Palm's Warning, Job Cutbacks Overwhelm Solid Third Quarter

Updated from 4:57 p.m. ET

Palm (PALM Quote) beat Wall Street's earnings expectations by a penny Tuesday, but that was hardly the real story. More significantly, the handheld device maker painted a gloomy outlook for this quarter, saying it sees flat sales and a surprising loss. It also announced layoffs of 10% to 15% of its workforce.

Shares of Palm finished regular trading Tuesday up $1.13, or 8%, at $15.50. But disappointed investors pummeled the shares in after-hours trading, as they dropped $4.50, or 29%, to $10. The beating spread to rival Handspring (HAND Quote), which tumbled in after-hours trading despite a big announcement earlier in the day. Research in Motion (RIMM Quote) also fell in after-hours trading, changing hands at $20.50 on Island. It finished regular trading at $24.68.

For the third quarter ended March 2, Palm reported income excluding certain items of $9.3 million, or 2 cents a share, lower than income excluding certain items of $15.8 million, or 3 cents a share, a year earlier. The consensus estimate of analysts polled by Thomson Financial/First Call was 1 cent.

Revenue rose to $470.8 million from $272.3 million a year ago, on the low end of the company's $465 million to $490 million guidance.

Worse

The numbers for last quarter and the forecasts for this quarter were "much worse than expected," says Tom Carpenter, an analyst at regional brokerage Hilliard Lyons. (He rates Palm a hold, and his firm has done no underwriting for the company.)

In the fiscal fourth quarter, which ends in May, Palm said "the effects of the deteriorating macro economic environment" are creating flat demand compared with the same quarter a year ago. It sees revenue in the range of $300 million to $315 million, as much as 45% lower than original expectations around $550 million. That's "clearly a significant decrease from the quarter just completed and previous expectations," Chief Financial Officer Judy Bruner said during a conference call Tuesday afternoon.

Palm, based in Santa Clara, Calif., also expects a fiscal fourth-quarter loss of about 8 cents a share, a drastic contrast to the consensus estimate of a gain of 3 cents.

Average selling prices eroded to $197 in the third quarter, 7% lower than the previous quarter and 20% lower than the year-earlier period. Gross profit margins came in at 32.5%, lower than the previous quarter's 36.1%, mostly because of a rebate on the IIIxe and price reductions for the IIIxe and VIIx. And they're expected to be in the 25% to 26% range this quarter.

"They can't get away from the laws of consumer retailing," says Todd Bernier, an analyst at Morningstar.com. "With the advent of competitors, they have to discount their products." (He doesn't rate stocks, and his firm doesn't participate in underwriting.)

Transition

CEO Carl Yankowski also blamed Palm's woes on "the most significant product transition in its history," referring to the introduction last week of the high-end m500 and m505 products. That transition was a sloppy one; the two products were introduced last week but won't be available in the U.S. until late April.

Yankowski conceded that part of the reason for launching so early was "competitors launching in the same quarter," namely Handspring. The rushed introduction also meant that Palm "probably had to discount their products earlier than they would have liked to," notes Carpenter at Hilliard Lyons.

In the end, as much as the company is repositioning itself as a software company by emphasizing the revenue it makes from licensing its Palm operating system, Palm is still the dominant maker of handheld devices in the world -- with hardware accounting for 96% of its revenue in the just-completed quarter. And it's steadily losing market share to rivals like Handspring, consumer electronics giant Sony (SNE Quote) and PC makers like Compaq Computer (CPQ Quote) and Hewlett-Packard (HWP Quote).

"They have the licensing business and if they can't have better gross margins than Handspring, they shouldn't be making devices," Carpenter says. When Handspring reported its numbers in January, gross profit margins had increased to 31.4%, and the company expected continued increases in coming quarters.