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Palm, Inc. (PALM)

F3Q07 Earnings Call

March 22, 2007 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

Michael Ounjian - Credit Suisse

Maynard Um - UBS

Tavis McCourt - Morgan Keegan & Co. Inc.

Jonathan Hoopes - ThinkEquity

Aaron Husock - Morgan Stanley

Jonathan Goldberg - Deutsche Bank North America

Lawrence M. Harris - Oppenheimer & Co.

Jeff Kvaal - Lehman Brothers

Vivek Arya - Merrill Lynch

Daryl Armstrong - Citigroup

John Lynch - Needham & Co.

James Faucette - Pacific Crest Securities

Jeff Walkenhorst - Banc of America Securities

Paul Treiber - RBC Capital Markets

Presentation

Operator

Good day everyone and welcome to the Palm Incorporated third quarter fiscal year 2007 earnings results conference call. Today’s call is being recorded. At this time, for opening remarks, I will 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 third 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 our 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 December 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 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.

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Edward T. Colligan

Thank you, John, and good afternoon, everyone. Thanks for joining us. On our conference call today, I will summarize our performance for our third quarter of fiscal ’07 and discuss our progress against our core goals and areas of investment as we continue to grow our company.

We have an investor day in New York coming up in a few weeks, where I will be joined by several members of Palm's executive team. At that meeting, which will be webcast, we will provide a broader picture of our goals for the future and give you an in-depth view of how we will execute on our plan to achieve those goals. So today, I intend to be brief.

Our business fundamentals remain strong. Treo smartphone sell-through this quarter of 738,000 units broke last quarter’s record numbers, up 30% year over year and up 20% sequentially. Smartphone revenue reached a record high of $354 million for the quarter, up 23% year over year and 25% over the previous quarter.

The international portion of our business is making significant gains, with Treo smartphone revenue more than double that of a year ago. Last quarter, we shipped two new smartphone platforms and have a total of four differentiated smartphones in production.

Our cash management was excellent. Our own and our channel inventory has been managed exceptionally and our balance sheet continues to remain strong. These results reflect the underlying strength of our business as we continue to create compelling products and drive end-user demand. We also are focused on laying the foundation for our future through innovative developments that will expand our product leadership position, our differentiation, and build our intellectual property.

We are excited about a number of developments we have underway and we look forward to continuing our rich history of innovation.

In addition to the outstanding organic development we are doing at Palm, we added to the strength of our team and solutions by executing against our plan to expand our ODM partnerships globally, and we made two strategic acquisitions this quarter which build on our technology base and add to the depth and breadth of our team.

Today Palm offers four differentiated Treo smartphones. We believe that the breadth of our offering, including a multitude of radio technologies, operating systems and application solutions delivered by numerous carriers around the world, provide us with a competitive edge in the marketplace.

Our record sales to end users, in most instances at a significant premium to competitive offerings, is evidence that smartphone users still care about the quality of the user experience and they trust the Palm brand.

As our continuing efforts to lower product costs bear fruit, we can expect an even more competitive and profitable Palm to emerge.

Our international expansion is being driven by our relentless delivery of new products to new markets and partners and by excellent execution by our global carrier sales and marketing teams. The Treo 750 is available in the U.S., Europe and Asia-Pacific, and we delivered the Treo 680 to 14 carriers around the world, and are on target to reach 20 carriers by the end of May. We also continue to expand the availability of the 700WX to five carriers in the U.S., Canada and Latin America.

We also recently announced our commitment to extend our presence in the Asia-Pacific region by expanding our capabilities and relationships in this rapidly growing market. As we did in Europe with the establishment of our Dublin development center a little over a year ago, we are opening an R&D center in China to ensure close collaboration with the local markets and our manufacturing partners as we continue our international push.

While we continue to drive international expansion, we are focused here on investing in our future growth through the work being done in two key areas of the company; research and development and marketing.

First, let me give you some insight into how we are approaching the development of new products. As you may know, we are a platform company at heart. We have a long history of building and leveraging core platforms from both a hardware and software perspective. Today we are designing hardware reference platforms that will allow us to increase the range of our products and bring new products to markets faster than we have ever done before.

With common hardware architectures and components, we will be able to deliver products with different operating systems, form factors or radio technologies while reducing the complexity of the product and the number of its components.

These efforts should shorten product cycles, increase the breadth of our line, lower costs and increase reliability and quality. These new initiatives differ from our earlier design practices when we focused on the serial development of an individual product design with a dedicated ODM partner. This limited our ability to spin-off differentiated products from the same design. While this approach is not uncommon when you are defining a new product category, now that we understand the core design elements more clearly, we can leverage a platform design to create more efficiency and scale.

