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Palm, Inc. (PALM)

F2Q07 Earnings Call

December 19, 2006 4:30 pm ET

Executives

John Shandler - Investor Relations

Edward T. Colligan - President, Chief Executive Officer, Director

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

Analysts

Mike Walkley - Piper Jaffray

Michael Ounjian - Credit Suisse

Lawrence M. Harris - Oppenheimer & Co.

Aaron Husock - Morgan Stanley

Maynard Um - UBS

Jeff Walkenhorst - Bank of America Securities

Jonathan Hoopes - ThinkEquity

Charlie Wolf - Needham & Co.

Jonathan Goldberg - Deutsche Bank

Mike Abramsky - RBC Capital Markets

James Faucette - Pacific Crest Securities

Presentation

Operator

Good day and welcome to the Palm Incorporated second quarter fiscal year 2007 earnings results conference call. Today’s call is being recorded. At this time, I would like to turn the conference over to John [Shandler]. Please go ahead.

John Shandler

Thank you. Good afternoon, everyone. I would like to welcome you to Palm's fiscal year 2007 second 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 quarterly report on Form 10-Q for the fiscal quarter ended September 1, 2006, and 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. Good afternoon, everyone. Thank you for joining us. On our conference call today, I will summarize our financial performance and business fundamentals and share what we are doing to grow our company. I will talk about our progress in several dimensions, in terms of geographic reach, demographic reach, pricing, user experience, and demand generation. I will conclude with an update on the four objectives I set out for the team this year.

Our business fundamentals continue to be strong. One of our most critical metrics, Treo smartphone sell-through, is at a record high. The international portion of our business is making significant gains. We completed a key license to the Palm OS, a critical strategic move to enable future product differentiation, and our balance sheet remains strong.

These accomplishments show the underlying strength of our business and that we are laying the groundwork for ongoing future growth.

Our one disappointment this past quarter was that we were unable to ship the Treo 750 into a U.S. carrier due to delays in the certification process. This product will ship this quarter and we are confident it will be well-received by customers. Over the coming years, we will continue to build a broader base of carrier relationships such that the impact of a certification delay can be minimized.

To recap this quarter, smartphone sell-through totaled a record high 617,000 units, up 42% year over year and up 8% sequentially. International sell-through contributed significantly. Overall, revenue totaled $392.9 million, down 12% from Q2 of fiscal year 2006. Smartphone revenue totaled $283 million in the quarter, up 5% from the comparable period a year ago, and EPS was $0.17 per diluted share.

We announced and delivered two new Smartphones in the quarter, the Treo 750v in Europe and Asia-Pacific and the Treo 680 around the world and with Cingular in the United States. The reviews are excellent and sell-through, as I said earlier, is strong.

Those two new smartphone platforms, plus the Treo 700w, using Windows Mobile, and the 700p, using Palm OS, add up to four major differentiated Smartphones we have introduced in the calendar year. Last year at this time, we had just one smartphone on the market, the Treo 650.

In terms of carrier reach, we announced new relationships with six carriers during the quarter, including several from the Vodafone group. We soon will begin shipping products to America Mobile, the leading carrier in Latin America and the world’s sixth largest carrier in terms of subscribers. Palm today has business relationships with six of the top 10 carriers measured by subscriber base.

Our ability to offer the Treo 680 smartphone in many regions of the world in very short order reflects our efforts to streamline our development and testing cycles for our generic rest of world [ROMS], and our relationship with a new ODM partner based in China. We expect to offer this phone in a total of 20 carriers around the world in the coming months. In total, we have 85 active carrier relationships.

As we head into the second-half of fiscal 2007, we plan to continue to enhance our portfolio and build further differentiation with our overall user experience. To communicate our differentiation and drive sales, we have begun investing in a $25 million marketing campaign focused in the U.S. but also reaching to Europe and other regions. We have done an excellent job of tapping into the mobile professional market, a group of people that truly values information on the go. Ask any of the medical professionals who use our products to improve patient care or the sales people who serve their customers better thanks to their Treos.

As we broaden our target demographic, we believe there is an opportunity to reach a whole new set of users who may not be as driven by e-mail on the go, but more interested in getting information access, getting access to the core information they care about, much of which resides on the Internet.

We believe Treo provides the best Internet access of any device on the market and we intend to make that better known. To do this, we have partnered with what we call passion brands, from e-bay and Google to Yahoo! and Fandango, in innovative ways.

Take Yahoo!, for instance. They are one of the millions of registered users who listen to music at Yahoo!, read Yahoo! e-mail or play in a Yahoo! Fantasy Football league. Instead of being tethered to your desk or laptop PC, you can get your music, your mail, or change your team lineup from just about anywhere you happen to be.

Our ads show a Treo with the Yahoo! logo on the screen and Yahoo!’s high-traffic website features our campaign as well. The tagline on these print, online and outdoor ads is this: Not just a cell-phone, a Treo. Interactive kiosks and street teams also make this a novel marketing campaign.

Since the new customers we attract may be less technical, we will help them feel comfortable trying a Treo through a unique program we call Butler, an effort to handhold our customers through the setup process. We piloted Butler quietly in the summer and saw customer satisfaction rise and our return rates drop by half in the pilot. We now have extended the program to several carrier partners that offer the Treo 700 and to new Treo 680 buyers.

