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Palm Inc. sells smartphones (the Pre and Pixi) based on its new developed WebOS. With 8 out of 10 Americans owning cell phones in 2007 and continuing growth in developing markets, the cellphone industry has boomed over the last ten years.^[1] In 2008, many consumers are beginning to trade up, exchanging their first basic cell phone for newer smart phones with data capabilities.

While Palm benefits from this trend, the company's upside is limited by the need to work with the major telecommunication providers to determine prices. Companies like AT&T (T) and Verizon Communications (VZ) compete for new contracts by giving customers device subsidies and changing the prices of data plans.^[2] For example, the highly anticipated 3G iPhone is estimated to have received a $200-300 subsidy from carrier AT&T (T) in order to reach a $199 retail price point.^[3] The need for phone and data plans to go with every device gives the telecom companies negotiating power in their relationships with cell phone hardware providers like Palm (PALM). This lack of pricing and distribution power is a major issue for Palm, and the company lost money in 2007 and Q1 2008. Furthermore, stiff competition and innovative products from Apple (AAPL), Research in Motion (RIMM), and LG threaten Palm's market share. However, Palm only need modest success in the smart phone market to be a winner for its investor. Palm current market capitalization is around $1.5 billion, just about 1% of Apple. A small gain in its market share will lift the stock price of this small company easily

Business Overview

Annual Data 2005-2007^[4][5]

Annual Sales Mix 2005-2007 ^[6]

Geographic Sales 2005-2007^[7]

Palm's major products on the Smart phone end used to be the Treo and the Centro. These products used either Windows mobile software, or Palm's own operating system PalmOS. However, after successfully introduced Palm WebOS at the beginning of 2008, Palm's focus is on Pre and now Pexi on WebOS. Palm announced it will no longer support its legacy PalmOS and Win Mobile. Competitors' substitutes and alternative products include Apple (AAPL)'s IPhone and various Windows Mobile platform devices by HTC, Samsung, and Hewlett-Packard Company (HPQ). Other devices include Research in Motion (RIMM)'s Blackberry, and a number of Symbian powered phones by Nokia (NOK).

The company's major handheld device line are in the Tungsten and Zire products. However, this segment is losing its sales as end users migrate to more integrated Smart phone devices, with revenues decreasing from $683MM to $310MM in 2005-2007.^[8] Substitutes and alternative products include an emerging segment of products known as "mobile internet devices", made by Nokia (NOK), Samsung, and other device manufacturers that are producing internet capable devices with no phone.

Financial Analysis

Note: Palm's fiscal year ends on May 31st. As of July 2008, full FY 2008 data is not yet fully available except through Press release rather than 10-K

The company's revenues have decreased steadily as its products have aged and the competition increased. Revenues decreased 1.1% in FY 2007, and 15.5% in FY 2008.^[11] At the same time, margins decreased and became negative, as a result of the company's #1 seller becoming the lower margin Centro product rather than the more expensive Treo products. The Centro is lower margin due to its lower price point.^[12]

In an effort to remain competitive and launch new competitive products in the face of the IPhone, Palm has been growing its investment in research, development, sales and marketing. R&D grew to 12.3% of revenue in 2007, up from 8.6% of revenue for fiscal 2006. The company wants to finish R&D on its newer Treo lines to rejuvenate its offerings in FY 2009.^[13]Meanwhile, sales and marketing expenses grew to 15.9% of revenue in 2007, up from 13.0% for 2006. The company hired Jon Rubinstein, who previously worked at Apple designing the iPod.^[14] The coming launch of products planned for 2009 will decide the financial future of the company, which took a major cash infusion from private equity shop Elevation Partners in 2007.^[15]

The revenue figures reflect a general trend in the phone and handheld computer industry. From FY 2005 to FY 2007, the revenues earned by the handheld computers (P.D.A.) segment at PALM fell more than 50%, from $683MM to $310MM. At the same time, smart phones grew from a smaller contribution than PDAs (from 46%) to 80% of total revenues in FY 2007. Palm's future growth will come from the Smart phone segment rather than its legacy handheld business, as a result of changing consumer expectations for increasingly sophisticated mobile devices. As further proof, the share of smart phones increased to 85% in FY 2008.^[17]

The majority of the company's contracts with wireless providers are with U.S. based providers, such as Sprint Nextel (S), Verizon Communications (VZ), and AT&T (T). As a result, its revenues come primarily from North America.