These platform efforts in the company are focused on the hardware side but we also continue to invest in both Windows Mobile and the Palm OS platforms on the software side to ensure that we give our customers, both carrier partners and end-users, the broadest range of possible solutions available on the market.

The second area that we believe is critical to our growth is innovative marketing campaigns aimed at increasing awareness of the Palm brand and driving demand for our products. This becomes particularly important as we reach out to new categories of potential customers. Our brand awareness campaign is in action across several U.S. cities. Our interactive kiosks and street teams were operating in major metropolitan areas during the holiday season and our print campaign can be seen in a broad array of publications and a major outdoor location.

This campaign, designed to communicate that Palm offers the best mobile web experience, reaches users through recognizable affinity web brands and it is showing early signs of success. Our total brand awareness increased 14%.

As we work to continue to differentiate the Palm brand and to attract a new demographic who may be less technical and are using a smartphone for the first time, we are providing a unique program designed to guide them as they get started.

I mentioned last quarter the pilot program called Butler was launched last summer to increase customer satisfaction, strengthen loyalty to Palm products, and reduce returns. After early success, we have expanded the availability of this program to include more users in the U.S. as well as a small base of users in Europe and Latin America.

This free 90-day service drives an improved customer experience and lower return rate. With continued evidence of success, we will be aggressive about working with our carrier partners to expand this program even further.

Well, that’s a quick update and Andy will provide you with more detail on the results in a moment, but first I would like to thank the members of the Palm team for their continued focus and execution against our core goals of driving continued growth and profitability, accelerating our international expansion, innovating and differentiating our products, and building our brand. I am confident our continued execution against our goals and our commitment to innovation will be reflected in better and better results as we continue to build our company.

Now, here’s Andy to review the numbers and provide guidance for next quarter. 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 to the Palm website and included with the press release.

Net revenue for the third quarter of fiscal 2007 was $410.5 million, up 5.7% from $388.5 million in the third quarter of fiscal 2006. During the quarter, we saw record smartphone revenues, driven by strong end-user demand which resulted in record smartphone sell-through.

Gross margin for the third quarter of fiscal 2007 was 37%, compared with 33.6% in the year-ago period and 35.6% last quarter. The primary reason for the sequential increase was a reduction in the costs associated with the Palm OS. Our December agreement with Access eliminates the per-unit royalty payments that were part of our product cost structure and replaces them with a substantially lower cost of amortization for the new license agreement.

Operating expenses for the quarter were $129.6 million, in line with our expectations. During the quarter, we continued to make investments in our product development engine and in marketing programs designed to drive sell-through of our products and increase our brand awareness in the marketplace. This resulted in operating income of 5.4% as a percent of revenue and earnings per diluted share of $0.16.

Revenue mix for the quarter was 86% smartphones and 14% handhelds, as we continue to drive our company to the more profitable, higher growth smartphone business. Smartphone revenue for the third quarter was $354.1 million, and we shipped 774,000 units, a 37% increase year over year.

We saw an increase contribution from lower priced smartphones as we introduced the Treo 680 to the market at a lower price point and a sleeker form factor to attract a new customer demographic. As expected, smartphone ASPs declined in the third quarter.

Smartphone sell-through continued to be robust, with a record 738,000 units sold through our channels. This represents an increase of 30% year over year and 20% sequentially.

Handheld revenue for the quarter was $56.4 million, a 44% decline year over year, reflecting sales of 277,000 units. Handheld sell-through for the quarter was 456,000 units, a decrease of 40% year over year and inventory held by our channel partners was 6.4 weeks, the lowest level in five years.

Geographically, we generated 77% of our revenues from the U.S., with 23% coming from outside the U.S. in Q3. We saw strength in the U.S. market over the prior quarter as we introduced the Treo 750. In addition, we saw international revenues increase 23% year over year.

Looking at the balance sheet, our cash and short-term investment balance decreased from the prior quarter to $504.1 million. Cash flow from operations was strong at $83.3 million, offset by a debt repayment of $35 million, the purchase of the source code license from Access for $44 million, and two small technology acquisitions during the quarter totaling $19 million. These acquisitions consisted of technologies that will be used in future products.

Accounts receivable decreased to $213.9 million and DSOs were 47 days, and a range we would normally expect.

Inventories decreased to $37.5 million and turns increased to 27 times.

Looking to Q4, we currently expect revenue to be between $400 million and $410 million. We expect smartphone sell-through to remain strong, with handhelds declining at a similar rate to what we experienced in Q3 on a year-over-year basis. We anticipate gross margin will be in the range of 36% to 36.5%, consistent with what we have seen over the past several quarters.