A notice in the box invites customers to call a toll-free number to talk with a Treo expert who will help them load the Treo software on the customer’s PC or Mac, transfer data from another device, download and set up whatever bundled software they would like, including e-mail. For the first 90 days after purchase, we help the customer become familiar with the basic functions, like making a phone call, sending an SMS, or e-mail.

We would not be surprised if the legions of Palm loyalists found this program something they heartily promote to friends, family and colleagues.

We are also broadening our customer reach in terms of pricing. Our new Treo 680 is priced by the carrier at $199, about half of what our premium smartphones cost at launch. For that price, customers get a fully loaded phone in their choice of four fun colors, and also a more intuitive user interface.

In addition to demographic and pricing moves aimed at growing our customer base, we are making great progress on expanding our reach geographically. Global expansion of our smartphones has been a key strategic objective, and we are accomplishing that objective by building infrastructure, creating smartphone solutions the world market wants, and signing up top-tier carriers.

This effort is paying off. The Treo 750v is now selling in nine European countries and five Asia-Pacific countries. This 3G, five-band world phone has received excellent product reviews.

Our European engineering center in Dublin, which is charged with collaborating with European carriers, is now contributing to our ability to deliver great products globally and we are in the process of opening an engineering center in Shanghai to collaborate with Asia-Pacific carriers and an operations hub in Taipei to better integrate our work with our ODM partners.

Now I will say a few words about the four objectives I set for the fiscal year.

The first and foremost objective is our commitment to profitable growth. We need to deliver more predictable financial results to our investors and we are driving toward that goal. We are making excellent progress, increasing the number of world-class carrier partners, so that issues that come up with any particular product or particular carrier have less impact on our quarters. Our expanded relationships with the Vodafone group across Europe and Asia-Pacific shows good progress. America Mobile in Latin America is another proof point.

The second major objective is to execute a roadmap of high quality, category defining mobile computing solutions. We introduced four new Smartphone platforms this calendar year, two in the quarter, as noted earlier. Reviewers from BusinessWeek and Computer World to Consumer Reports gave us high praise, specifically pointing to ease of use, the integration of hardware and software, and the Palm experience. We are committed to a heady pace of high-quality product introductions in the coming months and years, and to continue to demonstrate the kind of hallmark innovation Palm is known for.

I am also pleased to introduce a new leader for our product definition and worldwide marketing activity. A new Senior Vice President and member of my staff, Brodie Keast. Brodie has an amazing track record of creating inspiring products and building world-class brands at companies, including Tivo and Apple, and I know he is going to make an important contribution at Palm.

I hope you noted an announcement earlier this month about a new agreement with ACCESS, formerly Palm Source. We now have perpetual rights to the Palm OS Garnet source code and great flexibility to evolve that system software to support our roadmap. This agreement makes great strategic sense, looking at our roadmap and commitment to product differentiation. It is also excellent from a financial point of view.

Our dual OS strategy is now stronger than ever. Note that Palm is the only company that has enabled Microsoft’s push e-mail solution onto smartphones running either of two operating systems, Windows Mobile or Palm OS. The depth and breadth of the choices we offer our customers is unique in the industry.

The third objective is to increase our smartphone market penetration outside the United States. This is clearly the quarter’s highlight. Sell-through is up sharply. Carrier expansion was accelerated, and we are delivering Palm OS and Windows Mobile based products around the world. We have good momentum and we will not let up on our efforts to expand globally.

The fourth objective is to raise awareness of the Palm brand and its hallmark attributes. Our new passion brands marketing campaign, unveiled earlier this month, builds on the huge effort in Europe funded jointly by Vodafone, Microsoft, and Palm that began when we launched the Treo 750v. Brand is a key driver of long-term profitability, in our view, and we are investing in it to drive awareness and preference. We have already got an excellent base from which to build and IDC recently validated what we have long believed -- that the Palm experience engenders the highest loyalty.

Now, I would like to thank the members of the Palm team, our greatest assets. Your passion for delivering compelling products is amazing. We accomplished significant high-impact goals associated with worldwide reach, product differentiation, and control over our destiny in the last quarter. I am confident these accomplishments will be reflected in quarters to come, as we build our company for the long-term.

Thank you for your attention today. I look forward to answering your questions after Andy reviews more detail on the numbers. Andy.

Andrew J. Brown

Thanks, Ed, and good afternoon, everyone. Before I start, I would like to reiterate that all the commentary today is 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 is posted on the Palm website and included with the press release.

Net revenue for the second quarter of fiscal 2007 was $392.9 million, compared with $444.6 million in the second quarter of fiscal 2006. During the quarter, we continued to see sell-through of smartphones climb. However, our revenue was lower than anticipated since we were unable to ship the Treo 650 into the U.S. market.

Gross margin for the second quarter of fiscal 2007 was 35.6%, compared with 30.6% in the year-ago period. Our gross margin expanded as a result of continued execution on our plans to reduce our product costs and warranty expenses.

Operating expenses for the quarter were $116 million, in line with our expectations. During the quarter, we continued to make investments in our product development engine and in the last month of the quarter, started a new advertising campaign that will continue in the second-half of the fiscal year. This resulted in operating income of 6.1% as a percent of revenue, and earnings per diluted share of $0.17.

