Prediction: Palantir Technologies Won't Live Up to the Hype on May 5

Although tariffs have been the talk of Wall Street in recent weeks, the trend that's been captivating the attention of investors for more than two years is the evolution of artificial intelligence (AI).

With AI, software and systems have the capacity to reason and act without the assistance of humans. Additionally, these systems can evolve over time to learn new jobs and skillsets, which further expands the addressable market for this technology. Based on a prognostication from the analysts at PwC in Sizing the Prize, AI can add north of $15 trillion to the global economy by the turn of the decade.

Investors don't have to dig too deeply to find that stocks that have enjoyed outsized benefits from the rise of AI. For instance, graphics processing unit (GPU) giant Nvidia (NASDAQ: NVDA) surged from a $360 billion market cap at the end of 2022 to well north of a $3 trillion valuation in around two years. Nvidia's GPUs are effectively the brains that make AI-accelerated data centers tick.

Image source: Getty Images.

But a strong argument can be made that Nvidia's spot atop the pedestal has been usurped by another high-flying AI stock. I'm talking about data-mining specialist Palantir Technologies (NASDAQ: PLTR). Shares of Palantir have skyrocketed by 1,660%, as of the closing bell on April 25, since the end of 2022. It's also become the ninth most-valuable publicly traded company in the tech sector.

In less than a week, following the closing bell on May 5, Palantir will be lifting the hood on its first-quarter operating results -- and you best believe professional and everyday investors will be paying close attention.

While Palantir's run-up has been nothing short of phenomenal, there are tangible reasons to believe this AI colossus won't live up to the hype on May 5.

Palantir's parabolic ascent wasn't accidental

Before diving into the various reasons Palantir may be primed to disappoint next week, let's offer some background on how it became one of Wall Street's most-influential tech and AI-driven companies.

One of the prime catalysts for Palantir is its moat. This is a company with two core operating segments: Gotham and Foundry. The former is an AI-driven software-as-a-service (SaaS) solution that assists federal governments with data collection/analysis, as well as military mission planning and execution. Meanwhile, the latter enables businesses to streamline their operations by better understanding their data.

While there may be SaaS solutions that compete with select aspects of Palantir's operations, no other business comes remotely close to matching the services it provides at scale. What this means is Palantir's operating cash flow tends to be highly predictable and transparent.

To build on this point, the bulk of Palantir's growth has originated from its Gotham platform. When Palantir locks in contracts with the U.S. government and its allies, it's typically securing four- or five-year deals. Multiyear contracts further ensure that Palantir's sales and cash flow are predictable.

Something else investors get with Palantir, aside from sustained double-digit sales growth, is recurring profitability. Palantir turned the corner to generally accepted accounting principles (GAAP) profits well ahead of Wall Street's consensus expectations. This validated the company's core operating model (Gotham), and offers plenty of hope that Foundry will be a profit driver in the latter-half of the decade.

Speaking of Foundry, it closed out 2024 having added nearly 200 commercial customers -- up 52% to 571. This is still a relatively new segment that should have no trouble sustaining a rapid growth rate and landing larger clients.

To round things out, Palantir Technologies is sitting on an enviable treasure chest totaling $5.23 billion in cash, cash equivalents, and marketable securities, to go along with no debt. This cash affords management the ability to aggressively invest in its platform, as well as reward shareholders via stock buybacks.

Image source: Getty Images.

Prediction: Disappointment awaits Palantir after May 5

To give credit where credit is due, Palantir absolutely deserves a valuation premium for its sustainable moat, push to profitability, and healthy cash position. But with a market cap of nearly $265 billion, as of the closing bell on April 25, Palantir is highly unlikely to live up to the hype.

One of the bigger concerns is what the company's outlook for Gotham might entail. While its multiyear government contracts and subscription-based Foundry platform offer some level of cash flow transparency, it's no secret that the Trump administration is looking for ways to reduce government spending.

Though Republicans have, traditionally, supported robust defense spending, this administration's messaging has wavered on a number of issues. In February, the Pentagon proposed cutting its budget by 8% in each of the next five years. This lack of clarity on defense spending isn't good news for Palantir's outlook.

Wall Street's AI darling is also butting heads with history. Despite artificial intelligence being the hottest thing since sliced bread, no next-big-thing trend in more than 30 years has avoided an early stage bubble-bursting event. This is to say that investors have consistently overestimated how quickly a new technology would gain widespread adoption and/or utility. With most businesses nowhere close to optimizing their AI solutions, or even generating a positive return on their AI investments, it would appear artificial intelligence is following the same trajectory as prior next-big-thing bubbles.

The aforementioned silver lining for Palantir is that its multiyear contracts via Gotham and subscription revenue from Foundry should insulate its sales from any near-term drop-off. However, companies on the leading edge of next-big-thing technologies are often dragged down by weaker investor sentiment when bubbles burst. Nvidia's declining gross margin is an indication that we may already be on the downswing of the AI bubble.

PLTR PS Ratio data by YCharts. PS Ratio= price-to-sales ratio.

But Palantir's most prominent issue just might be its valuation.

Prior to the dot-com bubble bursting in the early 2000s, leading internet and infrastructure companies at the time peaked at price-to-sales (P/S) ratios ranging from 30 to 43. Similarly, Nvidia topped out at a P/S ratio of roughly 42 last summer. As of the closing bell on April 25, Palantir stock was commanding a P/S ratio of (drum roll) 96!

Companies on the leading edge of a next-big-thing trend have commonly seen their valuations crater following P/S ratios north of 30. Palantir Technologies is currently three times above this level. There isn't an industry-leading public company that's been able to maintain a premium anywhere close to where Palantir stock is trading at.

Regardless of what Palantir reports on May 5, it's unlikely to justify a P/S ratio of 96, or even half of this level.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia and Palantir Technologies. The Motley Fool has a disclosure policy.