For a long time we have thought the Palm Pre and WebOS would meet with modest success at best. One of the problems we've encountered among investors examining our analysis is that Palm management repeatedly indicated that business was much better than any of our work indicated. 

While we endeavored to explain Palm's highly discretionary revenue recognition, we see its pre-announcement of weak February 2010 results as resulting more from over ambitious revenue recognition in prior periods rather than recent setbacks. products have met with weak market acceptance and we expect that will continue.  Even with disappointing launch of the PRE, we believe Sprint’s current weekly volumes have dwindled to less than 5,000 units.

We believe Sprint sold less than half the number of units it needed to maintain exclusivity and that it and its resellers are still holding considerable inventory. Our best intelligence indicates sell through at both Telefonica/O2 and Verizon has been less than stellar. At $29, the Pixi is a good phone for distributors willing to take a modest penalty on a subscriber commission. We expect Palm’s Pre and Pixi will be available to AT&T later this year.

While this is may turn into a positive, market experience, management’s dedication to deception keeps our expectations low.

We, as analysts, can learn a lesson from Novatel’s (NVTL) financial report that applies to PALM as well.  Novatel, facing deteriorating financial results from a dated product line, released a new product (Mifi) that created overly optimistic expectations and dramatically disappointed shareholders. 

NVTL released Mifi, a device that combines a 3G data access with a wifi hub in the June quarter.  Consumer response has been strong, reviews have been good and in its first full quarter shipping, accounted for 40% of revenue.  This success has led to nosebleed high earnings growth rates for 2010.  However, these expectations were based on continued revenue contribution based on sell in. 

The company has been seeing increasing sell through each month since launch.  This success has attracted many additional carriers leading to 11 new customers for Mifi in C3Q09.  However, this success does not mean sell through has kept up with sell in.  The company owned up to this issue and guided C4Q09 results below consensus leaving shareholders with a 20+% overnight decline.  From our perspective, management should be commended for providing conservative guidance rather than aggressively anticipating new relationships to make up for a longer sales cycle which may lead to disappointing financial results.  Despite today’s sell off, if there are indications that sell through picks up as we enter the Christmas season, the stock will likely begin to recover quickly.

Not all companies take this approach to financial visibility however.  PALM launched the Pre in June and has led people to believe the discrepancy between sell in and sell through are negligible.  We have a contrary opinion and believe that the gap is much more substantial than PALM’s “devices sold” metric would indicate.  The belief that additional products, sold through additional carriers will cushion the blow of lower than expected sales, is a pipe dream based on ponzi like distribution.  We believe that holders of PALM into the November quarter financial results risk a negative surprise similar to what holders of NVTL are experiencing today. Consider the comparison of the two companies:
                                                                                                                                                                                        
Product launch - NVTL launched with Verizon and Sprint in May and June, PALM launched with Sprint in June

Follow on customers - NVTL signed 11 additional customers since the initial launch, PALM signed 5 additional carriers

PALM announced the launch of the Pixi this morning.  It will be available through Sprint on November 15 at the price of $99 after a $50 MIR.  We believe the competition at this price level will be difficult for the company to overcome and the price will need to drop to $49 with a store level rebate either before or shortly after Christmas.

Our channel contacts indicate that PALM has already begun shipping units of the Pixi and 250,000 will be available for the November 15 launch.  This is considerably higher than in the May quarter when 60k units of the Pre shipped ahead of launch.  The Pixi does not appear to be suffering from component issues and channel fill will benefit the PALM’s November quarter.  The key question is not supply but demand.  While the application list is impressive and the multi touch capacitive screen is likely to offer good user interaction, the price of the Pixi is on par with the iPhone 3G and the Pre.  We believe the Pixi’s weakness is its high $99 price tag.  We expect this will be a critical weakness restraining Christmas season demand.

We reiterate our Unfavorable Opinion on PALM.

Conclusion

 We believe Apple’s iPhone, sets the bar for smartphone pricing.  This presents a significant challenge for competitors and carriers alike.  We expect accelerating price declines to begin in Q4/2009 and smartphone margin pressure through 2010. 

