Staying Cool on Palm, For Now

We published our last full update on PALM (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 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 (S) 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 (AAPL) 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 (T), Android (GOOG)-T-Mobile, BlackBerry (RIMM)-Verizon (VZ) 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 longer term 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.

Long term outlook

So enough about the short-term. What about Palm post-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 (MOT)?) 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.

Anything below $3.25 is compelling

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.

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

Comments

[Kris Tuttle:]

Seeking Alpha deleted the link to the full report but you can find it over on our blog at www.research2zero.com/.../ and look at the Palm update there.

Mar 04 02:58 PM