February 4, 2002 4:00 AM PST

Two Palms better than one?

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OS development vital to Palm's future
Alex Slawsby, analyst, IDC
As David Nagel ponders the future of Palm, he is ever mindful of what happened to Apple Computer.

Both companies have a legion of loyal fans and both are considered leaders in making technology that is easy to use. Both walk a treacherous line by building hardware and operating system software. And a growing number of Apple refugees now work at Palm.

But there's also an important difference: Apple has less than 5 percent of the PC market, while Palm's operating system holds about 75 percent of the handheld market.

And that's a market-leading position that Palm executive Nagel doesn't want to let slip away.

"It is straightforward how you do an integrated company like Apple," Nagel said in an interview with CNET News.com. "You can control everything end to end. You also end up with 2.5 percent market share."

Trying not to meet a similar fate, Palm decided last year to split the company into two pieces--one that produces hardware and one that handles the OS. Nagel has been tapped to lead the new operating system company, tentatively called PalmSource. Although it was a drastic move, separation alone won't cure Palm's ills.

"I think the company is clearly better positioned (after the) split," said U.S. Bancorp analyst William Crawford. "But that doesn't mean that the challenges go away."

Sales dropped precipitously after peaking about a year ago. As a result, Palm and device maker Handspring, which uses the same OS, have had to slash prices to move inventory. Plus, Palm is looking to move its operating system onto a new type of chip and to add features such as multimedia support and security.

As if that weren't enough, Microsoft is lurking with its Pocket PC operating system. Although it holds only a 15 percent share now, nobody is discounting the giant's legion of developers, massive cash position (nearly $40 billion) and shrewd business acumen--nor the example of what it did to early market leaders such as Apple and Netscape Communications.

While Nagel's desire not to see Palm follow in Apple's footsteps is understandable, going the licensing route means giving up the bulk of the money from each device sold. As an OS company, PalmSource will typically collect less than $10 for each unit with its operating system.

Being an OS company works for Microsoft in the PC business, but it has better than 90 percent of the market and collects a higher fee for each copy of Windows. In addition, the computer market is much larger than the handheld market.

Even counting the royalties that the Palm hardware unit will be paying to the OS unit, analysts say the Palm OS business is doing less than $100 million in sales today, although it should reach that level in the next couple of years.

"It doesn't appear that the opportunity for the OS (business) is that significant when you consider the number of Palm OS devices that have been sold," said Brian Blair, a research analyst with hedge fund Bluewater Capital. "The question going forward is, Is there going to be an explosion of devices?"

Meanwhile, the hardware side, which comprises the bulk of Palm's revenue, is seen as likely to become just another combatant in a brutal price war.

Dollars and cents
So, if Nagel's OS company is the attractive part, how much is it worth? Estimates place the value anywhere from a low of $300 million to more than $1 billion.

"If we assume Palm takes just 20 percent of the smart phone and wireless organizer market by 2004, this is a $500 million to $700 million company," said U.S. Bancorp's Crawford. "But we think this number could be low given that they control 75 percent of the handheld market."

That's not insignificant, but it still represents about a third of Palm's current market capitalization and less than 1 percent of the market capitalization the company enjoyed on its opening day of trading in March 2000.

Nagel, a Palm board member and former AT&T Labs and Apple executive, said he is not worried that the OS company is generating less than $100 million a year in revenue.

"There are a lot of analogues in the industry," Nagel said in an interview. "If you look at the set-top box business, companies like Liberate are smaller than that but have significant shareholder value."

But to give the divided Palm anywhere near the kind of valuation it once enjoyed, the Palm OS will have to find its way onto tens of millions of wireless devices--something it has yet to do.

Although Palm initially signed up Motorola and Nokia as licensees, both companies have backed off their initial plans. Smaller players such as Kyocera and Samsung have come out with phones that use the Palm OS, but sales have been relatively modest for the devices, which were initially priced between $400 and $500.

Blair argues that the initial reaction to Handspring's new Treo could be a good indicator of whether the Palm OS can ever claim a significant chunk of the cell phone business.

"The Treo appears to be the first one to get it right," Blair said, noting that the device is small and easy to use. "The success of the Palm OS, to some extent, hinges on the Treo.

"If it's a hit, I think it's fair to say we will see a great deal of Palm OS cell phones. I think it will be evident within six months to a year," he said.

In an interview, Palm's chairman and interim CEO, Eric Benhamou, said the company needs to gain a significant share of the "smart phone" business, which he estimated will represent 15 percent to 20 percent of the cell phone market by 2005, or roughly 85 million devices.

"If you picture what success looks like a couple of years from now, success would look like having two to three dozen licensees...who produce several tens of millions of Palm OS-enabled handhelds per year and a business that would be several hundred million dollars in revenues," he said.

Blair and others have largely written off Palm's historic business of making electronic organizers. While that market still exists, it will be plagued by low margins.

"That business is not enough alone" to sustain the OS company, Blair said, adding that if the Palm OS is primarily used in traditional, non-connected organizers, the stock is unlikely to be well valued.

No magic remedy
While many in the industry support the idea of splitting Palm into the two units, there is also agreement that the split is not a magic cure to the problems that have plagued the company: an inability to persuade significant numbers of companies to use the devices, execution problems, and what some see as a slowing pace of innovation.

There is also the issue of whether the Palm OS unit will have enough resources to tackle those challenges. Palm has said it would like to see the company made fully separate this year. However, it has not said whether it believes it can raise additional cash, either through an initial public offering or through a strategic investment.

Banc of America Securities analyst Rob Sanderson said it would be preferable, though perhaps not necessary, for Palm to bring in cash in addition to just dividing itself in two.

"If I was managing the business, I'd definitely want to strengthen the balance sheet," Sanderson said.