Revenue mix for the quarter was 72% smartphones and 28% handhelds. Handheld mix was slightly higher than we anticipated due to the delay in shipping of the Treo 750 into the U.S.

Smartphone revenue for the second quarter was $283 million, a 5% increase both sequentially and from the year-ago period, with unit shipments of 603,000. Smartphone ASPs declined as expected, as we implemented pricing actions started last quarter more broadly with our carrier partners.

Smartphone sell-through was robust during the quarter at 617,000 units, increasing 42% year over year and 8% sequentially. This was driven in part by the introduction of the Treo 750 for the international markets, the Treo 680 in the U.S. and international markets, and strong performance in our U.S. carrier retail channels.

We exited the quarter with lower carrier held inventories and expect our carrier partners to continue this trend as we move into the second-half of the fiscal year.

Handheld revenue for the quarter was $110 million, a 37% decline year over year, reflecting sales of 603,000 units. ASPs, while down sequentially, were flat year over year. Handheld sell-through for the quarter was 500,000 units, a decrease of 29% year over year, and inventory held by our channel partners was 8.3 weeks.

Geographically, we generated 66% of our revenues from the U.S., with 34% coming from outside the U.S. in Q2. The international revenue benefited from the launch of the Treo 750v with Vodafone in September, and the launch of the Treo 680 worldwide in November. Had we shipped the Treo 750 into the U.S. market during the quarter, we would have still seen a strong international contribution.

Looking at the balance sheet, our cash and short-term investment balance decreased from the prior quarter to $518.4 million. Cash flow from operations was $22.2 million, offset by stock repurchases for the quarter of 2.2 million shares at an aggregate price of $31 million.

Accounts receivable increased to $247 million, and DSOs were 57 days, reflecting seasonal shipments of our handheld products and shipments of the Treo 680 late in the quarter. We expect our DSOs to normalize to a range of 40 to 50 days as we exit Q3.

Inventories decreased to $39 million, and turns were in our preferred range at 22 times.

Looking to Q3, we currently expect revenue to be between $400 million and $410 million. During the quarter, we are trying for sustained growth of our smartphone sell-through offset by lower inventory stocking levels with our carrier partners as they work towards tighter inventory management and seasonal declines in the handheld side of our business.

We anticipate gross margin will be in the 36% to 36.5% range. This includes the benefit we will derive from the newly concluded agreement with ACCESS, which replaces the historical per unit royalty rate with amortization of costs of the transaction over the next five years. The impact of this is an increase of gross margin of approximately 100 basis points.

Operating expenses are expected to be in the range of $128 million to $133 million, which includes continued investment in product development, increased marketing spend on our brand awareness campaign and for our demand generation. In addition, we anticipate an increase of $1.5 million to $2 million for litigation defense costs.

The tax rate for Q3 is expected to be 40%, resulting in earnings per diluted share of $0.11 to $0.13.

For those of you modeling our balance sheet, I want to remind you that our third quarter cash balance will be reduced by a payment of $44 million to ACCESS, a debt repayment of $35 million in early December, and any ongoing activity in our stock repurchase program. Under the current authorization from the board, we have $219 million remaining in the program.

I will now turn the call over to the Operator for your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

We will go first to Mike Walkley with Piper Jaffray.

Mike Walkley - Piper Jaffray

Thank you very much. Andy, I was wondering if you could give us a little more color on the increase in operating expenses. One, is it the marketing campaign, is this going to be a longer-term operating expenses, or could you give us a little color on where you see marketing as a percent of sales, maybe longer term, since you are in the middle of a big campaign?

Andrew J. Brown

Yes, well, a couple of things, Mike. Good question. First thing is we are going to continue the marketing campaign at least through the remainder of this fiscal year, which is the end of May. That is a component. The other thing that we are doing is actually accelerating some of our development programs in R&D to get products out sooner, so it is a combination of both the marketing side, what I will call the variable expense side in marketing, and accelerating product development.

Mike Walkley - Piper Jaffray

Thanks. So would you expect op-ex as a percent of sales to trend down into fiscal ’08? Is that a fair way to think about it, or I guess you will make that determination later on?

Andrew J. Brown

Yes, I am not going to get into ’08. We know at this point in time that for sure the marketing campaign is going to continue through the end of the fiscal year.

Mike Walkley - Piper Jaffray

Great. Maybe just a question, just thought a little on the smartphone market. If you look at some of the U.S. carriers are now carrying a lot more different selection of smartphones, and you mentioned a little less shelf space for you. Could you give a little color maybe on when you are launching at a carrier, the timing of the launch? Also, with some concern of a little bit of smartphone inventory build, maybe not yours but in the channel exiting the year, could that potentially delay the launch of the 750 or other new products for your carriers? Thank you.

Edward T. Colligan

Clearly there is, as you have seen, there has been more competitive products that have come on the market, and certainly the carriers have a choice of solutions. We have seen them picking up both of our solutions, depending on the Windows Mobile and Palm OS, and also the radio technologies that we have, and we have not seen us really being impacted on the shelf at this stage. In fact, the 680 sell-through, as we said, has come out of the gate really strong and we are very pleased with it.

So yes, it is a competitive environment. I think customers are still making choices out there as to which products work best for them and we are getting our fair share of that.

