Here’s the entire text of the prepared remarks from Palm’s (ticker: PALM) fiscal Q2 2006 conference call. The Q&A is here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.
Sandy O’Halloran, Director of Investor Relations
Edward T. Colligan, President and Chief Executive Officer, Director
Andrew J. Brown, Chief Financial Officer
Paul Coster, JP Morgan
Jonathan Hoopes, ThinkEquity Partners
Jeff Kvaal, Lehman Brothers
Mike Abramsky, RBT Capital Markets
Tavis McCourt, Morgan Keegan
Daryl Armstrong, Citigroup
Pablo Perez, ThinkEquity Partners
Ted Chung, Bear Stearns
Andrew Neff, Bear Stearns
Dominic Vignola, Merrill Lynch
Brian Harvey, Wm Smith
Good day, ladies and gentlemen, thank you for your patience, and welcome to the Second Quarter 2006 Palm Incorporated Earnings Conference Call. My name is Bill, and I’ll be your conference coordinator for the day. At this time, all participants are in a listen-only mode; however, we’ll be facilitating a question-and-answer session towards the end of today’s conference. If at any time, during our conference today you require assistance, please key “*” followed by “0” and an operator will be happy to assist you. As a reminder, today’s conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today’s presentation, Ms. Sandy O’Halloran, Director of Investor Relations. Please proceed, ma’am.
Sandy O’Halloran, Director of Investor Relations
Thank you, Bill. And good afternoon, everyone. I’d like to welcome you to Palm’s second quarter of fiscal year 2006 financial results conference call. On the call today are Ed Colligan, President and CEO; and Andy Brown, Chief Financial Officer.
Today’s call is being recorded, and will be available for replay on Palm’s Investor Relations webpage. In addition to the press release, an audio copy of today’s comments and slide presentation will also be made available on the same site. I’d like to remind everyone that today’s comments including the question-and-answer session will include forward-looking statements including but not limited to a forecast of future revenue and earnings, and other financial and business activities. These statements are subject to risks and uncertainties that may cause actual results and events to differ materially. These risks and uncertainties are detailed in Palm’s filings with the Securities and Exchange Commission, including its quarterly report on Form 10-Q for the fiscal quarter ended September 2, 2005, and its annual report on Form 10-K for the fiscal year ended June 3, 2005.
Also please note that in addition to reporting financial results in accordance with Generally Accepted Accounting Principles, or GAAP, Palm routinely reports certain non-GAAP financial results. These non-GAAP measures, together with the corresponding GAAP numbers, and a reconciliation to GAAP, are contained in our earnings press release, and are also posted on our website. We encourage listeners to review these items. I’d like to now turn the call over to Ed Colligan.
Edward T. Colligan, President and Chief Executive Officer, Director
Thank you Sandy. Good afternoon, everyone. This has been an excellent quarter for Palm. And we are pleased with our results. We are encouraged by the growth opportunities that exist for us, both in the short term and long term. Our employees deserve great credit for the way they are driving this Company forward. In the past quarter, we have achieved several important milestones and delivered measurable results against the five business objectives we have set for our company. I have outlined our objectives on previous calls, but would like to emphasize each for you once again as they are key to how we run the company and measure our progress. The objectives are: to deliver consistent profitable growth; invest in and strengthen our product engine; sharpen attention on the customer experience; expand geographically; and collaborate with partners to reach new markets. With those objectives in mind, I’ll start with our just reported results.
For the second quarter of fiscal year 2006 we reported our eighth consecutive quarter of double digit year-over-year revenue growth, and our seventh consecutive quarter of positive income before taxes. Revenue was up 18% totaling $444.6 million in the quarter. Because of the effect of the partial reversal of our deferred tax valuation allowance, I will call out our income before taxes rather than our net income. Income before taxes was $36.7 million, also up 18% compared to $31 million a year ago. For the first half, revenue was $786.8 million, up 21% from the first half of last fiscal year, with income before taxes increasing to $56.7 million from $54.1 million from the same period last year. Look to us to continue to deliver profitable growth.
Moving to our second objective, strengthening our product engine. Investment in R&D continues to be robust. During the quarter we invested $31.1 million compared to $20.4 million in the same period last year. Smartphones generally, and Treos in particular have achieved tremendous traction in the marketplace, and are the engine of Palm’s growth. Our focus is on developing additional breakthrough smartphones with new designs and at new price points. The handheld business plays a meaningful role in our growth strategy. Most importantly, the handheld products produce greater than $500 million in annual revenue, and generate strong contribution margin and significant cash flow. They also build our brand equity and a strong base of Palm users. Today we lead the handheld category with 78% US market share according to the NPD Group’s November 2005 report for all channels. Eight of the top 10 selling models are ours, also according to the NPD Group report. Our customers are loyal and likely to upgrade. Our studies show that 32% of them say they’ll upgrade to a smartphone at their next purchase. And given their satisfaction and loyalty, we think most will choose a Treo. Our smart, our investment in Treo smartphones continues to pay off.
