Internet Mini Case 1

Palm, Inc.
Maryanne M. Rouse

Palm, Inc. competes in the handheld device, operating system (OS) software, and wireless
services markets. Founded in 1992, the company was acquired by U.S. Robotics in 1995. Palm
launched its first organizer products, the Pilot 1000 and Pilot 5000, in the United States in early
1996 and in France later that year. In June 1997, Palm became a subsidiary of 3Com, when that
company acquired U.S. Robotics. In December of the same year, the Palm Pilot was selected as
one of Information Weeks Most Important Products of 1997 and named Newsweeks High
Tech Gizmo of the Year. In December 1997, Palm began licensing its Palm OS platform. The
platform comprised the Palm OS; the Palm user interface; standard personal information
management applications, including a date book, an address book, a to-do list, a memo pad, and a
calculator; developer tools; HotSync data synchronization technology; Graffiti script recognition
technology; and Web-clipping software.

Palms 1999 acquisition of Smartcode Technologies added advanced wireless communications

capabilities to the Palm OS and positioned the company to address the convergence of voice and
data streams in the rapidly developing market for mobile information appliances, including
cellular telephones, messaging devices, data communicators, and smart phones.
______________________________________________________________________________
This case was prepared by Professor Maryanne M. Rouse, MBA, CPA, University of South Florida. Copyright 2005
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Internet Case 1-1

In September 1999, 3Com announced plans to make Palm an independent, publicly traded
company. Palm went public on March 2, 2000, with an IPO of 23 million shares at an initial price
of $38. Concurrently with the IPO, America Online, Motorola, and Nokia purchased a combined
total of 5.9 million shares at that price. Immediately after the IPO, Palm had 560.9 million shares
outstanding, of which 3Com owned approximately 94.8%; these 532 million shares were then
distributed to 3Coms shareholders, completing the spin-off.

In June 2000, Palm acquired Actual Software Corporation, a provider of e-mail solutions for the
Palm OS platform. Concurrently with the launch of the Palm m500 series in March 2001, the
company acquired peanutpress.com, renamed Palm Digital Media, a web-based storefront
featuring approximately 2,000 titles from many of the major U.S. publishing houses. As part of
that acquisition, Palm also acquired the Peanut Reader, now called the Palm Reader, an eBook
reader application for Palm Powered devices. Palm Digital Media was combined with Palms OS
and platform business to form the Platform Solutions Group; the hardware side of the business,
which included the Palm series of handhelds as well as hardware add-ons, software, and
accessories, became the Solutions Group. Other key acquisitions included ThinAirApps, Inc., a
privately held New York based developer of software that enables secure wireless access to
corporate e-mail, which became part of the Solutions Group, and specified assets of Be, Inc., a
provider of software solutions for Internet appliances and digital media, which was integrated
into the Platform Solutions Group.

Restructuring: Breaking Up Is Hard to Do

In July 2001, Palm announced a bold turnaround plan to maintain its market leadership position
in a rapidly evolving competitive environment: It would essentially split Palm in two.
PalmSource, the renamed Platform Solutions Group, would develop and license Palms operating

Internet Case 1-2

system and software, and the Solutions Group would focus on building the hardware. Under the
new corporate structure, Palms Solutions Group would license the Palm OS platform from the
newly separate PalmSource as the foundation for its Palm handheld devices.

In July 2003, Palm filed with the Securities and Exchange Commission the required registration
statement for the spin-off of PalmSource in a tax-free transaction to existing shareholders;
shareholders were expected to approve the transaction at the companys annual meeting on
October 28. The benefits Palm touted included:

Greater clarity of mission and focus for both businesses

Increased speed and responsiveness to technology change and customer needs for both
companies

Increased number of potential licensees for the Palm OS

More direct access to capital markets for both companies, given that they could be more
easily understood by investors and securities analysts

The strategy appeared to be designed to help Palm avoid the fate of tech companies that didnt
split their hardware and software, such as Apple Computer. While Apple delayed, Microsoft
licensed its Windows OS to a broad range of hardware makers and became the industry standard.
With Microsoft now challenging Palm in handheld software, with its Windows CE and Pocket PC
and Pocket PC Phone Edition products, several members of Palms Board, many of whom were
also former senior managers at Apple, strongly supported the split. The strategy was expected to
enhance Palms licensee relationships by addressing their concerns that, while they licensed the
companys software, they also competed with its hardware.

