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Palm, Inc. (PALM)

F4Q06 Earnings Conference Call

June 29, 2006 4:30 pm ET

Executives

Ed Colligan - CEO and President

Andy Brown – CFO

Sandy O'Halloran – IR

Analysts

Michael Abramsky - RBC Capital Markets

[Amir Rosanowski] for Jeff Kvaal – Lehman Brothers

Analyst on behalf of Daryl Armstrong - Citigroup

Jonathan Hoopes – ThinkEquity

James Faucette – Pacific Crest

Tavis McCourt – Morgan Keegan

Lauren Sutton for Paul Coster - JP Morgan

Charles Wolf - Needham & Co.

Andrew Neff - Bear Stearns

Susan Kalla – Caris

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the fourth quarter and fiscal year end 2006 earnings results. (Operator Instructions) At this time, I would now like to turn the call over to Ms Sandy O'Halloran, Investor Relations. Please proceed.

Sandy O'Halloran

Thank you and good afternoon, everyone. I would like to welcome you to Palm's fourth quarter and fiscal year end 2006 financial results conference call. On the call today are Ed Colligan, CEO and President; and Andy Brown, Chief Financial Officer. Today's call is being recorded, and will be available for replay on the Investor Relations webpage at www.palm.com.

I'd like to remind everyone that today's comments, including the question-and-answer session, will include forward-looking statements including, but not limited to, our forecasts of future revenue and earnings, and other financial and business activities. These statements are subject to risks and uncertainties that may cause actual results and events to differ materially.

These risks and uncertainties are detailed in Palm's filings with the Securities & Exchange Commission, including its quarterly report on form 10-Q for the fiscal quarter ended March 3, 2006, and its January report on form 10-K for the fiscal year ended June 3, 2005. Palm undertakes no obligation to update forward-looking statements to reflect events or circumstances occurring after this call.

Please note today's results will be reported on a non-GAAP basis, except where specifically noted in the commentary as GAAP results or estimates. Non-GAAP reporting is provided to better help you understand our business. However, non-GAAP financial results are not meant to be considered in isolation or as a substitute for, or superior to, GAAP results.

You should be aware that non-GAAP measures have inherent limitations, and should be used only in conjunction with Palm's consolidated financial statements prepared in accordance with GAAP. Our press release includes a table detailing the non-GAAP measures, together with the corresponding GAAP numbers and a reconciliation to GAAP. You can also find this information in our earnings press release that is posted on the Investor Relations website. The slides that accompany this call include both GAAP and non-GAAP measures, and are also available on the website. We encourage listeners to review these items.

And now, I'd like to turn the call over to Ed Colligan.

Ed Colligan

Thank you, Sandy, and good afternoon everyone.

Our execution was very strong in our fourth fiscal quarter and throughout fiscal year 2006. We concluded the year as a clear and strong leader in mobile computing, with our broadest product portfolio ever and a more than 50% increase in operating income year over year.

Highlights included the introduction of two category-defining differentiated SmartPhone solutions on two platforms, the Treo 700w on Windows Mobile, and the Treo 700p on Palm OS. Those two new phones, which use 3G radios for fast web-browsing, streaming media, and downloading complex documents, represent the latest steps in what is nothing short of a strategic transformation of our Company.

In fiscal year 2004, SmartPhone revenue was 18% of total revenue, and as we completed this year, we generated 75% of our fourth fiscal quarter's revenue from SmartPhone sales. We have accomplished this strategic shift from handhelds to SmartPhones while simultaneously growing our annual revenues by 24% and delivering 11 consecutive profitable quarters.

This shift in emphasis required many changes, including that we redirect our design focus, components, strategy, and technologies; that we build our engineering talent, and that we invest in new sales and marketing strategies. Our distribution model has changed from largely selling to end users through electronics retailers to selling largely to carriers, who resell to end users.

We reinvented ourselves and our whole market orientation, as we continue to deliver category-defining, highly regarded SmartPhones with ever greater capability, and while achieving year-over-year revenue growth and consistent profitability. I'm immensely proud of how well Palm executed such a strategic move in so little time.

In my comments today, I'll describe the year's many accomplishments, and, towards the end, I'll update you on our objectives for the coming fiscal year. I've asked Andy to cover the quarter's performance in detail, although I'll just note that we delivered our tenth consecutive quarter of double-digit year-over-year revenue growth, as well as significant improvements in gross margin and operating income.

Our objectives for the past year were to:

  1. Deliver consistent profitable growth;
  2. invest in and strengthen our product engine;
  3. sharpen our attention on the customer experience;
  4. expand geographically; and
  5. collaborate with partners to reach new markets. ;

We delivered on our first objective to deliver consistent profitable growth, with stronger results in fiscal year 2006. We generated a record $1.6 billion in revenue, up 24% from fiscal year 2005. More than $1 billion of that revenue was from our family of Treo SmartPhones, up 85% from our SmartPhone revenue in fiscal year 2005.

Sell-through of our Treo 650 and 700w SmartPhones to end-user customers reached a record of approximately 2 million units this year, up 83% year over year. Most of the increase reflected strength in the Treo 650, which is supported by dozens of carriers globally. Sell-through on the Treo 700w, which went on sale in early January, was very strong out of the gate with our prosumer customers.

