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Yesterday morning, our teammate and partner, David Eller downgraded Palm (PALM) stock to Unfavorable from Neutral. Simultaneously, I published a report examining how this problem will likely disappear inside of Sprint (NYSE:S). We maintain our favorable opinion on Sprint.

PALM Pre: more than a handful in the channel

Since Palm reported its August quarter losses, we have been perplexed by a disconnect between PALM’s device units sold and our estimates of store level sell through. According to PALM’s reported sell through, inventory increased by 13k units and since the “vast majority” of both the device units shipped and the device units sold were units of the Pre, there couldn't be an inventory problem. The gap between the two is only 13k. However, since the company recognizes revenue on sell in to the channel and the company defines device units sold as units that have been shipped from Sprint (their primary customer) to either customers or second tier distributors, PALM could offer investors a high number of units shipped but still have a glut of inventory in the channel. We believe that channel inventory is currently about 11 weeks, which we believe will pressure reorder rates and make it more difficult to sell high ASP products going forward.

Sprint’s acts as PALM’s sole distributor in the United States accounting for 85% of revenue. Each of the second tier distributors such as Best Buy or Amazon.com buys inventory from Sprint rather than from PALM. PALM is accounting for this as devices sold. This does not appear to be understood by investors. We polled several of the investors who attended the Boston road show lunch and each was under the impression that sell through translated into customer activations. How can this be? Its documented on page 41 of Palm’s 10-k which states, “VSOE is based on the price determined by management having the relevant authority when the element is not yet sold separately, but is expected to be sold in the marketplace within six months of the initial determination of the price by management.” Of course this brings up two side issues -- how does a phone sitting on a distributor's shelf have an economic life, and -- FASB is likely to change subscription accounting rules for Smartphones and PDAs so that Palm will be able to bury this problem with new policies and in restatements.

We believe this means to PALM is that there is a glut of inventory in the channel that will prevent reorders from existing customers in the United States, reduced expectations for future carrier partnerships and if there is price protection or the ability for customers to return merchandise, potentially a large write off coming. At the very least, we believe that break even in 2H10 is in jeopardy.

The profitability turn hinges on PALM’s ability to build relationships with additional carriers. We highlighted the need for the company to raise capital after the 4Q earnings call in order to get more units in the hands of consumers before companies like Acer and Huawei gain a presence in the smartphone market. Companies like Verizon are trying to diversify away from their reliance on RIMM devices (which currently account for 85% of VZ’s smartphone sales) and PALM will be a beneficiary, but the level of carrier support is now in question. Despite the rumors to the contrary, Verizon will sell the Pre in January but the handset price subsidy and the marketing spend provided by the carrier are both up for debate. Verizon could offer to launch the phone at a price point of $129 with a $150 subsidy making the platform unprofitable for PALM.

It is minor for Sprint

Our best information says Sprint activated a little less than 375,000 Palm Pres as of the end of August. This left about 275,000 or 11 weeks of Palm Pres in “Sprint channels” at the end of August. This is not to say Sprint is carrying 100% of the cost of these phones. Best Buy (NYSE:BBY), Radio Shack (NYSE:RSH), Walmart (NYSE:WMT), Amazon (NASDAQ:AMZN) and Letstalk.com are all likely carrying some of this inventory cost. How much we do not know. What these dealers' return rights, price protection, rebates or other incentives are we also do not know. These dealer terms and conditions vary greatly with the phones. However, the core economics around the Palm Pre's market are slipping.

Sprint reduced the price by 25% to $149 only 93 days after first shipping the Pre. Amazon is selling it for $99. Walmart and Letstalk.com are both offered "specials" on the Pre for is $79. While undoubtedly some expect lower prices will improve demand, we believe the lower prices are more likely to blunt some competitive impact. There are more smartphone competitors today than at time of announcement. HTC’s Hero, Touch Pro2, and Snap, a reworked Blackberry Tour, and Palm’s Pixi are all recent entries to Sprint’s smartphone line up. Moreover, we do not believe Sprint has announced all of its new smartphones for the Christmas season.

We estimate Sprint on average, is paying Palm about $450 per unit during its September quarter. If Sprint has 100,000 too many units, the cost to it and its channel is about 45 million dollars. While this may be enough to limit Sprint’s short term financial flexibility and restructuring we must view it in the context of a company with more than $1.0B of quarterly operating cash flow.

Disclosure: Gerard is long Sprint bonds.

Source: Palm Has a PREcarious Channel Issue