Palm Beats the Street, Then Takes a Beating

Updated from 4:31 p.m. EST.

Palm (PALM) released earnings that beat estimates by a penny and trumpeted its dominance of the personal digital assistant market, even as analysts were discomfited by the numbers behind the company's happy talk.

Palm readers were especially distressed by revenue and gross margin projections for the next quarter.

Investors reacted by selling off Palm shares during tonight's after-hours session. Shares of the 3Com (COMS) spinoff closed regular Wednesday trading at $38.06, down $5.31 or 12%. In after-hours trading, they slid precipitously $6.50, or 17%, to $31.56 on Island ECN.

For the Palm's fiscal second quarter (ended Dec. 1) the Santa Clara, Calif.-based company said that earnings rose to $20.3 million, or 4 cents a diluted share, from $12.9 million, or 2 cents a share a year earlier. Excluding the effects of amortization of goodwill and other special items, the company reported earnings of 5 cents a share, beating by a penny the consensus estimate of analysts polled by First Call/Thomson Financial.

Revenue rose 102% to $522.2 million from $258.6 million a year ago. That figure beat the consensus estimate of $519.7 million in revenue. However, Judy Bruner, Palm's CFO, projected in a conference call that revenue in the next quarter will come in lower at $465 million to $490 million. Bruner ascribed the decrease to a post-holiday slowdown, but in fiscal 2000, revenue increased to $272.3 million in the third quarter from $258.6 million in the second quarter.

"They're not going to do as well as they did last year," says Danny Lam, an analyst with Communications & Computing Report. He doesn't rate stocks and his firm does not participate in underwriting.

"We polled store managers and found that 70% to 75% of the sales were gifts, which means that they were not bought by the end user," he adds. "What happens after Christmas, when there's a risk of higher returns, when 50% of the 70% of sales disappear in January and February?"

Gross margins were also disappointing, coming in at 36.1%, lower than the 38.3% in the first quarter and the 42.8% for the same quarter last year. Further, gross margins for the third and fourth quarters are expected to be in the 30% to 35% range. "The margins keep steadily eroding," says Todd Bernier, a stock analyst with Morningstar.com. He doesn't rate stocks and his firm does not participate in underwriting.

CFO Bruner explained that the gross margin erosion was due to a "more enthusiastic demand at lower price points than originally anticipated," along with paying higher prices for components in short supply.

The demand at "lower price points" means of course that low-end products like the m100, and not the most expensive products, are "flying off the shelf," Bernier explains. "That's not a good thing."

Indeed, Bruner acknowledged that the Palm Vx "in terms of our unit sales still exceeded the m100 during the quarter, but the m100 is fast approaching the Vx." At the same time, the Palm VIIx, the most expensive Palm product offering, typically accounts for only 5% to 6% of unit shipments. Palm shipped more than 2.1 million devices, a 45% increase from the previous quarter.

"This is a consumer product going into a difficult consumer environment," concludes Lam.

Separately, the largest seller of handheld devices in the U.S. also announced that it will buy WeSync for as much as $45 million in cash or stock, depending on market conditions at the time. WeSync, based in Portland, Ore., makes software that synchronizes calendars and contact lists for Palm and other handheld devices.

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