Description

Recommendation: Short

Current Price: $9.57

Price Target: $6.00, 37% profit potential

Investment Thesis

• Palm is making a late push into the overcrowded and highly competitive smartphone market on a struggling carrier in one of the most challenging consumer spending environments in decades
• Continued deterioration of financial position and cash burn
• Lack of economies of scale on the manufacturing side
• Historical execution issues and delays in product releases
• Reliance on the release of the Pre - Palm's new smartphone - to keep Company afloat
• The Pre is impressive but not a game-changer like the iPhone was when released 2 years ago
• New mobile operating system will likely have initial bugs that need fixed, causing slow adoption
• Software development kit not released to broad developer base far enough in advance of product release will lead to lack of applications available at launch
• Launch timeframe coincides with expected new iPhone product and other smartphone releases
• Large margin of safety given extremely lofty valuation even in FY 2010 best-case scenario

Key Risks

• High short interest (40%) may make borrowing the shares difficult and cause upward volatility
• Continued hype by management and Elevation could drive the stock up in the short term
• Announcement of partnership with carriers besides Sprint in US and internationally
• A price point below the iPhone could drive volumes, although unlikely
• Licensing agreements for mobile software with other handset manufacturers
• Potential to be acquired by a cash-rich, large tech company

Valuation & Price Target

• Using best-case assumptions for a FYE May 2010 P&L, Palm is currently trading at 15.5x EBITDA and 27.6x Adj. EPS
• $6 price target triangulating between comp multiples, Apple's higher multiples and a DCF analysis using best-case projections

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Investment Summary: Short Recommendation

Palm Inc. is a provider of mobile phone handsets and accessories, primarily to consumers. A lot of hype has surrounded the company in recent months since the announcement of its new smartphone - the Pre - which is being launched on Palm's new operating system, webOS. The company's financial position has been deteriorating rapidly and the release of the Pre is Palm's last breath. In the most recent quarter, revenue dropped 71% Y-o-Y and the company burned $100m of cash. When the Pre is released there is no doubt that existing revenues from legacy products will be cannibalized. S&P downgraded the Company's corporate credit rating to CCC from CCC+ on March 4^th.

Palm is making a late push back into the crowded and extremely competitive smartphone market on Sprint, a struggling carrier. Competition will only increase as Nokia pushes aggressively back into the US market, more phones are released on the Google Android platform (10-12 expected in 2009) and Apple continues to improve its iPhone product and software. Palm lacks the economies of scale that Apple, RIMM, Nokia and HTC have on the manufacturing side and does not nearly have the developer/application base that Apple has. The webOS software development kit has not been broadly released yet and the phone is supposed to be released within 3 months - this is not enough time to get significant applications ready for the phone by launch date. The company has had execution issues in the past and from talking to industry analysts it sounds as if the Pre release may well be delayed. It doesn't help that we're also in one of the toughest consumer spending environments in decades either.

Using what I believe are best-case assumptions for a FYE May 2010 P&L, Palm is currently trading at 15.5x EBITDA and 27.6x Adj. EPS. I arrive at my $6 price target triangulating between comp EV/EBITDA and P/E multiples, Apple's higher multiples and a DCF analysis based upon a best-case 2010 operating case. $6 is 37% below Palm's current price of $9.57. I believe shorting Palm has a considerable margin of safety due to the probability of certain events that would drive the price below my price target including 1) delayed Pre launch, 2) price point with a 2-year contract anywhere higher than $200 (current iPhone price point), 3) continued deterioration of the company's financial condition and cash burn, 4) any litigation between Apple and Palm and 5) underperformance to best-case scenario outlined below.

Key risks include 1) high short interest that could lead to upward volatility on the share price, 2) increased carrier adoption in the US after Sprint exclusivity runs out, 3) international carrier adoption, 4) unanticipated revenues from licensing webOS software to other handset manufacturers and 5) a takeout by a large tech company looking to enter the smartphone market (i.e. Dell, Cisco).

Business Overview

Palm is a provider of mobile phone handsets and accessories, primarily to consumers. Products include the Treo and Centro smartphones, handheld computers and related accessories. Currently Palm's devices use the Palm OS and Windows Mobile operating systems. In January 2009 Palm unveiled its new operating system, webOS and the accompanying smartphone, the Pre. WebOS is owned by Palm whereas Palm OS and Windows Mobile are licensed through third parties.

Palm was incorporated in 1992 as Palm Computing and in 1995 was acquired by U.S. Robotics Corporation. In 1996 the company sold its first handheld computer. In 1997 3Com acquired U.S. Robotics and in 2000 3Com spun out the company, renamed Palm Inc. as an independent, publicly traded company. At the IPO on March 10, 2000 Palm shares sold for $472.50! Palm formed a stand-alone sub for its operating system in December 2001 called PalmSource and subsequently spun it out to existing stockholders in October 2003. Also in October 2003, Palm acquired Handspring.

