The Problem with Auction Rate Securities.

The reclassification by Palm Inc. (PALM) of $75 million in short term investments to non current raises the issue of auction rate securities again. So what is the problem with them?

They are actually long term securities, not short term, with the rate reset on a short term schedule using a Dutch Auction methodology. If the auction fails, then the holder can't get access to its funds until the next auction.

Also, the issuer does not conduct the auction, it is done by Broker dealers.

A Threat to Value Strategy?

One of the bedrocks of Value Investing is margin of safety, which is sometimes manifested by owning a company with a large cash balance relative to its market capitalization. Most investors lump cash and short term investments into one figure, owing to the alleged safety of these investments. What if that cash wasn't really cash?

The latest hint of this problem comes from Palm Inc. (PALM) which stated during its conference call that $75 million of its cash balance has been reclassified to non current due to a "limited market" for these auction rate securities. The full quote from management, courtesy of Seeking Alpha:

"We also reclassified approximately 75 million of our investments to non-current. These are AAA and AA rated auction rate securities that currently have a limited market and are not needed to meet all liquidity needs for at least the next twelve months. As a result, they have been reclassified to non-current."

This looks to be classified on the PALM balance sheet as "other assets" which is now at $92.2 million. I am not sure what the other $17 million is.

There were no questions about this during the call.

PALM a Net Current Asset Value Play?

A number of bloggers have been pushing Palm, Inc. (PALM) as a "cash equals current market cap" play. This is not correct. PALM did report $622 million in cash and equivalents as of 8/31/07 compared to a current market cap of $573 million. However, they recently received a $375 million investment from Elevation Partners, and then promptly paid out a $900 million dividend to shareholders.

I don't usually bash fellow bloggers, mostly because one day I will make a mistake and don't want to be bashed myself, but this PALM investment theme was reported on Silicon Valley Insider, the blog authored by Henry Blodget, the former Wall Street super star analyst.

Here is an excerpt:

"Yes, we think Palm sucks. But it's worth observing that the company is trading for cash value.

At $5.50 a share, Palm has a market value of about $550 million, and at the end of August, it had about $550 million of cash. Thanks to its disastrous quarter, the company will undoubtedly take a restructuring charge, but it will still have a meaningful pile. And the 10% holiday headcount reduction should stem any cash burn for a while.

So the question is this: Can Palm be salvaged? Can it blow out its incompetent management team and recruit a better one? Can it be taken over by Research in Motion, Nokia, Motorola, or another gadget maker desperate to have a chance to compete with Apple?

If you think the answer is "yes," now is the time to look at the stock. Now, when everyone else is filled with feelings of love and admiration for Research in Motion and Apple and disgust and loathing for pathetic Palm."