Palm had $241 million in cash at the end of November, down from $321 million in cash a quarter earlier. Last year, as it slogged through a product glut, Palm burned through a substantial amount of the cash raised in its blockbuster IPO.

The company has not said how it might divide the remaining money, although Nagel noted that the software business is not typically cash-intensive. Splitting the two units could help Palm in a few key areas, particularly in signing up additional licensees for the operating system.

"Palm competed too well with Handspring," Crawford said. "Other companies have seen that and have been gun-shy relative to Palm."

Handspring, for example, says that in the past, it was not sure just how open it could be with Palm. Executives including CEO Donna Dubinsky said the split has been a positive for its relationship with Palm.

"We have felt better able to have a more open relationship with them," Dubinsky said.

The split also makes clear what work is being done by which part of the business. For example, Palm created a new version of its memo pad in 2000, one that allowed people to scribble handwritten notes rather than have to enter them as text. However, the unit said the software was created by the handheld side of the business and therefore not made available to licensees.

Another possible benefit of separation is that each part of the business will be more accountable.

Some say the hardware business has offered only incremental improvements to its devices, while Handspring and Sony have offered more revolutionary changes including the ability to make phone calls or listen to music.

Palm has been planning for two years to move from the relatively low-powered Dragonball processor from Motorola to chips using an architecture licensed from ARM. Intel, Texas Instruments and Motorola plan to make ARM-based chips for the new Palm OS. Meanwhile, Microsoft has been running on ARM chips for some time and last year revamped its Pocket PC operating system to boost security and support a wide range of wireless connections.

Nagel and Benhamou conceded that the pace of innovation at Palm had slowed, but added that things are improving.

Tipping its hand
This week, the public will get to judge for itself as Palm prepares to show developers the progress it has made with the new operating system at a weeklong conference in San Jose, Calif. Palm is expected to offer developers a beta, or test, version of the new Palm OS that will run on ARM-based chips.

Another wild card for the company is Nagel himself.

In picking Nagel to head the OS business, Palm went with an outsider, but one who knew the company well. He brings operating system experience from Apple and wireless contacts from his most recent position at AT&T Labs. However, running PalmSource will be his first time overseeing the business aspects of a company.

Benhamou said Nagel's technical acumen and understanding of the security and multimedia improvements the Palm OS needs make him the right man for the job, even if he lacks the experience of running his own company.

"PalmSource is almost purely a technical vision and technical execution," Benhamou said. "There's almost no operational skills required to run PalmSource. That's not really what counts. What counts is the quality of your vision as well as the quality of your leadership in leading a technical team."

And that may be a good thing for Nagel, whom former associates describe as strong on vision but weak on operations.

"Dave is not an operational guy. His best quality and where he shines most is when innovation is needed," said Tsvi Gal, president of E*AT&T, who has also worked with Nagel at Apple. "Dave and Hossein (Eslambolchi, AT&T Labs' president) made a great team. Hossein is a great operational guy.

"Dave is happiest and does his best work when he has a challenge in front of him. He's not as happy when the work involved is largely maintaining operations," Gal said.

Nagel has been a strong advocate of splitting the company since he joined the Palm board more than a year ago.

In many ways, the situation of the Palm OS is analagous to a challenge Nagel faced at Apple--shifting the Mac onto a new type of chip and modernizing the operating system. Though the former task ended up working well, Nagel's initial effort at modernizing the operating system turned into the ill-fated Copland, the successor to the Mac OS that never shipped.

"Copland was so incredibly ambitious. It took a lot of work to pull it together and try to get it out the door," said John Sculley, former Apple chief executive. "Apple's efforts to change its OS is a seven- to 10-year job and far more complex" than what Palm is facing.

Ian Diery, former executive vice president and general manager of Apple's personal computer division, said he would not blame Nagel for Copland's failure.

"He had a difficult job at Apple. He inherited the job of making the OS backward-compatible," Diery said. "He had to enhance an OS that was hard to enhance. There were a lot of ills at Apple at the time, and I wouldn't put them at David's feet."

Gabi Schindler, who worked with Nagel at Apple and AT&T Labs, offered a different perspective on Copland's failure.

"Dave took a lot of risks with Copland. He made the mistake of making too many requirements but not having enough (work force) resources," Schindler said.

She added, however, that Nagel was largely able to get projects out the door on time at both Apple and AT&T.

To bolster its effort, Apple ended up buying Steve Jobs' Next Software. Palm also looked for outside help, scooping up the assets of Be. Ironically, Be was the company Apple passed on when it was trying to revamp its OS.

Winning over the insiders
Although some Palm executives were skeptical of Nagel's ability to lead a company, given his lack of CEO experience, he has managed to bring some around.

"He's extremely motivated and reaching out to employees and our top customers," said a Palm executive. "So far I've been impressed with him...he has a clear picture of what he wants to do and what he wants to accomplish."

The source, who initially was skeptical, noted that Nagel has also set out to develop a new organizational structure for the OS company, recently hiring Dory Yochum as chief administrative officer. Yochum previously served as chief operating officer of AT&T Labs. In that position, she was responsible for the daily operations of the labs, its business planning and its partnerships.

Nagel has also hired two former executives with AT&T Labs, one a former engineer of AT&T messaging and the other in business development.

"He has an excellent reputation. He's a quick study and everyone liked and trusted him at Apple," Sculley said. "All his people also ended up in top positions elsewhere. He has an ability to attract good people."

Gal said of Nagel's work at AT&T: "Dave is an extremely bright guy. The reasons you don't see a lot of awards by his name is he gives his subordinates the credit...And if you're under attack, he'll put his chest out to stop the bullet."

Whether he can stop the bullets flying toward Palm is another question.

 

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