At Palm, a slice of Apple

As CEO of Palm's operating system unit, Nagel faces many of the same challenges he grappled with at Apple: modernizing an operating system, switching to a new chip architecture, and trying to compete with Microsoft.

While the challenges are many, Nagel stands to be rewarded richly if he can turn the OS unit into a standalone business. Nagel's contract gives him the right to acquire up to 6.5 percent of the OS company, known now as PalmSource.

On the eve of the company's main conference for software developers, also called PalmSource, Nagel spoke to CNET News.com about the challenges facing Palm, its decision to split the operating system business into a separate company, and making the switch from technologist to CEO.

Q: Given the size of the license fee that Palm gets for each unit sold, it seems the Palm OS business would need a fairly substantial market and have to grow reasonably quickly for the company to enjoy a good valuation. Is that your sense as well?
A: It's a size of market where it's clearly sustainable. We went past the 20 million mark for units, and the market is somewhere between 10 (million) and 15 million units a year just for PDAs (personal digital assistants). And we're just getting now into the whole "smart phone" arena taking off--I think slowly initially, but that should speed up.

In terms of interesting shareholder value, how large does it have to get? I think, frankly, it's within reach right now...I think that it's somewhere in the hundred million per year (in sales) territory, and we're not too far away from that. I think it's not only sustainable, but nicely profitable. There are a lot of analogues in the industry. If you look at the set-top box business, companies like Liberate are smaller than that and have significant shareholder value.

In trying to put a sense together of how something might be valued, analysts were able to piece together the revenue side of the business more easily than the cost side, since you guys haven't broken that out. Assuming Microsoft-like operating margins and a pretty decent multiple, analysts came up with a value somewhere in the $500 million to $700 million range for the OS business. Does that seem to be in the ballpark?
Various people have tried to estimate the size. The estimates range anywhere from $300 million up to a billion and a half dollars. That's probably not too far off the mark. It depends on what the market is doing; it depends on a lot of things. The ultimate test is always if and when it's publicly traded, what the public thinks.

You have talked about a couple of different ways of separating the business. Some involve taking in new capital and some don't. Is it feasible to separate the business and not take in additional capital?
This is a business unlike a manufacturing business. Once you get into cash-positive territory, working capital requirements to operate the core business are pretty minimal. In general, software companies are easier to capitalize and require much less working capital--which is one of the reasons, frankly, that they are valued higher, generally, than manufacturing companies or companies that do use a lot of capital.

My personal belief is that it is desirable for a number of reasons to at least consider taking in external capital, whether in the form of strategic investment (or an IPO) or perhaps both...There may be small acquisitions that you would want to look at, or acquisitions of technology, or getting into new lines of business or those sorts of things, which would require modest amounts of working capital.

Do you think that the OS business, long term, is simply developing, marketing, reforming, licensing and selling the operating system, or is there a need to get into other areas and applications to grow the revenue? Microsoft, obviously, has the operating system, but they have various applications and so forth.
I think Microsoft is the textbook example of how to run a platform business. They did a very good job in many ways of leveraging the platform business with a very profitable--perhaps even more profitable--application business. In answer to your question, sure, there are other opportunities. PalmSource has a small content business...selling electronic books. We have about 10,000 titles.

The analysts who get the most excited about the Palm OS unit as an investment opportunity say the key is getting the Palm OS into wireless devices. People are less and less enthused about the idea of disconnected organizers, at least on the financial side. How important do you see Palm OS being in the wireless devices, particularly cell phones?
I think your distinction is a good one. There is less pessimism in the market by customers than there is in the financial community about disconnected organizers...The big opportunity in the future is wireless. The i705 that Palm just announced and the Treo that Handspring just announced and the Samsung and Kyocera and so forth...are a very important new area for us.

It seems like one challenge facing Palm is similar to an issue you tackled at Apple--that is, switching to a new chip architecture and modernizing the operating system. Do you look at that as kind of a parallel for what you are doing?
Yeah, it's almost a perfect parallel. In some sense, the transition of the Mac from 68K to PowerPC was more difficult simply because the applications are more complex and larger, and the OS itself is more complex than the Palm OS. One big difference is the ARM architecture appears to be an easier architecture to transition to...We're not seeing much, if any, code expansion. We're working real hard on compatibility.

