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Palm Gets Punished

The stock loses nearly 20% as analysts differ on degrees of disappointment.

Investors slapped

Palm

(PALM)

on Friday, but analysts seemed to have differing ideas about why the gadget maker was so severely punished -- and whether it deserved it.

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What most seemed to agree on was that the company issued disappointing guidance for its current quarter on Thursday when it reported first-quarter earnings. But depending on whom you asked, the guidance was either "terrible" or only slightly below expectations.

And the company's breakdown of its results and guidance gave room for a range of interpretations about how it is really doing.

At least on Friday, investors seemed to believe the worst. In recent trading, Palm's stock was off $6.20, or nearly 18%, to $28.77 on heavy trading.

Although there seem to be "warning signs" in Palm's report, the selloff appeared to be "a rather dramatic overreaction," says Scott Rothbort, a fund manager with LakeView Asset Management and a contributor to

TheStreet.com's

sister site

Street Insight

. "It seems to be a confusing market right now," says Rothbort, who has no position in Palm.

Palm's first-quarter report

surpassed the Street's revenue and earnings expectations. Unit sales of the Treo smartphone, Palm's flagship product, came in higher than most analysts had forecast, helping to boost the company's results.

The quarter had a number of red flags for investors. End-user sales of the company's handheld computers, formerly Palm's core product line, fell 22% from the year-ago period. Meanwhile, the average price that the company saw for its Treo fell as well.

However, it was the company's guidance that seemed to trouble investors and analysts. The forecast was somewhat muddled, because the company expects to receive a huge tax benefit in the current quarter, but hasn't yet determined if it will actually record it.

If Palm receives the benefit, its reported tax rate ironically will go up, thanks to the windfall. If it doesn't get the benefit, its reported tax rate will stay the same.

Further complicating the outlook is that for each set of numbers, the company gave GAAP figures that include the effects of the tax benefit and certain non-cash charges and pro forma numbers that exclude those items.

Focusing on only the pro forma figures, the company forecast that it would earn 38 cents to 43 cents a share if it got the tax benefit and had to pay a higher tax rate, or 60 cents to 65 cents a share if it didn't record the benefit and was able to maintain its current tax rate.

Considering analysts previously had projected Palm would earn 66 cents in the quarter, its outlook was either dramatically -- or only slightly -- disappointing, depending on which range you looked at.

Investors seem to be focusing on the lower range Friday, says Brian Harvey, an analyst with William Smith. "That looks kind of bad compared to the original 66 cents," says Harvey, who doesn't have a position in Palm and whose firm does not do investment banking.

Regardless of whether the issue is more appearance than substance, the company is still likely to record the tax benefit. Assuming it does, analysts will likely have to bring down their earnings estimates not only for the coming quarter but for the full year. Indeed, some already did so on Friday, taking down their price targets as well.

Lehman Brothers' Jeff Kvaal, for instance, lowered his earnings forecast for this year to $1.59 a share from $1.78 a share. And he dropped his firm's price target on Palm to $30 from $36.

Likewise, Bear Stearns analyst Andrew Neff lowered his earnings predications for fiscal 2006 and 2007 and dropped his fair value estimate of Palm's stock to $29 from $35. (Neither Lehman nor Bear Stearns has done recent investment banking business for Palm.)

But analysts and investors argued that there was more than just confusing numbers to worry about. Palm projected, for instance, that operating expenses in the second quarter would jump to a range of $100 million to $102 million, up from about $86 million in the first quarter and about $79 million a year earlier.

Despite an overall bullish report on the company, Pablo Perez at ThinkEquity Partners took the company to task over this projected increase, which he said the company explained "poorly."

Following Palm's earnings call on Thursday, "We have a number of unanswered questions," among them: "Given the unexpected rise in

operating expenses, what is the long-term financial model for the company?" Perez asked. (ThinkEquity has not done recent investment banking for Palm.)

And then there were disappointments in the company's operating front. CEO Ed Colligan said himself that sales in Europe were disappointing. And a number of analysts worried that despite the introduction of new products, Palm's handheld business was declining faster than the company or they expected.

Still, some investors and analysts were left searching for other explanations for the market's strong reaction. Some noted that prior to the selloff, the stock had jumped nearly 70% since bottoming out in May. That run likely attracted a lot of momentum investors who tend to get scared off when companies lower their guidance.

And the run also attracted a significant number of shorts. As of last month, investors were shorting about 22% of Palm's shares, potentially weighing on the stock.

But some investors saw fault in the overall economic picture. With the rise in energy prices and the potential that Hurricane Rita could wipe out more oil-refining capacity, many investors are already worried about how consumers will react this holiday season. And Palm's guidance may have played into those fears.

"If you look at Palm's guidance, it's not horrendous," says Jay Somaney, a portfolio manager at TSG Capital Group who does not have a position in Palm. "But it could get a lot worse if all these fears turn out to be true."