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Commentary: Palm faces radical change

The handheld maker's current financial woes are a result of market conditions, changing consumer tastes, and its own business miscalculations.

Palm's current financial woes are a result of market conditions, changing consumer tastes, and its own business miscalculations.

Palm expected demand for its products to grow much more rapidly than it has, and as a result, the company has overproduced units and must offer discounts and other incentives to move the inventory. The once high-end Palm VII wireless unit is now priced at $99 after rebates. This inventory glut has been exacerbated by tough competition from Palm's licensees--primarily Handspring's Visor, but also Sony's Clie, and HandEra, formerly TRGpro.

Palm is also suffering

See news story:
Will Palm scrap businesses to survive?
from a maturing market. During the past few years, early adopters eagerly snapped up its PDAs. However, this consumer segment has become saturated, and new high-volume markets, such as education and health care, are not emerging as quickly as expected. Given the current economic situation, many consumers are keeping Palms longer than expected--as much as two to four years--severely extending Palm's expected upgrade cycle of 12 months to 18 months.

Most enterprises see Palm devices as discretionary or even luxury purchases, and with the downturn in IT spending and given cost-cutting measures, many have chosen not to use such "nonessential" devices. Business consumers who can no longer receive reimbursement for their devices are also less likely to upgrade from existing, older technologies.

Palm's problem is exacerbated by its recent introduction of an upgraded product set--the M500/M505--with a new version of the Palm operating system and the ability to handle plug-in memory cards and add-on modules. Word of the new products was leaked several months before general availability. As a result, many would-be purchasers waited for the new devices. With their relatively high prices and margins, sales of these devices should ultimately help Palm's bottom line. However, the pre-announcement has made it more difficult to sell off Palm's overstock of older-generation products.

While Palm is hurting from its failure to anticipate the impact of the slowing economy, we expect some of its problems will be short-term ones. During the next six months, Palm will readjust inventory, and we expect consumer demand for personal digital assistants to grow stronger as the economy begins to rebound and businesses once again subsidize these purchases for certain groups of consumers. More importantly, we also expect demand for handheld devices such as "business assistants" to increase as enterprise systems increasingly support them for commerce-chain and CRM (customer relationship management) applications.

What becomes a commodity
Palm, however, faces two serious long-term challenges: commoditization and Microsoft.

As the handheld market matures, it will undergo increased commoditization, following the example of the calculator, PC and cellular phone markets. The early-adopter market segment of individuals purchasing PDAs for their personal use and willing to pay a premium for such a device soon becomes saturated. To reach a larger, general-consumer market, devices must become much less Expensive--in a range of $49 to $149.

Palm sensed this trend and introduced low-end units (M100/M105) in the $129 to $149 price range last year. Manufacturers, however, must be exceptionally efficient producers to make profits on these potentially high-volume but low-priced and low-margin devices. Several consumer electronics companies are working on Palm-like device and are poised to enter this market in the next year. Sharp is already selling a PDA in Japan and is expected to enter the U.S. market with a Linux-based device soon.

It is unlikely that Palm will be able to compete in the low-end, high-volume segment with these new rivals, which have stronger manufacturing and consumer market muscle. To thrive, Palm must maintain its traditional profit levels by selling into the high-end markets. But competition is increasing both from its licensees, all of which are pushing the outside of the envelope in the technology, and from the PocketPC manufacturers such as Compaq Computer, Hewlett-Packard and Casio.

The question is whether the Palm OS has a lasting franchise. If a consumer can buy a small device that syncs with Outlook or whatever calendar system the consumer has on the desktop to carry basic contact information and appointments and receive e-mail, then does the customer care if the device has the Palm OS, Linux or a proprietary OS? Probably not.

Microsoft's long shadow
The second major challenge comes from Microsoft, or more specifically, from the Windows CE environment with PocketPC and Stinger-based systems. As the consumer market becomes more commoditized, the business application market will provide opportunities for higher-value and therefore higher-margin sales.

Palm has largely been a consumer-focused "personal assistant," even when purchased and used by businesses. As businesses look beyond personal organizer functions to bring business applications to mobile workers, Palm will face more serious competition from Microsoft and its OEM partners. Palm's devices have been limited in enterprise-level applications by its relatively underpowered processor (Motorola DragonBall 16-bit technology originally designed more than 20 years ago), its relatively simple OS, and--until the M500 series--its lack of expandability. Handspring, HandEra and Sony were all ahead of Palm in offering Palm clones that accept add-on modules.

Other issues, such as the lack of a multitasking capabilities and a weaker development environment than Microsoft's also reduce Palm's attractiveness. Although Palm has indicated that it will upgrade to a more capable processor (ARM) and port its OS to this 32-bit multitasking platform, we do not expect to see such devices for six to 12 months. The move to the ARM chip is important, given that many corporate IT groups have rejected Palm as a corporate PDA because the current Palm chip (DragonBall) does not give them the capacity they need to support enterprise applications on pervasive devices.

Palm and its licensees have always made enterprise marketing secondary to consumer marketing and have yet to demonstrate that they can provide the level of enterprise support. They also do not have the credibility with corporations that they need to compete in this market. The acquisition of Extended Systems, a vendor of enterprise data management and synchronization products, would not by itself have given Palm entry into this market, but the cancellation of that deal is another blow to its hopes.

Buying Extended Systems was a key component of Palm's strategy to offer server-level solutions for corporate application extension and enter the nascent corporate PDA marketplace, which we expect to accelerate once the economy strengthens. This will be the major marketplace for high-end PDAs, with companies enabling portable connectivity to corporate ERP (enterprise resource planning), CRM and other complex systems.

What businesses should do
In the current economic climate, companies are appropriately reducing subsidies for PDAs. Nevertheless, IT groups should still focus on establishing standards and guidelines for PDA use, such as defining what PDAs are supported and for what applications. They should also focus on synchronization methods that offer the broadest connection capability, such as both Palm and PocketPC support.

Given current budgetary constraints, many companies can safely defer PDA purchases with minimal effect, instead enabling some consumers to purchase and make use of their own devices. Companies requiring connection to mission-critical applications should consider only high-end devices--Palm or PocketPC.

For companies purchasing Palm devices, we expect increasing downward pressure on prices during the next six months, particularly on older and lower-end units, such as the Palm III, with Palm competitors--Handspring and others--matching Palm's moves.

Meta Group analysts Dale Kutnick, David Cearley, Jack Gold, Al Passori, William Zachmann and Val Sribar contributed to this report.

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