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Palm, Inc. (PALM)

F1Q07 Earnings Conference Call

September 21, 2006 4:30 pm ET

Executives

John Shandler - Investor Relations

Edward T. Colligan - President, Chief Executive Officer

Andrew J. Brown - Chief Financial Officer, Senior Vice President

Analysts

Jonathan Hoopes - ThinkEquity Partners

Vivek Arya - Merrill Lynch

Daryl Armstrong - Citigroup

Tavis McCourt - Morgan Keegan & Co. Inc.

Mike Abramsky - RBC Capital Markets

Jeff Kvaal - Lehman Brothers

Paul Coster - J.P. Morgan

Michael Ounjian - Credit Suisse

Jonathan Goldberg - Deutsche Bank

James Faucette - Pacific Crest

Charles Wolf - Needham & Co.

Presentation

Operator

Good day, everyone, and welcome to the Palm Incorporated first quarter fiscal 2007 earnings results conference call. This call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Mr. John [Shandler]. Please go ahead, sir.

John Shandler

Thank you. Good afternoon, everyone. I would like to welcome you to Palm’s fiscal year 2007 first quarter 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 our investor relations website at www.palm.com.

I would like to remind everyone that today’s comments, including the question-and-answer session, will include forward-looking statements, including but not limited to, a forecast of future revenue and earnings and other financial and business activity. 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 and Exchange Commission, including its annual report on Form 10-K for the fiscal year ended June 2, 2006.

Palm undertakes no obligation to update forward-looking statements to reflect events or circumstances occurring after this call.

Please note that 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 help you better 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 posted on our investor relations website. The slides that accompany this call include both GAAP and non-GAAP measures, and are also available on our investor relations website. We encourage listeners to review these items.

Now, I would like to turn the call over to Ed Colligan.

Edward T. Colligan

Thank you, John, and good afternoon, everyone. I would like to take a few minutes to update you on the quarter, give you a summary of our financial performance, and talk to you about how we are positioned in the marketplace. I will also cover our strategies to differentiate our solutions and to expand globally. I will wrap up with the four objectives I set out for the team this year.

Starting with the quarter, we delivered overall revenue of $355 million, up 4% versus Q1 of fiscal year 2006. Smartphone revenue totaled $269 million in the quarter, up 18% from the comparable period a year ago. Smartphone sell-through totaled 569,000 units, up 21% year over year and up 8% sequentially.

Our profits were strong. Operating income rose 28% on a GAAP basis, and 44% on a non-GAAP basis year over year. EPS was $0.21 per diluted share.

Our balance sheet remains very strong. We are in excellent shape to make short and long-term investments to benefit our business. Today we believe our stock is an excellent value and so, we announced earlier this afternoon, our board has authorized a stock repurchase program, under which we will buy back up to $250 million of Palm common stock.

We delivered profitable year over year revenue growth this quarter, as we have for the previous 11 consecutive quarters, but the top-line was below our original guidance and below what we expected of ourselves. While our business-to-business sales grew, sales in carrier retail stores did not keep pace with our expectations.

It is a fact that the Smartphone market is becoming more competitive. We have been saying for some time that we expected the market to heat up, and it has done that in the last couple for quarters. This is a growth market, and there are many players that will pursue a share of that growth. Competition will create pricing pressure and fragment the market, making differentiation more important to communicate.

Clearly our differentiation is understood in the business-to-business market, where sales were strong. The shortfall occurred in carrier retail stores, where customers are more easily influenced by price, fashion, or aggressive marketing.

Businesses weigh the comparative merits of Smartphones. They ask themselves if a purchase will answer a real need, if a product will deliver a full day’s work, and if people and businesses will be more competitive as a result of a purchase.

When those questions are asked, people choose Treo. Ultimately, people and businesses are willing to pay for products that work.

To address the retail market, we made some pricing adjustments and saw an immediate rebound in sell-through. We will address the retail environment further with the introduction of a lower priced product targeted at retail demographics in the very near future.

To build further on our competitive position, we expanded our product portfolio with the new Smartphone for Europe, and we have diversified our carrier base by signing up another world leading carrier.

Let’s not lose sight of the fact that despite an unprecedented competitive onslaught, Treo sell-through matched the highest in company history, and we delivered very strong margins and operating profits.

We continue to believe that our product portfolio is strong, and grew more compelling in recent quarters with its choice of operating systems, network technologies, e-mail partners and carriers. The next step is expanding our addressable market around the world, and we made excellent progress in that regard too.

Case in point is our launch last week of the Treo 750V. This is a product made from the ground up to captivate the European Smartphone market, a market comparable to that of the United States. The 750V is distinguished first by its slimmer form factor, with antenna integrated into the body, and operates on the Vodafone 3G UMTS network, so it is sleek and it is fast.

We are thrilled to have collaborated with Vodafone Group and nine Vodafone operating companies across Europe. Vodafone is Europe’s largest carrier, and between its retail stores, business stores, and dedicated business sales teams, we could not ask for a better partner.

They are also putting significant marketing muscle behind this product. Travelers in Europe are going to see our new Treo featured just about everywhere -- in airports across Europe and in key transit hubs, in traditional and in new media. Vodafone’s marketing support extends to pricing, too. The various Vodafone operating companies in Europe generally have set the subsidized price of the Treo 750V to the equivalent of $299 at the high-end, all the way down to free in some countries, depending on contract terms.

