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An Unlikely Value Play

In investing, buying a growth stock at a value price is ideal. Since the market does not hand out such chances very often, we must avoid letting great buying opportunities slip through our fingers. Today, a compelling contrarian candidate sits within our grasp in the form of Motley Fool Stock Advisor selection Palm Inc. (Nasdaq: PALM  ) . This one-time tech high-flier has had its stock fall from well out of reach to well within arm's length.

Contrarian investing is often associated with buying out-of-favor stocks in durable or cyclical hard-asset industries (think consumer products, natural resources, and industrial manufacturers). Contrarian investors loaded up on energy stocks when technology was in vogue and oil was selling below $20 per barrel in the late 1990s. Ironically, energy stocks are in favor today, oil is selling at over $70 per barrel, and the NASDAQ is down 60% from its year 2000 highs. Perhaps this is an auspicious backdrop for examining a seemingly-unloved tech idea like Palm.

Back to the future
For context, we can divide Palm's operating history into three distinct periods: growth, falter, and rebound. From 1995 to 2000, Palm grew revenues over 275% annually via brisk demand for handheld organizers. Operating cash flow peaked at $129 million in 2000. That year, the company spun off from 3Com and boasted an $18 billion market capitalization.

Fiscal 2001 and 2002 represented Palm's blue period. In a difficult macro environment, revenues stagnated, inventories mounted, selling prices fell, and Palm burned through $400 million-plus in cash. By 2002, Palm's market cap stood at $1 billion. Palm then began a remarkable turnaround.

In 2003, the company bought rival device manufacturer Handspring to bring the promising Treo smartphone into the fold. Palm also divested its PalmSource software business to set in motion an alliance with Microsoft (Nasdaq: MSFT  ) . Between fiscal 2003 and 2006, revenues grew 17% annually, driven almost entirely by higher average selling prices. Gross margins and earnings rebounded. In 2006, operating cash flow grew to $138 million and Palm's market cap grew to $1.6 billion.

Palm's YTD stock performance (down 6%) belies the wild ride it has given investors, falling from a high of $25 in April to $15 today. Given the market's recent disfavor for the stock, we can use a simple checklist to help us decide whether the company warrants consideration as a contrarian play.

1. Is the company's stock cheap on an absolute and relative basis?
With $500 million-plus in net cash and an enterprise value of $1.1 billion, Palm trades at 11 times trailing-12-month free cash flow. This represents a meaningful discount to the broader market and technology universe. Relative to Research in Motion (Nasdaq: RIMM  ) , a comparable device manufacturer, Palm looks attractively valued. On a trailing-12-month basis, Palm trades at 0.7 times sales versus 5.3 for RIMM. Palm trades at nine times EBITDA versus 21.6 for RIMM (RIMM did not generate positive free cash flow in fiscal 2006).

2. Does the company have competitive advantages to sustain revenue and cash flow growth?
Like other tech companies, Palm does not enjoy the structural or durable competitive advantages of repeat purchase consumer products companies like Pepsi or Procter & Gamble (NYSE: PG  ) . Palm's business model requires continued R&D investment, and its future prospects are driven entirely by product innovation. Today, Palm competes in the high-growth smartphone market, and its Treo offerings appear to be among the best in their class. Other positive factors are Palm's brand, loyal user base (my wife's accessory purchases are largely based on compatibility with her Palm PDA), and its success despite a relatively low level of annual capital expenditures (below $20 million for each of the past five years.

3. Does the decline in the stock price appear to be driven by temporary, short-term factors?
Palm stock traded off after management disappointed analysts with conservative guidance and a delay in releasing a smartphone for the European market. Palm still expects 20% revenue growth in fiscal 2007 and recently announced a deal with Vodafone to sell an antenna-less version of the Treo in Europe beginning this fall. The company will also be releasing a lower price point Treo in the U.S. later this year. Given all this, 15% free cash flow growth in 2007 appears achievable.

4. How might the company be affected by the competitive intensity in its end markets?
Many investors fear that new competitive smartphones will pressure Palm's pricing. Given the sensitivity of the company's cash flows to pricing, these fears have contributed to a sharply lower stock price. Surprisingly, Palm appears to have driven higher ASPs (average selling price) recently even in the face of multiple years of declining market share (based on figures from market researcher Canalys). Palm's ability to sustain ASPs through a superior product offering (Treo's better one-handed ease-of-use and battery life relative to the Motorola Q) or through market share gains in the corporate market (at RIMM's expense) through its Microsoft partnership remains unclear.

5. Is the company a potential acquisition target?
In the past, Palm has been rumored to be a target of Apple (Nasdaq: AAPL  ) , RIMM, Hewlett-Packard (NYSE: HPQ  ) , Dell (Nasdaq: DELL  ) , and Microsoft. Palm certainly has assets that would be attractive to each suitor. The company's current stock price would make it accretive on a cash flow basis to most acquirers, with the possible exception of Dell. HP is a less likely acquirer of Palm after recently buying Mercury Interactive.

6. Do insiders have skin in the game?
Insiders owned 12.8% of the company per the 2005 proxy statement. In fiscal 2006, insider selling was pronounced at prices above $20.

Like any contrarian idea, Palm's relative merits are a matter of debate. But for the more enterprising investors among us, it could be an opportunity for the taking, right in the palm of our hands.

For related Foolishness:

Palm is aMotley Fool Stock Advisorselection. Ask for us an all-access pass and you'll get a backstage look at all of the stocks that are helping David and Tom Gardner beat the S&P 500 by 33% as of this writing. It's free for 30 days.

Microsoft and Dell are Inside Value recommendations. Dell is also a Stock Advisor pick.

Fool contributorVikramMurthy welcomes your comments. He and his wife own shares of Microsoft and Procter & Gamble. The Fool has an ironclad disclosure policy.


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