Elevation Partners' Investments and the Apple Connections

In October 2007, as part of a recapitalization, the private equity firm Elevation Partners purchased $325m of Series B preferred stock convertible into common stock at a price of $8.50 per share. Along side the preferred offering, Palm also raised $400m of Term Loans. The proceeds from the preferred, term loans and some existing cash was used to pay existing common shareholders a one-time $9 dividend. In connection with Elevation's investment, Jon Rubinstein joined Palm as executive chairman and Fred Anderson and Roger McNamee, managing directors and co-founders of Elevation, became directors on the board.

Here's where it gets interesting - Jon Rubenstein will be leading Palm's product development efforts. He was previously head of Apple's hardware division and is known as "The Podfather" because he was a driving force in creating the iPod when he was at Apple. Fred Anderson was the CFO of Apple from 1996 through 2004 and served on Apple's board from 2004 to 2006. I think the key takeaway here is that behind Elevation's investment thesis is the thought that Palm could be revitalized by a breakthrough device that will be the "iPhone killer". One other key executive has an Apple connection, Mike Bell - SVP of product development, who spent 16 years at Apple, primarily as VP of Computer Software. Apple recognizes that ex-employees are now in the driver's seat at Palm and on a conference call explicitly said "We are ready to suit up and go against anyone. However, we will not stand for having our [intellectual property] ripped off and will use whatever weapons we have at our disposal." Who knows if anything will materialize between Palm and Apple on the litigation front, but if anything happens this could put a drain on Palm's limited cash. Apple, on the other hand, has $25.6bn of cash on its balance sheet.

In December 2008, after six quarters of losses, employee layoffs, restructuring and the shares were trading 83% off their 2008 peak of $8.50, Elevation Partners invested another $100m in Palm in the form of Series C preferred stock that is convertible into common stock at $3.25 per share. Elevation also received warrants to acquire 7m shares of Palm common stock at the same price of $3.25 per share. This offering had an interesting catch: Palm could re-market 49% of the shares underlying Elevation's preferred and warrants and receive the net proceeds between the re-marketed price and $3.25. Palm exercised this "option" on March 10^th and remarketed the shares at $6 each as well as sold ~8m additional shares. Palm received $104m of cash from this event, increasing their current cash balance to ~$323m.

On March 5^th, Roger McNamee - MD at Elevation and board member of Palm - went on a rant on Bloomberg TV about the upcoming Pre and how it was going to be an "iPhone killer". A few notable quotes taken from McNamee are as follows:

• "[Palm Pre is] going to be a million times - well, not a million times - several times faster [than iPhone products and is] going to run rings around them on the web"
• "You know the beautiful thing: June 29, 2009, is the two- year anniversary of the first shipment of the iPhone. Not one of those people will still be using an iPhone a month later."
• "The underlying technology of RIMM's BlackBerry is about 13 years old, while the technology behind the iPhone goes back almost nine years"

Subsequent to this event, Palm filed a Free Writing Prospectus with the SEC withdrawing or clarifying the statements above and 8 others. You can view the SEC filing, which includes the Bloomberg interview, at http://investor.palm.com/secfiling.cfm?filingID=1193125-09-48035. In my view the statements by McNamee are out of desperation and given that Elevation's investment in Palm represents 22% of their $1.9bn fund, if the investment goes bad it will have a sizeable effect on fund returns. The fund has had one successful exit, selling VG Holding Corp (video game developer and distributor) to Electronic Arts in 2007 for a rich multiple, but only after an ex-Elevation founder left and became CEO of EA. This makes me question McNamee's ethics and motives even more.

Recent Operating Performance

As seen in Table 1 below, Palm's revenue has seen a steep decline in the most recent two quarters. Units declined 60% y-o-y in Q309 reduced demand for maturing legacy smartphone products and a challenging economic environment. The average ASP has been declining steadily and dropped significantly in Q309 due to pricing actions to drive volumes of legacy products and a reduction in volume of Treo smartphones. Handheld revenue (PDAs) continues to decline significantly due to the phase-out of these products as a result of demand shifting to voice/data converged products. Total revenue for Q309 came in at about 50% of analyst estimates due to "reduced demand for Palm's maturing legacy smartphone products, the challenging economic environment and later-than-expected shipments of the Treo Pro in the US". Management has put significant focus on the launch of the new Palm Pre and stated that legacy products will suffer further declines in the fourth fiscal quarter. One has to question why any consumer would purchase the new Treo Pro at $199 when the Pre is supposed to come out on Sprint sometime in the first half of this year.