Customers in nine countries -- Austria, France, Germany, Ireland, Italy, the Netherlands, Spain, Switzerland, and the U.K. will be able to buy the 750V starting in October. We plan to announce the 750’s availability in other regions of the world by the end of the calendar year as well.

The Treo 750V is built upon the Microsoft Windows mobile operating system, specifically the Pocket PC edition, so it is extremely capable as an enterprise solution with the added benefit of the Palm experience.

That is much of why Microsoft will accord the Treo 750V “hero status” in extensive advertising efforts across Europe, where Windows is clearly the favored platform.

Microsoft is marketing the new Treo to their Exchange Serve 2003 customers. In Europe, about 80% of which we understand have deployed service pack two. A Treo in those business environments means free, secure, real-time push e-mail without the need for additional middleware.

Although we expect the Microsoft solution will appeal generally to the European market, a key attribute of Palm solutions is that we offer customers choice. With the Treo 750V, customers can deploy Microsoft’s push e-mail, use Vodafone’s Visto e-mail, or take advantage of RIMS’ BlackBerry Connect.

Together, Vodafone, Microsoft and Palm will spend nearly $30 million to market the Treo 750V. We believe these and other marketing activities will build brand awareness, Smartphone awareness, and preference for Palm and Treo in Europe, similar to what we enjoy today in the U.S.

Our strategic partnership with Vodafone and Microsoft for this European product represents the latest salvo in our drive for European market share. We started this initiative by appointing new worldwide leadership and regional management for Europe, Middle East, and Africa. We followed with a realignment of our marketing and distribution partners to favor carriers and to focus on Smartphones. We opened a European engineering center in Dublin to collaborate closely with European carriers, and we worked to build and expand relationships with the biggest of those carriers.

The culmination of our work leading to the launch with Vodafone and Microsoft for the Treo 750V represents a major milestone for this company, and we will have additional significant news later this year. The fourth new Smartphone is coming soon for worldwide distribution and aimed at a broader demographic. We will target people who want to get more out of their business and personal time, but who may be more price sensitive than our original target market.

This customer may today own a feature phone with basic text messaging capabilities, or perhaps a phone whose e-mail capabilities are limited or disappointing. We are collaborating with a new China based ODM, or outsource design partner, that is helping us lower costs and [user] customers. You will hear more from us about this product in coming weeks.

Now I will say a few words about the four objectives I set for the last quarter. The first and foremost objective is our commitment to profitable growth. We were very profitable in the quarter, and will continue to vigorously pursue a number of initiatives that will allow us to reduce the cost of our Treos to end user customers, build further product differentiation, and expand and deepen our market reach globally.

As we have discussed before, we have gone from having one ODM Smartphone partner in 2005 to two in 2006, and there will be three in calendar 2007. We plan soon to open an R&D center and operations hub in Shanghai to better integrate the ODM. We are reducing component and manufacturing costs. Part of this initiative has been to analyze our supply base, benchmark against our competitors, and partner with tier one component suppliers to deliver industry leading solutions at lower costs.

In addition, we continue to advance and scale our design practices. This includes developing products for a wider array of price points, creating reference designs that are easy to customize, and reducing the component count and complexity.

To spur top-line growth, we will invest further in marketing and carrier relations to drive sell-through on an ongoing basis. This fall, we will launch a U.S. based marketing campaign to demonstrate in a very tangible way how a Palm Smartphone can benefit the personal and business lives of our customers. We expect the campaign, which will be the largest we have funded in the last five years, to stimulate Smartphone adoption by users to the category, and to bring new awareness to our brand.

The second major objective is to execute a road map of high quality, category defining mobile computing solutions. We continue to earn the best reviews in the industry and our Treo 700D and 700W products are the gold standards for Smartphones. The accolades we have earned reflect our deep commitment to a proven design that works, delights, and that delivers a whole day through.

We will alter the design and form factor of our award-winning Smartphone, but only when the tradeoff preserves the overall user experience or enhances it. We will use batteries that last. We will offer a keyboard that makes e-mail and web browsing easy. We will make products with touch screens so you can speed through your tasks with a tap, and we will continue to deliver category-defining solutions using our duo-OS strategy, Palm OS and Windows Mobile, and we will continue to bring innovation to the marketplace.

The third objective is to increase our Smartphone market penetration outside the United States. Case in point -- the Vodafone and Microsoft relationship we just executed in Europe. As I mentioned earlier, this product will be sold in nine countries across Europe, and we intend to offer it in five additional regions in the coming months.

Another way we will expand our presence worldwide is with our fourth Smartphone due out soon. We expect to see it offered by more than 20 carrier partners worldwide by the end of our fiscal year.

The Treo 700WX, which we announced earlier this month on the Sprint EVDO network, also is bound for international markets where CDMA networks are deployed.

The fourth objective is to raise awareness to the Palm brand and its hallmark attributes. We absolutely believe the brand is the key driver of long-term profitability. I have already mentioned the large and collaborative campaigns planned for Europe for the Treo 750V Smartphone and the soon-to-be-launched U.S. campaign. We aim to replicate the awareness we have built in the United States in Europe and elsewhere.

Part of our brand campaign too is to continue to bring products to market that deliver on our brand promise -- simple, fast, and easy mobile computing.