Trends/Forces

=Neutral view=

1. The business model: The vertical integrated, closed ecosystem model is not for small and weak players like Palm. Even NOK and RIMM would find it hard to thrive or even survive. Palm's model is more open than Apple, yet less so than Android. 2. So far, webOS applications have been small in number but growing steadily. Palm's App Catalog will be exiting beta in December, at which time better assessments can be made as to its future and developer interest. 3. Through various financial maneuvers and public stock offerings, Palm has secured substantial amounts of capital with which to execute their goals. How far these funds go to sustain the company in the long run remains to be seen as clearly Palm is currently the smallest player at the table. 4. Palm Pixi could go great lengths to introduce new customers into the webOS ecosystem, mainly because of its low entry price by some retailers. It is inferior in many respects to the Pre, though Palm is expecting to have the same luck with entry-level smartphone consumers as they did with their popular Centro. The Palm Pixi can already be had for under $50 at multiple retailers, which is a better price point than that offered at launch by Sprint, at $99. 5. Verizon is currently pushing its hero device, the Motorola Droid, though the Palm Pre will release on Verizon in early 2010. It remains to be seen if they will employ the same kind of marketing muscle they applied for the Droid. 6. Still, there is the bottom line: Palm has $750 debt due in 2014, and if sales fail to generate cash flow, it will face death by then. Whether they will achieve sustained growth to meet that and thrive will play out in the ensuing months.

Carrier relationships critical to Palm device sales

Telecoms such as AT&T (T), Sprint Nextel (S), and Verizon Communications (VZ) are often the actual vendors for Palm's goods. These companies charge long term subscription fees on the service, and therefore subsidize the phones in exchange for multi-year contracts. This means Palm's telecom partners decide which technologies and smart phones to sell, putting a middleman between the company and consumers. In addition, each additional contract agreement with a telecom promises to help revenues, as more subscribes will pick up phones. For example, on June 12, 2008 Palm announced that it had landed a contract for the Centro on Verizon Communications (VZ) network, and the company's stock jumped 13%.^[19]

Increasing device sophistication and convergence of cameras, phones, and P.D.As

Not much more than a decade ago in the 1990's, expectations for digital devices were very different, with little market penetration for digital cameras, cell phones, or P.D.A.'s. However, each of these devices has become an important consumer electronic in its own right. The PDA and cell phone converged into the Smart phone, which is slowly taking share from non-smart phones. More and more phones also have an integrated camera. Finally, more devices also have internet capability, delivering rich media such as video and music to the end user. As such, although only 4% of the approximately 213 million US cell phone users had a smartphone, according to firm M:Metrics, the number had tripled since 2005.^[20] Moreover, estimates of the smart phone market suggest it is growing at approximately 30% a year, compared with overall cell phone market, which is growing in the single digit percentages by revenues.^[21] Much of this is caused by the lowering price points of the smart phones, which make them more accessible to consumers, so consumers buy them to replace their aging non-smart phones. For example, for Palm's new $99 Centro product, 70% of its new buyers upgraded from an non-Smart phone.^[22]

Palm is losing money due to stiff competitive rivalry and telecom negotiating power

Palm's market share by units is approximately 13.4%^[23], and the dated PalmOS has trouble competing with Apple (AAPL) iPhone software and the BlackBerry's interface. Pricing, margins, and share of products in this industry are in flux due to innovation. In this case, both Research in Motion (RIMM) and Apple (AAPL) lead Palm in market share for smartphones, with 44.5% and 19.2% unit market share of Q1 of 2008, respectively.^[24] In addition, the value chain dictates that all phones are passed through to the consumer through the wireless telecom companies, who also have negotiating power to dictate prices over the companies like Palm.^[25] This hurts Palm, which has been operating at a loss in FY 2007 and 2008 and could use the pricing flexibility. In a position without a high-priced and innovative product, Palm's negative margins cannot be improved through collaboration with its telecom partners; the firm's anticipated refresh of the Treo line is its best shot of margin expansion.

Competition

Major Smart Phone Manufacturers

• Apple (AAPL) - Apple is the company behind the IPhone, a successor to the iPod which integrates both internet and phone capabilities.
• Research in Motion (RIMM) - RIMM is behind the Blackberry series of devices, which are highly favored in the coprorate environment for their unique ability to deliver PUSH email around the world.
• Nokia (NOK)
• LG
• Samsung

Many of the phones offered by Nokia (NOK), LG, and Samsung would not be considered traditional "smart phones" in that they do not run an advanced OS like BlackBerry, AAPL, or Palm. However, their phones are competitive and have many "smart features", and some of their next gen devices also incorporate some sort of "smart" advanced internet capability.