How Apple sets smartphone industry pricing
 
When Apple set the price of the iPhone 3GS at $199 while reducing the price for the iPhone 3G to $99 it forced the handset industry to adapt.  The bar is set for not only high-end phones but also the mid tier, limiting the time handsets can prove themselves worthy of a premium.  This has implications for handset manufacturers and carriers that are willing to take risks with cutting edge but higher priced features.  Going forward, Apple’s pricing structure has implications for mid tier phones such as the CLIQ and the Pixi, which we believe, need to be priced at $99 and $49 in order to reach mass adoption.  These prices are considerably below current expectations.

Carriers have already started responding. 

• Verizon cut the Storm price to $99 shortly after Apple launched the iPhone 3GS and has followed suit with other cuts to $99 or below.  Today the only smartphones Verizon is selling above $99 are the Blackberry Tour HTC’s Touch Pro 2, Imagio, and Ozone.  Despite the price reductions at Verizon, field checks indicate that August was 8% below plan as the iPhone increased market share.  As we enter the Christmas season, we expect to see premium handsets offered at a peak of $199 with value and teen focused handsets offered for $99.
• Sprint continues to offer HTC’s Touch Pro 2 and Samsung’s Instinct HD at price points above $199. Not surprisingly, our field contacts see weaker post-paid subscriber metrics in the current quarter.  We expect Sprint's postpaid customer losses to exceed 1.0 million subscribers.   
• AT&T offers HTC’s Tilt and Garmin’s Nuvifone at price points above $199 but the Garmin handset with AT&T service is available for $149 via Amazon.  

Near term, this pricing structure makes us concerned about Motorola’s CLIQ and the coming launch of Palm’s Pixi.  T-Mobile’s CLIQ presales have been at a price point of $199 despite the phone’s clear focus on the teenage market.  While we do not have an indication of presale interest yet, conversations with store managers and higher-level industry contacts leads us to believe that a price reduction is likely before Christmas and possibly before Thanksgiving weekend. 

Palm’s “Pre lite,” the Pixi, has not yet been priced.  However, Amazon sells the Pre for $99 on Amazon with a 2-year contract.  In the UK, the Pre is free with a two-year contract.  We believe that in the US, a $49 price point for the Pixi is necessary to gain widespread adoption even if only to compensate for the smaller screen and lack of WiFi.
 
Going forward margins are likely to remain under pressure.  The implications for handset manufacturers are clear, we expect incumbent vendor’s margins will be squeezed going forward. 

BOM costs for the Palm Pre and iPhone are in the $170 range according to iSupply and we believe the $130 to $150 range for more streamlined devices such as the Pixi.  Handset pricing to the carrier is typically double the cost of manufacturing and distribution, which would price the Pre at ~$450.  For the carrier to offer the Pre to the consumers, it would require a $350 subsidy or $14.60 per month assuming a 2-year contract. 
We are seeing more rapid price declines for handsets, which drive greater subsidies from carriers that have committed to a certain level of units.  If ARPU, the source of these subsidies, stagnates, the carriers will in turn pressure the handset manufacturers for concessions on future models driving down margins.

This morning our teammate and partner, David Eller downgraded Palm stock to Unfavorable from Neutral.   Simultaneously I published a report examining how this problem will likely disappear inside of Sprint.  We maintain our favorable opinion on Sprint.  please email me or Jamie Townsend to access the full reports. 

PALM Pre:  more than a handful in the channel

Since Palm reported its August quarter losses, we have been perplexed by a disconnect between PALM’s device units sold and our estimates of store level
sell through. According to PALM’s reported sell through, inventory increased by 13k units and since the “vast majority” of both the device units shipped and the device units sold were units of the Pre, there couldn't be an inventory problem. The gap between the two is only 13k. However, since the company recognizes revenue on sell in to the channel and the company defines device units sold as units that have been shipped from Sprint (their primary customer) to either customers or second tier distributors, PALM could offer investors a high number of units shipped but still have a glut of inventory in the channel. We believe that channel inventory is currently about 11 weeks, which we believe will pressure reorder rates and make it more difficult to sell high ASP products going forward.