In summary, I believe we executed well on a number of fronts in Q1, including delivering strong profitability in spite of a much more competitive market. Since concluding Q1, we expanded our product offerings with the Treo 700WX with Sprint and the Treo 750V with Vodafone.

Despite very positive announcements and trends, we are not satisfied. We will work to be more predictable about our business. There is no question it is difficult to foretell the competitive front and product deliveries in this category are subject to change, given development timeframes and carrier certification trials, but we have to do better.

In addition, we must and have embraced a relentless focus on costs. We are hammering away on multiple programs to reduce them. We are confident that as we continue to drive down our costs, we can deliver a better product than those of our other vendors, and be price competitive while sustaining healthy margins.

Last, we need to be sure we communicate our compelling product differentiation more effectively to end users, and we will continue to build that differentiation through both organic development and strategic investment.

I will close by thanking our team. They are committed to Palm and its vision and have worked very hard. Together, we will continue to do what it takes to succeed.

I will now turn the call over to Andy and come back later to answer your questions. Andy.

Andrew J. 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 we have posted to the Palm website and included with the press release.

Net revenue for the first quarter of fiscal year 2007 was $355.8 million, in line with our updated guidance given on September 6th, compared to $342.2 million in the first quarter of fiscal year 2006.

The slower-than-expected growth rate during the quarter was primarily due to lower Treo sales volumes in carrier retail channels.

Gross margin of 37.1% for the first quarter was higher than our guidance. However, this included a one-time benefit of $2.6 million as a result of improved licensing terms for certain standards-based technology. Gross margin would have been 36.2% without this benefit, compared with a year ago gross margin of 30.5%.

We continue to see a healthy increase in gross margin as revenue mix shifts toward Smartphones and we benefit from reduced warranty costs.

Operating expenses for the quarter were $101.5 million, a total lower than our previous guidance. A couple of factors helped us manage to the lower spending rate.

First, we slowed our hiring ramp and second, revenue related expenses, such as MDF, commissions, and bonuses were lower than planned due to the lower revenue attainment.

This resulted in operating income of 8.6% of revenue and earnings per diluted share of $0.21 for the quarter, a healthy increase from the year-ago period when operating income was 6.2% of revenue and earnings per diluted share were $0.13.

Revenue mix for the quarter was 76% Smartphones and 24% handhelds. This compares to 67% Smartphones and 33% handhelds in the year ago period.

Smartphone revenue for the first quarter was $268.8 million, an 18% year-over-year increase on shipments of 550,000 units.

Smartphone ASPs declined relative to our expectations as we initiated new pricing through a rebate program on our 700 series products late in the quarter with one of our carriers. We expect continued ASP declines in Q2 as we implement these pricing actions more broadly.

Smartphone sell-through for the first quarter was 569,000 units. While this represents an increase sequentially and year over year, it was not as robust as we had expected. This was the result of slower-than-expected retail sell-through to consumers as lower-priced competing products were introduced to the marketplace.

Pricing actions we have recently implemented have increased retail sell-through, and we believe the future introduction of lower priced products will continue that momentum.

Handheld revenue for the quarter was $87 million, a 24% decline year over year, reflecting sales of 434,000 units.

Handheld sell-through for the quarter was 490,000 units, and weeks of inventory held by our channel partners was 7.6 weeks.

Geographically, we generated 83% of our first quarter revenue in the U.S., with 17% coming from outside the U.S. While this is a lower international contribution than we have seen in several years, we expect international business to pick up with the availability of our new Treo 750V Smartphones in early October on the Vodafone network in Europe.

Looking at the balance sheet, we generated $20.9 million in cash flow from operations, and increased cash and short-term investments to $527.9 million in Q1.

During the quarter, we made a one-time payment of $22.5 million to Xerox as part of a legal settlement. You will remember that we accrued for this payment in Q4 of fiscal year 2006.

Our future cash balance could be impacted by today’s announcement that our Board of Directors has approved a repurchase of up to $250 million of our common stock. We believe this is an appropriate use of our cash, given the low valuation of our stock, and at current values, such a repurchase would be accretive. We believe the repurchase program leaves us with sufficient cash for strategic investments and acquisitions.

Accounts receivable decreased to $168.1 million, and DSOs were at 43 days in Q1, in our expected range, and down slightly from 46 days in Q4.

Inventory decreased to $51.9 million at the end of Q1, with inventory turns slightly lower than we would like at 16 times during the quarter. We expect inventory turns to be in our preferred range of 20 to 25 times as we exit Q2.

Looking to the future, we expect revenue for the second quarter of fiscal year 2007 to be in the range of $430 million to $450 million. This reflects the full impact of the pricing actions we implemented in late Q1, which we believe will strengthen our competitive position in the retail consumer portion of our business.

In addition, we have two products currently in certification by a carrier partner, and although we are confident that these products will be launched during the quarter, a one or two week variance in certification process could impact revenue for the quarter.

As a result, we are providing a broader range than usual in our revenue projections for Q2.

We anticipate that gross margin for Q2 will be in the range of 33.5% to 34%, consistent with the recent changes to our product pricing.

Operating expenses are expected to be in the range of $115 million to $118 million, driven by continued investment in R&D and an increase in advertising and promotional activity to support the upcoming product launches in the U.S. and internationally.

The non-GAAP tax rate for Q2 is expected to be 40%, resulting in earnings per diluted share of between $0.20 and $0.23.