Mike Walkley - Piper Jaffray

Great, thank you very much. I will pass on to the next question.

Operator

We will go next to Michael Ounjian with Credit Suisse.

Michael Ounjian - Credit Suisse

Great, thanks. To start, could you talk about the contributions of enterprise versus consumer to the quarter, and how you see that tracking into the February quarter?

Edward T. Colligan

Yes, we categorize the enterprise business as actually our business sales, because we have a very large proportion of our sales into what we call small and medium businesses as well, not just the highest in enterprise. We do provide the widest range of e-mail solutions on the market, so we really serve a really broad range of business customers.

It has become a bigger and bigger piece of our business over time, and certainly at this point is in the 35% range, and even tracking more towards 40% at this point. It has continued to grow, but I think it is really reaching into a broader range of small and medium business customers as opposed to just the enterprise side of the business.

Michael Ounjian - Credit Suisse

Great, thanks. On the product side, could we get a sense of what the trends you have seen so far in the first few weeks at Cingular with the 680 have been? Just on the 750, just a clarification. I think when you put out the new guidance a few weeks ago, the expectation was to launch that here in the U.S. in the early part of the quarter. Is that still the expectation or have there been further delays since that time?

Edward T. Colligan

First, on the 680, as I said, sell-throughs have been great and the excitement around the colors has been really very positively received. We are pleased with how that has come out of the gate, and certainly contributed to our very strong sell-through numbers this quarter.

The 750, it is on track to be certified. Obviously a little behind where we had hoped to have it certified, but we are still on track for this quarter.

Michael Ounjian - Credit Suisse

Great, thank you.

Operator

We will go next to Larry Harris with Oppenheimer.

Lawrence M. Harris - Oppenheimer & Co.

Yes, thank you. I think it was indicated earlier that we could see some higher levels of R&D. As we look towards calendar 2007, could we see a similar number of new product introductions as we saw in 2006, or could we just see enhancements for the current product line?

Edward T. Colligan

I think you will see a similar kind of rate of introductions. I think you will see more diversification in the mix, and we are going to invest significantly in the software elements of our program too. As you have seen, we did do the licensing deal with ACCESS. We plan to continue to enhance our Palm OS products and build on top of that and around that platform, and so that will take some R&D investment too.

What we hope to be doing is accelerating some development and investing some more in others to put us in a stronger competitive position exiting the year and then be able to leverage that competitive position from the top line to continue to fund R&D going forward and deliver more to the bottom line. That is the plan.

Lawrence M. Harris - Oppenheimer & Co.

Could we see a greater emphasis upon newer suppliers, like Inventec, in terms of bringing the cost structure of the products down?

Edward T. Colligan

You can expect us to continue to leverage the ODM partners that we have, not only HTC but also Inventec and another new partner that we are bringing up on another program. It is our intent to be very strong at managing ODM relationships in Asia, such that we can deliver a broader range of solutions more quickly off of the core platforms that we develop. That is part of our plan.

We have for the long term of this company been a very virtual company with a flexible supply chain, and we hope to leverage that into something that can really make us more efficient and deliver more products to market and more profitable in the long run.

Lawrence M. Harris - Oppenheimer & Co.

Thank you.

Operator

We will go next to Aaron Husock with Morgan Stanley.

Aaron Husock - Morgan Stanley

Thanks. You had a very strong quarter internationally. Could you give us a sense for where you are in the ramp of the Treo 750 at Vodafone? Is most of that behind us and now you are at your run-rate there? Or is that still ramping?

Edward T. Colligan

I would expect it that it is still ramping some. We have obviously had to bring up each one of those operating groups independently, so U.K. comes up separately than the German partner, so those have been ramping over the last few months, and now in nine countries and some Asia-Pacific countries.

I think the overall group is probably still getting some critical mass, but we have ramped the vast majority of where we think we are going to go with at least a number of operating groups, and now it will be really trying to drive that brand position and the product differentiation in the mind of the consumer to help ramp the overall sell-through over time.

Aaron Husock - Morgan Stanley

Okay, and on your comments about how your carrier partners still want to work down inventory further, could you give us a sense for how much excess inventory, or excess inventory in their eyes, they think they have? Based on my math, I think it was around 70 to 75 days right now. How much lower do you think they want to get that?

Edward T. Colligan

I am not sure how you do your math, Aaron, but I think in general, what you are seeing with the carrier partners is you have a proliferation of Smartphones on the shelf. It is becoming a significantly bigger category than it was just 12 months ago when maybe there was just two partners in the line, and so what they are trying to do is manage their inventory more aggressively, like they do their standard handsets. We have seen that over the past couple of quarters. We have seen our inventory levels in aggregate come down at our carrier partners for the last two quarters. We are anticipating that will continue as we move into Q3.

Aaron Husock - Morgan Stanley

Do you have any sense for how much more they want to bring that down?

Edward T. Colligan

I do not think it is a massive amount. I would say it will come down slightly. It has not come down, you know, if you take a look at the differential between our selling and sell-through over the past two quarters, it has not been a massive amount. It has been fairly small, but as far as when you compare it to the relative sell-through, it has come down significantly more.

Aaron Husock - Morgan Stanley

Thanks.

