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...But Maybe Only Half Successful

Breaking up with their hardware brethren may be a good move for folks in Palm's (PALM) software unit, but it's another thing altogether for those left to shepherd the device's fortunes. After a formal tax-free spin-off to Palm investors in the next few months, PalmSource will focus on developing and marketing the Palm operating system, while Palm Solutions makes hardware that uses its sibling's OS (see "For Palm, a Successful Parting...")

With the Palm OS running as much as 80% of the world's handhelds and with licensing gains continuing, PalmSource's future looks bright indeed. Palm Solutions, though, could face some troubling times ahead. The hardware company is increasingly finding itself outclassed in design and outgunned in the battle for the lucrative corporate market.

Ironically, a spin-off that was designed to save the software division may end up making life very difficult for the hardware side. One of the biggest hindrances to making the Palm OS more ubiquitous had been licensees' justifiable unease at the cozy relationship between the software and hardware groups. As one company, the two worked hand-in-hand developing new products, and the hardware group got preferential pricing on OS license fees (which executives contended was justified, given Palm's dominant market share). The complaints got louder however, as Palm's poor execution on its own strategy dragged the entire category into a profit-busting price war.

OUT-PALMING PALM. Now the hardware group faces some tough choices. After a year of regrouping, Palm has released new products, including the eye-catching $99 Zire handheld, that have helped shore up its crumbling foundations. Yet Palm Solutions still has a long way to go before it can declare its house in order. In the consumer market, where Palm is strongest, OS licensees such as Sony (SNE) and Handspring (HAND) increasingly are doing a better job than Palm at making the crowd-pleasing hardware that enjoy juicy 20% to 30% profit margins.

Sony has all but locked up the market for consumers who think of handhelds as entertainment devices by incorporating into its high-end devices everything from digital music players to digital cameras. And Handspring is gaining traction with its Treo handheld/cellular phone combo device. Palm Solutions is looking to expand into China's less-crowded this year, but others are sure to follow.

Then there's the all-important battleground: the enterprise market, where smart bets say the best growth will occur as demand rebounds and more companies begin making bulk purchases. Researcher Gartner predicts that enterprise sales will make up 40% of handheld purchases by 2004, up from 27% in 2002. Competitors using Microsoft's (MSFT) Pocket PC operating system are at least a generation ahead in incorporating key technologies, such as wireless networking and security. Those moves go a long way toward pleasing chief information officers and other technology-buying decision-makers for thousands of employees.

NO. 1 BUT SLIPPING. Worse yet, Palm seems to be losing it edge in pricing. Handheld makers now are offering Pocket PC devices for as little as $200, bringing prices uncomfortably close to Palm OS-based handhelds. Dell (DELL) executives say they're struggling to keep up with demand following the fall rollout of its $199 Axim X5 handheld. Dell also is finding a surprising number of first-time handheld buyers stepping forward, lured by price and the belief they're getting more for their money with what's essentially a scaled-down version of the Windows operating system they know so well from their experience with PCs.

Palm execs argue that they remain the undisputed leader in handheld shipments, and they're right. Last year, Palm shipped nearly 4.6 million handhelds -- almost half the worldwide total, according to researcher UBS Warburg's tracking estimates.

However, a closer look at the numbers reveals an ominous trend. In 2002, Sony's shipments jumped 227%. And a category UBS defines as "others," including fast-growing Toshiba (TOSH) in the Pocket PC camp, saw 31% unit growth. Palm's shipments actually declined 14%, on top of a 9% decline a year earlier. UBS analyst Don Young estimates that Palm will experience a leisurely 9% growth in 2003, compared to 14% for Sony and 37% for that "others" category.

BEEN-THERE, DONE-THAT. Palm Solutions must do more to better compete -- and quickly. Its $500 Tungsten handhelds debuted in November, aimed squarely at the high-end corporate professional market. They have a slick design, with a slide-down hideaway keyboard, as well as integrated Bluetooth wireless technology for short-range connections to other electronic devices. A more expensive version also includes so-called GPRS for always-on high-speed data access.

The problems for Palm are that Tungsten smacks of been-there, done-that, and it costs a lot of money. Some Pocket PC devices already include such features and cost less by using Wi-Fi for wireless Internet connections in homes, offices, and such places as airports and coffee shops.

Palm's argument that its devices are easier to use also won't wash with a corporate set more concerned about ease-of-access to internal networks, training, and security. Hewlett-Packard's (HPQ) new iPaq one-ups Tungsten by adding fingerprint identification technology that ties the owner to the device.

With corporate buying expected to begin picking up later this year, Palm Solutions will need to move even faster to beat an increasingly crowded field. The alternative for the king of handhelds is an exile into the lonely land of mediocrity. By Cliff Edwards in San Mateo, Calif.

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