Internet Case 1-3

The breakup was not, however, entirely smooth. Eric Benhamou, Palms CEO, received a flood
of e-mails from concerned staffers, expressing doubts about the split and asking him to
reconsider. Many employees on the hardware side argued against the breakup, noting that
without the software unit, the hardware subsidiary would find itself in an intensely competitive,
low-profit commodity business. Some Palm executives, including the companys CEO, Carl
Yanowski, quit after finding their job responsibilities diminished under the new structure. Some
who remained continued to question the breakup. In response, Benhamou, who served as
Chairman of the Board of 3Com and who had stepped in temporarily as CEO at Palm, called a
company wide employee meeting at which he announced unceremoniously, The split will
happen. Get over it.

The separation process raised a number of nettlesome issues, including which entity would retain
Palms high-profile brand and the terms of the licensing agreement. Senior managers at both
groups developed detailed presentations intended to persuade Benhamou and the Board on the
brand issue. PalmSource won the contest for ownership of the brand on the basis that
encouraging hardware makers who licensed Palms software to label their devices as Powered
by Palm would give the brand more exposure than if it were limited to Palms own hardware.
Although terms of the final licensing contract have not been disclosed, it was expected to reflect
that Palms hardware group would be PalmSources largest customer.

Acquisitions and Mergers

Palms acquisitions had supported the companys product development strategies. Palms target
market had been relatively sophisticated professional users seeking usability, convenience,
flexibility, and expandability; however, Benhamou saw the opportunity to broaden the companys

Internet Case 1-4

reach into the business market by positioning its devices as business tools. One way Palm was
seeking to increase its appeal to businesses was through partnerships, such as a current one with
McKesson, to jointly market and promote their products to health care professionals.
Subsequently, Palm announced that key product strategies going forward would include:

Moving from basic PIM-oriented solutions to networked PIM and communications

applications

Moving from relatively sophisticated consumers to the broad consumer market and
toward the emerging enterprise market

Transitioning from mostly stand-alone solutions to mostly wireless solutions

Shifting from a U.S. focus to a global focus, including new markets such as China, India,
and Latin America

Moving from a first-generation microprocessor (the Motorola Dragonball) to the ARM

generation solutions

In early June 2003, Palm and Handspring, a maker of handheld computers and a global leader in
Palm OS based smart phones, agreed to a merger that would integrate Handspring into the
newly independent Palm Solutions Group in a move that would bring Jeff Hawkins, Donna
Dubinsky, and Ed Colligan, who invented the Palm Pilot and built the company, back to their
roots. The two companies maintained that the merger would create a stronger competitor in
handheld computing and communications and support the Palm Solutions Groups objectives of
growing the market, maintaining industry leadership, and achieving consistent profitability. The
merger would leave just two competitors that would still make traditional, stand-alone palmtops
that ran the Palm OS: Palm and Sony. Cited benefits included:

Internet Case 1-5

Maximizing Palm and Handspring's combined scale and operational excellence to take
full advantage of future growth opportunities

Delivering an unmatched portfolio of innovative mobile products from traditional and

multimedia handhelds to wireless handhelds and smart phones

Adding Palm's strong brand and distribution channels to Handspring's highly regarded
Treo product line and carrier relationships

Enhancing the Palm management team including hardware and software design,
engineering, and marketing to help drive handheld computing into deeper and broader
solutions

The merged companies expected greater revenue opportunities. They also expected to obtain
improved operating efficiencies of approximately $25 million in cost savings annually. The cost
savings assumed combined employee reductions of approximately 125 people, elimination of
overlapping programs and unnecessary real estate, and the advantages of increased volume in
manufacturing and distribution. Handspring employees were expected to move to the Palm
Solutions headquarters in Milpitas, California. Palm and Handspring shareholders were expected
to approve the merger in separate meetings on October 28, 2003.