Trials in the enterprise remain strong. However, it is taking longer than anticipated for trials to turn to closures, due to a number of factors. Enterprises typically take three to six months to pilot a deployment, and many waited for the April arrival of our push email solution. In addition, companies needed to have deployed Microsoft Exchange Server 2003 plus Service Pack 2, to take advantage of push email and enhanced security. We are confident our strategy is sound, and that we'll see trials turn into sales in the near future.

I'm very pleased with our increase in gross margin and operating income. Gross margin grew to 33% for the fiscal year, compared with 30.8% for the fiscal year 2005. Operating income grew 51%, to 8.6% of revenue for the fiscal year, compared with 7.1% for fiscal year 2005.

Turning to our balance sheet, we generated $156.2 million in cash and short-term investments during fiscal year 2006, which will allow us to further build our business. We remain committed to delivering profitable growth and creating shareholder value.

Moving to our second objective, strengthening our product engine, we invested significantly in R&D during the year, and it's paying off. We brought more SmartPhones to market faster than ever before. We began selling the Treo 700w in January with Verizon Wireless, and, four months later, we began selling our latest Treo, the 700p, on two carrier networks simultaneously, Sprint and Verizon Wireless.

These are significant accomplishments, given the carrier customization required for each SmartPhone model, the two operating systems, and the unique application set on each device.

Our new management team and attention to leading-edge processes also have helped us build higher-quality products, and a growing reputation among our carriers for being able to deliver the categories' best products and on schedule.

Our improved product processes have allowed us to move to carrier certification much faster. We strengthened our ability to deliver even more SmartPhones by selecting two additional ODM partners, in addition to our current partner.

You'll see two additional SmartPhones this calendar year, in the new fiscal year's first half, as promised. On their heels are more. These introductions will be distinguished by new hardware design, new radio technology, or other significant advancement, and always feature the Palm experience, our hallmark ease of use.

Our strengthened product engine enables us to continue offering customers a product portfolio based on a commitment to open platforms and to providing a choice of operating systems, industry-leading email providers, radio technologies and carriers.

On the third objective, which is sharpened attention to the customer experience from pre-sales to customer support, we achieved a great deal during the year. I’ll start with commendations from our customers, which validate our brand attributes. Because we want to be sure that we are walking the talk, we asked our customers about the roles our products play in their lives. 95% of Treo 650 customers who responded to our survey agree our products were, “Truly useful.” 99% of our entry level Z22 customer respondents said the same thing. In fact, all our products are in scores in the mid to upper 90s for being truly useful. 86% of the responding Treo 650 customers said our products were, “Simple to use,” and 97% of our Z22 customers said the same.

We also learned that 36% of the Z22 customers surveyed say, “Their next product will be a SmartPhone.” These customers, we believe, will likely choose Treo’s. Having a well regarded and high profiled brand is key to attracting new customers and to upgrading the millions of existing ones. Our brand is strong and rising in the United States, and we intend to make it as well known overseas.

While our products are being praised for being easy to use, we’re never satisfied. That’s why we built in further improvements to the new Treo 700p, and we look forward to seeing the early buyer’s feedback. We streamlined our setup poster to have only three steps, made instructions more graphics faced and improve e-mail setup and Treo to PC synchronization. We’ve eliminated some steps for the customer, such as screen calibration, and we reduced the time it takes for customers to make that first phone call.

The sales process is another important part of the customer experience, and we have invested in it. In the last fiscal year we trained nearly 57,000 US based carrier sales professionals. Because we are committed to seeing our product used by people in all walks of life, you can expect us to continue working to improve the Palm experience. We will continue to measure our progress on a variety of customer and brand surveys through our own research and that of third parties. As we make our products more powerful and more capable, we intend to work even harder to mask the underlying complexity. This is our strength and we are resolved to continue earning this brand hallmark of a great customer experience.

Now I will turn to our fourth objective, which is expanding our geographic reach. We have excelled in the United States for the last several years, and continue to do so. The United States has been the region for our largest and most immediate opportunity, and where we have strong and mutually beneficial relationships with the largest carriers. With our product engine better tuned, with compelling solutions on two OS platforms, and with a roadmap tailored for international customer expectations, we will now focus on building our presence overseas.

Europe is our next target geography for expansion, because it has grown to be a larger market for business oriented SmartPhones as the United States or larger. We’ve used the last year to focus on carriers, realign our European sales and marketing effort, and also consolidate our distribution partners. We opened a staff and engineering center in Dublin, and it is aligned to support European carriers in areas such as the development of 3G UMTS, and user applications focused on European local markets. Even more important, we specifically re-engineered our product road map to address what European customers and European carriers want.

These efforts have positioned Palm for success in Europe, and to become a significant player on the world stage. Execution of our EMEA strategy will begin to deliver revenue growth, I believe, in the first half of fiscal year 2007.

The fifth and last objective is to collaborate more extensively with key partners with the goal of reaching and expanding into new markets. During the last fiscal year, we grew our partnerships with leading companies, including Microsoft, Good Technology and RIM. We delivered solutions to the marketplace with each of them.

With Microsoft, we are building on Windows Mobile 5.0 Pocket PC Edition. We chose this version of Windows Mobile specifically because it is what the enterprise requires. Pocket PC Edition allows for easy data collection and signature capture because of its enabled touch screen. Web browsing is faster too for the same reason. The Pocket PC Edition also lets customers interact, edit, cut and paste documents they carry or that they receive by wireless e-mail.

With Good Technology we have deployed the very compelling Treo good length combination in a total of 11,000 sights in the United States, which compares to 6,500 companies this time last year.