Table 1: Historical Quarterly Revenue

As seen in Table 2 below, Gross margin has continuously been pressured, mainly due to the shift in sales to a majority of low margin Centro handsets. In Q309 Gross Margin fell to 5% due to the significant drop in average selling price, costs for purchase commitments from third party manufacturers, increases in manufacturing overhead and the delay in the shipment of the Treo Pro.

Table 2: Historical Quarterly Gross Profit & Margin

Palm has been going through cost savings initiatives and has taken actions to contain costs and manage cash burn "while carefully ensuring that they are adequately funding next-gen product development". Cost savings cited in the Q209 conference call transcript include reducing US and international workforces, consolidating European operations and shifting Asia-Pacific sales, marketing and admin support to US offices. On the Q209 earnings call, Palm noted that by Q409 the restructuring initiatives listed above and others will allow the company to drive opex to $90-95m and maintain that level on a quarterly basis. As you can see, the company managed to meet this goal in Q3, with total opex coming in below $95. However, I believe that cost containment in tandem with the launch of the Pre will be a difficult task. In order to market the device successfully and get the consumer excited about the launch, Palm will have to spend more marketing dollars than historically. As webOS is developed further, unexpected bugs will need to be fixed and developer support will be demanded. I would expect R&D expenses to be hard to contain as well. Historical opex and operating income are outlined in Table 3 below.

Table 3: Historical Operating Expenses and Operating Income

The Palm Pre

Palm's new device, The Pre, was showcased at this year's CES in January and impressed the audience. The device itself looks fantastic and the OS seems to be powerful with unique functions such as multi-tasking and pulling contact information from various sources (Facebook, Outlook, Gmail, etc.) into one view. The stock rose over 2x around this timeframe. However Palm is late to the game, entering a crowded market owned by powerhouses such as Apple, RIMM and Nokia and is going exclusive in the US with Sprint, whose subscriber base is declining. Not to mention they are launching the product in one of the most challenging consumer spending environments in decades. Palm has had execution issues and launch delays in the past. Most recently, in the preliminary FYQ3 press release, Palm cited that shipments of its new Treo Pro phone were delayed! By the time the Pre is launched 2009, the iPhone will have been out for nearly two years and a new iPhone is expected to be released around the same time. On March 17^th, Apple hosted an event showcasing their new iPhone 3.0 software which will be available mid-year. The software looks impressive and counters many of the functions that the Pre touts as its differentiation. Among the improvements in Apple's new software are a cut and paste application, better gaming, enhanced search, improved navigation and connectivity and in-app purchasing capabilities (which is very attractive to developers). Apple's new software will not have multi-tasking capabilities, which the Pre does offer, however it will include "push notifications" which can alert users by sound or pop-up if a there is a change or message through an application. Apple's reasoning for push vs. multitasking is that it is more battery-efficient.

Increasingly, handset differentiation is moving away from the actual hardware and more towards the applications, experience and "ecosystem" surrounding the device. Palm has been quite secretive about the WebOS software and has yet to do a full release of the software development kit, only a few limited private releases. Because of this, I believe the Pre will not have significant applications available to users at launch compared to the massive amount already available on the iPhone (over 10,000). The Google Android SDK was released a year before any phones with the Android OS on them were released! I believe this lack of apps at launch will cause delayed consumer purchases.

Projected FYE May 2010 P&L

Note: The P&L below would be non-GAAP for Palm. The Company announced that it would be providing new software features to customers of webOS products, including the Pre, and that in accordance with GAAP subscription accounting will recognize revenue and COGS with these products on a straight-line basis over the products estimated economic life. This accounting change has no effect on cash flow.

Table 4 below outlines what I believe a best-case P&L would look like for the first year after the Pre's launch - let's assume that the Pre launches on schedule and it is the LTM period ended 5/31/2010. Assumptions are outlined below the table.

Table 4: Projected P&L

(1) Legacy Treo & Centro Revenue = 1.3m units @ $300 each = $396m. This is units in the most recent quarter annualized times an ASP of $300 (up 28% from MRQ due to volume shift away from lower-priced Centro to the new Treo Pro). In my view this is aggressive given the Pre will likely cannibalize sales of legacy handsets once it's released. The Company said itself that it "expects declining revenues and continued margin pressure from its legacy product lines in the fiscal fourth quarter."

