Palm slapped for its grand ambitions

Poor timing for new Palm products Alex Slawsby, handheld devices analyst, IDC

Palm shares plunged nearly 50 percent Wednesday when investors realized the handheld giant vastly overestimated demand amid a weak economy and let inventory build up.

"The revolution is not over, but it has been put on hold," C.E. Unterberg Towbin analyst Scott Miller said.

Palm has become a victim of its own optimism. Buoyed by strong consumer demand for its products and double and triple growth in shipments at times, the company expected to ride out the U.S. economic downturn in style. Palm must now deal with a bloat of excess inventory, cost-cutting measures, and layoffs.

The company is experiencing the downside of being the market leader, as nearly every other competitor is trying--often successfully--to take market share away from Palm.

Several financial analysts said the No. 1 handheld maker will need to shift quickly to adjust to a market in which sales are falling to levels seen a year ago. Price cuts and lower profit margins could materialize.

A number of financial institutions reduced their expectations Wednesday based on the company's outlook, though some analysts urged investors to stick it out, saying that the handheld market is not fading away and that Palm's market-leading position should help the company recover.

On Tuesday, Palm beat analyst estimates for its third quarter by a penny. At the same time, it reduced revenue expectations for the current quarter to between $300 million and $315 million--far below the $573 million previously predicted by Wall Street.

The company now expects to lose 8 cents per share for the quarter, despite measures to trim 10 percent to 15 percent of operating costs. Cost-cutting measures include reducing its work force by 10 percent to 15 percent, or 250 employees and contract workers. In addition, it will postpone construction of its new corporate headquarters.

Palm may be forced to take more cost-cutting measures, Miller said. "I think you should read it as a developing story," he said. "It is not clear how long the downturn will last, and it is not clear how deep the cuts will need to be."

Channel stuffing
Several analysts are expressing concerns about "channel stuffing," saying that there is far too much inventory sitting on the shelves of retailers and distributors at a time when consumer spending is decreasing. Channel stuffing refers to when companies continue to ship their products to distributors and retailers, despite a slowdown in demand.

"Clearly, the impact to Palm will be in the next quarter where Palm will have to work off channel inventory by slashing production, reducing sales into the channel, and providing incentives to stimulate sales out" of the channel, UBS Warburg analyst Don Young wrote in a research note.

Young cut his price target on the stock from $14 to $10.50 and dropped earnings estimates for 2002 from 26 cents per share to 12 cents.

Gartner analyst Abha Garg says Palm will have to continue to build revenue in Palm operating system licenses and other segments to guard against pressure on its hardware revenue. see commentary

Even analysts who were upbeat about the stock noted that the company will have a tough time resolving its inventory issue as it launches new products.

Palm saw its cash levels drop from $743 million in its second quarter to $596 million during its third quarter. Meanwhile, inventory increased from $34 million to $102 million in its third quarter, according to Bear Stearns analyst Andrew Neff.

While a decline in consumer spending is hurting Palm's core market, the company is also being squeezed by cuts in corporate budgets.

"The assumption was that businesses would buy into these devices, but their recent cutbacks in spending could really hurt Palm and other PDA manufacturers," IDC analyst Kevin Burden said.

One reason that many companies started buying handhelds for their workers was to aid recruitment and retention. Now that the job market has eased, Miller said, companies may be putting such buying on hold.

At the same time, Palm and Microsoft's handheld partners are squaring off for a fight over the corporate market. And if the handheld market follows the usual pattern, this will mean lower margins and price cuts for both. Revenues from wireless subscriptions and licensing are also on the horizon, but these businesses will take time.

Counterattack
Palm also faces increased competition from Handspring, which said Wednesday that it is confident about estimates for its fiscal year that ends in June. Handspring's handhelds use Palm's operating system.

"Palm was pressured into announcing its m500/5 product line before it was ready to ship because of Handspring's launch of the Visor Edge, a product aimed squarely at the Vx, Palm's best-selling product," Vik Mehta, an analyst at Goldman Sachs, wrote in a research note.

"Palm counterattacked by announcing the m500/5 and lowering the price point of the Vx to make way for the m500/5, even though the m500/5 will not be available until the end of the quarter. Had Handspring not launched the Visor Edge, it is possible that Palm may have maintained the Vx price and pushed back the m500/5 announcement until it was ready to ship," he said.

Mehta lowered his rating on Palm to "market outperformer."

Others expect that Palm's struggles could benefit its upstart competitor.

Specifically, Handspring "has rising weighted (average selling prices), a lower revenue base, significant new channels being introduced in the quarter, stronger sell-through, market share in-roads with new products, and a more linear revenue stream," CS First Boston analyst Marc Cabi wrote in a research note.

Cabi did lower estimates for Handspring based on Palm's report, dropping revenue for 2001 from $575 million to $540 million, and earnings per share for 2001 from a 14 cent loss to a 25 cent loss. But he maintained a "buy" rating on Handspring.

CIBC Oppenheimer analyst Thomas Sepenzis lowered his target price on Handspring to $25. "We feel it prudent--although we have seen no evidence of slowing growth at Handspring--to take numbers down a bit to reflect the current economic environment," he wrote in a research note.

His colleague at CIBC, Barry Richards, dropped his target price Research In Motion from $115 to $50, citing similar concerns. RIM makes the popular BlackBerry two-way e-mail pager.

On Wednesday, Palm's stock closed down $7.44, or 48 percent, at $8.06 on a volume of 134 million shares--12 times its average daily volume.

Its rivals also fell. Shares of Handspring closed down $5.31, or 33 percent, at $10.88. RIM slumped $4.43, or 18 percent, to $20.25.

News.com's Ian Fried and staff writer Richard Shim contributed to this report.