Sprint’s acts as PALM’s sole distributor in the United States accounting for 85% of revenue. Each of the second tier distributors such as Best Buy or Amazon.com buys inventory from Sprint rather than from PALM. PALM is accounting for this as devices sold. This does not appear to be understood by investors. We polled several of the investors who attended the Boston road show lunch and each was under the impression that sell through translated into customer activations. How can this be? Its documented on page 41 of Palm’s 10-k  which states, “VSOE is based on the price determined by management having the relevant authority when the element is not yet sold separately, but is expected to be sold in the marketplace within six months of the initial determination of the price by management.”  Of course this brings up two side issues -- how does a phone sitting on a distributors shelf have an economic life  AND -- FASB is likely to change subscription accounting rules for Smartphones and PDAs so that Palm will be able to  bury this problem with new policies and in restatements. 

We believe this means to PALM is that there is a glut of inventory in the channel that will prevent reorders from existing customers in the United States, reduced expectations for future carrier partnerships and if there is price protection or the ability for customers to return merchandise, potentially a large write off coming. At the very least, we believe that break even in 2H10 is in jeopardy.
The profitability turn hinges on PALM’s ability to build relationships with additional carriers. We highlighted the need for the company to raise capital after the 4Q earnings call in order to get more units in the hands of consumers before companies like Acer and Huawei gain a presence in the smartphone market. Companies like Verizon are trying to diversify away from their reliance on RIMM devices (which currently account for 85% of VZ’s smartphone sales) and PALM will be a beneficiary, but the level of carrier support is now in question. Despite the rumors to the contrary, Verizon will sell the Pre in January but the handset price subsidy and the marketing spend provided by the carrier are both up for debate. Verizon could offer to launch the phone at a price point of $129 with a $150 subsidy making the platform unprofitable for PALM.

IT IS MINOR FOR SPRINT

Our best information says Sprint activated a little less than 375,000 Palm Pres as of the end of August. This left about 275,000 or 11 weeks of Palm Pres in “Sprint channels” at the end of August. This is not to say Sprint is carrying 100% of the cost of these phones. Best Buy, Radio Shack, Walmart, Amazon and Lets Talk.com are all likely carrying some of this inventory cost. How much we do not know. What these dealer’s return rights, price protection, rebates or other incentives are we also do not know. These dealer terms and conditions vary greatly with the phones. However, the core economics around the Palm Pre's market are slipping. 

Sprint reduced the price by 25% to $149 only 93 days after first shipping the Pre. Amazon is selling it for $99. Walmart and Letstalk.com are both offered "specials" on the Pre for is $79. While undoubtedly some expect lower prices will improve demand, we believe the lower prices are more likely to blunt some competitive impact. There are more smartphone competitors today than at time of announcement. HTC’s Hero, Touch Pro2, and Snap, a reworked Blackberry Tour, and Palm’s Pixi are all recent entries to Sprint’s smartphone line up. Moreover, we do not believe Sprint has announced all of its new smartphones for the Christmas season.

We estimate Sprint on average, is paying Palm about $450 per unit during its September quarter. If Sprint has 100,000 too many units, the cost to it and its channel is about 45 million dollars. While this may be enough to limit Sprint’s short term financial flexibility and restructuring we must view it in the context of a company with more than $1.0B of quarterly operating cash flow.

Opinion:

We believe Sprint’s share price does not reflect the company’s underlying value.  This is the overriding reason management is pursuing its “slow liquidation” strategy.  In total this liquidation will likely realize at least $12 per Sprint share.  We suspect this deal may be about DT or T-Mobile forming a JV with Sprint and possible Level3 for backhaul than DT buying the company.

The question becomes, is it a good value for Deutsche Telecom? 

The last time we heard Deutsche Telecom was considering buying Sprint we put a very low likelihood of success on a deal.  The operational economics would likely be terrible.  Too many chiefs, too many incompatible networks, not enough innovation. 

