The Day Ahead: Will Palm's palm reading rattle investors?

What a difference a few days makes. On Monday, Palm's quiet period ended and underwriters talked up the stock. Optimism was everywhere. And now you'll be hearing a lot from Palm execs.

The problem? You might want that quiet period back.

The more Palm execs talk, the more the company sounds like a hardware company subject to the whims of price competition and component shortages.

Of course, there were no worries shortly after Palm's first earnings as a public company were released. Palm topped estimates with third quarter operating earnings of 3 cents a share, and revenue was up sequentially. Palm "performed extremely well."

Then came Palm's palm reading.

Speaking to analysts on a conference call, Judy Bruner, Palm's chief financial officer, gave guidance that sounded like it could have come from any PC maker about to enter battle.

Bruner said average selling prices fell sequentially from the second quarter to the third quarter. In addition, component shortages will also hamper Palm growth. "We're seeing strong demand, but there's an industry-wide shortage," she said. "We don't expect supplies to meet demand for the next several quarters."

Demand from wireless phone manufacturers has created a shortage of flash memory and LCD displays. "Recently we've seen it tightening dramatically," CEO Carl Yankowski told analysts.

The shortages mean Palm will have to pay more for parts as it cuts prices to gain market share. That means margins will come down a bit. Gross margins of 43.6 percent represented a decline year-over-year, but an improvement from the second quarter.

But Bruner said it won't last. "We are also cognisant that growth rates are unlikely to continue at current levels," she said. For fiscal 2001, Bruner said margins will be in the 35 percent to 40 percent range.

Palm expects fourth quarter revenue ranging between $280m (£176m) to $295m (£185m), or year-over-year growth of 61 percent to 69 percent. Fiscal 2001 will likely see growth between 40 percent and 45 percent, Bruner said.

As for the bottom line, Palm sees operating losses for the next few quarters as it invests heavily, unveils a marketing campaign and fends off competitors such as Microsoft and Handspring.

Microsoft is unveiling its new CE handheld operating system, and Palm execs said they expect the usual Redmond marketing blitz. Windows CE powers devices from Casio, Compaq and Hewlett-Packard.

Despite Palm's lead, the company will face a big battle in upcoming quarters on many fronts. Palm OS licensees such as Nokia, Sony and Qualcomm are also likely to be competitors.

And new revenue streams such as operating system licensing and Palm.net access fees are growing, but not enough to boost profits immediately.

Simply put, if you didn't know you owned a hardware company, you do now. Despite the optimism around the wireless market and Palm operating system, Palm primarily lives and dies by selling gadgets. That fact shouldn't come as a surprise. Management reiterated a lot of the risks found in Palm's regulatory filings.

The main thing to watch today is how analysts react to the Palm conference call. Wall Street is likely to boost projections for Palm, but there may not be many analysts pounding the table on the stock.

As for objective advice, you'd be well advised to watch the comments from the three brokerages -- AG Edwards, ABN Amro and Bear Stearns -- that didn't underwrite the Palm IPO.

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