For the remainder of the year, we will balance top-line growth and market share over profitability. In view of dynamic market conditions, including our launch of new products and expansion into new geographies, we are not reaffirming previous annual guidance at this time, and are providing guidance only for the second quarter.

Now, I would like to turn the call back to the operator for your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

We are going to take our first question from Jonathan Hoopes with ThinkEquity Partners.

Jonathan Hoopes - ThinkEquity Partners

Thank you for taking my question. Ed, during your prepared remarks, and also during Andy’s comments, you both mentioned that retail sell-through was the main driver for the revenue shortfall, while business-to-business remains strong. I have two questions on this line.

First is what percent of your sell-through is associated or is destined to the business? Second, you also mentioned that you are doing pricing activities to convince consumers -- how do you keep the pricing incentives to the retail to not flow into the business, if in fact business appreciates and will pay for the gold standard?

Edward T. Colligan

First of all, on the percentage of business, we have seen the percentage of our business based on business-to-business sales increased this quarter, and some of that is driven by the lower retail sales, but also we believe some of it is driven just by overall growth in the business-to-business segment of our market. We have traditionally seen around 35% and we saw significantly over that, actually, this quarter.

As far as the pricing activities, if you are purchasing the products directly through the carrier as an enterprise purchase, you generally get different pricing offers, depending on your plan that you are buying into, relative to those products. The place where our pricing activities are mostly impacted is at retail. We have done mail-in rebates, essentially, to give additional pricing breaks.

Jonathan Hoopes - ThinkEquity Partners

Then how do you keep them separate? I am just trying to figure out. You mentioned that the businesses appreciate the gold standard nature. They are willing to pay for performance and price. I am just trying to clarify how you separate the two.

Edward T. Colligan

I do not think we really necessarily actively keep them separate -- if a business-to-business customer wants to get a better price, they can. They certainly negotiate that price. All I was saying in my remarks is that we saw a lot less impact. You get a lot more of the marketing hype and the pricing at that consumer point of sale, and the business-to-business customer is making more of an informed decision that they are working on over a period of time, and they do not just switch because someone came out with a new design. They generally look to what product works for them, how is it going to perform in their environment, and we continue to be successful in that side of the market.

Jonathan Hoopes - ThinkEquity Partners

Over what period is the buyback? Is it open until the 250 is done?

Andrew J. Brown

The buyback is up to $250 million, Jonathan, and there has been no specified timeframe for that buyback.

Operator

We will take our next question from Vivek Arya from Merrill Lynch.

Vivek Arya - Merrill Lynch

Thank you. My question is when you look at your second quarter outlook, what assumptions are you making about the timing of the lower-priced Treo Smartphone?

Edward T. Colligan

As we look at the second quarter outlook, we are obviously not announcing today when we are going to exactly deliver that, but as I said, we believe in a few weeks, you know, we will be giving more information about that and give more detail about it. It is planned into our outlook from the standpoint that Andy mentioned we put a pretty wide range on it, mostly because we are still in certification with those products and you just never know if an issue is going to come up that would stall that certification. So we wanted to give a reasonably wide range and make sure we are being prudent about it.

Vivek Arya - Merrill Lynch

The other thing is the gross margin outlook. You have benefited in the last two quarters from this standard industry-based system that has helped your gross margin. How sustainable is that? Do you expect that in the second and third quarter also? How long should we think of that providing a benefit to your gross margin?

Andrew J. Brown

The benefit that I actually referred to this quarter and, as you will recall, last quarter, was about an $8.9 million benefit. That was a one-time benefit, and we get ongoing benefits from that because we are accruing at a rate that is lower.

As far as the guidance goes for Q2, it does not anticipate any one-time benefit.

Vivek Arya - Merrill Lynch

So you are not going to get the one-time benefit, or you are not including it yet?

Andrew J. Brown

We are not anticipating a one-time benefit in the guidance that I gave you. What is in the guidance I gave you, however, is the ongoing benefit that we are getting from the reduced royalty rates.

Vivek Arya - Merrill Lynch

One last question, Ed, what are your general thoughts about the Smartphone market, given that ASP in the new Smartphone launch from Research In Motion, also Nokia is planning to introduce something soon -- has your thinking evolved as you look at the company’s strategy as to how you need to respond to these competitive launches?

Edward T. Colligan

I think it is clearly an incredibly competitive market right now. I think -- let’s be real. I do not think this is going to, you know, every quarter is going to look like this many launches happening, so I think in the face of all those launches and all that is going on there, including the Q and others, we had our best sell-through quarter ever and delivered a high level of profitability. I am pleased with that.

Obviously we have to address the competitive environment. I think we do that by continuing to create the best products that people want, driving down costs so that we can definitely be competitive at the point of sale in the sense of pricing, continuing to push our designs, work with more ODM partners to spin out more designs faster -- there is a lot of work being done here to make sure that we are competitively positioned in the Smartphone marketplace.

In addition, there is work here to make sure we are competitively positioned in the mobile computing marketplace as a whole, so we are going to continue to push on that to make differentiated solutions. That is the way we think we can continue to compete over time.

Operator

We are going to take our next question from Daryl Armstrong with Citigroup.

Daryl Armstrong - Citigroup

Thank you very much. Two questions -- the first one is, could you give us any sense in terms of the size of the advertising campaign that you are talking about? Are you saying it is the largest in the company’s history? I am just trying to get a better sense in terms of what the magnitude looks like.

