We have been keeping tabs on Galleon’s open market purchases for two quarters, but none of has grabbed our attention like the fund’s recent decision to gobble up shares of Palm (PALM), a global technology leader and manufacturer of PDAs/smartphones. On February 2nd, our AlphaFuel™ screener triggered a curious 13G filing: Galleon Management and various other Galleon funds had acquired 6.345M shares of Palm stock, a 6.2% stake in the firm based on 102M Palm shares outstanding. In this brief report, we look at both the bull and bear case for Palm shares, as well as ponder over why Galleon may be rooting for the underdog, whose shareholders have had little to cheer about lately.
Business Description: Palm Puts Cool Technology in the Palm of Your Hand
Palm (formerly PalmOne) is a leading purveyor of mobile devices. Its Treo product line (92.3M units shipped out in FY06), acquired from Handspring in 2003, has been a massive success and has made the name Palm synonymous with advanced personal communication equipment. Palm targets consumer, business, and professional education and government users worldwide for its smartphones, add-ons, and accessories. Its products are sold primarily through a global network of wireless carriers and retail distributors. Insiders own approximately 15% of the company, which touts a $1.58 market cap and employs over 1,100 people.
Palm Fundamentals Lack Vigor, Visibility
Escalating SG&A, flat EBIT margins, and a negligible cost advantage characterize Palm’s current operating predicament. Cheaper competitive substitutes and aggressive rebating have contributed to a sour reaction from investors, who’ve slowly come to realize that Palm’s small size puts the company, even though it boasts seasoned management, at a large disadvantage to bigger players like Nokia and Sony-Ericsson, both of which have adversely impacted Palm’s profitability. Unless Palm can successfully leverage its Treo line and position its products as dynamic business tools, we expect Palm’s current 40% market share in the handheld device space to contract sharply. In short, the bear case on Palm consists of three factors: little room for multiple expansion, ugly pricing pressure, and disgruntled shareholders.
Two major risks for Palm are a) the degree to which carriers will support its product lines and b) product cannibalization. Patent infringement lawsuits are another recurring theme; in 2006, Palm incurred over $23MM in legal expenses and related settlements at the mercy of Xerox. Palm’s engineering problems still seem to drag the company, as well, another reason a potential alliance with a bigger player could make strategic sense. Most critically, Palm gets a huge proportion of its sales from a small product suite and a few large customers, like Microsoft (MSFT), which accounts for ~50% of sales. It is for this reason that we think 15% of Palm’s float is being sold short, not to mention Palm’s mediocre margin profile. However, as we describe in the next section, a large short interest may actually work in Palm’s favor and have a positive material impact on stock returns over the next 2 quarters.
Valuation: Trading above Fair Value, but Compelling Nevertheless
Palm is sitting on over $500M in cash/short term investments and holds no debt. Based on our proprietary dCore Multiple™ -- which disaggregates, scrutinizes, and blends a firm’s optimal ROE, forward PEG, and CAPM-based required rate of return -- Palm appears fairly priced at $13.66, but we note that our valuation excludes Palm’s brand recognition, talented management roster, and potential synergies coming from a merger, as well as, of course, the potential “surprise” sales emanating from the Treo750 launch, which our retail channel checks confirm consumer electronic stores are briskly preparing for. Because of heightened competition from RIMM (which recently launched the sleek Blackberry Pearl phone) and Motorola, Palm’s R&D efforts mushroomed 51% y/y in FY2006, and the fruits of the company’s engineering endeavors could be much greater (or worse) than what the Street is projecting. At the most conservative level, we believe Palm, currently trading at a 26% discount to its peer group on a price/sales basis, is a $12 to $14 stock.
Possible Markets, Potential Suitors
Galleon may be long Palm because the firm’s managers think Palm is buyout bait. We believe the most likely suitors for Palm include Microsoft, Dell, and Hewlett Packard. We think a Dell-Palm deal would be one way for Michael Dell to announce to the world that it is serious in bringing innovation back to Texas (having recently given the boot to CEO Kevin Rollins) and that it has product expansion on its mind. Coupling the fact that over 130M people use Microsoft Exchange with the fact that Palm controls barely a fraction of this market substantiates the bull case for Palm. We believe Palm will have to team up with one of these larger forces (and leverage its vast sales army) if it aims to penetrate the lucrative enterprise market. An acquirer could offer Palm a better distribution network as well as help reduce Palm’s general/administrative costs. With a communications/consumer electronics giant pushing Palm’s raft, in other words, Palm may have a better chance at offering targeted, bundled solutions to the more profitable business market.
Trading Strategy: Give It a Quarter or Two, Then Kiss It Goodbye
For our less risk-averse subscribers, our AlphaFuel™ optimizer (which simultaneously screens over a thousand option trades, SEC filings, and explosive chart breakouts daily) recommends going long the out-of-the-money Mar $17.50 calls and sitting tight for at least 3 weeks. With a potential short squeeze on the periphery, an upward move in Palm shares could be accelerated. The market has already demonstrated that the $15 price level can be breached and a pop above $16-$17 would register a breakout from a sideways seven month channel glut.
Conclusion: Palm is Far From Being Knocked Out of the Game
Palm has fallen on hard times, but one aggressive NYC hedge fund is showing us with its wallet that it thinks the stock is poised for price recovery, and possibly a buyout. We believe a combination of short covering, acquisition rumor, and renewed product interest (due to the long-awaited Treo750 launch) will send shares of Palm drastically higher over the next quarter. We like the Mar 17.50 calls as a short-term trade on Palm’s comeback and would easily swallow the common on any pullback south of $15.
Disclosure: Author holds a long position in PALM calls.