In cooperation with RIM, we completed the BlackBerry Connect client software for our Treo 650 SmartPhone, and a number of carriers already have made it available to their customers. Other carriers are in the certification phase now.

The list of companies that have deployed our products reads like a who’s who of business. We now have more than 2,500 trials going on across our Palm OS and Windows Mobile products. Our partnerships helped us open doors and close deals in the last year, and we expect our collaboration with these partners, and others, will help us bring the Palm experience to more customers in more regions, and in larger deployments across businesses large and small.

Before I share our new FY ’07 objectives, I’d like to say something about the competition. There is a lot of it, but that’s business as usual for Palm. As an executive in the mobile computing arena for the past 14 years, I have seen a lot of buzz and hype. More recently, I have seen significant growth. When categories grow, you can expect new forays into that space. In an expanding category, many players can be successful. This is not a zero sum game.

Palm already has demonstrated it can invent a successful category, lead its development, foresee how the market will evolve, and anticipate and satisfy customer needs. We view competitors as more than validation of the SmartPhone category’s attractiveness. Competitors spend money building awareness, and they persuade new people to consider what SmartPhones offer. That’s good news for us. If a competitor can help entice owners of 12 key feature phones to consider a full QWERTY keyboard device, that’s even better news for us. That’s because people considering buying a SmartPhone will read what’s being said in news outlets such as the Wall Street Journal and the New York Times.

When potential customers weigh what we offer versus the competition, we believe, they’ll choose a Treo. If you want to read your e-mail and also work with attachments or manage your inbox, you’ll want a Treo. If you want to use a SmartPhone for data collection, signature capture or fast web browsing, you’ll want a Treo. If you want to attach a barcode reader or printer to your device, you’ll want a Treo. If you want simplicity of operation at a choice of open platforms, Palm OS or Windows Mobile, you’ll need a Treo, because despite competitor after competitor, Palm remains know for setting the bar for innovation, power and performance. We are energized by competition and confident we have the road map, the talent, and the partners to succeed on a global scale. We certainly have a unique value proposition. Ours is a singular focus on enabling mobile computing.

I have set a number of major objectives for Palm to accomplish in the next year. We want to grow revenue more than 20% year-over-year and deliver an operating margin at or above 9%. Strong and consistent growth and improvement in operating model will remain key for Palm. We need to execute against a product road map that delivers high quality, category defining mobile computing solutions. We’re a product company. We intend to continue delivering innovative solutions that strengthen our long term position in mobile computing. We need to increase SmartPhone market penetration outside the United States. We’ve done well in the US, and now we need to expand internationally to keep our growth trajectory strong. We will invest to raise brand awareness to the Palm brand and its hallmark attributes, because I believe brand is a long term driver of profitability.

As we work toward executing against these goals, we’ll become an even stronger company, better able to compete in the mobile computing market, and better able to deliver the Palm experience to customers the world-over. I look forward to reporting our continued progress in future quarters.

I will now turn the call over to Andy.

Andy Brown

Thanks Ed and good afternoon everyone. Before I start, I would like to note that my commentary today will be based on non-GAAP financial measures except where specifically identified as GAAP. I encourage you to refer to the reconciliation of GAAP to non-GAAP financial results that are posted to the Palm website and included with the press release.

As Ed mentioned, we are very pleased with our financial performance for fiscal 2006 and the fourth quarter. We have consistently delivered on our commitment to profitable growth, and made significant progress against our financial objectives.

Focusing on the fiscal year results first, our revenue, operating income and diluted earnings per share, were the highest in the Company’s history. Revenue totaled $1.579 billion, up 24% from fiscal 2005. SmartPhone revenue grew 85% in fiscal 2006, as our company continued to transition towards SmartPhones. Overall, SmartPhones comprised 69% of our revenue, compared with 46% in fiscal 2005.

During fiscal 2006 we shipped approximately 2.3 million SmartPhones, up 81% from the prior year and growing faster than the overall market, which grew approximately 75%. We shipped 2.5 million handhelds, down 24% from fiscal 2005, and in line with the overall handheld market year-over-year decline of around 25%.

Growth margin expanded to 33% in fiscal 2006, up 2.2% points over the prior year, primarily the result of the product mix shift to SmartPhones from handheld and ongoing product cost reductions driven by our volume ramp.

Operating margin increased to 8.6% from 7.1% in fiscal 2005, and earnings per diluted share increased to $0.85 for the year.

We also grew our cash and short term investments by $156 million in the fiscal year by generating strong profits and continuing to effectively manage our balance sheet with the ending balance at $518.9 million.

Now, turning to the fourth quarter of fiscal 2006 results, revenue of $403.1 million increased 20% from the year ago quarter. As the fourth quarter came to a close, we began shipments of our next generation Palm OS, Treo 700p to both Sprint and Verizon Wireless. Both products are receiving favorable reviews and we expect them to do well.

Gross margin expanded to 37.2% in the quarter, which included a benefit of $8.8 million as a result of negotiating most favorable license terms or standard space technology. Gross margin would have been 35% without this benefit, which is a healthy improvement from prior quarters and better than our original forecast. This improvement was primarily due to our team’s outstanding job of reducing product costs, and improving the out-of-box experience which helped to reduce return rates and decrease warranty costs.

