Is Palm's IPO Really The One to Catch? Sure, Palm's got the edge on Windows CE. But be careful: The company being offered may not be what you think.
David Rynecki
02/07/2000
Fortune Magazine
Time Inc.
Page 213+
(Copyright 2000)
The coronation of the next great superstock could occur the week of Feb. 14, when 3Com sells 20% of Palm Inc. in a much ballyhooed IPO. The 3Com division is the undisputed king of handheld computing, a palm-sized juggernaut that boasts Microsoft-like numbers: 75% market share, sales growth in excess of 100%, real profits, and a worldwide brand. For that matter, Palm's numbers are a lot better than Microsoft's in the market for handheld operating system software, where the two companies compete. Its Palm OS is the de facto standard, while Windows CE, Bill Gates' entry in the segment, is sucking wind. "Palm is going to be one of these IPOs that go out at seemingly silly valuations," predicts Sanford C. Bernstein analyst Paul Sagawa.
Still, a little healthy skepticism might be in order. The fact is, the Palm that is the subject of this pre-IPO lovefest is not the same company investors will own six months from now. It stands on the verge of three fundamental changes: in strategy, in competition, and in leadership. Those are concerns an investor should hardly brush off.
First, strategy. Palm wants to change from mostly a hardware company--one that sells the popular Palm III, V, and VII series of personal digital assistants to businessmen and organization freaks-- into a software company that licenses the Palm OS and collects a royalty. Though it won't stop making the gadgets, software will be the priority. "It will eventually become a game where Palm will benefit no matter who sells the device," says analyst Gary Mobley at Banc of America Capital Management.
Analysts say Palm had little choice and applaud the decision. Now, rather than competing with Sony and Nokia, much wealthier gadgeteers with more sophisticated marketing skills, Palm is partnering with them and collecting a licensing fee. In fact, Nokia is even teaming up with America Online and Motorola to buy a combined 4.5% of Palm at the IPO.
All that is to the good. But investors may not have focused on the downside of Palm's new direction. During the transition from hardware to software company, Palm expects to lose money--remember, it's profitable now--and could shed market share on the hardware side. If you're a momentum trader who has just paid big bucks to make a killing on the IPO, are you going to wait for Palm to find itself?
And then there's the matter of competition, which is getting fiercer. First, Palm must fend off the new Handspring--a company run by Palm's founders, Donna Dubinsky and Jeffrey Hawkins--as well as other manufacturers.
The uglier battle is with Microsoft, a company that doesn't like to be No. 2. At the moment, the Palm OS has a comfortable lead over Windows CE, an adaptation of Microsoft's desktop system that consumers so far have found awkward and rather short on useful features. That could change. Rogers Weed, Microsoft's marketing chief for handheld, claims his engineers have spent the past 18 months improving Windows CE, making it simpler and adding options such as an MP3 player and an e-book reader that are as good for entertainment as business. And remember who we're dealing with. Microsoft already owns a lot of desktop investors' eyeballs and has a virtually bottomless marketing war chest to spend luring them to Windows CE-based handhelds. "It's easy for Palm to sign deals and do press releases," says Weed. "It's another to get in the trenches."
Does Palm have the leadership to take on Gates, Ballmer, and company in trench warfare? If you had asked that question 18 months ago, the answer would have been yes. That's before Dubinsky and Hawkins left to start their own company. Since then, Palm's been a revolving door for talent.
The 3Com CEO, Eric Benhamou, attempted to settle things down in December by hiring Carl Zankowski, former president of Sony Electronics, to run Palm. Zankowski is known for having doubled Sony's consumer electronics business to $10 billion. However, he comes to Palm after a year at Reebok, where he failed to stanch the bleeding at the ailing footwear division.
Zankowski's work is cut out for him at Palm. Among other juggling acts, he'll have to develop new hardware that appeals to a wider audience while he manages the transition to a software business. He'll also have to raise morale among engineers and marketers, who are said to be feeling shell-shocked with all the changes. (Maybe it's nothing a few stock options couldn't cure.) And he'll have to get out from under Benhamou's formidable shadow.
That could be the hardest part of all. Palm is one of the few successes Benhamou can point to in his otherwise misbegotten $7.4 billion purchase of U.S. Robotics in 1997. In preparing to unload Palm, he has stacked the board and senior management with loyalists. And, of course, even after the IPO, 3Com will continue to own 80% of the division for about six months. (At that time 3Com intends to distribute the remainder to 3Com shareholders, although it reserves the right to sell its stake outright.) Once the gusto of the initial offering has dissipated, Benhamou will have to show Wall Street that he's willing to let Palm pursue its own course without interference. Says analyst Diana Hwang at International Data: "Palm has done well, and it has a lot to work with. But it has to execute what it is promising."
So should you buy the stock? Unless you're among the lucky few granted shares at the offering price, Palm is best viewed from the sidelines. Or better yet, buy 3Com . Though the distribution ratio has yet to be confirmed, you can count on getting some shares of Palm along with one of the tech industry's rare value plays. Despite doubling since September on IPO euphoria, 3Com has been flat since the U.S. Robotics merger, while Cisco is up 630%. Executives insist letting go of Palm will let them focus on the 90% of 3Com 's business that still comes from networking. The plan is to move into homes and small businesses, where the growth potential is greater and Cisco's presence isn't so suffocating. "I think we have some aces," says 3Com President Bruce Claflin. If he's right, 3Com at 38 times earnings might be the real gem in this deal.
[BOX]
The Child Will Outgrow the Parent Even before the first trade, analysts say Palm is worth more than 3Com . Projected Annual Target 2000 revenues Net revenue share in millions margin growth* price Palm $813 9.8% 36.6% $35 3Com $4,989 7.7% 2.9% $30 without Palm *Projected through 2003. SOURCE: PAUL SAGAWA, SANFORD C. BERNSTEIN [BOX] PLUS: THE AGONY OF THE SHORT-SELLER | THE DEATH OF WEB FREEBIES | THE BEST RETIREMENT STASH
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