Operating expenses are expected to be in the range of $124 million to $129 million, which includes continued investment in product development and marketing to increase our brand awareness and to generate demand.

The annual tax rate for Q4 is expected at 40%, resulting in earnings per diluted share of $0.13 to $0.16.

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

Question-and-Answer Session

Operator

(Operator Instructions)

We will take our first question today from Michael Ounjian from Credit Suisse.

Michael Ounjian - Credit Suisse

Thank you. Andy, could you give us a little more color -- you talked some about the Access relationship contributing to gross margin, which I believe was already incorporated in the guidance. So anymore color on the upside to your previous guidance on the gross margins would be helpful.

Also, just some thoughts as to why we would expect operating expenses to decrease next quarter.

Andrew J. Brown

Good questions, Mike. Relative to the guidance that we gave last quarter, it is up maybe slightly. The Palm OS, the change in the Palm OS agreement was clearly contemplated in that but there was really a lot of factors there. We had slightly better product costs. Our warranty costs were slightly better than anticipated, but there was no real what I would call silver bullet that really made a big change. It was in shouting distance of the guidance that we gave at the beginning of the quarter.

On the operating expenses, right now we are anticipating even though we are continuing to invest in both development and marketing, we are anticipating that the expenses there will be just a tad less than what we saw last quarter. There are a lot of functions there, clearly. The timing of product introductions has a big -- or product development, I should say, has a big impact on things like NRE costs that are not really a function of normal increase. It is a function of where the products are in the product development cycle.

I would say those are the primary factors that we are looking at as we are putting our guidance together for this quarter.

Michael Ounjian - Credit Suisse

Just looking into gross margins for next quarter, should we think of the guidance going to 36% to 36.5% as just being conservative, or is there something in particular that you think would drive it down? Is it a function of product mix within the Treos you are selling?

Andrew J. Brown

Like I said in my commentary, it is in the range that we have seen over the past few quarters. I mentioned last quarter, if you recall, that we were anticipating about a 100 basis point increase from the Access license and in Q2, we were right in the mid-35, so there is really nothing specific there. Maybe some small mix changes, but nothing that I would say, like I said, is any big silver bullet that is hitting us.

Michael Ounjian - Credit Suisse

Okay, and the final question, as we are modeling the Treo business for the next quarter, what kind of ASP trend should we think about? What factors should we think about when thinking about the ASPs?

Andrew J. Brown

We just started to see the ASPs start to decline a little bit here as we broadened our product line. There’s the Treo 680 that has come out and that has diversified the product line. I think that continues somewhat. We do not have a practice of giving specific ASP guidance and I am not about to start it here, but I think that general trend will continue as we penetrate the marketplace with some of these, with products like the 680 that are in the marketplace attracting a different demographic.

Operator

We will take our next question today from Maynard Um from UBS.

Maynard Um - UBS

To start, how many operators did you have ending the quarter?

Edward T. Colligan

The total number of operators I believe we tracked was 81. There has been some consolidation.

Maynard Um - UBS

Just looking at your inventories, they were obviously down sequentially and if you look at the number of operators that you have been adding, it is probably a little bit of a surprise that the inventories are going down. Is there something there happening, or is it more related to the PDA side? Can you just talk a little bit about the dynamic?

Andrew J. Brown

Maynard, can I just get a little bit more specific with you? Are you talking about the channel-held inventories or our own inventories?

Maynard Um - UBS

Your own inventory.

Andrew J. Brown

Okay, thanks. Nothing specific there. We have said all along that we think the mid-20s was about the right target for our inventory turns, in the 25 range. We were a little bit lower than that over the past couple of quarters. I would say that what you see with our inventories now are kind of in the range that you would normally expect. Nothing unusual there.

Maynard Um - UBS

Okay, and then you guided to 40% annual tax rate. Could you just provide any update on the tax programs that have been worked on to reduce that tax rate?

Lastly, there has been a lot of speculation about hiring of an investment bank and speculation of M&A. Any comments that you can provide there? Thanks.

Andrew J. Brown

On the tax rate, the issue on the tax rate is the contribution from international sources. As you know, we still are only 23% international. We do have some tax strategies in place that when that contribution expands, we could see a lower overall tax rate. So that really is the primary factor there.

On the other question, as you can imagine, there are a lot of rumors and speculation out there and it is just our practice that we are just not going to comment on that stuff.

Operator

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

Tavis McCourt - Morgan Keegan & Co. Inc.

