Some Fund Managers Are Buying Palm, Despite Lofty Price

Palm Pilots ended up in many a Christmas stocking this year. Should Palm(PALM Quote) end up in your New Year portfolio?

The Palm File

Business: Makes handheld personal digital assistants.

FY 2000 Revenue: $1.1 Billion.

FY 2000 Earnings Per Share: N/A

Revenue Growth for Last 12 Months: +105%

Stock Snapshot

Share Price: $28.31.

52 Week Range: $165-$19.88

Percentage Change: 83%

Forward P/E: 218

Shares Outstanding: 566 million

Source: Baseline, Morningstar.

That's the question we put to fund managers, analysts and researchers for this week's Gut Check. The market's answer seemed clear last week, when the company's stock dropped 14% after Palm posted earnings that included licensing revenue figures that disappointed many Palm watchers.

And there are other big question marks floating over Palm that give many investors pause: Can it move fast enough to meet ambitious growth expectations and justify a price-to-earnings multiple of 218? Can it maintain its role as the dominant operating system for handheld computing devices? The answers offered by our experts were mixed, but there are many fund managers who are making big bets that wireless handheld personal digital assistants, or PDAs, represent the future of computers, and that if Palm executes it can be the Microsoft(MSFT Quote) of that new landscape.

Last week, the company announced that revenue for the fiscal second quarter rose 102% from the year-earlier quarter and that earnings topped expectations. But Wall Street was focusing its attention on the licensing revenue from Palm's operating system, which currently makes up a minuscule portion of the company's business but may be the key to the company's future.

For the quarter ended Dec. 1, Palm's second quarter earnings rose to $20.3 million, or 4 cents a diluted share, on revenue of $522.2 million. Licensing revenue totaled $6.7 million, up from $4.6 million in the first quarter.

Even though Palm beat First Call/Thomson Financial estimates of 3 cents on revenue of $519.8 million, the stock tumbled after the release. Palm is now down 83% from the $165 high it reached in March, when it was spun off from 3Com(COMS Quote) at the tail end of the spectacular technology run-up.

Gut Check on Palm
Pros	Cons
Palm's revenue for the fiscal second quarter rose 102%, topping expectations.	The stock is off 83% from its high, but its P/E is still a lofty 220.
The company has 88% of the nascent market for licensing for handheld operating systems.	Licensing makes up a tiny portion of its business, and there's fierce competition.
Three times the number of programmers are writing handheld programs to Palm's operating system than they are to Microsoft's O/S.	Palm is also facing competition from upstarts Handspring and Research in Motion.

Fund managers and analysts said licensing, while only about 1% of Palm's total revenue, is definitely the way to go. That's because handheld computing devices with wireless Internet connections, like the Palm VII, are facing increased competition from all kinds of other devices, including cell phones. Just as Microsoft became the dominant operating system of the PC industry, many fund managers and analysts believe that Palm has the potential to become the preferred operating system of PDAs and even cell phones.

"Everybody has figured out that they need a mobile device more complicated than a telephone and less cumbersome than a notebook PC," says Roland Whitcomb, portfolio manager of the (FATAX Quote)First American Technology fund, which has a large stake in Palm. Whatever the final PDA device turns out to be, it may not be a Palm, a cell phone, a pager or even a laptop, but something altogether different, says Adrian Brass, co-portfolio manager of the (IWWDX Quote)Investec Wireless World fund, which also owns a large stake in Palm. This is why both Whitcomb and Brass believe it is a smart move for Palm to try to become a preferred handheld operating system, rather than selling a piece of hardware that may become obsolete.

However, judging from Palm's current licensing revenue, which represents 1.3% of total revenue, Seamus McAteer, a research fellow and senior analyst with Jupiter Research, is skeptical that Palm will make big licensing inroads.

The Yankee Group argues that while Palm's licensing fees are small, Palm has captured 88% of the total market. Also, the demand for PDAs, including mobile Internet devices, is going to surge, according to both the Yankee Group and Gartner Group. By 2003, Yankee expects Palm will license its operating system to nearly all of the top-tier PDA handset manufacturers. Gartner says 33.7 million PDAs will be sold in 2004, up from 9.4 million this year, and 560 million Internet-enabled cell phones will be sold in 2004. With an eye toward capturing this market, Palm so far has struck licensing deals with IBM, Sony, Samsung, Nokia and even its competitor Handspring, says Ken Dulaney, vice president, mobile computing, at Gartner Group.

According to Todd Bernier, a stock analyst with Morningstar, an even more impressive figure forecasting Palm's potential growth is that 120,000 programmers are creating applications for the Palm operating system, whereas only 40,000 programmers are creating applications for Microsoft's PDA operating system, dubbed Pocket PC.

"These developers have probably ignored Microsoft's Pocket PC platform for good reason," Bernier says. "Palm's approach is simpler, smaller, battery-efficient, modular" and, last but not least, "fashionable," he says. Microsoft, on the other hand, "has tried to integrate as many functions as possible," Bernier says.

"It is these developers who will ultimately drive the popularity of the platform, much as the programmers did for Microsoft Windows in the 1980s. From this perspective, we think Palm has nothing to worry about," Bernier says.

"We think this move to wireless data is probably one of the big stories of the next five years," says Whitcomb of the First American Technology Fund. The ability to transmit data from the Internet or from Word or spreadsheet documents could drive more Palm Pilot sales in the next few quarters, in both the retail and the business markets, Whitcomb adds.

Linda Killian, portfolio manager of the (IPOSX Quote)IPO Plus Aftermarket fund, which is one of the largest holders of Palm, also believes the popularity of the PDAs is only in its infancy. "We think handheld devices are going to vastly increase in popularity as people who are not technology proficient realize that this is an efficient way of managing personal affairs, including e-mails and, eventually, even telephone calls," Killian says.

While the promise of PDAs may be a big story the next few years, it remains to be seen whether Palm will emerge from the competitive field as the dominant player that justifies the current lofty stock valuation.

Pilots of Palm These funds have made big commitments to Palm.
Fund:	Total % of Fund Assets:	Date of Portfolio:
Transamerica Premier Aggressive Growth	7.97%	Oct. 31
INVESCO Blue Chip Growth	7.68	Sept. 30
PBGH Technology & Communications	6.44	Oct. 30
Gateway Small Cap Index	6.42	June 30
Transamerica Premier Equity	5.90	Oct. 31
Source: Morningstar

Selling Out These funds have sold big stakes in Palm in recent months
Fund:	Shares Sold:	Date of Portfolio:
Warburg Pincus Capital Appreciation	142,000	Oct. 31
Salomon Brothers Capital	134,000	Oct. 31
USAA Growth	70,000	Oct. 31
First American Technology	21,000	Oct. 31
WM Growth	16,000	Oct. 31
Source: Morningstar