Upgrading costs of $103.2 million was slightly higher than anticipated. Also on a GAAP basis, we took a charge to earnings of $23.2 million, which reflects legal settlements, the majority of which is a recently announced settlement with Xerox and stock compensation expense. These were offset by favorable adjustments to prior restructuring reserves. All this resulted in healthy operating income of 11.6% of revenue and earnings per diluted share of $0.29 for the quarter.

Revenue mix for the quarter was 75% SmartPhones and 25% handhelds, consistent with our expectations. This compares with 54% SmartPhones and 46% handhelds for the year ago period. SmartPhone revenue for the fourth quarter was $302.3 million, based on shipments of 623,000 units. SmartPhone ASPs were down from the prior quarter, as we hit new volume based pricing tiers to carriers.

SmartPhone sell-through for the quarter was 524,000 units, up 19% year-over-year. As a reminder, Q4 of fiscal 2005 had one extra week of sell-through due to quarter being 14 weeks long versus 13 weeks for the quarter just ended. On a weekly basis, sell-through for the quarter increased 28% year-over-year.

We continue to see strong demand for our Palm OS based SmartPhone products. With respect to the Treo 700w, we are pleased with the initial number of enterprise trials. However, the conversion to sales has been somewhat slower than we first anticipated for two main reasons. First, Push e-mail is a requirement for many enterprises. This requirement was addressed with the Push e-mail feature becoming available in April. Second, enterprises have a longer decision cycle. In addition, we suspect that some enterprise customers waited to evaluate competitive offerings before making a purchase decision. With several thousand customers in product trials, we expect adoption of Treo’s by enterprises to continue to grow.

Due to the timing of initial shipments of the 700p late in the quarter, carrier sell-through for this product was not material in the quarter. This resulted in an increase in carrier reported SmartPhone inventories at quarter’s end. This is strictly a timing issue, and our carrier partners are comfortable with the overall levels of inventories they are currently carrying.

Handheld revenue for the fourth quarter was $100.8 million, reflecting sales of 495,000 units. Handheld ASP’s increase over those of the previous quarter as the mix of products shifted to higher priced units. Handheld sell-through for the quarter was 490,000 units, and our channel partners reported 8.1 weeks of inventory at quarter’s end.

Our continued strength in the US market in Q4 generated 78% of our overall fourth quarter revenue. For the year, 76% of our revenue came from the US.

Looking at the balance sheet, cash and short term investments were $518.9 million, which is down $17.4 million from the previous quarter, but up from the year ago balance by $156.2 million. Accounts receivable increased from the third quarter to $204.3, reflecting the first shipments of the Treo 700p at the end of the quarter. This resulted in DSOs of 46 days, higher than the extraordinarily low number we saw in Q3, but in an acceptable range.

Inventory increased to $58 million with turns at 19 times. We expect inventory turns to return to our preferred level of 25 times during the first half of fiscal 2007.

Before providing guidance for the next fiscal year, please note that my comments are based on the full fiscal year, and there will be quarterly fluctuations. With this in mind, for fiscal 2007 we expect revenue growth to be in the range of 20% to 25%. This growth will be driven by additional SmartPhone products coming to market later this calendar year and increased sales in Europe.

We expect to see greater revenue growth in the second half of the fiscal year than the first half, with no change in our commitment to profitability. SmartPhones are expected to comprise approximately 85% of our revenue in fiscal 2007 versus 69% in fiscal 2006.

With respect to gross margin, we expect ongoing benefits from our efforts to reduce product returns coupled with the continuing revenue shift to SmartPhones. As a result, gross margin for fiscal 2007 is expected to be in the 34% to 35% range.

We are managing our expenses and investments to increase profitability. We expect operating income as a percentage of revenue to be in the range of 9% to 9.3% in fiscal 2007. To achieve this goal, we believe sales and marketing expenses will remain in the fiscal 2006 range of 12.5% to 13% of revenue.

We expect to continue investing in research and development including a greater contribution to the development of a broader array of software offerings around our SmartPhone products. This will result in R&D spending of 9.2% to 9.7% of revenues for fiscal 2007.

We expect G&A expenses to be less than 3% of revenues for fiscal 2007, similar to fiscal 2006 and our tax rate is expected to be around 40% for fiscal 2007. But cash taxes will be much lower, due to the remaining NOLs, which we expect to utilize.

Regarding FAS-123R, or stock compensation expense, we currently estimate a charge to earnings before any tax benefit in the $34 million to $38 million range.

Moving more specifically to the first quarter of fiscal 2007, we currently expect revenue to be in the range of $380 million to $385 million. We anticipate a slight increase in SmartPhone revenue, offset by two things:

First, the Treo 650 will not ship into Europe after June 30th, because we have decided not to make it RoHS compliant. RoHS is a European Union environmental directive, which the Treo 650 does not meet. We expect this situation to be remedied with our European introduction of a new SmartPhone later in the calendar year.

Second, we expect to see sequential decline in the handheld business due to seasonality.

In the first quarter of fiscal 2007, we expect gross margin to be in the range of 35% to 35.5%. Overall operating expenses are expected to be in the range of $105 million to $106 million, driven by a ramp in engineering to support ongoing road map expansion, which requires increased staffing and project-related materials.

The non-GAAP tax rate for Q1 is expected to be at 40%, resulting in earnings per diluted share on a non-GAAP basis of $0.18 to $0.19. On a GAAP basis, we expect our stock compensation charge to be $9 million to $9.5 million in Q1 fiscal 2007.