Second of all, I was hoping if you could maybe touch upon the software platform issue with the Palm OS that you cited in the 10-K. Specifically, are you concerned that the pace of development for subsequent versions of the Palm OS, will that impact your level of competitiveness going forward? Thank you.

Edward T. Colligan

I will take the first question, which is the marketing. This will be the biggest campaign we have done in quite a few years. It is going to be somewhere over a period of time here -- I am not going to give the exact timeframe, but we will spend more than $25 million in various ways, not just all in advertising. We have to be very smart about how we spend our money. We certainly do not have the resources of a Motorola or Nokia to spend money just on advertising, so we have to be quite a bit more gorilla oriented and be smarter about how we spend our money, and we will do that.

As far as the competitiveness of Palm OS, if you read all the reviews, it continues to get the reviews that say it is the best solution on the marketplace. We have two offerings and two options of industry-standard platforms with Microsoft’s Windows Mobile platform. If people choose that, like our partners at Vodafone and like many customers in Europe, then that is a great option for them. If you want Palm OS, you are a loyal Palm customer, you will love the executions we have done on Palm OS. We plan to continue to execute against that platform because it has stood the test of time. We will continue to innovate on top of it.

If you look at the history of the Palm OS, you cannot make a Treo by licensing Palm OS from access. All the radio interface, all the telephony applications, all the SMS functionality, all the MMS functionality, all the integration into those radios, all that carrier testing -- that software and all that work is owned by Palm. To make a Treo, you have to have Palm software, and that is why that is a great product.

Daryl Armstrong - Citigroup

The base OS in your view, then, whether there is additional innovation or not, really does not impact the majority of the functionalities that you expect [inaudible] on?

Edward T. Colligan

It does not impact the majority of the functionality, and interestingly enough, if you look at most of the cell phone suppliers and most people who are shipping products into the market today, the vast majority of those sales are happening with products that no one has any clue what the OS is.

The fact that it is Palm OS or Windows Mobile, it matters more and more in the enterprise level, but at the consumer level, frankly, we want them to think about it is a Palm Treo, and it is the differentiation that we bring to the marketplace that makes our products great.

Operator

We will take our next question from Tavis McCourt with Morgan Keegan.

Tavis McCourt - Morgan Keegan & Co. Inc.

First, a clarification. I was just doing some backing up on math and wanted to make sure I had it right. I have Treo ASPs somewhere in around 490 for the quarter. Does that sound right?

Andrew J. Brown

You are in the ballpark.

Tavis McCourt - Morgan Keegan & Co. Inc.

Okay, and in your commentary, Andy, was that included some of the price discounting you did this quarter. I was wondering if you could give some color on, my understanding was most of those rebates were kind of real late in the August quarter. How low is low in terms of the ASPs for next quarter, in terms of they have been flat for now basically three quarters, obviously. Was there any of the rebates in that 490 number or are we going to feel 100% of that impact in the fiscal second quarter?

Andrew J. Brown

In the 490 number that you are referencing, at least as far as the revenue on the ASPs for last quarter, there was an impact from the mail-in rebates. As you are aware, those were implemented basically in mid-August to late in our quarter. Like I said in my prepared remarks, in fact, that we will see more of an impact of that as we move into Q2.

In addition, as we have mentioned earlier, that we are planning on introducing a lower priced product for that consumer segment of the market. That will also have an impact on ASPs.

Tavis McCourt - Morgan Keegan & Co. Inc.

Then, the lower retail price point that the Vodafone subs are launching with across Europe, is that all on their part or are you providing them lower pricing than you have on the 700’s in the U.S.?

Edward T. Colligan

No, it is really -- Vodafone, I have been incredibly impressed with their marketing capabilities. These guys are really focused on driving volume. They look at e-mail as a huge growth driver for them in Europe, for ARPU and data revenues. They understand that if you put a Treo in someone’s hands, they will use data services. So they are being pretty aggressive about putting Treos in people’s hands.

Tavis McCourt - Morgan Keegan & Co. Inc.

I have not done the calculation per channel inventory, but it was a little bit high last quarter. It looked like your sell-through was in excess of shipments this quarter. How would you characterize the channel inventory for Treos at this point?

Edward T. Colligan

It is great. Also, our handhelds, we have brought down the channel inventory, and so both products, both lines are in good shape.

Tavis McCourt - Morgan Keegan & Co. Inc.

Then a final clarification question. You had mentioned on one of the products, you expect to have into 20 carriers worldwide by the end of your fiscal year. Were you referring to the 750 or the new product launches coming up?

Edward T. Colligan

We were referring to the lower-priced product when we referenced that.

Operator

We will take our next question from Mike Abramsky with RBC Capital Markets.

Mike Abramsky - RBC Capital Markets

Thanks very much. There have been some comments made regarding the similarity of past Treo designs to newer designs, or recently new designs. Do you think you need to radically alter the designs, as well as the pricing, in order to reinvigorate momentum? Do you think that some of the newer products that you have in plan will address this?

Edward T. Colligan

Treo continues to be one of the hottest selling Smartphones on the market and continues to garner an enormous amount of buzz in the market, so from what I see on all the TV shows and everywhere you go, people are using Treos. I do not think it has lost any luster or buzz.