Operator

We will go next to Maynard Um with UBS.

Maynard Um - UBS

Thank you. On your prior call, you indicated the shortfall occurred in the carrier retail stores because they are more influenced by price, fashion, marketing. Could you just talk about what you have learned about the dynamics of the retail channel, and any thoughts on your strategy between the mix of rebating or carrier marketing promotions?

Secondly, if you could, you both have discussed the ramp-up of the number of carriers. Any thoughts on how many operators you think you will be adding, let’s say by the end of this fiscal year? Thank you.

Edward T. Colligan

The retail, I think we have been successful at retail this quarter. The launch of our new product in particular, the 680, in that price point and trying to drive the message of more fun colors and so forth has appealed to the consumer. We certainly have taken some pricing actions over the last quarter, mostly in the form of rebates, to try to make sure that our prices at retail are competitive.

That being said, I think what we saw there at the end of last quarter was probably more related to the competitive onslaught that was happening at the time and our ability relative to the different carriers promoting various solutions. For ours to be promoted above that or in addition to that, and for that probably -- it was part of the impact there, not a lack of knowledge relative to retail markets or retail capabilities. In fact, we have a great retail training team that is out with the carriers and is looked at from our carrier partners as being a really stellar retail effort.

Really, product timing there and again, you see product timing here on this particular situation with the 750. If we had gotten it out a little earlier for the holiday season, I think this quarter would have been significantly better and we would be much more excited about the results. Despite that and in spite of it not going out, the sell-through year over year was up 42%, so you can imagine what that number would have been if we put that one on the market.

Look, no excuses there. We have to do better. We have to hit those base, but I do not think it is related to our retail execution. I think we are actually quite strong at that.

The second part of the question, I am forgetting. I’m sorry.

Maynard Um - UBS

The number of carriers by the end of the year, fiscal year.

Edward T. Colligan

We are going to bring up 20 new carriers in reasonably short order here, relative to the 680. Off the top of my head, I can imagine that our total number of carriers would be in the range of 100.

Maynard Um - UBS

Great, thank you.

Operator

We will go next to Jeff Walkenhorst with Bank of America Securities.

Jeff Walkenhorst - Bank of America Securities

Thank you so much. I am wondering if you could maybe dive a little bit deeper into what is happening in Europe. When you look at these countries, these Vodafone operating carriers that you brought on board, which of Germany or U.K. or the others that you already signed into, where have you seen good strength so far, and what has the feedback been?

Edward T. Colligan

It’s been strong across the board. I would say the strongest countries that we have seen so far has been the U.K. in particular, and then Spain actually is a very strong country for us. It has been one of the countries that we have had a consistent presence in. Vodafone in Spain has carried our products for quite some time outside of this deal with the operating company, so they were shipping our Palm OS product. They are very knowledgeable about those products, and so they have been very successful with the product.

Italy is another country where we have seen some strong success. Again, they have been partnering with us prior to the overall group relationship. I think what you learn out of that a bit is knowledge about Treo, knowledge about Palm, knowledge about our solutions and already talking to those customers. We already had some built-in momentum with those teams and those groups selling our solutions.

Jeff Walkenhorst - Bank of America Securities

Okay, thanks, and the marketing campaign that Vodafone and Palm and Microsoft embarked upon, do you expect that is going to continue on? Have you seen any strong results because of that?

Edward T. Colligan

Yes, we expect it to continue and as we have said, our sell-through, the European results relative to our expectations were strong. We are looking to continue that marketing effort, both in conjunction with Vodafone and Microsoft and in addition, some of our own branding efforts, as part of our overall marketing campaign we talked about during the call so far today.

Jeff Walkenhorst - Bank of America Securities

One last question. On the gross margin, it looks like that’s a little better than what most people had expected, around the 36% range and on a go-forward basis, how sustainable do we think this is? You talked about the initiatives, but the lower warranty expense, better part quality and so on, give us a little more detail in terms of how you think that might evolve over the next three quarters or so? Thank you.

Andrew J. Brown

Well, clearly the gains we have been seeing over the past couple of quarters have been a combination of several things. One is we are just -- the team is executing really well on reducing the core product costs, the component costs that go into our products. As Ed had mentioned earlier, as far as moving forward, clearly diversifying the ODM base can have a positive impact as far as we now have ODMs competing for the business. We believe that will continue.

The other component is the warranty side of the costs. We have seen a combination of things there. We are seeing reduced returns and we are seeing reduced costs of actually repairing the products, and so that has been a benefit over the past couple of quarters. But we can still make improvements there.

The big impact going forward, however, is what I had mentioned in my prepared remarks and that is the cost of the change that we did with ACCESS, where we are now no longer paying the royalty cost to ACCESS and we are amortizing the cost of the $44 million license over four years. If you recall, the minimum payments that we had through the last 12 months was $42.5 million, so that was one full year. We now have $44 million that is going to be amortized over four years. We believe that today is about a 100 basis point increase to the gross margin over what you have seen over the past several quarters. That will continue and like I said, we are still working pretty diligently on reducing both our core product costs and warranty expenses.

Operator

We will go next to Jonathan Hoopes with ThinkEquity.

Jonathan Hoopes - ThinkEquity

Thank you. Ed, I have two questions for you. I was wondering if you could characterize the sense of urgency that has been driven inside of Palm.