(2) Pre Revenue = 2.5m units @ $437 each = $1,091m. Approximately 4m Sprint handsets are sold each quarter, 16m on an annualized basis. I've assumed 2m Pre handset sales are sold on Sprint in the US, representing 12.5% of annual volume. The iPhone became 20% of AT&T's total handset volume in the first quarter after launch and the G1 (Android-based phone) became 10% of T-Mobile's handset volume in the first quarter after launch. This is support for the 12.5% assumption for Pre's launch on Sprint. The other 500k handsets sold above 2m represent international Pre sales and are 20% of the total Pre units sold - an assumption based on historical international revenues as % of total and based on the fact that there are only rumors that Palm is going to be released on Telefonica, which already offers the iPhone. The unit price of $437 is based on the assumption that the phone will cost the consumer $200 after Sprint provides a $237m subsidy based on the average of 8 recent smartphone subsidies provided by Sprint (see table below).

(3) Legacy Treo & Centro Gross Profit = 27% x $396m = $107m. I've assumed they achieve their Q209 Gross Margin of 27% on legacy Treo and Centro handsets. Given their Gross Margin declined to 5% in Q309, it seems unlikely to me that this trend could be reversed without the release of new versions of these legacy handsets.

(4) Pre Gross Profit = 30% x $1,091m = $326m. I've assumed Palm is able to make each unit for ~$300, which is similar to estimated costs to manufacture the iPhone 3G, Blackberry Storm and Blackberry Bold. HOWEVER, I believe that this is an aggressive assumption considering Palm in no way has the economies of scale and negotiating power with 3^rd party manufacturers like Apple and RIMM. Also, the complexity of the Pre - with its pop-out keyboard, which none of the above devices have - would make the device more complex to manufacture.

(5) Operating Expenses = $360m. This assumption is based run-rate quarterly opex of $90m based on the following statement from Palm on it's last earnings call transcript last December: "We expect by Q4 this FY, the restructuring actions I'd noted plus other cost containment initiatives will allow us to drive quarterly operating expenses to the low to mid-90mm range". I think this is a very aggressive assumption given the company will need to spend significant marketing dollars before the Pre's launch and ongoing R&D spend to fix bugs and maintain the webOS software. Management stated in the Q309 conference call that it "doesn't include spending we would undertake for R&D acceleration or launch spending" and is strictly "core opex".

(6) Interest Expense = $395m debt x 7% rate = $28m

(7) Tax Expense = $0. The company has significant NOLs ($250+ as of 5/31/08) and if Palm becomes income positive, should be able to shield taxable income.

(8) Diluted Shares Outstanding.

Current Capitalization & Valuation

Price Target Rationale

Using both public comparables and a DCF valuation I arrive at an estimated value of $6.00 per share. Both valuations are using what in my view are best-case operating assumptions for FY2010 and the price target is still 37% below the current price, providing a considerable margin of safety to the investment.

In Table 5 below, applying comp multiples to Palm's best-case FY2010 LTM EPS and EBITDA gives you a valuation range of $4.98-7.41 per share depending on if you assume average multiples or Apple's multiples.

Table 5: Comparable Company Valuation

In Table 6 below, is a high-level DCF. Key assumptions are:  1) EBITDA grows 15% per annum post best-case 2010, 2) all $250m of NOLs can be used to shield taxable income, 3) capex is $17m a year consistent with historical averages and 4) the business is net working capital neutral. At a 15% discount rate and 8.0x terminal value multiple the intrinsic value per share is $6.35. I've also included a table which outlines the intrinsic value at varying TV multiples and discount rates.

Table 6: DCF Analysis

Key Risks

• High short interest (40% float) may make borrowing the shares difficult and cause volatility on the upside - Palm is a very liquid stock (~7.5m daily volume) and moves due to a short squeeze are not based on Company fundamentals
• Hype and public statements by Elevation that could elevate the price in the near term - I believe McNamee's recent rant on Bloomberg caused him to lose some credibility and any statements going forward will likely be discounted or ignored by the market
• Launch on other carriers in US and internationally shortly after Sprint release in the US could drive increased volumes - Sprint has at least 6 month exclusivity in US and Palm's international presence has been minimal historically
• Consumer price point below $200, sub-iPhone price, could significantly increase demand - lack of economies of scale will keep manufacturing costs high and Sprint may not subsidize the device enough to lower the price below $200
• Licensing agreements for webOS with other handset manufacturers could be a new source of revenues now that Palm owns the software - other major handset providers either have an in-house software or use Windows Mobile
• Acquisition by a cash-rich, large tech company looking to get into the consumer products/mobile handset market such as Dell, Cisco or HP - Palm doesn't manufacture it's own devices so a large acquirer could license software and work with the same 3^rd party manufacturers for the hardware, with better negotiating power/economies of scale than Palm itself

Catalyst

1) Delayed launch of the Palm Pre

2) Price point of Pre w/2 year contract above $200 (current iPhone price point)

3) Continued deterioration of the company's financial condition and cash burn

4) Any litigation between Apple and Palm

5) underperformance to the best-case FY2010 scenario outlined above