Operations

Palm relied heavily on outsourcing for manufacturing and distribution. The company also used
third parties to provide services including customer service, data center operations, desktop
computer support, and facilities services. Palm outsourced some product R&D as well by
entering into agreements for the development and licensing of third-party technology. The
companys distribution facilities were physically separated from manufacturing locations,

Internet Case 1-6

requiring additional lead time to move products to customers. Although Palm relied on
distributors, retailers, and resellers to sell its products to end users, the company also sold
products directly from its Palm.com web site. Palms introduction of three new, lower-priced
handhelds in late fall 2002, including the Zire, which sold for under $100. The company believed
it could design a product to be sold at that price and still meet profit margin targets while giving
the Solutions Group a market of four times as many consumers. The lower-priced products
would also benefit the company longer term as first-time Palm users sought to upgrade.

Finance

Palm reported a fiscal 2002 year-over-year revenue decline of $528.5 million, or 35%, and a net
loss of $108.8 million, or 10.6% of sales, despite gains made in its fourth quarter. (The company
announced that its fourth quarter loss had narrowed to $27.5 million as it had cut expenses while
sales rebounded from a year earlier, when product delays had cut its revenue in half.) In addition
to reducing its workforce through layoffs and attrition, Palm cut marketing expenditures for
product branding, advertising, and promotion and R&D costs. (Overall, sales and marketing
expenses as a percentage of revenue increased, however, because of lower revenues.) Although
Palms revenue growth rate had been faster than the industrys, the company had reported losses
in five of the previous six quarters as the slowing global economy had led both consumers and
businesses to spend less on technology, affecting sales at Palm and rivals such as Handspring,
which licensed the Palm OS. Palms shares closed at $.74 on October 1, 2002, having lost over
95% of their value in the tech meltdown of the preceding 18 months. (Access to detailed
financial information for Palm, Inc., is available via the Palm site, www.palmsource.com, or
www.freeEdgar.com)

The Industry

Internet Case 1-7

For more than a year, the handheld device market had struggled with demand, deflated by a U.S.
economic slowdown that forced consumers to think twice about buying electronics even as device
makers cut prices on older models and rolled out new products with advanced features. Overall
global shipments of hand held computers in 2001 totaled 13.1 million units, according to
researcher Dataquest, up 18% from the previous year but well behind the explosive 114%
increase in shipments from 1999 to 2000. Analysts predicted that a weakening global economy
plus a buildup of channel inventories would lead to 2002 industry sales of up to 20% lower than
those in 2001, with only modest industry wide gains in 2003.

While a weak global economy had strongly influenced industry sales, there was also concern that
the market may have been becoming saturated: Most consumers who wanted electronic
organizers already own them, and current users saw little reason to buy others. However,
because hybrid devices with sophisticated features were expected to lure experienced users back
into the market, the ability to develop and introduce new products was critical to building
competitive advantage. And, while innovation and alliances would be critical to attracting and
retaining traditional business customers, industry observers believed that a product priced below
$100 would lure a whole new segment of users into the market.

Competitors

Palm competed in three segments: the handheld device, OS software, and wireless service
markets. Palms handheld computing device products competed with a variety of smart
handheld devices, including sub-notebook computers, keyboard-based devices, smart phones,
and two-way pagers. The companys principal competitors in the handheld segment included
HP/Compaq, Casio, Handspring, Sony, Sharp, and Research in Motion (RIM).

