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Technology > Tech Biz
Cracking the PalmSource code
Based on reaction to PalmOne's guidance, PalmSource's earnings report might be tough on investors.
September 23, 2004: 1:59 PM EDT
By Eric Hellweg, CNN/Money contributing columnist

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BOSTON (CNN/Money) - After the market closes on Thursday, PalmSource, the software company created by the split of PDA maker Palm Computing, will report its fourth-quarter and annual earnings.

The stock has had a rough calendar year but started to rebound during the past month, shooting up nearly 30 percent over its bottom nine months ago.

How fast is the stock moving? One research firm, Fulcrum Global Partners, issued a "buy" rating on Aug. 18 but downgraded it to "neutral" on Aug. 27.

"The stock moved up pretty quickly, so we changed," says Jamie Friedman, an analyst with the company.

It's a fast-moving stock in a fast-moving category -- supplying operating systems for PDAs and smartphones (which pack much of the functionality of full-featured PDAs).

While the PDA market is having a tough time these days, the smartphone segment is heating up. Research firm IDC projects that smartphone shipments worldwide will reach 90 million in 2008, up from roughly 17 million this year.

On the fence

I have to admit I'm being pulled in opposite directions regarding this company's stock.

I'm a long-term bull on the prospects for smartphones and the continued integration of functions into cell phones. With Samsung recently unveiling the first cell phone to feature a hard drive, I think the drumbeat for the death of stand-alone MP3 players just got a little louder.

What's more, this stock -- despite its recent run -- is probably reasonably priced. Its forward price/earnings ratio is 17. That's a little high for a value stock, but the company does have growth prospects.

PalmSource, with 2004 revenue of $73.1 million, has signed some smart recurring-revenue contracts that help shield it from wild fluctuations.

"The financial model is terrific; it's a fixed-cost operation," says Charlie Wolf, an analyst with Needham & Co. "If revenues rise above $75 million level, a lot of the gross margins fall right to the bottom line." Wolf has a "buy" rating on the stock, and Needham participated in PalmSource's spinout from Palm and was in the syndicate for the company's secondary stock offering in February.

The problem is...

But here's the rub: While PalmSource has made great gains in its efforts to diversify its customer base, recently signing up Kyocera and Samsung, I'm not sure it has found enough key players in the industry.

And Sony's withdrawal from the organizer market in the United States and Europe was a tough hit (although PalmSource has an arrangement with Sony whereby it still pays PalmSource $9 million, or 4 percent of unit sales).

Furthermore, the company is still too reliant on the PDA market, a segment whose best days may be behind it. In the most recent quarter, handhelds accounted for $11.1 million in revenues, smartphones $4.9 million.

Finally, despite the formal separation from Palm Computing and PalmOne, PalmSource is still tied to the fortunes of PalmOne.

That company reported boffo first-quarter earnings on Monday, but its guidance was cloudy, sending its stock price down more than 15 percent the next day. In after-hours trading Monday, PalmSource dropped 4 percent on the PalmOne call, and on Tuesday it was down another 3 percent.

So what needs to happen for me to stop worrying and learn to love PalmSource? Licensing arrangements with bigger players, for one.

Stock Research
Wireless Phones

I'm also looking for more information on what I'm hearing about the company's talks with low-cost manufacturers in Asia to provide inexpensive smartphones to cellular network providers. Right now, smartphones target only the high end of the market, and the extent to which PalmSource can grab market share in the largely nonexistent low end today will mean good things tomorrow.

But with PalmOne -- one of PalmSource's major customers -- reporting murky guidance and getting hammered for it, I can't recommend picking up PalmSource at this time.

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