Not all the applications are what our folks call well-behaved, because a lot of developers did optimize (for the chip) because we were on a relatively slow processor...Our goal is that about 80 percent of all the applications would eventually run--not initially, but eventually--on the ARM architecture.

It seems like the chip part went smoothly at Apple, but modernizing the OS itself proved to be a more difficult task. I mean, OS X just came out this year. They went on to buy Next; you guys bought the assets of Be. Where are you in terms of modernizing the OS? Adding the features you have talked about-- security, multimedia?
Things, when they work, always look easy retrospectively. I do recall the PowerPC thing was a real nail-biter...On the modernization piece, this is an area where I feel I have learned from the Apple experience. I will say I don't regret trying. One of the things you do in the technology business, if you are successful, is you take reasonable risk. If you don't, you end up with pedestrian products.

Was that one of the reasons that Copland never got out the door? Was that a time when resources were being cut and you were trying to do too much?
Yeah, I think that's pretty simple. A lot of the really good OS engineers had left. The guy who had done the emulator on the PowerPC, he had taken off for other pastures. Just as a measure of the difficulty: Steve Jobs--along with Avie (Tevanian, Apple's top software guru)--is a very good engineer and has a fantastic team that he brought with him. It still took them six years to get OS X out. It's a big task, but I think we are well on our way to doing it here at Palm.

People talk about you as definitely a visionary, but some people wonder whether the operations role managing the company is going to be a new thing. When you started the job as CEO, what was your thinking about that?
Well, I look at it as a challenge and an interesting one. This is a pretty straightforward business. If I were starting a new Enron or something, I might be worried about my business acumen. This is pretty much it: You crank out great products, you find good licensees and encourage them to make great products, and they pay you for it.

Obviously, running the company, you do all the things that CEOs have to do. You have to find great people. I have a growing number of really good people that have operational experience. Chief Product Officer Steve Sakoman, who also came from Be, was the chief operating officer and president at Be. We just hired Dory Yochum, from AT&T, who was my chief operating officer at AT&T Labs. There are certain aspects of the job that are a challenge, but it's the kind of thing that I think is certainly doable. Fortunately, I think there have been a number of other very successful CEOs that started in similar territory.

Splitting the business--was that something that was talked about for a long time? What were the criteria that made you decide this was what you wanted to do?
I was only on the board for about a year and a half. It certainly was a topic of discussion of growing intensity over that time. I think the decision to license the OS to someone other than (Palm's own hardware company) certainly pointed the way to eventually doing a more formal separation.

It is straightforward how you do an integrated company like Apple. The software and hardware sides are technology and development plays, and the two of them work together to make great products. You can control everything end to end. You also end up with 2.5 percent market share. I think the great concern--and certainly I shared it, having been in that play before--is that you can't make a better enough product to deal with the superior economics of a more open model. You just can't do it.

There was a sense before the last few months that the pace of innovation at Palm had slowed. The hardware group had the benefit of the Palm name and enjoyed market share even though the products had been relatively incremental. And on the software side things had not progressed that fast.
Well it's certainly changing. There was probably a little more progress than people gave the Palm guys--my predecessors--credit for. The thing that if I could term it a mistake, or at least a lapse in some sense, is we didn't put enough attention into putting in innovations in both the hardware and software sides that were actually detectable by the user.

The original OS, although it was extremely clever and extremely compact, was not something that was architected to evolve. There has been a lot of work, frankly, in the foundations of the OS, to make it better. But it's not the kind of thing that users see and appreciate. Whether or not you agree with that, I think it's certainly the case that we have cranked up the rate of innovation, and that is certainly one of my goals in coming here.

How far along are you? When people meet at the PalmSource conference, is it going to be, "Wow, this is a process they are just starting," or is the progress going to be pretty tangible and palpable?
I don't know if it's going to be like, "Wow!" I've only been here for four months. I hope that people get a sense that things have changed...We have the resources to do it; we have the horsepower to do it and the brains to do it. We'll be providing some evidence of a down payment on that promise.