I think the new products we come out with, we are clearly trying to continue to improve its designs, but we are not going to change the design and make it thinner just for the reason to sell for a quarter or so.

We want people to keep our products and to love them, and we think battery life through the whole day really matters. We think the usability and all the issues around the usability really matters, like the touch-screen or a full keyboard.

Look, this is a category-defining design. We are going to continue to improve it. Then, we are also going to expand the product line in other areas, you know, and design other types of products around the Treo, in the sense of trying to come out with some new breakthrough designs. I am not saying we do not want to do that, but no sense in breaking something that is really working and is very successful for an awful lot of people. We are going to continue to improve it on an evolutionary basis, but we are really pleased with the Treo and how well it has performed.

Mike Abramsky - RBC Capital Markets

With regard to your full-year guidance, and with the delay of providing that for now, you mentioned the justification for that is -- I think you said two things, expansion into new geographies and I think it was regarding change in the new products, was that the two points you made?

Andrew J. Brown

Yes, it was market dynamics, we have our own new product introductions, and clearly moving into new geographies, that is correct.

Mike Abramsky - RBC Capital Markets

Could you just give us maybe a sense of what has changed in those regards that has altered your thinking on guidance from the last time that you provided it? At that time, clearly you were still focused on both of those things.

Edward T. Colligan

Clearly the competitive environment has gotten quite a bit more aggressive, so the dynamics of the marketplace, taking into account both that competitive environment and our plans and what we are executing against, so with all of that going on, we are basically saying let’s give a clear sense of what is going to happen in Q2, make sure people understand that. For the rest of the year, let’s continue to gather data. When we know more, and at that time, we will provide further guidance. Right now, we think we should stick to Q2 and deliver those results.

Mike Abramsky - RBC Capital Markets

On that regard, is it where the price points fall and where your costs fall that is the thing you are trying to get a better read on in the market and what the response in terms of sell-through will be to those changes, or is it on the top-line in terms of demand through, say, international expansion? What are you looking at to give you that confidence to resume full-year guidance?

Edward T. Colligan

Obviously as we went into the fiscal year, we anticipated additional competition. One of the things we had anticipated is that those competitors would actually grow the market. What we have seen is they really have not grown the market as much as we had anticipated.

So that is one of the dynamics. Although we recognize the dynamic as the competition, we really thought something different would happen, it would expand the market to more of a consumer based -- bring more people into the category. That has not happened, and that is one of the things we are continuing to monitor.

On top of that, clearly we have multiple product launches that are occurring here in fairly short order and we have a very aggressive international expansion plan, so when you take all of those things into account, we feel that at this point in time, that giving Q2 guidance is the appropriate thing and then we will give the future updates as we see appropriate.

Mike Abramsky - RBC Capital Markets

Just last, very briefly, do you expect that you will -- is it on the table to stimulate demand in Europe the way you are stimulating demand, or attempting to stimulate demand in the U.S.?

Edward T. Colligan

Absolutely. Our campaign with --

Mike Abramsky - RBC Capital Markets

As I meant to rebates, sorry.

Edward T. Colligan

No, our launch pricing is set on the 750V. We are going out with that. We do not plan on doing any additional rebates at this point in time. The product has not even really launched yet. Some of the price points at the carriers, and this is what -- I mean, it is not the carriers, it is Vodafone, some of the price points with a very reasonable kind of mid-line plan for a business user takes that product to free, so not a whole lot of rebates we could do beyond that.

Operator

We will take our next question from Jeff Kvaal of Lehman Brothers.

Jeff Kvaal - Lehman Brothers

I was wondering if you could update us a little bit on your tax outlook, to what extent does the tax rate look solid and, I think more importantly, where do you stand on the net operating losses? Thanks very much.

Andrew J. Brown

Our tax standpoint, one of the things, if you notice our tax rate, we are right now not taking advantage of the structure that we have put in place internationally, so we are basically the full boat tax rate. We believe that will continue for the remainder of this fiscal year, and then obviously, we would hope to take advantage of those tax structures as we move beyond this fiscal year.

You should expect it to stay at this rate for the remainder of the fiscal year.

Jeff Kvaal - Lehman Brothers

Okay, and your net operating losses?

Andrew J. Brown

The net operating losses, yes -- I do not have that right off the top of my head, but we essentially have, if I recall my 10-K that we issued just about 90 days ago, we are right around -- a little bit over $800 million of net operating losses that we could take advantage of, but we can get that information for you.

Jeff Kvaal - Lehman Brothers

Great. Ed, there is a lot of talk about potential M&A, and I was wondering if you might share some of your thoughts on how that might develop.

Edward T. Colligan

M&A in what respect?

Jeff Kvaal - Lehman Brothers

Well, there has been talk in the investor community, Ed, that you might become an attractive element of other folks’ portfolio, perhaps, in --

Edward T. Colligan

The only M&A I am focused on right now is building our strategic position from a software and services perspective, and we are really driving very hard on that front to make sure we are using our resources as effectively as possible to build our business.

Our total focus is on executing against our plan. That is what we are doing today. There are a lot of rumors in the marketplace. I really cannot comment on those.

Jeff Kvaal - Lehman Brothers

Are there any particular product areas that you feel are particularly appropriate?

Edward T. Colligan

I am not going to get into details about that. It is just something that is a competitive situation.

Operator

We will take our next question from Paul Coster with J.P. Morgan.