First, I want to make sure I was doing the math right. It looks like on a sequential basis U.S. revenues were up quite significantly, international was down a little bit sequentially, obviously up year over year. Remind me; was there a big sell in last quarter in the international business that did not reoccur this year?

Andrew J. Brown

Well, there were a couple of factors. One is last quarter the U.S. was unusually low. We had originally anticipated that we would be shipping the Treo 750 in the U.S. markets and that did not occur, and that product got introduced in January to Cingular, as you are aware.

Then secondarily, yes, we did have -- we had two products that were introduced into Europe last quarter; the Treo 680 and the Treo 750v to Vodafone, so there was some -- it was a combination of that.

I think more importantly however is the fact that when we look at our year-over-year results, the 23% increase overall year over year internationally I think is certainly a significant positive sign, and as Ed had mentioned earlier, the fact that we doubled smartphone revenues year over year means we are really making what I believe is some really good traction internationally.

Tavis McCourt - Morgan Keegan & Co. Inc.

And then can you run us through the economics again on the Palm licensing deal, the OS licensing deal? You mentioned a 100 basis points improvement to gross margin. What is the quarterly amortization on that now? Are you backing that amortization out of the non-GAAP EPS as well?

Andrew J. Brown

That is a really good question. The answer to the latter part of that is no. That is actually part of our operating results. It is the cost of having the operating system, so that is in our non-GAAP and our GAAP results. I want to make sure that is clear.

With respect to what the economic differences are, like I said, basically on a combined basis, about 100 basis points is the economic gain that we get from the change in that agreement.

Tavis McCourt - Morgan Keegan & Co. Inc.

Well, that’s a no-brainer. Ed, I guess one question for you would be, you mentioned last quarter the marketing and branding campaign and I think the number thrown out was like a $25 million budget number. Where are we on that? Is that something that you will continue to reinvest in the future? Is that part of the op-ex coming down next quarter? Just some clarification there.

Edward T. Colligan

We are in the middle of that campaign at this point. We continue to invest in it. You can expect us to continue to spend at least marketing funding on both branding and programmatic areas going forward. We really think investment in the brand at this stage of this market is very, very important.

Operator

We will take our next question today from Jonathan Hoopes with ThinkEquity.

Jonathan Hoopes - ThinkEquity

Thank you. Andy, could you tell us what the channel inventory is on a weeks basis? I missed that, if you told us.

Andrew J. Brown

The channel inventory for the handhelds, which is the only one we report on, was 6.4 weeks, which as you know is the lowest you have probably ever seen for the company. It is the lowest we have seen in five years.

Jonathan Hoopes - ThinkEquity

How can you characterize if you are not going to give us the weeks number for the smartphones? You typically give us at least --

Edward T. Colligan

As I said in my comments, Jonathan, we are managing inventories -- I think it is managed at an exceptional level right now across the board, both our own and channel inventories, and inventories with our carrier partners.

Jonathan Hoopes - ThinkEquity

If I could, one final question; are you still finding that Windows Mobile is critical for your international, especially your European expansion? Or is there more acceptance now with the 680 out of the Palm OS based device, or is it too early to tell on that?

Edward T. Colligan

That’s a good question. I think both products are doing well. There is no question that we continue to get more interest, at least early interest, with carrier partners on our Windows Mobile product. I think what happens with that is what has happened to some extent with some of our partners in international markets, is as soon as they start working with Palm and they see how we perform from a marketing and sales standpoint and as partners, they are open to considering our other solutions as well. We think we will have additional traction with Palm OS products going forward.

Operator

We will take our next question today from Aaron Husock with Morgan Stanley.

Aaron Husock - Morgan Stanley

Thank you. To start, it does not look like you were active on your stock buy-back in the quarter. Can you explain why and talk about how much of that authorization you have left now?

Andrew J. Brown

Certainly, Aaron. As you know, I think we talked about this before, that the program that we have in place certainly is not systematic. We take into account a lot of factors when we look at the stock buy-back. If you look at this past quarter, early on in particular, we had two very large cash outlays; one for the Access transaction and then one for the debt repayment. And then the stock really started to take off, so we decided not to engage this quarter in the buy-back.

With respect to your second question, which I think was the total amount left back in the buy-back -- which, by the way, the buy-back is still in place -- is approximately $219 million.

Aaron Husock - Morgan Stanley

On your Butler service, I remember last quarter you talked about a very high reduction in product returns. As you have rolled that out more broadly, can you quantify what type of improvement in return rates you are seeing?

Edward T. Colligan

We are not going to get into specifics. We have seen the overall cost of doing that come down, and so we are feeling like the investment in prevention -- I guess prevention is a great cure or something -- investment in prevention is really helping us lower return rates, especially with new users, people who have not tried the products in the past. I think that is where we see a big win.