I would now like to ask the operator to poll for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael Abramsky - RBC Capital Markets.

Michael Abramsky - RBC Capital Markets

Yes, hi guys. Could you just talk further about the impact to Q1 on the delay and availability of the 650? Just try to give us a bit more color on potentially the significance of that to your revenue momentum and the impact to your guidance, which obviously was below consensus expectation.

Ed Colligan

Yes, Mike, thank you. It's got some impact. There's no question about that. It is not significant, but it's real.

The decision on the 650 is something that we had to make nine months ago relative to making that change, we felt like the product was long in its life cycle, and to make that change at this point did not make sense. It's something that you see as an anomaly.

As you can see from the long-term guidance, we still feel very strong about the business, and so it's something that's a transition issue that we have to deal with, and we're dealing with it in this way. We obviously would hope to get our European product out as fast as we possibly can, and we're doing everything we can to do that.

Michael Abramsky - RBC Capital Markets

Okay. Again, perhaps you could just take us through the remainder of what might cause your momentum to be built a little bit later in the year rather than in Q1?

Ed Colligan

Yes, I think the momentum is built through additional carrier deployments, new products coming on the road map. In a broad range of areas, different segments, hitting new price points, new functionality. I also believe the momentum will build because of international expansion. We are going to bring on significant new carrier relationships around the world.

Michael Abramsky - RBC Capital Markets

Regarding the operation side, planned spending; can you talk about brand spending? Is this largely going to be a media spend, or are there other dimensions to this?

Ed Colligan

From my perspective, there's an enormous number of dimensions to building a brand. There will be spending in various areas, relative to everything from the out-of-box experience to our customer service areas, to potentially advertising efforts, as well. As we launch new products in different geographies, we feel like we need to put a significant effort behind that, and so you can expect us to spend for those efforts, as well.

Some of the other areas of spending, the R&D in particular, again, broadening that product line, investing more in software, elements of software around the products, which I can't get into detail about, but we're making some significant efforts there. So that's driving spending.

One of the things we're really trying to focus on is build this business for the long-term, set us up for long-term growth, but continue to increase our profitability, which we're managing to do in this plan. So it's a balancing act, but it's one we think we're managing reasonably well.

Michael Abramsky - RBC Capital Markets

Thanks very much, Ed.

Ed Colligan

Thanks, Mike.

Operator

Your next question comes from the line of Jeff Kvaal – Lehman Brothers.

[Amir Rosanowski] for Jeff Kvaal – Lehman Brothers

Hi, guys. It is [Amir Rosanowski] for Jeff Kvaal. I was wondering, at the end of your last fiscal year, you were able to give a SmartPhone backlog; is that something we're able to get again?

Ed Colligan

I don't believe we've ever given SmartPhone backlog. We certainly have given SmartPhone sell through, which is a number we consistently give, but I don't recall giving backlog, Andy, do you?

Andy Brown

Amir, We're required to give total backlog in the 10-K, and we will do that when we file the 10-K, but we don't give specific SmartPhone backlog.

[Amir Rosanowski] for Jeff Kvaal – Lehman Brothers

Oh, okay. Thanks. In terms of the 2007 guidance that was issued, what gives you comfort or visibility to give that guidance right now?

Ed Colligan

Well, we do a very detailed bottoms up, tops down analysis of our business, looking at the market dynamics and the competitive environment that we see. We know exactly or we feel strongly about our road map and how we're going to deliver against it. We have a number of exciting products coming down the pipeline. We have already established a number of carrier relationships that we can't really talk more about at this stage since they're still confidential, but we believe those will add to our business over time, and we know the general timing of that, as well.

Taking all of these various elements into account, we try to forecast our business as effectively as possible and that's what we're providing you.

[Amir Rosanowski] for Jeff Kvaal – Lehman Brothers

Thanks. Lastly, I was wondering, as we continue over 2007, how should we think about the ASP trends? Certainly you highlighted a number of new products that are planned to be introduced and some of the competitive dynamics in the marketplace. How should we think about the ASP mix within your guidance?

Andy Brown

I think the way you need to think about it is somewhat similar to the way the handheld business evolved over time, and that is the ASP on the handheld is fluctuating primarily by the mix of products that we are shipping. As we develop and ship a broader portfolio of products -- which we expect to do -- I think that's the way you need to think about it as far as the mix between those products, how we think about it is the mix between the products and the portfolio; obviously subject to the standard volume pricing breaks that we have in our carrier contracts.

[Amir Rosanowski] for Jeff Kvaal – Lehman Brothers

Okay. All right. Thank you very much.

Andy Brown

Thank you.

Operator

Your next question comes from Daryl Armstrong - Citigroup.

Analyst on behalf of Daryl Armstrong - Citigroup

On this is [inaudible] on behalf of Darrell Armstrong. I have a question regarding the possible impact from Q4. Can you give us a little color on the 700 product shipment on a weekly basis before and after the QPhone launch? Because on channel checking, we heard about a volume drop because of the QPhone launch? Can you confirm that?

Ed Colligan

We don't get into weekly sell through on this. You know, we're really planning our business for a longer time horizon. We have obviously seen the Q come into the market. Motorola has put a pretty significant effort behind that initially. It's a little early I think, to see the ultimate impact. You've probably seen a number of reviews of our products against that product, and we've generally been very favorably received in those reviews.