Since then, we learned that DT/T-Mobile has floated several trial balloons with the FCC so its ardor for Sprint may be greater than its common sense and cash.   We also believe Sprint, T-Mobile and Level Three have discussed forming a JV for backhaul.  Sprint/Clearwire needs more Tier 1 capacity, T-Mobile has virtually none of its own and Level three has excess.  So perhaps DT/T-Mobile is only looking at one or two of Sprint’s various operations, most likely its Wireline business. 

Arguments for some kind of deal:

We believe Sprint and Clearwire are severely undervalued.  If broken up, we believe its assets are worth two to three times the current stock price.  

T-Mobile has virtually no-backhaul operations

Sprint is organized to be liquidated:

• Clearwire stock can likely be spun out to shareholders tax free
• There are two separate wireless units:
  • PCS – Sprint CDMA Service and Virgin Mobile
  • iDEN – Nextel and Boost
• The Wireline business is healthy and is a reasonably well positioned Tier 1 carrier.

There is reasonable overlap between the two companies spectrum

• Sprint’s CDMA network runs on 1.9 GHz
• T-Mobile’s GSM network runs on 1.9 GHZ

T-Mobile is way behind the 3-G network curve,

• Sprint is the best 3G overall service provider
  • Coverage
  • Performance

Customer Service:

• T-Mobile is a strong retailer with excellent customer service
• Sprint is a weak retailer with decent, slowly improving customer service.

Neither carrier has an 4G operational investment at this time.

• T-Mobile plans to go to LTE someday
• Sprint sold its 4G properties and we expect it will ultimately spin off its Clearwire stock.

Our government probably likes the idea of a strong third carrier to challenge Verizon and AT&T.

Arguments against a total merger:

Disparate Current Operating Technology

• Sprint uses CDMA and iDEN and has had a nightmarish experience trying to merge the two
• T-Mobile uses GSM and is moving toward LTE.  It does not need two more incompatible networks.

Government regulation/politics

 

• Foreign ownership of “strategic assets” like spectrum and carriers
  • Excluding Clearwire the two companies would likely exceed spectrum ownerships caps.  With Clearwire it would be way off the chart. 
  • When Clearwire was formed the FCC waived the spectrum cap issue despite AT&T protestations. It is hard to see the three companies under common ownership.
• While T-Mobile is a foreign operator it is number four.  It is not clear the FCC would want them to be as large as the combined company, even if that company excluded iDEN and Clearwire.
• Sprint’s iDEN network is rebanding to help public safety operators.  It is likely this would have to be completed before any deal consideration. 

 

TownHall Comments: Motorola Clicks with the Cliq
David Eller

Motorola's new Android Cliq handset looks solid. We believe there is pent up demand for a quality handset geared to that demographic and the announcement of two European carriers is sweet icing on the cake.  This is not Motorola’s high end Android handset that will ship with Verizon but if they can get a base hit with the Cliq it will make investors more aware of the Scholes launch.

Rethink Research: European cellcos sign for Motorola’s first Android phone:
Caroline Gabriel

Motorola pulled the sting of its first Android launch somewhat, by going for a two-stage announcement presumably forced upon it by Verizon Wireless. As expected, it announced a midrange model, now called the Cliq, with T-Mobile USA, together with – probably more importantly in terms of how the Android line-up competes – a MotoBlur user interface skin, heavily geared to social networking. Moto said it would unveil another product within a few weeks, expected to be the more heavy duty ‘Sholes’ device for Verizon Wireless, and also – in a very positive surprise – said it had signed two European carriers, O2 and Orange, for next year.

Motorola changed the handset goalposts once in recent times with the RAZR, and now is looking to another superslim phone to repeat the trick. The Cliq looks quite cool, even if its name seems to be an HTC cast-off, but it is more vital that MotoBlur, which will appear on all the Android phones (carriers willing – we may not see it in China), captures the imagination of users.