Operator

For our next question, we will go to Jonathan Goldberg with Deutsche Bank.

Jonathan Goldberg - Deutsche Bank

Thanks for taking my call. I was just wondering if you could tell us what we could look forward to for the rest of the year. Do you think we are going to have any new products? Any timing, any important dates? We have the analyst day coming up. Anything we can expect then?

Edward T. Colligan

That is a pretty big question. Obviously we are making significant investments in R&D. We expect to continue to rollout exciting new products for our customers, both carrier partners and end-user customers. We clearly have been working on one major new area that has been speculated in the press and that Jeff Hawkins has talked a little bit about. But we are not going to get into details about any of that right now.

But you can expect a number of new products coming out this year that we are excited about.

Jonathan Goldberg - Deutsche Bank

And then, along these lines, how much progress have you made in upgrading the Palm OS? How long do you think that process will take before it is ready for 3G networks and ready for primetime?

Edward T. Colligan

We have not really gotten into detail again about our plans there. I think it is safe to say that we do believe there is a future for that platform and we do want to invest in it. We are doing that but I cannot get into specifics about exactly what we are doing. Just stay tuned. We will roll out those products when they are available.

Jonathan Goldberg - Deutsche Bank

Let me put it a different way; in terms of the operating system, I think we all know that Access did not upgrade it, did not invest in it enough for your needs. Now that it is more under your control, is it progressing as quickly as you had expected? Is it ahead of schedule? How would you characterize it that way?

Edward T. Colligan

I would say it is progressing as quickly as we expected. One of the issues obviously was getting to a point where we had some certainty around its future, and so that happened reasonably recently, as you know, when we signed that deal.

I think there is only so much we could have done before then. If you look at a Treo today, I like to say it is like a house -- all the rooms and the places you live in it, those are all Palm software. The foundation was what was Access, and so people who continue to enjoy Palm software from a user experience standpoint, but you are right; if we want to run that software on 3G networks or do simultaneous voice and data, we will have to do something with the foundation and we are focused on that and we will roll that out at the appropriate time.

Jonathan Goldberg - Deutsche Bank

Last question, you have opened a design center in China. Could you just tell us, how long do you think the adoption rate for carriers there will be? Will it be similar to what we saw in Europe? Do you think it will take longer?

Edward T. Colligan

I think it will be similar. We just launched a great launch with Telstra down in Australia that has gone really, really well. That relationship is expanding rapidly and we also just brought out some products in partnership with China Mobile. We have not put a lot of focus, at least sales and marketing focus, in that region.

I think the first thing we really felt like we needed to do was get grounded from the development standpoint to enable us to do effective testing and certification on networks, and also for us to understand those markets more clearly and be able to build products that will satisfy the needs of those customers in those markets.

That is where we are focused first. Where appropriate and where opportunistic and where we can put our existing products, we will certainly be aggressive about doing that.

Operator

We will go next to Larry Harris with Oppenheimer.

Lawrence M. Harris - Oppenheimer & Co.

Thank you. Congratulations on the results for the quarter. If I look at the midpoint of the revenue guidance for the fourth quarter, it seems slightly lower than the third quarter. I was wondering if there are any items sort of contributing to that, maybe the fact that we had a high level of shipments of the 680 this quarter, or is it just conservatism or seasonality? What is accounting for it being down, at least at the midpoint, down sequentially slightly?

Andrew J. Brown

There are a couple of factors that we look at when we look at guidance. Clearly it is our best estimate at a point in time. As I mentioned in my prepared remarks, we have seen some higher declines in the handheld business than we had seen in prior quarters, and so that got factored into the guidance.

Beyond that, nothing unusual. We continue to expect strong sell-through of the smartphone products, like we saw this past quarter, muted maybe a little bit by the handheld side of the business.

Lawrence M. Harris - Oppenheimer & Co.

Just looking at the analyst meeting on April 10th, will you be talking in greater depth about your new platform strategy?

Edward T. Colligan

We will certainly get into more detail about directionally. We do not plan on announcing any new products there, but we will certainly give you some more directional detail.

Operator

For our next question today, we will go to Jeff Kvaal with Lehman Brothers.

Jeff Kvaal - Lehman Brothers

Thanks very much. I realize that you folks cannot comment directly on what M&A activities might be going on, but I am wondering if you would be able to share with us the process by which such activity might be evaluated on your end?

Edward T. Colligan

Jeff, as we said, I’m sorry, but we are just not going to comment on the rumors and speculation. I just would really appreciate if the questions would be focused on the business. We are focused on operating our standalone company and driving our plan.

