World's Scariest Stocks: Palm

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What else is stewing in our cauldron of evil? Prepare yourself before proceeding to the rest of our world’s scariest stocks.  

A stock tale for Halloween 2009:

The children on the block all feared old Mrs. Johnson; her heart knew nothing but cold, calculating evil.  Even worse, each Halloween her gifts became increasingly diabolical. One year it was a shrunken head; the next a free test drive of a Pontiac Aztec; then a lock of David Hasselhoff's hair. Her wickedness knew no bounds.

It was a rite of passage for older kids to go to her house each year and dare themselves to receive her newest diabolical gift. On this Halloween, a new group of children gathered on her doorstep, quivering with fear as the bravest of them rang the doorbell.

The door banged open with a heavy thud. "Hello, my pretties!" Mrs. Johnson shrieked.

The children jumped back, a series of small puddles forming around their shoes.

"This year, I have my most diabolical gift of all," she cackled, dropping something into their waiting bags. The children looked inside, howled in terror, then panicked and ran, dropping their treat bags. Mrs. Johnson laughed and collected back the fiendish treat that scared the children so: a leveraged share of Palm (Nasdaq: PALM) stock.

Not scared? Well, I tried my best, but fear not, Foolish trick-or-treaters. There's still plenty of ghoulishness to behold below.

The announcement
Excitement started building around Palm earlier this year after the company announced a new mobile phone operating system named webOS. The platform contained numerous software features that the iPhone and other competitors lacked. Even better, Palm's first webOS phone, the Pre, had slick styling that featured a slide-out physical keyboard. Early reviews were quick to praise the Pre. Fueled largely by hype, Palm saw its stock rise rapidly throughout the first half of the year.

Excitement builds
However, hype is no guarantee of major profits to investors. As colleague Nick Kapur said about Palm in a May stocks to sell roundtable, "A megapopular new product doesn't make a good investment. Just ask shareholders of Crocs (NYSE: CROX)."  Nick's opinion came before the Pre's launch, and highlighted some of the uphill battles the Pre had to face:

• It was entering a highly competitive market that featured several entrenched competitors. The Pre would have to move fast to capture market share and make the most of heavy promotions from its launch partner.
• It launched on Sprint Nextel (NYSE: S), a carrier far smaller than rivals AT&T and Verizon (NYSE: VZ), and which has been hemorrhaging subscribers in recent quarters.
• It had to swallow the high costs of launching a major phone with significantly fewer resources than its competitors.

Reality is a cruel master
Nearly five months after Palm's June launch, let's see how these threats have evolved:

• The competitive situation has become even more precarious. Apple (Nasdaq: AAPL) and Research In Motion (Nasdaq: RIMM) are the obvious titans in America's mobile market, but the largest threat to Palm is actually Google's (Nasdaq: GOOG) Android. When plans for the Pre were announced, the Android was a minor threat, having only one middling handset launched on T-Mobile's network. Today, the Android platform has exploded. The Android will be on every major U.S. carrier by early next year, and it enjoys major support from most handset manufacturers. For example, Verizon is heavily promoting Motorola's Droid this holiday season. Months ago, Palm's planned expansion to Verizon in early 2010 had investors salivating at the possibilities. However, with Verizon adding Android phones and Research In Motion's Storm 2 to its arsenal, the idea of the Pre becoming a focal point for Verizon is dimming with each new product announcement.
• Sprint continues to flounder. Its latest quarter witnessed another 800,000-plus postpaid subscriber losses. Even worse, despite heavy promotions and a record breaking debut, the Pre hasn't quite lived up to expectations. In the last quarter, Palm refused to break out total sales for the Pre and gave forward sales guidance that was 20%-30% below what analysts were expecting. When you have a make-or-break product that needs to establish a foothold quickly, sequential revenue declines are never a good sign. Now that the initial marketing blitz for the Pre is drying up, the company is struggling to maintain momentum.
• To secure greater resources, Palm announced a secondary offering along with its last earnings report. Granted, the offering closed at a price near Palm's trading level. However, this demonstrates the company's continued need for resources in battling its rivals. If demand for Palm's shares dries up, future rounds of dilution will be painful.

A competitive environment full of frights
It's a big mobile market out there. Tech researcher Gartner predicts that smartphones will be a $200 billion product by 2012; Palm doesn't need to be the dominant force in smartphones to be successful. However, with Android's widespread adoption, each handset maker now has a powerful software solution that matches many of Palm's early technological advantages, and which can link to a centralized applications hub. As we've seen with the iPhone's App Store success, having scale and locking your customers into an ecosystem of tools and apps is a major competitive advantage in the mobile world.

In short, Android -- and to a lesser extent, the new Windows Mobile 6.5 -- have once again given handset makers like LG, Motorola, Sony Ericsson, and Samsung a chance in the smartphone race. That's bad news for a scrappy upstart like Palm, which is fighting for the table scraps left by Apple, RIM, and Nokia.

Combine Palm's prediction of weak revenue in a traditionally strong quarter for electronics sales with a new study from Changewave Research indicating the Palm Pre has done nothing to increase the company's U.S. market share, and it's hard to argue that the phone has achieved the success investors hoped for. Yet Palm still trades at the same optimistic highs it enjoyed before the Pre's release.

That, my friends, is a recipe for the world's scariest stock. Just ask old Mrs. Johnson.

Warning: We’ve rounded up more scary stocks. Click if you dare.