Paul Coster - J.P. Morgan

Thanks very much. Andy, if I heard you right, the revision, the downward revision to expectations on the top-line is just a function of price and volume. In reducing the volume outlook, presumably your supply chain has been advised. Does it have any implications in terms of the cost structure and gross margin outlook that you had for the full year?

Andrew J. Brown

The only outlook that we are providing at this point, Paul, is for Q2. I am not going to comment on beyond Q2.

As far as the volumes that we are assuming in Q2, they are all baked into the guidance that I gave you.

Paul Coster - J.P. Morgan

As we think out to second half of the year, the ASP decline, do you sort of see this as a one-time thing, or is this just for the state of the business from this point forth, that the sweet spot price point is coming down?

Andrew J. Brown

Like I said, we are providing guidance for Q2. I am not going to provide additional guidance beyond Q2 at this point. We do anticipate in Q2, like I said, that we will see some ASP declines for a couple of reasons. One is we get the full implementation of the pricing actions we have taken on the current products, and then secondarily, as we have mentioned earlier, we will be introducing that lower price product this quarter, and that will also have an impact on ASPs.

Paul Coster - J.P. Morgan

Fair enough. The gross margins on the new product, the low price point products, are they expected to align with corporate average, be accretive to the average gross margin? What is your sense there?

Andrew J. Brown

They fall within the blend that you would expect in the Smartphone part of our business. As you are probably aware, the Smartphones command a slightly higher gross margin than our handheld products, but they fall sweetly within that range that you would expect with Smartphones.

Paul Coster - J.P. Morgan

Then, my last question, it is a bit of a soft ball one, but what is the differentiation -- how is Palm different from Nokia, Motorola, and RIM and so on?

Edward T. Colligan

Kind of a soft ball one -- look, I think the way we focus on mobile computing. We are just 100% focused on that. We try to do everything we can. You know, you were saying, are the ASPs, is this the state of ASPs in the future? I hope not, because we are going to continue to differentiate our product and drive new features and functionality that the customers are going to demand and want to pay for.

I think the big things we try to do is really focus on that design, make sure that user experience is great, you know, and over time, from our experience, that will win out. You might have blips of new announcements and things coming out, but we are really focused on building a total mobile computing solution. We will continue to focus on that and that is where you will see us differentiate over time.

Operator

We will go next to Michael Ounjian with Credit Suisse.

Michael Ounjian - Credit Suisse

Thank you. Ed, as you are looking to get into new markets and really broaden the reach of the product, and at the same time in an, as you mentioned, increasingly competitive environment. How are you thinking about how many new products you will need to introduce each year going forward? I mean, this year, as you have said all year, the four new products. How do you think about that going into next year? Will you need to really expand that significantly? What are the implications for the business model?

Edward T. Colligan

Clearly as the business scales, you know, we hope to have more and more capability to do more things. It may not be just in numbers of products. It may be in how those products work and how we interact with the customers through those products. It may be extending that total mobile computing solution in different directions.

The reality is it is likely that next year, the pace of Smartphones is very similar to what we are doing this year, but we are really trying to invest around our Treos to make them even more compelling and useful and more and more different than everyone else’s. That tends to drive more of a software development effort than it does necessarily device development.

This year we said four new ones mostly because everyone is saying we are a one-product company, and so we wanted to be just very clear that we are expanding that and we are expanding aggressively.

I do not really today want to predict the next number. I would just say a similar pace of development will happen in the next year.

Michael Ounjian - Credit Suisse

Andy, as we think about the November guidance, how much of that -- you gave some indication to the variation potential with the new products, but in terms of the 750 versus the products you have been shipping, can you give us some sense of how you are thinking about the mix within that guidance?

Also, you talked about that coming to a number of new regions. Should we expect the U.S. to be one of those regions in the upcoming quarter?

Andrew J. Brown

I am not going to get into specifically the mix of the new products versus the existing products, but we would anticipate that the new products would ship to -- some of the products will ship to several regions. That is about it.

Edward T. Colligan

We are absolutely targeting the U.S. market for additional expansion. We are not going to not support our core marketplace.

Operator

We will take our next question from Jonathan Goldberg of Deutsche Bank.

Jonathan Goldberg - Deutsche Bank

Andy, quick housekeeping question. I just want to be clear. The rebate that you guys enacted in August, does that flow through revenue or cost line?

Andrew J. Brown

That actually flows through the revenue line, which as I mentioned, it reduces the ASPs.

Jonathan Goldberg - Deutsche Bank

Then, Ed, in your comments, you made the point very clear that Palm differentiates itself through its software and user experience. My question is, how does that impact your R&D spending going forward? With access becoming less and less engaged in the OS process, does that mean that Palm now has to pick up more of the slack and spend more R&D dollars to maintain that, or do we get to some point where eventually the R&D effort, the spend is declining?

Edward T. Colligan

I think at some point with scale at the top-line, we will get some leverage. I think right now, we have been, to a large extent, doing most of the differentiation, all for the differentiation, really, from my perspective, on top of Palm OS, so we are making that investment today. We will continue to make that investment.

We are also investing on differentiating on top of Windows Mobile, and we want to continue to do that too.

It really is an area of focus for us. It will continue to be. I expect to get some leverage as the top line grows. We have planned those investments into the outlook that we have given.