Jeff Kvaal - Lehman Brothers

Okay. Well, would it be fair at least to say that the Board would get involved at some point with these types of discussions?

Edward T. Colligan

We are a public company. Our Board evaluates all of our strategic opportunities on a consistent basis. That would not be a new thing. We are just not going to comment on the rumors that are out there.

Could we have the next question?

Operator

Sure. Our next question comes from Vivek Arya with Merrill Lynch.

Vivek Arya - Merrill Lynch

Thank you. Ed, my question has to do, I know you are not commenting on the M&A part, but because you have hired a banker, obviously people are interested in knowing what is really going on here. Obviously that has been a big part of the stock price. But my question on the fundamental business that is related to it is if I look at your operating expenses this quarter, they were at the lower end of your guidance, which is very surprising to me given all the competition that is coming into the market, given the fact that you plan to really spend a lot on sales and marketing and that spend has not gone up.

So my question is because you are exploring all these M&A options, is there any impact on your underlying business? Are you clamping down on expenses? Has your fundamental business strategy changed in any way because you are exploring those M&A options?

Andrew J. Brown

Clearly we are not going to comment on any of the speculation, but what you need to understand is we are running the business. That is what we are 100% focused on, this management team, as an independent supplier of mobile computing products into the marketplace. End of story.

Edward T. Colligan

I don’t think relative to the expenses, I think there were some minor areas where, for instance, MDF spending was a little lower than we may have expected but there are not big swings in that. We certainly are continuing to drive our marketing programs going forward.

Vivek Arya - Merrill Lynch

I see. When I look at the next quarter, obviously in June, Apple has spoken about launching their product into the category. Is your guidance anticipating that? Where I am going with that is last year, for example, when the Motorola Q was launched, for whatever reason your performance was hurt by that competitive entry. Given that Apple will be launching their new product into Cingular, which is where you have been launching new products, my question is, is your guidance taking that new competitive entry into account?

Edward T. Colligan

Of course we look at the competitive market and try to take that into account. The only thing that at all I think caught us off-guard was the aggressiveness of the Q pricing, frankly. We knew that was coming into the market. It was probably priced a little lower than we had expected.

I did not believe at the time, and I think I stated at the time, that I thought the pricing was not a big driver. Certainly they put some product into the market at that point in time but as you know, it has not done very well and I think the pricing has not been a very good idea, being that aggressive.

We clearly track the competition. We try to make the best call we can relative to what is going to happen there. If Apple brings a product into the market, which is still unclear because they obviously had a demonstration but we still have to see delivery. If that happens, then we will certainly -- we are taking that into account assuming it is going to happen, but if that happens, we will compete with that as effectively as we can.

Vivek Arya - Merrill Lynch

One last question; why is the gross margin going to be down sequentially? I know sales are going to be probably flat to down sequentially, but if the mix, if your Palm OS based products are doing better, why is gross margin going down sequentially?

Andrew J. Brown

Like I said, I think I answered this question a few minutes ago. It is in a range of what we have seen over the past few quarters. There is nothing specific in there. There are slight changes in mix. There are different things going in there but there is nothing specific. We have been running in that what I will call the mid-30 range for several quarters now, so there is nothing specific, Vivek.

Edward T. Colligan

I guess the key thing to focus on there is that it is up quite significantly from a couple of years ago, so it has been driving quite a bit higher.

Operator

For our next question today, we will go to Daryl Armstrong with Citigroup.

Daryl Armstrong - Citigroup

Just touching back on the competitive situation, last year you guys made a pretty insightful comment, saying that even though you anticipated the entry of the Q and the E61, E62, you were surprised that you did not see an expansion in the overall marketplace. While none of these products have really burned it up from a unit standpoint, they did take out a slice of the overall tam.

Based on what you are seeing so far on a year-to-date basis, do you still stand by that comment or do you think that the dynamics in the overall market have changed? Then I have a follow-up.

Edward T. Colligan

I still mostly stand by that comment. I have seen some changes in some different demographics. I see with our early 680 sales, we see a shift to more women, which is great -- a pretty significant shift, and I am even seeing that anecdotally.

I would say I think the Palm brand is attractive to that consumer market still who has bought Zires and bought other Palm products over the years. I think they trust the brand and when they think about moving to a smartphone, we are going to see some support there.

I still do not believe we are in a position where price is a huge driver here in this space. I think there is evidence of that based on the fact that we are selling at a significant premium over most of those competitive products and we have record sell-through.

