Wednesday, August 09, 2006

Calls of Note Part 4

- Merill Lynch notes Palm (NASDAQ:PALM) is underutilizing its considerable cash balance and the board should consider an aggressive share repurchase program, in their opinion. Palm stock is down 43% from its recent highs while the company holds over $5 in cash/share or 35% of current market value. Increasing leverage could support a larger buyback and. could be sustained with Palm's strong and consistent cash flow generation ($119mn in free cash flow, up 22% YoY, in recent FY06.)

Another critical, albeit more modest, use of cash could be for Palm to develop its own next-gen operating system (OS) for the consumer-focused Treo smartphone. We believe the relationship with current OS vendor Access is not fruitful and has led to delays that could impact Palm's long-term competitiveness. If, like Apple, Palm intends to differentiate through software and ease of use, ownership of the OS is crucial, in firm's opinion.

With four new Treo product cycles, the firm believes Palm can maintain a lead in the smartphone market that Gartner projects to grow at a 72% CAGR over next four years. While competition is increasing, they believe Palm stock, trading at <10x forward PE ex cash, well discounts the risks. Furthermore, Palm could be an attractive acquisition target for PC vendors looking to diversify into mobile handsets; or a target even for mobile handset vendors who want to expand in the high-end smartphone space. Firm's $19 DCF-derived price objective (eqv. to 16x forward PE) may be conservative as shares show theoretical upside to $25 on EV/EBIT basis vs. comps.

Maintains Buy.

Notablecalls: I expect PALM to trade up today.

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