Palm hands Wall Street an unusual deal

With more traditional buyout deals, shareholders get cash, typically at a slight premium over where the stock is trading, with all future risks and rewards going to the private equity firm. Deals of that ilk have been announced in recent weeks for cellular carrier Alltel, telecommunications equipment maker Avaya and reseller CDW. On occasion, private firms buy just a stake in a company, adding cash to the firm's coffers.

Under the Palm deal, announced Monday, Elevation is buying 25 percent of the company. However, while billed as a recapitalization, Palm will actually end up with less capital than it had before the investment as the company returns $940 million in cash to shareholders.

Palm and Elevation are quick to tout the benefits of their approach: Shareholders get $9 a share in cash--more than half of Palm's current share price, while at the same time retaining a 75 percent interest in the company.

To make that happen, Palm is handing over not just the $325 million that Elevation is investing, but also the proceeds of a $400 million debt offering as well as some of its own cash.

Wall Street has generally reacted favorably--Palm shares have risen more than 9 percent since the deal was announced. However, the move to add debt to the balance sheet has raised some eyebrows.

Palm is already a small firm competing against larger device makers, such as Motorola and Nokia. And, though Palm's business is not typically capital intensive, the company does have to manage inventory, particularly as it launches new products.

Longtime Palm watchers recall problems the company encountered back in 2001 that led to a glut of inventory, causing Palm to burn through a substantial amount of its cash reserves.

Financial analyst Charlie Wolf said he was surprised Palm chose to return so much cash to shareholders, wondering why the company didn't choose a lower amount, say $7 or $8 per share.

"Nine dollars a share seemed pretty outrageous to me," said Wolf, a longtime Needham & Co. analyst who is now president of his own company, Wolf Insights.

That said, Wolf noted that Palm has plenty of cash on hand as well as tax benefits that mean that, provided its business remains on track, its cash flow should be more than ample to pay off the interest on its new debt.

Attempting to assuage any concerns about having to borrow cash to complete the deal, Palm Chief Financial Officer Andy Brown noted that the company's ratio of net debt to its earnings remains quite low.

"We feel very comfortable that this is the right capital structure and leaves us with a strong balance sheet," he said on a conference call with investors on Monday.

Once the transaction is completed, the company will have $300 million in cash and around $400 million in debt, Palm has said.

"Sure it's debt, but we think it's an extremely reasonable amount of debt to put on the company that leverages it a little bit," said Bret Pearlman, an Elevation partner and one of the deal's architects. "It's well within the means of the company."

In coming up with the deal, the companies "started with a white sheet of paper," Pearlman said.

"We showed up with a very open mind," Pearlman said. "We didn't start with a term sheet or another transaction that we marked up."

Folks at Palm also point out that it is a good time to be borrowing, with favorable rates and terms being offered. It also should help the company with criticisms that it was carrying too much cash on its books for a company of its size.

In a research note Wednesday, ThinkEquity Partners said the deal offers the potential for better returns on equity for investors and said that the borrowing is not a concern.

"It is our opinion that the proposed debt issuance poses little financial risk," the firm said in the report. ThinkEquity maintained its $20 price target and buy rating on Palm's shares.

For Elevation, which also counts U2 frontman and international activist Bono among its founding partners, it is the firm's biggest deal, with the company investing $325 million in Palm, out of the firm's total $1.9 billion in committed capital.

"Our fund is only of a certain size and we are investing a lot of it--17 percent," Pearlman said. By returning so much cash to shareholders, Elevation was able to get a 25 percent stake in the company for its investment.

It's not the first time Elevation has poured money into a publicly held company. In November 2005, the firm invested $100 million in Move, then known as Homestore.

Beyond the financials though, Palm is also getting an infusion of new leadership, with former Apple hardware executive Jon Rubinstein joining Palm as executive chairman and leading its product development efforts. Two partners at Elevation, Roger McNamee and former Apple CFO Fred Anderson, are also joining Palm's board.

And, more than anything else, that may be the most important element of the deal. Ultimately, for Palm shareholders or Elevation to succeed, the company must deliver in the marketplace.

In his research note, Bear Stearns analyst Andy Neff praised the deal and upped his rating on the stock, but noted that the company still must tackle the same issues it was facing it before.

"Fundamentally, Palm faces numerous challenges with intense competition in its phone business, a decline in its old handheld business and the lackluster response to the new product (demonstrated) last week."

In an interview Wednesday, Anderson said Elevation was attracted to the cell phone market, which is just at the beginning of moving from telephony to more capable devices.

"You've got over a billion cell phones being shipped this year," Anderson said. "Less than 10 percent of them are smart phones, which is where this mobile computing opportunity is centered."

While there is competition, Anderson said Palm's biggest competitors are really Research In Motion and Apple. "The major cell phone makers don't have the software skills."

That's not to say that Anderson is betting against his former employer by investing in Palm.

"Clearly, (Apple) will be a competitor and our assumption going in is that the iPhone will be successful," Anderson said. "We think there is plenty of room in this huge market for more than one leader."