Second Tier Smart Phone Makers Likely To Struggle With Profitability

When shares of Palm (PALM) were trading in the mid single digits I was quite bullish on the company’s stock simply because a revamped product line and a private equity capital infusion would likely serve to keep the company afloat and give it a chance to reverse a declining sales trend. We now find ourselves in round two of the story. Palm and the other second tier device companies are trying to grab market share in a rapidly growing smart phone market but the Blackberry and iPhone are unlikely to give up their leadership positions.

With a market growing so rapidly (3-5 years from now pretty much everyone is likely to have a smart phone device) selling devices is one thing, but making good money on them is quite another. Last week Palm reported that it shipped nearly 800,000 phones in the latest quarter, but the company lost a whopping $50 million in the process. Gross margins are only around 25-27% despite about 80% of sales coming from the new Pre and Pixi phones.

That does not leave much room for profitability when second tier firms have to spend so much on marketing to be noticed by a consumer who may be focused on the iPhone or Blackberry. The introduction of a Google phone into the mobile market (rumored to be early next year) will only make it harder for second tier players. In fact, Palm stressed on their conference call last Thursday evening that they are focused on gaining market share, not margins, so there is little reason to expect them to even care about profits in the short to intermediate term.

To me this makes the investment merit of companies like Palm a lot less attractive. I would add a company like Motorola (MOT) to this list too. Sure they have the new Droid phone, but the competitive landscape is so crowded that sustainable profitability seems difficult. Again, a rapidly growing market can lift all boats in terms of device sales, but future stock price performance will be based on profits, not sales, now that the market believes (correctly) that Palm and Motorola will survive to compete in the marketplace.

At Peridot Capital I was a buyer of Palm early in 2009 but pared back the position a lot as the stock rose into the mid teens. Now that the story has played out I will be less bullish on the shares unless they can reach sustainable profitability. And I do not think the prospects for Motorola are any more promising.

Full Disclosure: Peridot Capital has just a small long position in Palm and no position in Motorola at the time of writing, although positions may change at any time.

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5 Thoughts on “Second Tier Smart Phone Makers Likely To Struggle With Profitability

  1. Chad Brand on December 22, 2009 at 6:09 PM said:

    Don’t you think it is pretty much a foregone conclusion that Verizon get the iPhone sometime in 2010? That seems to be the consensus view and would be huge for Apple.

  2. Brendan on December 22, 2009 at 5:07 PM said:

    I will still stick by the fact that Motorola’s Droid continues to be overlooked and the world seems to initially flock to the smartphones such as Apple and Blackberry. In another year when the next version of the Droid comes out, people will begin to see that Motorola is still here, that people enjoyed their product, word spread and their customers will be back for more. The larger-sold smart phones are still enjoying their the result of successful marketing over the course of 5+ years and a long-lasting model which has become a household name.

    Unless Verizon gets the iPhone, I wouldn’t count MOT out just yet.

  3. Jing Liang on January 15, 2010 at 4:01 PM said:

    Hi Chad,

    Long time reader here. I think the strategic value of PALM can not be underestimated. While the google android is turning up the pressure on PALM, it makes its assets (mainly its OS, but also the new Palm Pre plus, etc) even more valuable to strategic buyers as they know they are running out of time.

    I would argue that Palm WebOS is a much better OS than android and blackberry. It was designed by ex-apple engineers. On the hardware side, Palm Pre is the closest to the iPhone in terms of ease of use and functionality. If you check out the new Palm Pre Plus, its even better (e.g., use as a wifi hub). Don’t forget the CEO of PALM is ex-apple. If anyone is most adapt at anticipating Apple’s next move, it would be JOn Rubenstein.

    I have checked out the Google Nexus One. It’s okay, but I don’t think it’s anything spectacular. With the exception of Gmail, it’s not in the same league as my iPhone. It is much better than my company issued blackberry.

    Acquisition of PALM by RIMM, MSFT, NOK, MOT, and even Amazon (to make its Kindle more competitive with Apple’s upcoming tablet) would instantly give them a leg up on the smartphone market. My bet will be on RIMM or MSFT if they can get pass the sunk cost mentality of their own mobileOS

    My prediction is that Palm will get acquired this year. Too many strategic buyers and the willingness to sell by Palm – Elevation Partners must want to have something to show for their relatively new fund.

  4. Chad Brand on January 16, 2010 at 10:53 AM said:

    Jing,

    I agree with you that Palm is worth more to a competitor than on a stand-alone basis. The only thing that may hold them back from selling would be the certainty that the team they have assembled would be untouched post-deal. Personally, buyout potential is not a good enough reason to hold a stock, but I agree that the premium would be large if both parties were amenable to the idea.

  5. @Jing – Palm has a huge investment in WebOS and as such is not an appropriate target for anyone already having their own OS, namely Apple, Microsoft, Google, RIM and Nokia.

    Except at sell-off prices, maybe, in which case all of the above may be potentially interested.

    Amazon…is an interesting idea. I don’t know if Palm will like to be bought just for the WebOS, though. They already tried that once and it didn’t play well :-)

    While of course surprises are possible for the time being I just don’t see where they would come from and as such any holds on the stock are more speculation than valuation.

    In regards to this I am fully with Chad’s decision, even if it turns out incorrect.

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