Palm Has a PREcarious Channel Issue

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 (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 (BBY), Radio Shack (RSH), Walmart (WMT), Amazon (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.

Comments

[Yagottabe K...:]

If Palm has quietly changed the used-over-and-over-again definition of "sell-through" to simply mean that someone they sold to has in turn sold then they have materially changed a key number that they discuss in their earnings calls.

Since Day One "sell-through" has ALWAYS meant "sales to a consumer" and has NEVER meant "sales to a retail venue". The difference is SO radical (especially the "hidden inventory" angle) that such a change would require overt mention, IMHO.

In their 10Q Palm does not define sell-through, however they say only that they are relying on their customers to accurately report sell-through numbers. That is a rather wide hole in the reporting of a key statistic.

Sep 30 09:06 AM

[Yagottabe K...:]

According to AllThingsD Palm has finally admlitted that their use of "sell-through" includes sales by those to whom they have sold to other non-end-consumer venues.

>>> UPDATE: This just in from Palm …
“The sell-through data we post reflects carriers’ sales to their customers. For example, Sprint customers include consumers who buy in a Sprint store, and Sprint retail partners such as Best Buy and RadioShack. We rely on our wireless carriers to provide us with sell-through data, and we note this fact in our 10Q.”
<<<

So forget everything you assumed about "sell-through", including its utility as a measure of a particular device's success.

Sep 30 02:08 PM

[Gerard Hall...:]

Most of our competitors and even some of our customers believe that sell through represents end user purchases. However the SEC/PCAOB mandates that companies tell the truth and clarify investor misconceptions.

We give kudos to Palm for its continuing clarity on this issue. Palm's most excellent and responsive IR team, a presentation from March of 2009 on Palm's investor web site, and language in Palms most recent 10K and 10Q explain thoroughly and plainly how the company defers both revenue and cost using the subscription accounting. If you call Palm investor relations, I am highly confident you will be disabused of old notions of sell in and sell through.

When we discussed the matter with Palm, it indicated we were asking about things that no one had yet asked. That may be kind words, but the stock price tells us that many do not believe our estimate that fewer than 375,000 Sprint customers had activated a Pre as of August 28, 2009. .

Because of adverse reaction, we thought it important to step away from our industry research and don a ready CFA suit and clarify the point.

Below is an excerpt for the 9/17 10Q relating to revenue recognition. As you read this bear in mind that Sprint was Palm's largest customer in its August quarter. The two that speak loudest to me are:

We recognize revenues from sales of mobile devices under the terms of the applicable customer agreement upon transfer of title to the customer, provided that the sales price is fixed or determinable, collection is determined to be probable and no significant obligations remain.

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.

Now if you really want to nitpick, Palm's concept of economic life seems flawed especially if the device can sit on a distributors shelf for the first six monhts.

Palm also has the greatest out in the world for all of this, FASB is about to change the rules for PDA and Handset recognition. When they do I believe Palm will make a thorough restatement of these periods and the issue will be buried.

Finally, 500,000 or more activations of a single phone would set a record at Sprint which usually announces such things. Common sense also says the pre is unlikely to represent 25% of postpaid handsets shipped.

The following is taken from Palm's 10Q filed on September 17, 2009 for the period ending August 28, 2009.

"Revenue Recognition

We recognize revenues from the sales of our mobile devices. We may periodically provide services and unspecified software free of charge to customers of Palm webOS products. Therefore, as required by generally accepted accounting principles, we recognize Palm webOS smartphone product revenues on a subscription basis. We recognize revenues and related direct product cost of revenues for our Palm webOS products on a straight-line basis over their currently estimated economic lives of 24 months. If the actual economic lives of our Palm webOS products are different than these estimates, we revise the economic lives we are using to recognize revenues and related direct product cost of revenues, which may result in a lack of comparability between products and/or periods. Certain other related period cost of revenues will be expensed as incurred. If we offer specified upgrade rights to our customers in connection with Palm webOS products for future delivery, we will defer commencement of revenue recognition until the future obligation is fulfilled, the right to the specified upgrade expires or vendor specific objective evidence, or VSOE, is established.

Revenues are recognized when earned in accordance with applicable accounting standards and guidance. We recognize revenues from sales of mobile devices under the terms of the applicable customer agreement upon transfer of title to the customer, provided that the sales price is fixed or determinable, collection is determined to be probable and no significant obligations remain. Sales to our customers are subject to agreements allowing for limited rights of return, price protection and rebates. Accordingly, revenues are reduced for our estimates of liability related to these rights. For Palm webOS products, returns are included in subscription accounting revenue in the period in which the return occurs. For other Palm products, the estimate for returns is recorded at the time the related sale is recognized and is adjusted periodically based on historical rates of returns and other related factors. The reserves for price protection and rebates are recorded at the time these programs are offered . Price protection is estimated based on specific programs, expected usage and historical experience. Rebates are estimated based on specific programs, actual wireless carrier purchase volumes and the expected percentage of customers that will redeem their rebates, which is estimated based on historical experience. Rebate estimates are refined over the program period as actual results are experienced. We have accrued rebate obligations of $51.2 million as of August 31, 2009 which were included in other accrued liabilities. Actual claims for returns, price protection and rebates may vary over time and could differ from our estimates.

