K.C. Swanson

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Palm Shareholders OK a Marriage of Desperation

K.C. Swanson

The spun-off software company will be known as PalmSource, while the Palm-Handspring hardware entity will go by the name of palmOne. The two will begin trading respectively on Nasdaq under the tickers PRSC and PLMO tomorrow.

While the merger and spinoff create some momentary light and heat around the stock, the moves gave off a whiff of desperation, as big-cap competitors threaten to shoulder Palm aside.

Under the terms of the deal, Palm shareholders will receive about 0.31 shares of PalmSource for each share of Palm they own, while Handspring stockholders will receive 0.09 palmOne shares for each share of Handspring common stock. In Tuesday trading, Palm shares closed up $1.64 or 6.4% to $27.24.

Yet despite the warm market reception to the news, many onlookers say it's hard to get too excited about a deal between two players in a shrinking market. Despite buy-side interest, a number of analysts cast the union as a tactical response by Palm and Handspring to fend off irrelevance, rather than any bold stroke to regain momentum and growth.

They say the two companies, which climbed to prominence as leading players in personal digital assistants, have fallen too far behind in the emerging smart-phone market. And they're likely to have a hard time catching up, given rapid strides in the space by rich, giant players such as Nokia(NOK Quote) and Microsoft(MSFT Quote).

Granted, there's been a fair amount of buy-side interest in Palm since the deal was announced. Prior to the merger announcement, retail investors accounted for 70% of Palm's stock ownership, with institutional investors holding only 30%. But money managers have upped their stakes and now account for a full 50% of the pie, according to the company.

"We typically don't like gadget companies. When we do like them it's because we feel like they've survived the worst," says John LaForge, co-manager at the (PDSAX Quote)Phoenix-Hollister Small Cap Value fund. Palm fits that profile, he says, which is why his fund has about 1% of its holdings in the name.

"When Mister Softee gets into the business you expect them to be like Wal-Mart. But Palm's weathered the storm quite well. If you walk into a Best Buy or Circuit City, Palm has very good name recognition, even over Microsoft," says LaForge. "I think the brand name will help sustain them. And the fact that Dell's starting to push them more and package them in different deals is very good for Palm."

Against that backdrop of buy-side interest, Palm shares have more than doubled since the deal was announced in June, shooting up from $12.15 to $25.60 as of Monday's close. With a rise of 111%, the stock has sharply outpaced the Nasdaq's climb of 17.4% in the same period.

But some skeptics say the wild stock appreciation may have more to do with an upsurge in investor sentiment than any clear-eyed take on the combined company's prospects.

"We've seen a lot of companies of late that we're not too bullish on that have pretty much doubled. I don't read too much into the fundamentals from that," says Gabriel Erdi, a trader and analyst for the (TPFQX Quote)Marketocracy Technology Plus fund. He says the fund he works for is looking at palmOne as a possible short candidate.

"In terms of the merger itself, it's probably a good thing. But more likely than not it's delaying the inevitable," says Erdi. "Combining resources will help them survive in the interim, but in 2005 or 2006 I don't know how likely that will be."

The new Palm-Handspring entity will face tough competition from the likes of Hewlett-Packard(HPQ Quote) and Dell(DELL Quote) on the PDA side. And in smart phones, the real growth market, palmOne will have a hard time competing with big sharkish rivals.

Competitors like Nokia, Samsung and Motorola(MOT Quote) can afford to invest in R&D at a rate the combined palmOne entity will be hard put to match, he adds.

The tough growth picture is clearly evident in Palm's August quarter, in which sales grew only 3% above last year's levels to $177 million, falling short of analyst expectations for $184 million.

In the third quarter, the worldwide market for handheld gadgets or personal digital assistants grew by a mere 1.1% -- which counts as progress, given the preceding two quarters in which sales were below last year's levels. But IDC analyst Alex Slawsby says the growth was likely a one-time boost prompted by the debut of five new H-P devices, rather than the start of any broader upturn.

Even assuming the economy continues to recover and companies start to increase their IT spending, the likely beneficiaries will be vendors of smart phones rather than PDAs, he adds.

To be sure, Handspring has won kudos for its new Treo 600, a combination phone and PDA. On the strength of those sales, Handspring could potentially show decent growth, particularly given its much-diminished revenue base.

In the September quarter (which didn't really reflect sales from Treo 600, which started shipping in the last two weeks of September), Handspring garnered sales of a mere $13.1 million, down from $54.1 million a year ago.

Yet Handspring's sales as of the most recent quarter were equivalent to a mere 7% of Palm's revenues -- meaning success with the new Treo line won't necessarily have a huge impact at palmOne.

Overall, Palm can claim to have steadily narrowed its hardware losses in the past couple of years. In the most recent quarter ending in August, Palm Solutions (the hardware unit) posted an operating loss of $16.4 million, roughly halving the August quarter 2002 operating loss of $32.2 million.

That, in turn, marked progress from the 2001 August quarter loss of $39.4 million.

But the company remains in the red, with its path to profitability unclear.

OS On Its Own

The outlook is likewise murky for PalmSource, the new company that will own and market Palm OS, the operating system used in handhelds and smart-phone devices.

PalmSource has plenty of traction outside its parent company: In the September quarter, it drew just over half its revenue from software licenses sold to external (non-Palm) customers, including Kyocera (KYO Quote), Samsung and Sony(SNE Quote).

And the software division has managed to narrow its losses, though it's still losing money. In the most recent year ending in May, it posted a loss of $21.8 million, an improvement from the $84.0 million loss it posted in 2001.

But sales have shrunk dramatically in the past three years to $26.3 million in the most recent fiscal year, compared with $73.4 million two years ago.

PalmSource CEO Dave Nagel says the new company will focus on winning share in the GSM market, where it's a latecomer. Though Symbian has a lead in Europe, he says, "Judge us where we are in a couple of years. We haven't gotten fully cranked up in the GSM market."

PalmSource also aims to push harder into entirely new niches, he says, citing recent design wins into Tapwave's Zodiac, a handheld gaming platform that he describes as "a Gameboy grown up" and Garmin's iQue 3600, the first PDA with a GPS receiver.

One buy-side vote of confidence comes from LaForge of Phoenix-Hollister, who says his fund definitely plans to retain its PalmSource shares following the spinoff.

Palm still owns the lion's share of the operating system for PDAs, with an estimated 54% of the market this year, down from 58% in 2002. But Microsoft is gaining on it: IDC estimates the software giant will wrap up 2003 with 28% share, a rise from 23% a year ago.

"The Palm OS continues to be the most important and still dominates the handheld market in general. But that said, it's a market that really hasn't seen any unit growth over last few years," says James Faucette, an analyst for Pacific Crest. He has a neutral rating on Palm; his firm hasn't banked for the company.

Meanwhile, in the market for handhelds with voice capabilities, Palm's share is expected to fall behind Microsoft this year. The two are projected to claim a respective 13% and 14% of the space in 2003.