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For the Palms, a Firmer Grip?

By Cliff Edwards Both before and after Palm split into two separate outfits, devotees argued that the combination of a straightforward operating system and easy-to-use hardware was sure to secure a permanent place in the hearts and hands of buyers. But on June 1, news that Sony (SNE) was pulling out of the handheld business in both the U.S. and Europe ratcheted up Wall Street's fear that the future may not be so bright for the two outfits -- PalmSource (PSRC), which handles the operating system, and PalmOne (PLMO), which makes the hardware -- whose product lines have been restricted to personal digital assistants (PDAs).

Then, on June 21, PalmOne issued quarterly numbers that showed it's hardly on its last legs. The maker of the Treo600 smart phone and Zire and Tungsten handhelds capped a year of above-consensus results by logging a fiscal fourth-quarter profit of $13.3 million -- 27 cents per share -- on revenue of $267.3 million.

PalmOne's news, just three days ahead of PalmSource's expected good results, underscores the notion that the pair can do a lot more than survive against deep-pockets competitors such as Dell (DELL), Microsoft (MSFT), HP (HPQ), Samsung, and Nokia (NOK). Says PalmOne CEO Todd Bradley: "We continue to focus on our vision, to put the power of computing in everyone's hands."

AGE OF CONVERGENCE. Investors and analysts seem to think both Palms have a good chance of realizing that vision. After falling to around $16 in March, PalmOne's shares have been on a steady upswing, leaping more than 5% on June 21 to $21.50, within striking distance of the stock's 52-week high.

Why the shift? In PalmOne's case, it turned the corner from 2003 losses of nearly half a billion dollars due to inventory mismanagement and bloat. And while PalmSource shares slipped in the wake of Sony's announcement, most analysts continue to rate the stock a buy, despite the fact that the Sony license last quarter represented 14% of PalmSource's revenue.

Their futures are far from certain, however, even though investors continue to smile. To survive, both PDA players must accelerate their shift out of the traditional handheld business and into the market for converged devices. Simple digital organizers that hold addresses and calendars are being rapidly supplanted by digital music players, phones, and other gizmos that also offer scheduling, e-mail, and other functions.

The numbers tell the story. Tech researcher Gartner has reported that the worldwide market for traditional PDAs declined 11% in the first quarter. Researcher IDC predicts worldwide sales of converged devices will climb to 39 million in 2005, up from its estimate of 21 million this year and 9.4 million in 2003.

HUNGRY RIVALS. PalmOne already has a big hit in this market with the Treo600, and additional wireless devices are expected to roll out by yearend. To ensure its success, the hardware maker has struck a number of deals to bring new features to the devices. It's teaming up with e-mail service providers, such as privately held Good Technology, to add corporate e-mail to the Treo600, in addition to text messaging, Web browsing, and a built-in digital camera.

In the fourth-quarter, PalmOne sold 151,000 Treo600 units and logged revenues of $75.4 million on that device alone, helping boost the outfit's average selling prices and gross margins. After closing at $21.50 on June 21, PalmOne soared past the consensus target price of $22.33 in after-hours trading, as investors reacted to the unexpectedly strong earnings and increased guidance for the new fiscal year, which began in June. With the Treo600 continuing to be a hot seller, many analysts believe the stock could easily best its presplit 52-week high of $27.55, set in October.

PalmSource appears to be the more risky bet. The lost Sony license will hurt, and analysts expect sales to slip in the second half. Researcher Gartner reports that PalmSource's market share tumbled nearly 21% in the first quarter of this year, to 40.7%, as Microsoft's Windows CE and Research In Motion's (RIM) BlackBerry software made inroads in the smart-phone segment. PalmSource's stock now trades at a 52-week low of $15.30, well off its high of $48. Still, with an average analyst target of $24.33, that means it may have plenty of potential upside to impress optimists.

THE INNOVATION IMPERATIVE. PalmSource CEO David Nagel acknowledges that progress must be made in the market for cell-phone/PDA combos, but he also adds that the updated and soon-to-be released Cobalt operating system will be suitable for a wider variety of products. PalmSource also hopes to sign licenses with Ningbo Bird, an arm of top Chinese phone maker TCL.

No two companies' fortunes are more tied to the handheld computer business than the Palms. Unlike competitors such as Dell, Hewlett-Packard, and Microsoft, each is a relatively small fry and neither has a line of fallback products to soften the blow from slack sales. If they're to thrive, that means innovative products and sales-boosting features are vital, as are secure relationships with carriers and licensing partners.

If they can maintain the pace of innovation and produce numbers like PalmOne did on June 21, they've got a shot at pulling it off. Edwards is a correspondent in BusinessWeek's Silicon Valley bureau

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