Revenues from software arrangements with end users of our devices are recognized upon delivery of the software, provided that collection is determined to be probable and no significant obligations remain. For arrangements with multiple elements, we allocate revenues to each element using the residual method. When all of the undelivered elements are software-related, this allocation is based on VSOE of fair value of the undelivered items. 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. When the undelivered elements include non-software related items, this allocation is based on objective and reliable evidence of fair value. We defer the portion of the sale price equal to the fair value of the undelivered elements until they are delivered."

Sep 30 04:08 PM

[Gerard Hall...:]

There is an error in the above comment. Sprint ships approximately 1.0 million postpaid CDMA phones a month. 500,000 would represent 16.7%, 600,000 would be 20%.

My error and I apologize.

Sep 30 04:10 PM

[Yagottabe K...:]

I'm not sure what your reply is saying vis-a-vis what we NOW know "sell-through" means when Palm says the word, but at least we NOW know "sell-through" does indeed include devices that are NOT in end-consumer hands - exactly as you guys said (and MUCH to the surprise of Palm-observers far and wide!).

That's really all that matters - that little factoid screws up all SORTS of analysis, even off-the-cuff statements like "The X is being well received by the end consumer" for all 'X'.

And when you're discussing "marketshare" WHAT number is being used to represent Palm;s devices in that market? Could it be...gasp!..."sell-thr... as reported by Palm?

Oct 01 09:38 AM

[Turley Muller:]

Sell-in is what is counted as sold and recognized in revenue. Sell-through doesn't have any accounting implications in terms of revenue recognition. Certainly it plays a role in what the next quarter's sales or (sell-in) will be.

The accounting rule you are referring to about the six months doesn't apply to Pre, it's for specified elements not yet delivered, but will in six months and it's value is known. An example would be- buying a computer that includes new OS for free when in comes in two months. If management knows that it will sell it for $50 to others, then the revenue from the computer can be recognized, and just the $50 is deferred until delivered. if VSOE can't be established, all of the revenue has to be deferred.

The Pre accounting is totally different. PALM may time to time provide free software upgrades. They are not specified, so the revenue is amortized on straight-line basis for 24 months.

It doesn't matter how long a phone sits in inventory with respect to it's economic life. The economic life is based on concept of how long the device still retains value before it becomes obsolete. New software upgrades might not be supported for older phones, so the rationale is that after 24 months that the device is introduced, OS upgrades will still likely run on that device, but in 3 years? or longer ? no guarantee. OS upgrades are developed around the most recent devices. Like there are features in iPhone OS 3 that only work on 3Gs and some that won't work on the 2G iPhone (MMS) and it's possible that OS 4 won't run at all on 2G iPhones. as iPhone hardware becomes more advanced resulting in more powerful software not capable of running on old hardware.

Apple does the same thing, when iPhones are sold to carriers or resellers, it's a sale and it starts amortizing the revenue even if it's not sold to an end-user for months. There are probably iPhones in Russian carrier inventory that could be 6-12 months old.

I didn't realize, and I would agree many didn't know that Palm's sell-through included sales to non-carrier resellers. In Apple's case, since they distribute direct to Best Buy and Wal-Mart, as wells as carriers, there isn't a 2nd tier distributor, so Apple's sell-through is units sold + change in channel inventory.

I estimated that activations were 600K-650K, not I see why that's too high., Analysts didn't underestimate sales (in the sense of activations), if they based them on in-store activations at Sprint. I knew end-user demand had to be lower. Great find, thanks for pointing this out, terrific analysis.

Oct 01 10:09 AM

[vanova:]

Wait a minute. It says that the sell-through number is how many Sprint paid for. Whether Sprint is sitting on them, waiting for months, or selling them to Best Buy, Palm itself has booked the sale for whatever the price of a unit is to Sprint.

Which is to say, Palm reports as sell-through when the unit is out of Sprint's inventory. That also implies Palm has no liability with a sell-through if a retailer can't sell the unit, while Sprint does. Not that I have looked, but it is also possible that the Sprint sales of 600K+ activations includes a number of the other handsets and smartphones they support.

Oct 01 12:30 PM