Also in the marketplace, we work with a broad range of enterprise customers, and most of the ones that I have talked to that our team has talked to directly who have analyzed both products have decided to stay and continue to grow with Treo because of some of the issues with the Q.

Look as I said , this is a big market, with a lot of expansion opportunity. There is a lot of growth opportunity. If they end up expanding the market because suddenly everyone has woken up and decided they want a QWERTY keyboard product with Windows Mobile, then we'll be really happy about that, because we really feel that will be an opportunity for us to grow as well.

Early returns are maybe a slight slowdown of our sell-through looking at that product and then the early sell-through in this quarter has been very strong. That's the only data I can share with you.

Analyst on behalf of Daryl Armstrong - Citigroup

Okay. So you don't see a long-term impact because of the Q Phone or Nokia?

Ed Colligan

I think it's a competitive market, and we're going to deliver a wide range of competitive products too. I believe they will need to worry about us just as much as we worry about them.

Analyst on behalf of Daryl Armstrong - Citigroup

Okay, makes sense. Another question about the R&D spending. Do you think the level of R&D spending you forecast for next quarter will be consistent through the course of the year? Next fiscal year? What's the trend?

Ed Colligan

I think as our business continues to scale and as our top line continues to scale, we believe we will be able to get some leverage off of that. The dollars that we're generating will provide us with the growth that we need for R&D spending. Right now we're really investing in this business, we're trying to expand our product line.

I talked about the just huge transition we've gone through in this business and what we've had to do to build our capabilities in the SmartPhone space. That takes an investment. We think it's a prudent level of investment at this point in time. But over time, we do believe we'll get some leverage from it, and our business model will continue to improve on the bottom line.

You're seeing us do that year over year, having gone from 7% to 8% and now our prediction that we'll go from 8% to 9%

.

Analyst on behalf of Daryl Armstrong - Citigroup

Okay. Thanks.

Operator

Your next question comes from the line of Jonathan Hoopes – ThinkEquity.

Jonathan Hoopes – ThinkEquity

Thank you. During your prepared remarks, you made some comments on sell through for the full year and channel inventories increasing through, I believe it was the end of the quarter here. Doing some quick calculations, you come up with sequential decline in sell-through for the May quarter.

Could you walk us through your thoughts on what happens to sell through as you do the things you mentioned? Expand internationally, roll out new products, ramp up with existing carriers? What I'm really getting at here is where do you see the market in terms of just the secular trend? Is this something you believe that your growth, your sell-through accelerates with the entry of new competitors?

Your comment there, Ed, if everyone were to wake up tomorrow and decide they needed a QWERTY keyboard, is that to make us believe, as well, that most of the products on the road map there contain a QWERTY keyboard? Can you walk us through some of those?

Ed Colligan

All right. You're picking up our design trends out of my comments. That’s great. Listen; we're very focused on mobile computing. I think it's straightforward to say that we're not going to produce products that aren't great with mobile computing devices. We believe the data entry is crucial to doing mobile computing applications on the road. So it's safe to say that our products will have some kind of robust data entry methodology.

That being said, I do believe that our sell-through will continue to grow over time. We would not be able to predict the long-term acceleration in our growth trends without that sell-through growing. So we do feel strongly about that. Sell-through in the 650 continues to remain very strong, which is great.

What we talked about a little bit in our prepared remarks is it's probably a little too early on the 700W sell-through, is what’s happened. 700w requires an installation of Exchange 2003 and service pack 2 to get the push e-mail. We have a lot of trials going on. We obviously had hoped they would have converted a little faster, which would have raised our sell-through, but we still believe that will happen and that our strategies is sound in having done that product. Because not only will it bring into the enterprise, but also allow us to expand internationally.

So, yes, I guess the net answer to your question is that we believe over the long run that this category will continue to grow, it will expand into a broader, broader segment of the standard cell phone business, and that we'll be one of the beneficiaries of that.

Jonathan Hoopes – ThinkEquity

Can I just slice that one more way? As SmartPhones become the predominant, almost 100% part of your revenues, you don't have to go very far out for non-SmartPhones to be less than 10%. Does growth for Palm accelerate on an overall basis there?

Ed Colligan

Yes, I think one of the things you look at today is at least our top line growth is being mitigated, pushed down a little bit by the fact that a part of our business, the handheld business, is shrinking. If you look at our SmartPhone business, as we said, 85% up year over year on those units and growing faster than the overall market. We see that continuing to take place.

So those percentages will be stronger when it ends up being more and more SmartPhones. In addition, that's an area of the business that we're really focused on. We will continue to innovate in the mobile computing space and diversify our product line over time.

Jonathan Hoopes – ThinkEquity

Thank you.

Operator

Your next question comes from the line of James Faucette – Pacific Crest.

James Faucette – Pacific Crest

Thank you. I just wanted to go back to the issue on the 650P. Can you just clarify there what you said about not being able to ship that because of a regulatory issue?

Ed Colligan

James, there's a regulatory requirement that is about lead content in the products, and that requirement has been coming for a while and there are a number of companies. I will tell you, a broad range of our products that we're shipping into Europe are compliant with that, and will be going forward.

This particular unit that we're shipping there, about nine months ago when we had to make the decision whether we're going to transition the whole product line over to that, we made the decision that we weren't going to do that with this particular product.

Obviously we hoped at that time that we might be in a little better position to ship other products into Europe at this point. We're reasonably close to that, but it's likely not going to happen this quarter. Therefore it's affecting our guidance. But as you can see from the year’s guidance, we believe that the long-term trends are strong and that will be an anomaly.