Jonathan Goldberg - Deutsche Bank

It is getting late in the call, but no one has asked yet. What is the outlook for PDAs, the handheld business, going forward? How do you model those declines?

Edward T. Colligan

We are pretty relentlessly focused on Smartphones here, so we clearly see that as the huge growth area opportunity of our business. We have modeled the handheld business to decline at a 20% to 30% kind of rate, consistently.

What we are seeing in this quarter is -- we are not expecting the huge bump that we used to get. I mean, 50% of the handheld sales would happen in the holiday season in years when that was the core line here.

Despite the fact we still have four of the top-selling PDAs in the marketplace, we just are not expecting it to be quite as robust at the holiday season, so we have also modeled that into our guidance.

Operator

We will take our next question from James Faucette with Pacific Crest.

James Faucette - Pacific Crest

Thank you very much. Most of my questions have been answered, but one question I had is you have recently announced the availability of BlackBerry Connect for the Treo 650 in a few markets, et cetera. How important and what kind of response do you typically see as you enable Treos for different e-mail platforms, whether it be Good or BlackBerry or Microsoft, and how soon can we expect the availability of those platforms to expand completely onto your 700 devices?

Edward T. Colligan

It is really interesting. Our relationship with Good has just been phenomenal. It has driven literally -- I mean, we are in 12,000 different deployments now. It is a huge part of a great partnership that really is a great way of driving some of our enterprise sales.

With the 750V at Vodafone, we deployed both a solution with Visto that is a great out-of-box solution that Vodafone pushes, and we are doing a BlackBerry Connect deployment there. In Germany, for instance, they are very much focused on selling BlackBerry as their e-mail solution, so having BlackBerry Connect there I think is going to be really, really important.

It just really depends on the carrier situation. One of the great things is we have been an open platform. We have worked with a wide range of partners. We have gotten really good at deploying any one of them in any situation. We really provide the most choice and the widest range of solutions for any customer in the marketplace when it comes to delivering an e-mail solution.

I do not think there is any particular pop off of, you know, a deployment. We announced reasonably recently that BlackBerry Connect got on the Treo 650 with Cingular, and we had an incredibly successful webinar and we are out feeding those devices and so forth, but it takes time for enterprise customers to test those and put those deployments, put those trials into deployments, so I cannot say today how much BBC has popped Cingular sales, but we are monitoring that closely and hopefully over time, we will be able to provide you some more color on that.

James Faucette - Pacific Crest

Just related to that, particularly for the large e-mail partners and providers, or at least the ones that are perceived to be large, like Microsoft, Good, and Research in Motion’s BlackBerry Connect, how challenging is it right now and what is the lag time that you are typically seeing in terms of getting the appropriate software being made available for new devices for you?

Edward T. Colligan

You know, all three of those systems you mentioned, we were pretty much lock step. I would say with BlackBerry Connect, it is one step removed. Clearly we are in a competitive relationship too, so that is not quite as close as the others, but with Good, we are literally testing our devices, we are doing co-development. We really work very closely together. The same with Visto, with Microsoft -- the products we are releasing have Exchange active sync in the box. You can configure your exchange server in 30 seconds on our devices if your IT department’s enabled wireless e-mail for you at your company.

We are delivering that stuff in real-time and we are working with those partners very closely.

Operator

We will take our next question from Charles Wolf with Needham & Company.

Charles Wolf - Needham & Co.

I have a couple of questions. Just to be sure, on your new phone, Ed, I assume it is going to have a touch screen?

Edward T. Colligan

Yes.

Charles Wolf - Needham & Co.

Okay, and on the last conference call, you noted that the trials in corporations were proceeding perhaps more slowly than anticipated. Is it fair to assume that the increase in Treo sales in the August quarter resulted from a step up in the completion of those trials and some volume deployments?

Edward T. Colligan

I absolutely think it is fair to assume that. We are tracking that. We have seen some increase in B2B sales, as I said. It is a constant, ongoing process.

One of the things about this competitive -- I think we would have seen a bigger up-tick in that. With all of these products being announced, people end up needing -- they want to check them out. The fortunate thing is when they check them out, they quickly figure out the Treos are better. That is a good thing. But it does impact the deployment timeframes.

It would be great if all these products got on the market. Everyone would be able to make a reasonable judgment about what strengths and weaknesses they have, and I think we will get more than our fair share of those deployments.

Charles Wolf - Needham & Co.

Is it fair to assume that there will be a continued increase in volume deployments as we go through fiscal 2007?

Edward T. Colligan

I certainly would hope so. Absolutely. Now, I also hope that we have a better performance at the retail level, specifically with our new product announcements and the new pricing position we are in, so I do not necessarily expect the percentage of our enterprise sales to continue to increase, but we certainly are driving hard on the trials that we have to turn those into full-fledged deployments.

Operator

Ladies and gentlemen, due to time constraints, that will conclude today’s question-and-answer session. I will turn the conference back over to Mr. Colligan for any additional or closing comments.

Edward T. Colligan

Thank you very much. It is great of you all to join us today on our call. We appreciate your ongoing interest in Palm, and we will talk to you next time. Thank you.

Operator

Once again, ladies and gentlemen, that concludes today’s call. Thank you for your participation. You may disconnect at this time.

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Source: Palm F1Q07 (Qtr End 9/1/06) Earnings Call Transcript (SeekingAlpha)
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