Palm Reaches Out For A Hand

But will a merger with Handspring be enough to fend off ferocious rivals?

Palm Inc. (PALM ) has learned the hard way that being a pioneer brings mixed blessings. In the 1990s, the creator of the original PalmPilot personal digital assistant (PDA) opened up the market for handheld devices that combine calendars and address books. But its success attracted stronger, deeper-pocketed competitors such as Dell Inc. (DELL ) and Hewlett-Packard Co. (HPQ ), and Palm piled up nearly a half billion dollars in losses in its most recent fiscal year.

On Oct. 28, shareholders will vote on the company's best hope for survival. That day, investors are expected to approve a complex restructuring in which Palm will merge with Handspring Inc. (HAND ), the innovator behind sleek smart phones that combine PDA and cell-phone capabilities, to create a new company called palmOne Worldwide. At the same time, Palm plans to spin out its software division, PalmSource Inc. The idea behind the revamp is that, with the resources of the combined companies, palmOne will have more muscle to fend off increasing competition in Palm's traditional PDA market and a better chance of grabbing a slice of the fast-growing market for smart phones. PalmOne is forecast to have some $1 billion in sales this year. And although it's expected to lose $60 million during the year, palmOne says it can save $25 million annually after the merger through layoffs and bulk inventory purchases. "We're bringing a new vision of handheld computing together," says palmOne CEO-to-be Todd Bradley. Investors are applauding: Palm's stock is at $26, up sharply from the low of $9 this spring.

Still, the celebrations may be overdone. PalmOne looks destined to be a slow-growing, niche player in the overall mobile-device market. Its revenues will probably increase at only single-digit rates for the next few years and it's unlikely to reach profitability before 2005. With dozens of rivals using Microsoft Corp.'s Windows handheld software, palmOne's share of the PDA market will very likely slide slightly during the next few years, down from 40% now. And while Handspring's innovative new Treo 600 should help regain some ground in the smart-phone market, it will probably never be more than a minor player, compared with heavyweights such as Nokia (NOK ) and Samsung. "Palm can be like Apple, in terms of offering simplicity in elegant packages, but never having more than a 3%-to-5% share of the [smart-phone] market," says analyst Kevin Burden of researcher IDC.


One of the obstacles for palmOne is a simple combination of math and competition. Palm is still the leader in the market for traditional handhelds, but rivals are gaining fast. Just a year after releasing its first PDA, Dell is the fourth-largest seller worldwide. Palm is fighting back by segmenting its handhelds into $199-to-$499 Tungsten devices for executives and lower-priced $99 Zire offerings that have attracted new customers. Still, its dependence on the traditional PDA market creates a longer-term problem. IDC predicts demand for the devices will increase only marginally as consumers opt for smart phones. In 2007, about 15.2 million units are expected to ship, up from 11.3 million this year.

That's why Palm is turning to Handspring. By buying the upstart, Palm is pushing into the growing market for smart phones that combine traditional organizer functions with the ability to surf the Internet, talk, play games, and take pictures. Handspring Chairman Jeffrey C. Hawkins and co-founder Donna L. Dubinsky were the original Palm dream team, winning accolades for creating the first PalmPilot and the follow-on Handspring Visor device. When they left Palm in 1998 to found Handspring, the duo jumped into the market for cell-phone/PDA combos too early, nearly going bankrupt. Now, with faster wireless connections and sleeker design, demand for the devices is taking off. The market is expected to triple this year, to 13.1 million units, and to hit 81 million by 2007, IDC estimates. Hawkins is confident palmOne can grab a chunk of that business. "You can compete with these guys, especially if you have a very unique understanding of the market and the vision," he says.

Handspring, though, is on the defensive in the smart-phone market. Giants such as Nokia, Samsung, and Motorola (MOT ) are pouring money into research and are aggressively pushing their better-known brands. This year, Handspring dropped to 2% of the market, half its 2002 level, because it didn't release a new model last year. Nokia dominates the segment with a 61% share, while Sony Ericsson (ERICY ) holds 10% and Motorola has about 6%.

PalmOne's chore is further complicated by its delicate relationship with the Palm software company. The restructuring was designed to give both the hardware and software operations more leeway. PalmSource, which develops the basic operating system, could market its wares to rivals without the complications of close ties to the Palm device maker. PalmOne could use different operating software to satisfy certain customers.

But a key question is whether PalmSource will have the financial resources necessary to develop new versions of the software -- or effectively support palmOne. At the time of the spinout, PalmSource will have only $39 million in cash and a few hundred in-house software developers. PalmSource CEO David C. Nagel says he can tap a $15 million credit line and seek more equity investment if needed. Still, software maker Symbian Ltd., whose operating system is backed by Nokia, and Microsoft spend hundreds of millions annually on their mobile operating systems. "At best, [PalmSource] has a toehold in this market, and they risk getting left behind in the race for new types of devices without a lot of money to play the game," says Juha Christensen, Microsoft vice-president for mobile devices.


PalmOne has worked hard to keep its options open. Of the company's 825 employees, more than 60% are expected to be software engineers who will work on different operating system improvements for palmOne devices. Bradley and Hawkins says palmOne will continue to work with PalmSource. But the company is not wedded to the software and could conceivably mix and match between programs from Symbian and Microsoft. What's important, the executives say, is that palmOne be responsive to wireless carriers' needs and churn out new products more quickly.

Bradley also is working to trim costs. This year, Palm shifted all production and some design work to low-cost manufacturing plants in China. That will save $16 million annually and will give the company margins of about 25% on every device. Before the switch, some devices logged margins only in the single digits.

Churning out new devices has had some payoff. Palm in the past year has upgraded its operating system and switched to faster processors to allow for more colorful screens. That helped Palm grab 2% of lost share in the PDA market. Still, even after this month's restructuring, palmOne's biggest battle lies ahead of it.

By Cliff Edwards in San Francisco

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