No pricing for the Cliq (formerly codenamed Morrison), but the other details looked promising, as was the promise to launch the product worldwide from early next year, under the name Dext (Cliq is a TMo-specific brand), and the revealing of two European carrier partners, Orange and Telefonica O2. While Motorola still has strong ties to US carriers and consumers, its recently drastically diminished international presence remains a major question mark over its ability to stay in the handset top five, and all its supporters will breathe a sigh of relief at the first Dext cellco deals.

There is no indication of whether these will be exclusives for individual countries or whether Dext will launch with multiple cellcos in Europe (sources favor a non-exclusive strategy), but both O2 and Orange are beefing up their smartphone ranges in the face of the loss of iPhone exclusives and a reinvigorated high end assault from Vodafone, so Motorola – which had virtually exited the European market from last year – has chosen a good time to push its new phones. It remains to be seen how much profile Dext and other MOT handsets are given by these international cellcos of course, with Europe becoming incredibly crowded with Android and Symbian smartphones and featurephones, plus the high impact proprietary models from Samsung and LG.

We see Sprint’s Any Mobile, Anytime as a modest positive. It fills a check box, which we see as necessary but not sufficient condition for success. << MORE >>

 The ongoing battle between TiVo and DISH/Echostar is primarily of financial interest.  Yes, it looks like DISH/EchoStar will have to hand TiVo large piles of cash, but we believe investors need to pay attention to TiVo’s large and growing intellectual property portfolio.  To be sure, the company’s original “Time Warp” patents, which are at the center of the battle, are important, but the big asset looks like subsequent patents.  Currently the US Patent Office is re-examining a number of TiVo’s claims that DISH had not previously challenged.  This re-examination could well be a material event for investors.  At present TownHall makes no forecast as to its outcome, however we do point out that Rethink expects a positive ruling for TiVo.

In Friday’s ruling that awarded TiVo $200MM for contempt from Dish, the court established a royalty rate of $1.25 per subscriber per month and an additional $1.00 per month as a sanction.  Interestingly the court based this ruling on its perception that Dish charges $5.98 per month for DVR service.  According to its website though, Dish’s current DVR pricing is $20 per month.  In its ruling, the Texas court said “If, however, EchoStar is unsuccessful on appeal and nevertheless continues to disregard this Court’s orders, the Court will seriously entertain the award of enhanced sanctions. 

Our man in London, Peter White, lays out a passionate case for TiVo based technology it developed after the hotly contested “Time Warp” patents.   Request your copy of this report from by emailing Jamie@townhallresearch.com.  

Earlier today, we heard a rumor that AT&T was considering purchasing Leap Wireless at a very hopeful $30.00 per  share.  We think economics argues against such a deal and even at Leap's current share price of $17.51 the economics would be challenging.   Making a deal less likely is that LEAP has a CDMA network while AT&T's runs on GSM. 

Leap's cost per gross addition was $201 in the June, 2009 quarter.  For comparison purposes we remind readers Sprint paid less than $140 per customer for Virgin Mobile.  We believe cost per gross addition is a reasonable benchmark to use when valuing prepaid carriers. 

In the unlikely event that LEAP's acquirer spent only enough money to maintain the current subscribers on the current network and based on last quarter's results, we would value each subscriber at roughly $620.  If this was truly strategic and complementary to a buyer, this price might become relevant.  However, with churn at 4.4%, the average life of a customer is short, less than 2 years.  This makes is difficult for a strategic deal.

At $30 per share:  with about 78 million fully diluted shares outstanding  and about $2.1B in net debt the company's enterprise value is $4.3 Billion.  Assuming the company's spectrum is worth what it cost (reasonable) that would have AT&T paying about high $770 per customer.  if the spectrum is worth twice what the company paid for it (aggressive) that would have AT&T paying a still high $620 per customer. 

At $17.51 per share (the current stock price) the economics are still tough.  Factoring spectrum at cost puts the price at $570 per customer, using our aggressive spectrum value shows a still high $421 per customer price.

With respect to LEAP's AWS spectrum we do not see AT&T as a natural buyer.   We would expect T-Mobile or Verizon to be willing to pay a higher price than AT&T as both T-Mobile and Verizon hold similar AWS spectrum.