James Faucette – Pacific Crest

On that unit, when do you have to cease shipping that unit into the European market?

Ed Colligan

June 30th is the last time we can ship the Treo 650 into the European market.

James Faucette – Pacific Crest

Okay so for the months of July and August, you won't have any real shipments into Europe?

Ed Colligan

Correct – of SmartPhones, that is correct. That's also shipments into Europe. We've obviously thought about this, and tried to put some product in Europe in our various distributors and carriers such that we can continue to satisfy some end-user demand.

James Faucette – Pacific Crest

Right. What's your expectation as to when you need to have a product into Europe before that supply will be exhausted?

Ed Colligan

Well, obviously, we want to do that as quickly as possible. I can't give you a specific date for our next product launch at this time, though.

James Faucette – Pacific Crest

Okay, looking back to the sell-through, I'm sorry I missed it, but can you repeat what the handheld sell-through was?

Andy Brown

The hand held sell through was 490,000 units.

James Faucette – Pacific Crest

Okay, and just a last question on cell phone sell-through. That was down a little bit sequentially on the SmartPhone side; can you explain why? I mean is there anything beyond just the longer evaluation cycle in the enterprise?

Ed Colligan

You know, I think that's certainly the vast majority of what we see. Obviously there was some competitive products that came out and there was probably some stall associated with that when they were first launched. As I said, people have evaluated those and our sell-through this quarter has picked back up here.

I think it's a combination of a few things. It's getting our Exchange release out the door; the release that allowed for push e-mail on our devices.

The second thing was just the evaluation timeframe. We continue to push those opportunities and we're expecting them to turn over into sales, but everything hasn't happened yet.

Third, I'd say, definitely related to a number of competitive announcements. We can't dismiss those completely.

James Faucette – Pacific Crest

Okay, and final question. You've got about two months now since you had your push Exchange solution available. Has that changed at all the rate of conversion? Or have you been able to measure that yet? Do you still think you're suffering from the stall associated with competitors?

Ed Colligan

I think it's a little early. I'll tell you that our 700P products and our Treo 650 products have continued to sell quite well, both to prosumers and in the enterprise. So I think it is an evaluation issue at this point.

James Faucette – Pacific Crest

Okay, great. Thank you very much.

Operator

Your next question comes from the line of Tavis McCourt – Morgan Keegan.

Tavis McCourt – Morgan Keegan

My first question is, you've got in the press release a non-GAAP EPS number for this year for $0.85. Do you have what you're using for the first three quarters of the year? I guess that's using $0.29 for the fourth quarter?

Andy Brown

Yes, that's using $0.29 for the fourth quarter, that is correct.

Tavis McCourt – Morgan Keegan

Do you happen to have what you're using for the first three quarters?

Andy Brown

Yes, we've got that. Let me read that off to you. This is on a non-GAAP basis, let me be real clear. $0.13; for Q2 $0.24; and for Q3 $0.19. $0.13, $0.24, $0.19, $0.29.

Tavis McCourt – Morgan Keegan

Great. Not to beat a dead horse on the sell-through, but is one way to look at the sell-through in May, did you guys kind of get a big initial launch from the 700w in the February quarter and basically that fell off in the May quarter?

Ed Colligan

Well, what I think you're seeing here the prosumer sell-through initially was very strong. That tends to be made up of pent-up demand, and people are willing to go in and make this evaluation themselves and buy it off the shelf.

We expected that product to really be more of an enterprise product, and that is what's happening with it; that sales cycle just takes longer. So that's what we're facing today.

Tavis McCourt – Morgan Keegan

Great. In terms of the two new product launches, does your Q1 guidance assume either of the new products get launched in Q1?

Ed Colligan

Well, we just can't give any new launch dates, but our guidance obviously assumes those products coming out before the end of the year.

Tavis McCourt – Morgan Keegan

Got you. Can you tell us if those are going to be launched as single carrier products this year? Or will we see them on multiple carriers?

Ed Colligan

I think they will be products that do have multiple carrier relationships before the end of the year.

Tavis McCourt – Morgan Keegan

Great. Thanks a lot.

Operator

Your next question comes from the line of Lauren [Sutton] - JP Morgan.

Lauren Sutton for Paul Coster - JP Morgan

Hi, I'm calling on behalf of Paul Coster. Just another quick question about the new product launches, will we see a consumer device that is priced for entry level subscribers soon?

Ed Colligan

I'm sorry just for competitive reasons, we're not going to get into segmentation and what the products are, and the different features and functionality.

Obviously we see the marketplace expanding, and reaching new customers, we're reaching new customers with our 650, we'd love to expand our market opportunity to a broader range of consumers.

Lauren Sutton for Paul Coster - JP Morgan

Okay. Thank you.

Ed Colligan

Thank you.

Operator

Your next question comes from the line of Charles Wolf – Needham & Co..

Charles Wolf - Needham & Co.

Ed, I'm a little bit confused. The 650 can't be sold in Europe after June 30th, but what about the 700p?

Ed Colligan

The 700p is a CDMA product, Charlie; the only reason why it can't be sold in Europe in its current configuration. Clearly we're working on new products that will run on GSM, UMTS style networks. Those are the products we would ship into Europe.

We made a decision a while back that this product because the volumes were not that significant in Europe on the 650, we made a decision not to do the entire transition of that product, which is complete redesign and a complete new set of components to go into it.

