PALM: Worries become more tangible.

We pub­lished our last full update on PALM on Jan­u­ary 12th and pro­vided in the note a “few rea­sons to stay cool” in terms of buy­ing the stock.   Here is the excerpt from the full note:

1. Pric­ing is yet to be announced. The end-user price is prob­a­bly one of the most crit­i­cal ele­ments to the “take rate” for this phone. The spec­u­la­tion is that it will come in at $199 although Palm man­age­ment has hinted that it could be higher. Our best guess is that in order to be suc­cess­ful they will have to be at the same price as a com­pa­ra­ble iPhone or Black­berry model. Higher price points will cost Palm some crit­i­cal momen­tum. If I were advis­ing the com­pany I’d say to fig­ure out a way with Sprint to get the Pre to $99 or even free with a high-end plan. Palm needs to keep the excite­ment going enough for peo­ple to open their wal­lets. A $249 or higher phone from Sprint isn’t going to get any­one to cross the street.
2. Six months is a long time in the mobile Inter­net device mar­ket. Between now and May we expect more new devices to be announced and pos­si­bly ship­ping. There have been per­sis­tent rumors of Apple prepar­ing low-cost mod­els of the iPhone for intro­duc­tion in 2009. We’d point out that already the 8GB iPhone price is well under $200 in many mar­kets and there are fairly pow­er­ful smart phones that are sub-$100 or even free.
3. You can’t expect the big guys to play nice. Right now every­one seems to have a dance part­ner (Apple-AT&T, Android-T-Mobile, BlackBerry-Verizon and now Palm-Sprint) but as the mar­ket devel­ops ser­vice provider exclu­sives will give way to a more open mar­ket. Larger play­ers are likely to use terms and allo­ca­tions to incent car­ri­ers to limit addi­tional rela­tion­ships wher­ever they can. We all know that it’s not always the best prod­ucts that win out in the face of com­mer­cial realities.
4. We still face a mar­gin mys­tery. Gross mar­gins have been declin­ing sharply and were only 20% last quar­ter. Even though the com­pany has taken actions to lower oper­at­ing expenses the longert­erm run rate for gross and net mar­gins is hard to pin down. Man­age­ment has stated a long-term gross mar­gin goal of 33–36% but it is based on a “great ASP” which is unknown and pos­si­bly not sus­tain­able in the mar­ket. Long-term gross mar­gins are a huge swing fac­tor in terms of equity value. For exam­ple if we use 2013 rev­enues of $2.2B and oper­at­ing expenses of $600M and use a gross mar­gin of 36% we get to an intrin­sic value of $16; if we use 30% we get to $5.

The other obvi­ous rea­son to be care­ful with the stock was the fact that the com­pany was already suf­fer­ing from weak fun­da­men­tals in the busi­ness and the poten­tial to be “saved” by the Pre would require two more quar­ters of acute weak­ness before investors could start to see a return of pos­i­tive momentum.

Esti­mates for the Feb­ru­ary quar­ter set­tled into the $150M range and with a slightly bet­ter expec­ta­tion for the May quar­ter of $160M or so the num­ber for the year came in at $880M or so.  With the recent pre-announced result of $80-85M for Feb­ru­ary we can expect ana­lysts to quickly reset fig­ures.  Rev­enues for the cur­rent year should set­tle into the $700-750M range. Clearly the loss will widen and may again raise con­cerns of via­bil­ity or at least clue investors in to the dilu­tion they suf­fer from the recent Ele­va­tion Part­ners investment.

So enough about the short-term.  What about Palm post the Pre launch?  Unfor­tu­nately most of the unknowns above are still unknown. And since then the eco­nomic sit­u­a­tion hasn’t bright­ened.  Look­ing at cur­rent esti­mates we can expect ana­lysts will lower the bar again for the year end­ing May of 2010.  Right now esti­mates call for $1.28B in rev­enue.  At this point it prob­a­bly makes sense to start to look at the busi­ness with­out any legacy prod­ucts or rev­enues given their rate of decline.  Hence top-line fig­ures come down to mostly a guess­ing game of how many units can they ship, at what price, at what gross mar­gin and so on.

The major wild­card is whether Palm might be able to license the WebOS to any­one who thinks it can give Android or the iPhone a run.  We think any inter­ested par­ties (Motorola?) are prob­a­bly going to wait and see how well it does in the mar­ket­place before mak­ing any deci­sions.  That puts the mat­ter into Q3 or Q4 of this year as a guess.

So what to do with the stock?  PALM still has a siz­able short posi­tion which helps limit down­side unless the worst case sce­nario mate­ri­al­izes.  We will rerun our intrin­sic value model later this month but in the mean­time expect the fig­ures of $11–12 on a suc­cess­ful path are cor­rect.  How­ever given the unknowns we wouldn’t be aggres­sive unless share prices reflect real con­cern that Palm “won’t make it.“  Last time that trans­lated to $1.20 a share.  We may not see that again but sub-$5 the risk/reward looks rea­son­able.  Any price below the last round of $3.25 is compelling.

Some details of the Palm WebOS are emerg­ing and the first book is out there already.  We have to do our own home­work on the devel­op­ment model to ren­der an opin­ion on it ver­sus com­pe­ti­tion but would encour­age any inter­ested investor to do their own work on that too.  Unless an ecosys­tem forms around WebOS, the value will be limited.

Here is a link to the short report we pub­lished in Jan­u­ary for those want­ing to spend a few dol­lars to read it.

[UPDATE: S&P cuts Palm debt rat­ings to CCC from CCC+.  Still on neg­a­tive watch. — March 5, 2009]

[Dis­clo­sure: At this time Research 2.0 has no posi­tion in PALM shares.]

Tagged as: Companies, Mobile, Palm