract the best talents in the world, you need to offer them safety and brand recognition; a new brand could create serious difficulties in attracting new talents and retaining the existing ones.
If you invert a “split” you get a “merge”
From the technical standpoint of investment banking, a spin-off is an extraordinary operation called a “demerger.” As an “extraordinary operation,” for the company, it would make sense to pursue it only if the value at the end of the operation is higher than the value before the operation.
If the operation would destroy value, there is no reason to pursue the transaction.
As Charlie Munger often suggests, by inverting the problem, the situation could appear clearer.
“Invert, always invert” - Jacobi.
Therefore, if we invert, the split question would become:
“If Palantir Commercial and Government were separated, would it make sense for them to merge?”
If it would make sense to merge Commercial and Government, then splitting them would be a poor decision.
M&A case: Should Palantir Government buy Commercial?
Let’s assume Palantir Government and Commercial are two separate entities and we need to assess whether it would be convenient to merge them. We will value:
Synergies: is the merged company better?
Price: is the operation financially worth it?
Culture: is there a common goal?
1 + 1 = 3
We can think of synergies as those operating factors that unlock value so that the merged company is operationally more valuable than the two companies working as standalone entities.
Synergies make 1 + 1 = 3.
Synergies are mainly related to:
Revenues: can I sell more? This mainly comes from cross-selling products.
Costs: can I cut overlaps? This mainly refers to G&A and R&D.
Significant Revenues synergies could be unlocked by merging Palantir Government and Palantir Commercial. For instance:
Government could sell Foundry to Government Agencies to help optimise their workflows and save costs.
The closeness with Government agencies could help Commercial reach companies in the defence sector.
The innovation developed for the Government, especially in Defence, could be adapted to help improve the business of Commercial companies and vice-versa.
For context, these are already true deployment cases:
Foundry is being used by the Department of Health and Human Services (HHS) as the software backbone of its operations;
Lockheed Martin, Prime Defence Contractor, is a “Commercial Client” soon to empower its Aegis combat system with Apollo, which can manage even “Top secret” workflows thanks to its DoD IL-6 clearance authorization.
Sonnedix uses Meta Constellation, the software deployed in war to localize enemies through satellites, to identify misaligned solar trackers in need of repair.
Splitting the two businesses would disrupt the synergies already in play.
In the short term, a potential split could increase the aggressiveness of the go-to-market strategy of the Commercial side, which currently seems cautious about spreading mass-scale products. However, that would come at the cost of destroying the network effects deriving from the integration, which are crucial for Palantir to scale.
A merger between Government and Commercial would allow generating economies of scale by:
Optimizing General & Administration expenses (HR, Accounting) since the two companies operate in the same geographies.
Easily share R&D: the technology developed for Government can empower Commercial customers and vice versa.
Providing financial support: while the Government business already has a substantial Contribution Margin, the Commercial side is not financially strong enough to operate as a standalone business yet.
Price: would it be a good moment?
The Commercial business valuation is mainly determined by the cloud sector multiple, which now stands at a multi-year low.
Therefore, if the businesses were separated this would be a good moment to pursue an acquisition of the Commercial side.
On the other hand, splitting the Commercial business as a standalone company would receive a low valuation given the relatively low interest in the sector.
This would damage shareholder value.
Culture: is there a common goal?
In terms of corporate culture we observe:
Palantir Commercial seeks to become the Op. System of the Modern Enterprise.
Palantir Government seeks to become the Op. System of Modern Governments.
Both goals could be achieved by helping clients increase their efficiency with platforms that help them perform data-informed decisions.
Both companies are driven by the purpose of seeking technological superiority to make the world safer and more efficient. Peter Thiel would say they both seek to make their clients go from “Zero to One.”
The culture of Government and Commercial match perfectly and would integrate well under the same hood.
We briefly demonstrated that Government would be better off merging with Commercial: there are substantial synergies to be unlocked and the current market valuations make Commercial an attractive target.
The soundness of this conclusion automatically invalidates the spin-off idea.
While in the short term, there could be some benefits in the stock price from having Palantir as a pure Defence/Government company, that would destroy value for shareholders in the long term as that would break network effects.
“We are going to thrive as this hybrid company that is both bull and baron, comes into full stride in both environments, but in absolutely anomalous stride when times are rough and people are hiding.” - Alex Karp, Palantir CEO, 22Q1 Earnings Call
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View expresses are my own and do not represent Financial Advice in any way.
I own (many) PLTR stocks.