Second, I was hoping that you could tell us what you see, what you perceive as the critical success factors based on your experience here recently with some of the delays and more longer term, as you look out.

I guess I will cheat and mention a third. Last year at this time, you drove a real stake in the ground and gave us a pretty clear outlook and objective as to how many products you were going to shoot for in ’06. I believe you achieved that objective. Why the reluctance at this juncture to do the same for ’07? Thanks.

Edward T. Colligan

I will answer the last question first, which is there is no reluctance, really. It is just I do not think we should necessarily be measured by number of products. I hope to be measured more by the impact that our products make, and so we are more focused on creating the best, most differentiated products that are really going to drive the market, as opposed to numbers right now, whereas last year, we were really focused on trying to gain some critical mass, having just one product in the lineup. That is the last question first.

The other two, sense of urgency -- boy, I have to tell you, this team is running hard here. As you can imagine, trying to compete in the marketplace against companies that are 10 and 20 times your size, and effectively doing that with the highest sell-through ever and lining up against a number of major competitors and beating them in the market in a number of ways, that is something that takes every ounce of energy our team of 1200 people.

Is anyone satisfied with having not delivered the Treo 750 on time as we expected? Absolutely not. There is not an employee in this building, in this company that is not disappointed by that. We absolutely want to do better and we will do better.

I guess there is nothing more I can say than everybody is doing everything we can to make it happen. Some of those things just are -- no excuses here, at the end of the day, we have to do what we have to do, but there are things that are just not in our control when it comes to doing certification efforts. Some of these issues are network issues, some of them are just timing issues relative to the carriers working on other things. It is just not something that is totally in our control, but we try to build that into our expectations and we did not nail that.

At the end of the day, I do not think it is a reflection of any sense of lack of urgency here.

Critical success factors -- boy, I think I laid them out. International expansion, product differentiation in the sense of our platform developments that we are working on. Really, refer back to the four big objectives that I laid out in my comments earlier and I think you get the critical success factors.

We want to drive ongoing, profitable growth and we are going to invest in doing that. Andy alluded to those comments relative to our marketing campaign and our R&D investments.

But the result of those should be a broader product line, more diversification, a broader set of carriers, really enabling us to be more predictable, which is one thing about our results, and then also more successful, driving our business higher and then generating more profits. Those are our critical success factors. I think as a culture here at Palm, we have a high sense of urgency to go make that happen and that is what we are going to do.

Operator

We will go next to Charles Wolf with Needham.

Charlie Wolf - Needham & Co.

Listening to your comments, it appears that the 700w may have been a disappointment. I was just curious as to how that product is selling versus the 700p. Then I have a follow-up.

Edward T. Colligan

Charlie, I would not categorize it that way at all. I think our Windows Mobile products are actually doing quite well. When you line them up against the Palm OS products, they are head to head at this point, you know, the 700w, the 700p.

Now, we have more Palm OS products. The 680, $199 new product coming out. That is certainly driving some sell-through numbers. They have not gotten to the range of being 50-50 in our product line, but it really has been a successful product for us. Frankly, internationally, it is the biggest seller.

I would not categorize it at all that way. If there is anything that you could look at and say we would like to see it happening faster, it is probably the adoption of exchange active think and that side of the e-mail solution that Microsoft delivers by larger businesses, really looking at that and saying yes, I want to adopt that and making that a more seamless, easy sale. Perhaps we expected that to happen a little more easily, but that has been mitigated by the fact that we have a wide range of solutions we work with.

In the end, I think we are pleased with what has happened with Windows Mobile. Our key thing is getting our differentiation across in the marketplace. We have put a significant investment in differentiating those products. People who use them recognize that differentiation. We have to rise above the noise and that is part of our marketing efforts, is to rise above the noise and make sure our differentiation is understood by the user going in to buy a Windows Mobile based product. That is what we have to make happen.

Charlie Wolf - Needham & Co.

Let me follow-up on this differentiation issue. As I understand it, this perpetual license with ACCESS allows you to modify Garnet in virtually any way you want. I am curious as to how you plan to make the Palm OS on the Treo even easier to use.

Edward T. Colligan

Well, as you can imagine, that is a big task, since it is already easy to use among most people’s set of assumptions. But we have some ideas to do that, and in particular around the experience on the Internet. We think there is a big opportunity there. We think there is a big opportunity in the out-of-box experience, so there are different areas where we can make an impact there.

In addition to that, there is a whole new range of applications that will be coming down the pipeline that we hope to enable in compelling ways. It is really the vast majority of the effort behind the licensing effort that we did was one, we thought it was a great financial transaction. We were going to pay royalties anyway, so this essentially is an up-front payment to eliminate that and we feel like it was a strong financial transaction, but in addition, it gave us a lot of flexibility, a lot of control over our future so that we felt comfortable investing in that operating system, that area of investment to drive the best end user solution we possibly can. This gives us that flexibility.

We think in the end it was a strategic deal for us and also a strong financial deal too.

Charlie Wolf - Needham & Co.

Okay, that’s it. Thanks a lot.

Operator

We will go next to Jonathan Goldberg with Deutsche Bank.