Mobile Device Manufacturers

• Lenovo Group (LNVGY)
• Hewlett-Packard Company (HPQ)
• Dell (DELL)

Many of the major computer manufacturers also entered the P.D.A. business given that their competencies in making computers carried over to the PDA segment. As such, Dell's Axim line, HP's IPAQ line, and Lenovo's PDA phones all directly compete with Palm's Smart phone, and Palm's older line of non-phone PDAs.

Market Share

2008 Smartphone Market Share^[26]

Corporate Smartphone Market Share^[27]

There are two critical markets when it comes to Palm - first the Smart Phone market at large, which includes general users who are converting from normal phones, and the Corporate market, which has long been competitor Research in Motion (RIMM) main market. According to Palm, 70% of its new Centro buyers upgraded from an non-Smart phone.^[28]

According to the data service IDC, which tabulates sales by units, the domestic Smart phone market is 44.5% in BlackBerry hands, with competition from the IPhone. Motorola, and HTC are all second-tier players in this field. Palm has share at 13.4%, largely due to many Centro sales during FY 2008.^[30]

In the corporate arena, due to access requirements and security demands, as well as a general corporate aversion to Apple (AAPL) due to closed standards, BlackBerry and Palm are the primary competitors. Even as such, BlackBerry leads Palm 76% to 18%, according to ChangeWave, which conducted a survey among corporate IT groups. The number tabulates % of adoption among 2,000 different enterprises.^[32]

References

1. ↑ CNet.com "Developing markets fuel cell phone sales growth" May 29th, 2008
2. ↑ CNet.com "Only U.S. Apple retail stores getting iPhone 3G" July 8, 2008
3. ↑ Seeking Alpha "Who needs carrier subsidies" June 12, 2008
4. ↑ Palm FY 2008 Earnings Press Release. June 26, 2008
5. ↑ Palm FY 2007 10-K "Selected Financial Data" pg. 33
6. ↑ Palm FY 2007 10-K "Product Information" pg. 86
7. ↑ Palm FY 2007 10-K "Geographic Information" pg. 86
8. ↑ Palm FY 2007 10-K "Product Information" pg. 86
9. ↑ Palm FY 2008 Earnings Press Release. June 26, 2008
10. ↑ Palm FY 2007 10-K "Selected Financial Data" pg. 33
11. ↑ Palm FY 2008 Earnings Press Release. June 26, 2008
12. ↑ SeekingAlpha PALM Q4 FY 2008 Earnings Calls Transcript. May 30, 2008
13. ↑ SeekingAlpha PALM Q4 FY 2008 Earnings Calls Transcript. May 30, 2008
14. ↑ Wall Street Journal "Apple's'Podfather' Now Aims to Revive A Wilting Palm" Decemer 13, 2007
15. ↑ Barrons Tech Trader Daily "Palm: Elevation Takes Stake" June 4, 2007
16. ↑ Palm FY 2007 10-K "Product Information" pg. 86
17. ↑ SeekingAlpha PALM Q4 FY 2008 Earnings Calls Transcript. May 30, 2008
18. ↑ Palm FY 2007 10-K "Geographic Information" pg. 86
19. ↑ Information Week "Palm Jumps As Verizon Picks Up Centro Smartphone" June 12, 2008
20. ↑ CNET "Braining Smart Phones to the Masses" September 28, 2007
21. ↑ CNET.com "Smartphone sales skyrocket" November 13, 2007
22. ↑ SeekingAlpha "Palm’s Good News: The Centro is a Hit. That’s the Bad News Too." March 21, 2008
23. ↑ Information Week "BlackBerry Leads, iPhone Follows U.S. Smartphone Sales" May 30, 2008
24. ↑ Information Week "BlackBerry Leads, iPhone Follows U.S. Smartphone Sales" May 30, 2008
25. ↑ CNet.com "Only U.S. Apple retail stores getting iPhone 3G" July 8, 2008
26. ↑ Information Week "BlackBerry Leads, iPhone Follows U.S. Smartphone Sales" May 30, 2008
27. ↑ Information Week "BlackBerry Defies Stagnant Tech Spending" June 5, 2008
28. ↑ SeekingAlpha "Palm’s Good News: The Centro is a Hit. That’s the Bad News Too." March 21, 2008
29. ↑ Information Week "BlackBerry Leads, iPhone Follows U.S. Smartphone Sales" May 30, 2008
30. ↑ Information Week "BlackBerry Leads, iPhone Follows U.S. Smartphone Sales" May 30, 2008
31. ↑ Information Week "BlackBerry Defies Stagnant Tech Spending" June 5, 2008
32. ↑ Information Week "BlackBerry Defies Stagnant Tech Spending" June 5, 2008