Ever since Palm split itself into a pair of independent companies last year, its software scion,

PalmSource

(PSRC)

, has been the proverbial unwanted stepchild. On the surface, PalmSource looks like a company investors should run away from. But despite an unquestionably difficult road ahead, the company is showing potential signs of a turnaround.

PalmSource shares have stayed in the basement since the spinoff began trading on Oct. 29, 2003, off 48% from its initial close heading into Thursday's session. That kind of performance is galling enough, but to add insult to injury, Palm's other offspring, hardware maker

PalmOne

(PLMO)

, has appreciated 22% in the same period.

Meanwhile,

Microsoft

(MSFT) - Get Report

, the 800-pound gorilla in any market it chooses to enter, seems to have found its footing in the handheld arena with its mobile version of Windows, called Windows CE, or PocketPC. Once a very weak offering, Windows CE has been vastly improved, and with Microsoft's massive marketing help it is now nearly neck and neck with PalmSource's operating system (OS).

At the end of the first quarter of 2004, preliminary data by market researcher Gartner showed the Palm OS with a market share of 40.7%, down from 49% a year earlier, while Windows CE's share has risen to 40.5% from 36.7%. Equally disturbing, the market for the devices that run on those operating systems is shrinking, says Gartner. Worldwide shipments of traditional personal digital assistants, known as PDAs, slipped 4.6% in the quarter vs. year-ago levels.

If PalmSource really does have a future, it can largely be summed up in one device: smart phones, which are cell phones with high-quality screens that can run the applications consumers have grown to love on their PDAs.

"PalmSource can make a more attractive smart-phone OS than Microsoft," said Ryan Jacob, portfolio manager of the famously volatile

(JAMFX) - Get Report

Jacob Internet fund, one of the top-10 institutional owners of PalmSource, with about 152,000 shares.

PalmSource Loses Its Grip
Some eight months after its trading debut, PalmSource trails its sister company and the Nasdaq

Indeed, Microsoft's effort in this arena have been slow to take off.

Market researcher NPD gave the Palm OS a 47% share of the U.S. smart-phone market, while operating systems from Microsoft and Symbian, a former joint venture of several handset makers now controlled by Nokia (NOK) - Get Report, tied at 20% each.

"We are increasingly turning our attention to smart phones, and to a lesser degree wireless-data devices like Blackberry," CEO Dave Nagel said at a Lehman Brothers investment conference earlier this week.

And well the company should. Worldwide, the market for smart phones is expected to exceed the market for PDAs for the first time this year, said Gartner analysts Tod Kort. According to Gartner, sales of smart phones will range from 12 million to 15 million units, while PDA sales will be about 11.5 million.

Worldwide, the Palm OS powers about 10% to 15% of smart phones, Kort said.

PalmSource has performed so poorly and is traded so lightly (volume averaged just 253,000 over the last three months) that only four analysts on the sell side follow it. But one of them, First Albany's Mark Murphy, put a buy on the stock when he initiated coverage in mid-May.

What's to like? A big user base -- more than 30 million Palm OS devices have been sold -- and thousands of developers who write for the application and a library of existing applications, which Nagel estimates exceed 23,000.

Although the company's track record is short, it's already moving in the right direction, Murphy said. "It achieved a

pro forma operating profit in four of the last five quarters and is approaching sustained profitability."

Also noteworthy is the company's alliance with highflying

Research in Motion

(RIMM)

, makers of the popular Blackberry pager. Sometime later this year or early next year, Palm devices will be compatible with RIM's operating system, a major win for both of the Palm sisters, although secondary to PalmSource's focus on smart phones.

PalmSource has developed a new flavor of its operating system, called Cobalt, "written from the ground up for wireless devices," Nagel said. With the heavy lifting of developing that OS now out of the way, the company should be able to hold the line on R&D, he said.

Nonetheless, PalmSource is a risky play. "It's a quasi-value stock," said buy-sider Jacob.

It's not impossible, but a lot has to go right to really turn the stock around.