Those are our data points. I continue to believe there is a big opportunity in front of us as more and more of the feature phone business, those people who are buying those products that just make phone calls have a desire for more robust applications, I think we are well-positioned to take advantage of that.

Daryl Armstrong - Citigroup

In terms of the Treo 680, as that continues to ramp, how should we think about the potential margin implications on that one product? Are there specific break points relative to components or manufacturing efficiency that should help the margins on that particular product, or are you expecting that the unit margins are going to stay relatively stable?

Andrew J. Brown

There are two elements here. One is the break points that we obviously give our carriers based upon volumes that they take and then we get also component breaks. What we have seen historically and fairly consistently as we have been able to keep up, or maybe even do slightly better in some cases with respect to cost reductions over the carrier price breaks. We are not anticipating that will materially change for the Treo 680.

Operator

For our next question, we will go to John Lynch with Needham & Co.

John Lynch - Needham & Co.

I am just curious what you are seeing with the adoption of Exchange Active Think and if Active Think played any material or meaningful role in your strong sell-through? Thanks.

Edward T. Colligan

We are seeing additional business-to-business adoption pretty much across our product line. Certainly we have a lot of focus on Active Think and in partnership with Microsoft as a selling partner out there. In particular, in Europe, Vodafone and us and Microsoft have been focused on that. I know there was one program where we did some seating with 10 Fortune 100 companies in Europe and eight of them ended up buying some products, so it was a very, very positive result with our partners. We believe that there is some real opportunity there. We are going to continue to drive that.

In addition to that, earlier today I was looking at a pretty extensive list of new customers that we have in the enterprise area, including Primerica and Medpoint, and the San Diego Police Department and Sherwin Williams and Kimberly Clarke and the U.S. Army Corps of Engineers and a whole host of others, so I think we are seeing some pretty significant traction there. I do not think it is just related to Active Think. I think that is part of the mix, but I am hopeful that with the roll out of Windows Mobile 6 and some additional more functionality in that platform, that we will see even more traction happen there in the future.

Operator

We will go next to James Faucette with Pacific Crest.

James Faucette - Pacific Crest Securities

Thank you. I just had a couple of questions. Firstly, on the move to increase your use of platforms, how should we think about its impact on your targeted model going forward? Will this help primarily to improve your margin outlook or are you looking at this as a way to reduce retail price, become more competitive with other products that may be in the market and maybe hit lower elasticity curves?

Edward T. Colligan

I think it is one of those fundamental things that can impact you in a lot of different ways. I would say relative to pricing, certainly the number one intent here is to get the cost to be better, such that we have the option to either lower pricing or make more profits, or spend more on branding and other R&D investments. We really want to get a drive -- we have had a major program underway to just drive out costs as fast as we can and those platform development efforts are part of that.

As I said in my comments, they have a whole range of other benefits to, including lower component counts, which increases reliability. That gives us a lot more flexibility on rolling out multiple different products and different form factors a lot more quickly. We can take it to multiple ODM partners so that we can certainly drive costs in that way from a competitive environment. There is a whole host of benefits.

We are excited about those developments. They are coming along well. We will have products based on those new platforms before the end of this year.

James Faucette - Pacific Crest Securities

Great, and then quickly, can you just comment on any changes you have seen in the working relationship with Good, or that you have been notified that there will be changes in the working relationship with Good since it has been acquired by Motorola?

Edward T. Colligan

So far, that relationship continues to be very strong. We continue to see wins out in the marketplace in combination. I think Good would support the point that Treo continues to be a big, big part of their device deployment. We are still pleased with that relationship and we continue to work well with it.

James Faucette - Pacific Crest Securities

Have you seen any change in the rate? I know that a lot of times was a key part of enterprises looking at the Palm solution. Have you seen any change in the rate of those trials or anything like that?

Edward T. Colligan

You know, off the top of my head, I cannot give you a rate change. As I said earlier, I think we are seeing a lot of continued growth in our business-to-business marketplace and I think that is driven by the fact that we have the widest range of solutions. It is not just Good. It is Good. It is Intellisync, which by the way is owned by Nokia. It is a partnership with our carriers. It is with Exchange Active Think. It is with a whole host of solutions that we have deployed and I think all of them are coming to bear to drive that business-to-business business higher. Sorry about that. One too many businesses.

Operator

We will go next today to Jeff Walkenhorst with Banc of America.

Jeff Walkenhorst - Banc of America Securities

Thanks for taking the question. Andy, last quarter you guided to an incremental $1.5 million to $2 million of litigation defense cost related to NTP. Does today’s news change that guidance at all on a per quarter basis?

