Palm Makes for Intriguing Contrarian Pick

The Sunnyvale, Calif., company, which pioneered the personal digital assistant, is now focused almost solely on smartphones, the combination cellphone and PDA. Fully 80% of its revenue comes from its Treo line, and given that the market is booming, Palm's future should be bright. Manufacturers shipped more than 80 million smartphones globally last year, according to market researcher IDC, a figure that's expected to balloon to more than 300 million by 2011.

The problem is that fewer and fewer of those smartphones are Treos. Last year, Palm was about even with rival with Research in Motion (RIMM) in North American market share, with each company commanding about a third, according to market researcher ABI Research. Now Palm's down to less than a quarter while RIM, thanks to its ubiquitous BlackBerry device, is up to almost 45%.

That's made for some painful results. On Thursday, Palm said its fiscal first-quarter adjusted income, to be reported Oct. 1, will come in at eight to nine cents a share. That's in line with the Street's average estimate, but a good 60% below last year's EPS. For the last full fiscal year, net income plunged more than 80%.

So what happened? The Treo is simply too chunky at a time when thin is in. Moreover, the operating systems offered on the Treo are not up to snuff. The Palm OS is old and decrepit and can't multitask — you can't talk and send data at the same time, for instance. Meanwhile, Treos that run Microsoft's (MSFT) Windows Mobile OS don't offer the sort of differentiated "wow" features like those found in Apple's (AAPL) iPhone.

"The Treo is an excellent device, but the design is several years old," says Lawrence Harris, an analyst with Oppenheimer, who rates Palm shares at Neutral. "And we've seen a lot of new entries into the marketplace over the past two years, so you have a number of companies with deep pockets effectively targeting Palm's market."

Things are certainly bleak, but thanks to a bunch of recent developments, all hope is not lost.

Earlier this month Palm canceled development of its much-maligned Foleo, a so-called mobile companion that seemed like an answer to a question no consumer had asked. More important, Foleo was taking time and resources away from the development of a new OS, which will be critical in making future Palm smartphones cooler and more functional.

In an even more critical move, last week Palm shareholders approved the sale of a 25% stake in the company to private-equity firm Elevation Partners, something that bodes well for the company's design future. As part of the deal, Elevation's Jon Rubinstein will become Palm's executive chairman. As former head of Apple's iPod division, it's safe to assume that the days of the fat Treo are over.

And finally, also last week, Palm unveiled its latest Treo, the 500v, available in Europe through carrier Vodafone (VOD). So far the early reviews are quite good and it is blessedly not chunky. A similar version, believed to be called the Centro, is supposed to hit the U.S. shortly.

Now none of that means a turnaround is in the offing soon. The 500v and the Centro are holding actions, not home runs. Plus it takes a good 18 months to get a brand new handset on the market, and the scuttlebutt is that Palm's new OS development is behind schedule. But if Palm can just hold on a while longer, there's reason for optimism, says Morgan Keegan analyst Tavis McCourt. In a strongly contrarian move, he upgraded the stock to Outperform (buy, essentially) from Market Perform (hold) last week. (The average analyst rating on Palm's stock is Hold.)

"Things aren't going great for this company, but they're not nearly as bad as people perceive either," McCourt says. Sell-through of Treo smartphones, for instance, fell sequentially from the fiscal fourth quarter to the first, but they still gained about 20% year over year.

The fact that Treo growth came despite no new product launches and at a time when iPhone grabbed share from just about everybody says something powerful about the brand. "What happens when they actually start putting better product on the shelves?," McCourt asks.

Then there's Palm's track record of excelling at the hardest, behind-the-scenes, part of the business, like developing relations with carriers and application developers. "They've done all that extraordinarily well," McCourt says. "What they've screwed up on is the easy thing: Just listen to the market. The market says they want a thin phone, get a thin phone out there."

Palm's well-known missteps and rich valuation have the Street giving the stock the back of its hand — roughly 25% of the float is sold short. That means that even just OK news could touch off a short squeeze, but that's not enough reason to like this stock. The fundamentals can't improve anytime soon because it takes so long to get new product on the market, and Palm's forward P/E is too high. At 43, it stands at a 30% premium to Research in Motion and at almost three times that of the broader market.

Still, longer term, it's too soon to write Palm off. The company's got a top brand and some cheaper, thinner smartphones coming out. And perhaps most important, iPod guru Jon Rubinstein's on board. Take all that together and it's tough to believe that Palm has irretrievably lost its grip.