Palm Disappoints but Reaffirms

We do not see a turnaround at Palm Inc. (PALM) in the near future. The shares fell 8.7% after market closed yesterday, following the company’s second-quarter of fiscal 2010 earnings announcement. Although its loss narrowed, driven by improved sales of the new line of webOS (operating system), revenue declined considerably compared to the year-ago period.

Revenue on a GAAP basis for the quarter came in at $78.1 million, a sharp decline of 59.2% from the year-ago quarter. While Palm expects to focus on expanding distribution with more carriers and boosting its customer base, we believe the biggest challenges facing the company are an increase in its carrier base and customer preference for its smartphone over its competitors.

Palm defers revenue from products that run its new WebOS to later periods. Thus on a non-GAAP basis, adjusted revenue (excluding subscription accounting) for the quarter was $301.9 million.

The company posted a loss (for the tenth consecutive quarter) of 37 cents per share excluding one-time items, beating the Zacks Consensus earnings estimate of a loss of 41 cents per share. The comparable year-ago period results included a charge of $396.7 million for writing down the value of assets. Excluding this item, the company posted earnings of 73 cents per share in the year-ago period.

Moreover, expenses increased considerably in the quarter (up 21% from the year-ago period). This led to a rise in operating loss which grew 73.5% from the last year. Adjusted EBITDA for the quarter was -$48.3 million versus -$55.8 million in the year-ago period.

Palm exited the quarter with $610.6 million in cash, investments (including short-term and restricted portion) and non-current auction rate securities versus $221.2 million in the previous quarter. The current quarter included net proceeds of approximately $360 million from the public equity offering, which closed on Sept. 23, 2009. The company generated $16.7 million cash from operations in the quarter, compared to $45.1 million cash used in the previous quarter.

Smartphone Sell-Through Declined

Smartphone sell-through during the quarter was 573,000 units, down 29% quarter over quarter and down 4% year over year, as a result of slowdown in sales of both the Pre and Pixi smartphone at its exclusive carrier Sprint (S - Analyst Report). By comparison, Research In Motion (RIMM - Analyst Report) sold 10.1 million smartphone units in the current quarter. Inability by Palm to sell its phones increased inventory to $38.8 million.
 
Smartphone shipments of 783,000 units in the quarter were up 41% year-over-year, but down by 5% from the previous quarter. As a result of the launch of the low-cost Pixi smartphone, the average selling price for the smartphone was $375 in the current quarter, down from $427 in the previous quarter. As a result, gross margin in the quarter was 25.6%, down from 27.9% in the previous quarter.

Guidance Reaffirmed

Palm reaffirmed its fiscal 2010 forecast for revenue of $1.6 billion to $1.8 billion. The company expects R&D and sales and marketing expenses to be up sequentially in the upcoming quarter. Palm expects to use over $80 million in cash in the coming quarter.

Palm expects to grow its shrinking smartphone market share. Palm could also sign a carrier deal with Verizon (VZ - Analyst Report) to sell its smartphone. The company expects to launch a new developer program at the Consumer Electronics show in January. Palm plans to do away with the subscription accounting model and start recognizing revenue up front from the handsets.

Palm will continue to struggle as it competes against much larger competitors in the smartphone market such as Apple Inc. (AAPL - Analyst Report), Research in Motion, Nokia Corp. (NOK - Analyst Report), HTC, Motorola (MOT) and Samsung Electronic Android phones developed by Google Inc. (GOOG - Analyst Report). With weak fundamentals and waning market share, our confidence in the company’s long term prospects is low.

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