Andrew J. Brown

We have a pretty wide range of guidance for the operating expenses, as you are aware. Clearly the news that we heard today has an impact on it being -- it is more likely to be at the lower end of the range. We kind of incorporated that in there. We were not sure exactly when the ruling was going to come in but it is incorporated in the range that I gave you earlier.

Jeff Walkenhorst - Banc of America Securities

Okay, thanks. On the handheld business, it is decelerating faster than expected, which I guess could be a good thing if the smartphone is offsetting that. 40% down year on year, is that -- I think the prior range that you guided to is 20% to 30% down year on year, but is management now thinking that on a go-forward basis into next fiscal year, it is at the 40%, maybe even 50% level as they move out into the year?

Edward T. Colligan

We have certainly forecasted in part of our guidance here is that it continues at the rate we just saw, which was in the 40% range. I think the thing we are doing is we are managing this as effectively as we can and that is why you see inventories continuing to trend down out in the channels.

I should point out that even though it is down, it continues to be a profitable business for us and continues to throw off margin that we can apply to other investments that can make us more effective in the future in the core strategic areas of our business. That is why it is still there. It is still contributing and it continues to bring customers to us too, in the sense that there are a number of people who buy one of those devices first and then upgrade to a Treo later.

Jeff Walkenhorst - Banc of America Securities

Okay, good, and one last question; can you talk about your success at your retail stores, maybe the New York store and how that has worked out for you?

Edward T. Colligan

Our retail stores continue to be a great marketing vehicle for us. We obviously sell products there. We have not invested a ton in it so we try -- what we try to do is have those be something where they contribute and they are not a money-losing thing in any way, but it is not a huge channel for us. It is really a place where you can get really expert advice on our products and we put them in places where people who buy our products travel and have a lot of high-traffic areas for that, mostly in airports but also in more broad marketing locations that can give us some visibility there too.

So the New York store has actually done really well, of all the stores. But I would not say that it is a big contributor to the business.

Operator

We will take our next question today from Paul Treiber with RBC Capital Markets.

Paul Treiber - RBC Capital Markets

My question is, in an increasingly crowded smartphone market, what do you think represents Palm's sustainable differentiation? For example, what do you mean by superior Internet experience? Is it being faster or better usability? Also, is this enough to sustain an ASP premium? Thanks.

Edward T. Colligan

I think there is a whole host of things that make up the Palm experience. It is the user interface and user experience around that. When I talk about the web experience, I really believe we have the best web experience on the market. We do the best job of rendering pages. We can go anywhere on the Internet, not just to WAP sites.

You see this in evidence of various research firms who track the actual usage pattern of product. The Palm website, our mobile website, is one of the highest hit mobile sites off of mobile phones. You also see much higher rates of Palm, of usage of the web off of Treos than any other smartphone, so there is real evidence that our experience is better from real usage patterns.

What we want to do is continue to invest in that but also take it to other application areas that we think are critical. But the web, from our perspective, even though we have the best experience today, we are not done with that. We think there is a huge opportunity to continue to drive that and make that better and better in a mobile environment and we are investing that today.

In addition to that, we want to keep delivering innovative solutions. We are obviously going to push the design of our products, from the standpoint of form factor and certainly in cost. There are a lot of different areas that we plan to differentiate going forward and have what we hope is the most compelling product line in the marketplace.

John Shandler

Operator, we will take one more question.

Operator

Our last question today comes from Jonathan Hoopes with ThinkEquity.

Jonathan Hoopes - ThinkEquity

Great. Thank you for taking another question from me. It is two parts. Could you characterize the channel inventory of other high-end smartphones, those of your competitors against which the Treo competes? In the past, you have mentioned that was surprising you, as well as the price, for example, that the Q came out on.

Edward T. Colligan

We cannot comment on other competitors’ channel inventory. That would be completely speculative.

Jonathan Hoopes - ThinkEquity

You are not hearing anything from your carrier partners though?

Edward T. Colligan

No, not that we can share.

Jonathan Hoopes - ThinkEquity

Longer term, I was wondering if on the operating margin, from an operating margin expansion standpoint, is there something we can expect in calendar ’07 or do we have to wait for longer than that?

Andrew J. Brown

We will talk more about that at the analyst day in a couple of weeks, but I would say that getting to our target operating margin is probably going to be on this calendar year.

Jonathan Hoopes - ThinkEquity

Thank you very much.

Edward T. Colligan

Thank you, Jonathan, and thank you for your interest in Palm, everyone. I look forward to seeing some of you in New York at our investor day on April 10th. Thank you.

Operator

Ladies and gentlemen, this does conclude our conference. We appreciate your participation. You may disconnect at this time.

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