Palm

(PALM)

got slapped around after warning last night. It was losing almost half its value in early trading as investors and analysts alike expressed surprise the handheld gizmo maker won't post a profit in the second quarter.

It did announce

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better-than-expected earnings of 2 cents a share in the just-announced quarter.

Before the announcement,

Goldman Sachs

analyst Vik Mehta had the lowest forecasts for Palm's future -- and even he was surprised by the depth of Palm's warning. He reduced his rating on the company to market outperform from his firm's U.S. recommended for purchase list and cut his already low earnings targets.

"We were blindsided by the significant reduction in next quarter's guidance," he wrote to investors. "We had the lowest estimates on the street at $556 million (in revenues) and 3 cents a share (in earnings) and Palm guided to approximately $310 million and an 8-cent loss."

Gillian Munson, an analyst with

Morgan Stanley Dean Witter

, cut her rating to market outperform from strong buy, while slashing earnings estimates. Munson said the miss could affect investor faith in the company. "We expect investors' loss of confidence in management will be significant," she wrote. "It appears that Palm has stuffed the channel in the midst of slowing economic issues and a product transition."

In other words, Palm took a ton of Palm Pilots and stuck them in stores right at the end of the quarter to help burn off some inventory. The problem with that is that Palm will have to lower prices and cut into future profit margins. The same phenomenon occurred this Christmas at retailers like the

Gap

(GPS) - Get Report

, which took high-margin clothes and hung them on low-margin sales racks to make room for the new season's fashions.

Indeed,

Robertson Stephens

analyst Eric Rothdeutsche said Palm was planning to do just that -- lower prices to burn off inventory. "The company is planning on accelerating discounts and promotional activity to move inventory, further weighing on gross margins moving forward," he wrote in a note that downgraded the company to long-term accumulate from buy, citing "ballooning inventory levels."

He wrote that "inventories grew $70 million quarter-over-quarter and are expected to grow by $200 million in the fourth quarter due to a significant inventory build that already has been committed to, in spite of the company's attempt to cancel incoming orders and postpone production."

Palm is stuck between two floors. Its feet are stuck in a massive inventory glut -- a problem many tech companies face. Meanwhile, its head is looking ahead, hoping to launch innovative products that'll help spark demand. But the company cannot push new products if its old ones are taking up all the shelf space. It'll end up cutting into profits, something that Palm recognized last night.

Merrill Lynch

analyst Melanie Hollands cut the company to neutral from accumulate and said she would not be a buyer of the stock because of an inventory build-up of older models and a near-term saturation in the market -- very similar to what Morgan's Munson and others were saying.