Jonathan Goldberg - Deutsche Bank

Hi, thanks for taking my call. A couple of questions. Looking forward, I know you do not want to talk about numbers of new products, but are you looking also at new services or new software, something sort of novel that is really going to cement a competitive advantage?

Edward T. Colligan

Well, absolutely. Of course we are looking at how we can really differentiate in the marketplace. A big part of that is somehow coming up with a set of functionality, services, software application functionality that people say wow, I have to have that, and that makes my use of these products easier and more effective, and it is clearly from Palm.

Those are the kinds of things that excite us here. It is what really has driven our innovation history and it is what we are going to do. We have not exposed everything because it is a very competitive marketplace. It is something that we have to hold our cards pretty close to our vest, but it is part of why we are spending the money we are spending on R&D, is because we hope to develop some things that will really drive our differentiation and then drive the value of the company and the profits we can generate.

Jonathan Goldberg - Deutsche Bank

Do you think we can hear an announcement in calendar ’07?

Edward T. Colligan

I am not going to get into speculating on dates. Of course we are going to keep driving to get these things out as fast as possible.

Jonathan Goldberg - Deutsche Bank

How is the pending acquisition of Good by Motorola going to affect your enterprise sales effort?

Edward T. Colligan

Well, we still have a great relationship with Good. We have spent the last couple of years really working very closely together, mostly on just making the products work really seamlessly and also on the sales front, really lining our sales efforts up and making that happen. That has not changed. We are continuing to work well together.

The carriers have assured us that they are going to push very hard. That means it remains a neutral solution. We have been assured by both Motorola and the Good guys that they really want to continue to have a relationship with us. Assuming that is all true, then we will continue to work together well to serve our enterprise customers.

We of course have a number of other options and probably the biggest among those is Microsoft as a partner, but we have a history of working with some of our competitors. We have some BlackBerry Connect solutions, as you know, and also I think Telesync we continue to support, which is owned by Nokia.

This is not unusual in this space and based on the assurances of the companies, we think we will continue to provide solutions together.

Operator

We will go next to Mike Abramsky with RBC Capital Markets.

Mike Abramsky - RBC Capital Markets

Just still trying to -- maybe you could give us a little bit more color on your views, vis-à-vis differentiation. If I think about what is happening, for example, at Cingular with your impending 750 launch. You have Blackjack there at Samsung at $199. It is thinner, lighter, HSDPA, Windows Mobile. I would imaging you are going to have to price the EMPS 750 somewhere around $300, given that the 680 is a $199. So exactly what differentiates Palm in that situation? Do you think that the impact to sort of the other analyst’s comment on urgency, besides marketing what you have today, what do you think you need to have to do pretty quickly before the window closes on Palm, or narrows, to leapfrog again, as you have historically, these competitive trends?

Edward T. Colligan

First, Mike, I cannot imagine the competitive number of offerings that has come out in the last quarter is sustainable on a consistent basis. We have had a number of major releases that have come into the marketplace and a number of different price points. Our sell-through is up record levels.

Closing the window on Palm or in any way characterizing it as that I do not really think is fair, since we are executing well in the marketplace against these players today. When you look at that product, just as the Q was, it is deficient in a number of ways, relative to our offering. So it is not full-pocket PC. It does not handle documents the way people have said is absolutely critical for them, especially in business to business usage, and we think our battery life, for instance, is something that is going to differentiate us against the Blackjack. Our product, as you know, is HSDPA capable too.

The reality is that we think if we -- and the differentiation I talked about earlier, we really think it is significant in the usability of the products.

We have to go out and communicate those things. Part of that is, and part of the underlying communications effort and underlying differentiation is our brand. People trust Palm to deliver them great products that work. We have done that over the years and we are going to continue to do that and we have to put that brand out there and make sure it is visible to that customer set, and that is part of the efforts that we are doing.

Do we want to continue to build more differentiation and do some leapfrogging efforts? Absolutely, and we are working on those that we hope will really further separate us from the crowd. Part of that is responding, to a certain extent, on cost and also on form factor. We are definitely doing some new and exciting designs there, but part of that is also in the software side, where we hope to really differentiate on a number of other fronts that we are not going to get into detail on, but we have a high sense of urgency to make those things happen.

Mike Abramsky - RBC Capital Markets

Okay, thanks, and could you help us understand, on your guidance, your next quarterly guidance, there is a slow quarter, I would imagine, of Cingular 750 in there and also the 680 would probably hit its stride, along with distribution expansion. Why is your quarter to quarter growth so light? You are essentially calling for a 4% growth in revenue, which is what you did year over year Q1, and also quarter-to-quarter total revenue, about 3%. Are you assuming a fairly healthy decline in ASPs or shipments? Is it this inventory issue? Could you just give us a little color as to what is going on, given the products shipped at product launches?

Andrew J. Brown

Sure, Mike. First thing is we are not anticipating a full quarter of shipment of the Treo 750 in the U.S. It has not been announced yet, so that we are not expecting. In general, what we are expecting is strong sell-through on our smartphone products. We have had some strong momentum coming out of Q2. We are anticipating that will continue in Q3.

We do anticipate that carriers, like I mentioned earlier, that carriers will in fact continue to reduce their overall inventory and we are anticipating that right now. Also remember that we do have the seasonal dip in the handheld business, so that is something that is fairly normal and ordinary at this time of the year.