Internet Case 1-8

Although Palm still sold far more handhelds than Compaq (Palms global share was
approximately 40%), the iPaq, because of its higher price tag, generated comparatively more
revenue than the average Palm. Sales of the iPaq had grown quickly since the device was
introduced in 2000, with first quarter 2002 sales reported at $160 million, up 18% from a year
earlier. At the end of April 2002, market share estimates by industry research firm Gartner place
the former Compaq product line at number two, with a 10.1% global share, while HP, which came
in at number six with a 4.4% share, saw its worldwide unit shipments off 43.9% from a year
earlier.

As HP completed its post merger integration of Compaq, managers from both companies noted
that the HP unit that included handhelds would be made up of products from both HP and
Compaq, but it had not specified whether it would keep both the iPaq and HPs Jornada.
Analysts speculated, however, that the iPaq product line, with its greater market share and growth
prospects, would be the survivor. In 2004, HP/Compaq was focusing on getting large companies
and government entities to use handhelds. BMW sold the iPaq as an option with its Z3 in
Germany, allowing executives to use it for navigation in the car and as an organizer outside the
car.

Handspring fell from number two to number three worldwide, with a sharp decline in unit sales,
resulting in a market share drop of more than five percentage points, to 9.9% for the same period.
Sony, with shipments up 250% from the prior year, moved into the number four position, with a
7.7% global market share. Sharp, which began shipping its Linux-based Zaurus to the United
States in April 2002, gained the number five spot, helped by its strong performance in Japan.
Casio, with 4.4% of the global market, placed at number seven, just behind HP.

Internet Case 1-9

In the United States, Palm was the leader, with a 47.5% market share, while Handspring
maintained the number two spot, with a 14.6% market share at the end of April 2002. Sony had
10.8% of the U.S. market, followed by Compaq with 8.6% and RIM with 5%.

On July 2, 2002, a San Francisco startup, OQO, announced that it had developed a computer that
was only slightly bigger than a deck of cards but as powerful as a desktop. It could be used as a
handheld or connected to accessories to transform itself into a notebook or desktop. Unlike
handhelds then on the market, OQOs device ran the Microsoft Windows XP operating system,
didnt have to be synchronized with a PC to receive e-mails, and had more memory, processing
speed, and storage. It also had sockets for connecting the device to accessories such as a folding
keyboard or DVD player, and it came with a cradle that transformed it into a PC by hooking it up
to a keyboard, mouse, and standard video monitor. Other companies, including IBM, were
working on similar modular computers, which were expected to pose a real threat to the
popular handhelds.

Of more immediate concern were plans by Danger, Inc., a San Francisco startup, to introduce a
hiptop device, essentially a laptop no larger than a bar of soap, in late October 2002. Dangers
T-Mobile Sidekick would offer wireless Internet, e-mail, and instant messaging, all in a
combination cell phone, personal digital assistant, and digital camera. The Sidekick was to have
a black-and-white screen that swiveled and flipped to reveal a full keyboard with an adjacent
thumbpad that would serve as a joystick for playing games. With an always on wireless
Internet connection, the Sidekick would alert users when e-mail arrived, and AOL Instant
Messenger would allow real-time chat. T-Mobile Wireless would provide unlimited Internet use
to Sidekick owners for $39.95. Danger believed that the $199 price tag would make the Sidekick
extremely competitive.

Internet Case 1-10

Competitors in the wireless services segment included EarthLink, Go America, RIM, and other
device manufacturers, such as Sony, that offered Internet services. Palms wireless services also
competed indirectly with other providers of wireless access, ranging from dedicated providers of
Internet access such as AOL Time Warner to local phone companies and telecommunications
carriers.

The companys Palm platform competed with operating systems from Microsoft, Java-based
platforms such as those used by cellular telephones, proprietary operating systems from
companies such as Sharp Electronics, and systems based on Linux. Microsoft appeared to be
investing aggressively in efforts to assist its licensees in marketing handhelds that used
Microsofts operating systems, including the Pocket PC 2002 operating system.

Internet Case 1-11