So we made that decision not to do it. That's what's happening right now. If we could ship the 700p into Europe, we'd do it in a heartbeat. Unfortunately it won't run on those networks there.

Charles Wolf - Needham & Co.

Okay, I'm going to ask a question, and phrase it slightly differently than a previous one. To date, you really have targeted mobile professionals, clearly you're targeting the enterprise with the 700w, as well as the 700p.

My question is conceptual: do you think there's a role to be played for SmartPhones in the consumer space?

Ed Colligan

Absolutely. I would be shocked if over the next few years, more and more people who are exposed to the kind of features and functionality you can get on a 3.0, don't want to browse the Web, get access to music and video, do streaming information off of the Web. GPS, e-mail, these kind of capabilities, they're going to be demanded in standard handsets in the long run.

I think what you're seeing right now is more and more companies trying to deliver products that can reach that consumer. We hope, because of our user experience expertise and our design capabilities, that we will deliver the best, easiest to use products, that will reach that broader market as it develops.

Charles Wolf - Needham & Co.

One last question, Ed. Have land values gone up at all over the last couple of years?

Ed Colligan

Is this related to our land sale? Real estate's been okay here in California, I believe.

Andy Brown

Commercial real estate hasn't really moved much over the past several years, Charlie.

Charles Wolf - Needham & Co.

Okay, fine, thank you.

Ed Colligan

Take care.

Operator

Your next question comes from the line of Andrew Neff - Bear Stearns.

Andrew Neff - Bear Stearns

Yes, I'm not sure, you may have gone over this, but the gross margin issue, can you clarify in a little more detail what the issue was, and if it was a one-time item?

Andy Brown

Yes, the gross margin benefit in Q4 is that what you're referring to?

Andrew Neff - Bear Stearns

Yes.

Andy Brown

Like I said in the prepared remarks, that was a benefit of about $8.8 million for the standard base technologies. We can't get into the specifics because the negotiations are confidential, but it was a one-time $8.8 million benefit to Q4. Without that, just as a reminder, our gross margin would have been right around 35%.

Andrew Neff - Bear Stearns

Was it with just one vendor, one party or was it with other parties?

Andy Brown

It was with several, it wasn't just one, but that's about as far as I can go.

Andrew Neff - Bear Stearns

Was it retroactive? You say it was one-time, was it going back over several quarters or was it going forward several quarters? What do you mean?

Andy Brown

There's two things. We took the one-time benefit that you saw, the $8.8 million, and it will contribute somewhat to our gross margin expansion as we move into fiscal '07.

Andrew Neff - Bear Stearns

Okay. Thank you.

Andy Brown

Thank you.

Operator

Your next question comes from the line of Susan Kalla - Caris.

Susan Kalla – Caris

Yes, could you just fill us in? The change in guidance for the next quarter, is that largely because of Europe, or the slower than expected acceptance of the 700s?

Ed Colligan

Well, first of all, there's no change in guidance. We have never guided to Q1 before. This is the first time we've put those numbers out, and the only thing we've ever said about it.

Second thing is, we've mentioned what the elements were that made up that guidance. Clearly, some of that is related to our ability to ship the 650 into Europe.

Susan Kalla – Caris

Then the customer acceptance, you mentioned that you had 7,000 customers that were in trials. Can you just describe the major gating factors for those customers, and the usual timing until close?

Ed Colligan

Yes, the actual number was 2,500 customers in trial. The timing in general that we've seen, enterprise sales over the years, in doing a lot of them, is three to six months.

We hope, certainly that that would have been a little quicker in this particular situation, because people already understood what Treos did, and so forth and so on, so we thought maybe conversion could be a little faster.

What we're finding is that they're evaluating a wide range of products, and the Windows Mobile platform is new to a lot of them. They had to wait to upgrade to Exchange 2003, which was an element. They had to wait to get Service Pack 2 which was an element.

All of those things had to happen. It was kind of a multi-tiered sales process. That, of course, is making it little longer than we had hoped. We're going to keep pushing those sales, and hopefully transition them over the next quarter.

Susan Kalla – Caris

Then one last thing, the market growth for SmartPhones and your market share. Do you have a perspective on whether the market growth on SmartPhones is still double, triple digits, and will continue to be so for the next six months? And then what your expectations are for your market share.

Ed Colligan

Well the market basically over the last four trailing quarters according to Canalis grew about 44%. Now, the big question is how you define that market. I mean, there's a whole lot of different people who have different -- what is a SmartPhone?

So if you go look at Canalis' numbers, they define it very close to what a Treo is, and the things that look and act a little bit like that. So in that market, it grew about 44%, Palm grew 92% over the same period of time. So we're outpacing the market, what is defined as the market at least by Canalis. We expect to continue to do that.

Susan Kalla – Caris

Thank you.

Operator

At this time, there are no questions in the queue. I would now like to turn the call over to Mr. Ed Colligan for closing remarks.

Ed Colligan

Thank you, we appreciate your participation in our conference call today. We're committed to delivering profitable growth through outstanding products and service, and by delighting customers around the world. Thank you very much for your time today.

Operator

Thank you for your participation in today's conference, this concludes the presentation. You may now disconnect. Thank you, and have a good day.

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Source: Palm, Inc. F4Q06 (Qtr Ending June 2, 2006) Earnings Conference Call Transcript (PALM)
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