When you take all of those into account, we think we are taking a reasonably prudent, cautious view on guidance.

Mike Abramsky - RBC Capital Markets

Okay, but I guess year over year, if you had -- last year at this time you had a 23% decline in handheld units shipped. If you assume it is between 17% and 20% decline, it still seems like a fairly conservative forecast based on the product launches that are coming. Is the inventory that material to that?

Mike Abramsky - RBC Capital Markets

The first thing is, we want to be reasonably cautious, given the fact that we have just missed a couple of quarters. But on your handheld side of your assumption, we have said continually that our year-over-year declines in handheld is going to be between 20% and 30%. You saw 30% this past quarter, and we were anticipating something similar to that, but overall, what we are anticipating is like I said -- strong sell-through on the smartphone side of the business, continued seasonality declines in the handheld side, and some moderate decreases in the carrier-held inventory. We are not talking about large decreases. You just take a look at -- maybe similar to the decreases that was, you know, for the past couple of quarters, which are fairly moderate.

Mike Abramsky - RBC Capital Markets

Okay. Last question is actually relative to Research in Motion. Obviously they have had very strong performance, some of which significantly has come off their new Pearl product, as well as expectations that is going to continue. Do you think that the market for these devices is strong? Do you think those kinds of growth rates are reflective of -- is it only RIM that can deliver that kind of growth? Is there something unique about the way they are approaching the market than you guys? Is there some difference to the products and strategy that you have that might account for the differences in the current growth rates?

Edward T. Colligan

I do not want to comment on RIM’s business here. I think at the end of the day, the facts are that they shipped that product in front of the holiday season and we were a little late on ours. That is just the reality. I think we could have, if we had been a little further ahead with our, even the 680 product, we would have seen a significant sell-through at this quarter already, relative to that.

To me, a big part of what you are seeing is sell-in, which is what the analysts track and that is a product delivery timing issue. Would we like to have the 750 for the holiday quarter? Of course we would and we are doing everything we can to deliver all those.

One of the things that they have as an advantage, I would say, at this point in time, because it has not been recognized in the other case over time, but I think it will be, is that they have a proprietary platform that they only produce for one platform. It is a little easier to get products to market on that, a set of more narrow applications and more narrow functionality, but you can get the products to market.

We think over time, the more and more people who want to add functionality to these products, businesses who want to add functionality to these products will start to recognize the open platform advantages that we have, and that will be an advantage at that point.

Right now, if it is only about design and form factor, then getting products to market faster makes a difference and they were ahead of us.

Mike Abramsky - RBC Capital Markets

Thank you very much, appreciate it.

Operator

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

James Faucette - Pacific Crest Securities

Thanks. Just a couple of follow-up questions, primarily related to questions that have already been asked.

Firstly, as it relates to Good and the enterprise, it is clear that Good would like to keep it device independent, or company device independent. Motorola said they would do the same, but just from where we can kind of gauge how important Good is to you, could you give us an idea what proportion you believe of devices that are going into the enterprise are ultimately ending up attached to a Good service?

Edward T. Colligan

The numbers we have seen are in the range of 10% to 12% and we, like we said, one of our things is to obviously continue to deliver that business and to grow that business, but we also have a number of options to replace that, should that not be available to us.

We think, and relative to everything that Microsoft has said, they are going to produce a more capable solution, specifically in the area of device management and control out in the field, which is the place where Good and RIM tend to excel relative to that solution today. As those capabilities get delivered on the Microsoft platform, I assume that Microsoft will be a major player in remote e-mail delivery. We are certainly the only company today that has a Windows Mobile and Palm OS push solution for Microsoft, and we intend to take advantage of that position.

James Faucette - Pacific Crest Securities

That 10% to 12%, that is 10% to 12% of total Treo shipments or 10% to 12% of your enterprise destined shipments?

Edward T. Colligan

Total.

James Faucette - Pacific Crest Securities

Great, thanks. The other question that I had related to the 680 and how we should think about that mix, or what proportion of Treos would be the 680 or consumer related devices versus the new 750 and 700 devices, as we think out to next calendar year?

Edward T. Colligan

In the next calendar year, our mix of devices? Is that -- I’m sorry?

James Faucette - Pacific Crest Securities

Yes, sorry, just the mix between the 680 and then the 700 series in its various forms.

Edward T. Colligan

Oh boy, we do not get into that level of detail on the product mix. I am sorry, but I am not going to be able to provide that to you. Certainly our goal is to continue to expand our prosumer small and medium business efforts. That will drive us towards those lower price point devices, we believe, but that is just my gut at this point. Also, our new developments are in areas where we are going to add on the high end and the low end of our product line. We are going to add products with more capabilities, the Mercedes of our line, certainly will be things we will be working on. We are also going to add products that have more focused functionality that we hope will appeal to more kind of crossover consumers. Take people who are interested in feature phones and move them into smartphones.

So those things are going to happen, and therefore the mix will likely stay relatively consistent.

James Faucette - Pacific Crest Securities

That is very helpful. Thanks very much.

Edward T. Colligan

Okay. Thank you, everybody. Thanks for your interest in Palm, and Happy Holidays to everyone. Thank you.

Operator

Thank you, everyone. That does conclude today’s conference. You may now disconnect.

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