The shipment growth rate of Treos consistently outpaced that of the overall smartphone marketplace in United States in each of the last five quarters, according to Canalys. We now account for 36% of the US converged device market, up 8 points from the 28% we had a year ago. Our Treo shipment growth rate was more than double that of our nearest competitor in the last quarter. We shipped 602,000 Treos to carriers in the second fiscal quarter, up from nearly 332,000 in the year ago period. In the first half of this fiscal year, we shipped 1,093,000 Treos, up 488,000 from the year ago period. We hired aggressively during the quarter, increasing our engineering headcount by 75% year-over-year. We redesigned our software development processes and established new quality metrics. Mike Farese, who recently joined us as SVP of engineering, has implemented programs for higher quality and better predictability. A great proof point is that we will ship our Treo 700w on the Windows Mobile platform on time.
We also introduced two handheld computers, the entry-level Z22 and the Palm TX. Both products have been very well received by reviewers and by the marketplace. And they reflect our decision to focus our handheld line on the sweet spot of the market, concentrating on the $99 to $299 price range. Our continued investment in R&D will not only allow us to add the Windows Mobile platform to our smartphone product line, but we will deliver next calendar year 4 new major smartphones at varying price points, and we will implement next-generation radio technologies and offer new industrial designs.
On the third objective, which is sharpened attention on the customer experience from pre-sale through customer support, we’re building on our hallmark strength of great product design, and well integrated hardware and software, all contributing to excellent ease-of-use. For example, our Treo 650 customers gave us the highest marks in user experience tests for ease-of-use versus other popular smartphones according to Strategy Analytics. In addition, BRANDWEEK recently found that the Treo 650 best met or exceeded customer expectations in the ideal mobile phone category. They said, "Treo has the most powerful brand equity and the highest degree of customer loyalty. "We’ve improved our "Out-of-Box" experience for quick setup and instructions, and we’ve released software updates for all our smartphones on key carrier networks to improve performance.
We’re already seeing the benefits of this work in our customer service statistics and in a reduction in return. We will measure our progress on our third objective by increasing customer satisfaction, lowering our warranty costs, and increasing gross margins.
Turning to our fourth objective, which is expanding our global reach, we have made a number of moves that we believe will pay off in the coming months and years. Today close to 75% of our revenues come from the US business. However, we believe the highest growth opportunities over time are outside the US We will capture a growing share of this emerging global business by investing in infrastructure, and go-to-market capabilities globally. We recently put worldwide sales under John Hartnett to capitalize on his extensive international experience, and proven success driving our US business. One change John has already made was to realign Europe, Middle East, and Africa operations to focus more sharply on the smartphone space. We also opened an engineering center in Dublin to collaborate more closely with European carriers.
In addition, we expanded our business with seven new carriers worldwide during the quarter: In Canada with TELUS Mobility; in Mexico with Lusacell and Telefonica Movistar; in India with Hutch; in Brazil with TIM; in Chile with Entel; and in the US with Alltel. And finally our smartphones are now available in China for the first time.
Looking ahead, you’ll see us introduce new products and new designs that provide us new global growth opportunities. In fact, one of our 4 new smartphone product slated for release in calendar 2006 is designed specifically for a large international carrier.
The fifth and last objective is to collaborate more extensively with key partners, with the goal of reaching and expanding into new market segments. We now have customer relationships with 72 carriers around the world. Carriers gave us excellent support and product, with product reorders, and with co-marketing funds used for advertising, including our new "Time for Treo" campaign running in print magazines, and outdoor in several major cities. They also supported us with new point-of-sale displays. In addition, we announced a Windows Mobile based smartphone, the Palm Treo 700w, an enterprise grade product with out-of-the-box access to Microsoft Exchange 2003 ActiveSync and broadband like speeds from Verizon Wireless EVDO network. Customer interest is high for this new member of the Treo family which will complement our very attractive Palm OS based Treo. Both platforms will continue going forward.
We announced a relationship with RIM (Research In Motion) to offer our existing and future Treo 650 customers, BlackBerry Connect capability on certified carriers. We’re on track for customer availability in early 2006, and this solution too has attracted strong customer interest.
In one of our enterprise sales wins PHT, the clinical trials company, is deploying 1,500 Treo 650’s to collect and transmit clinical trial information using their data gathering software. And with our continued support of Palm OS, and our addition of the Windows Mobile platform, our solution opportunities expand dramatically. I believe our adherence to industry standard open platforms will continue to pay off.
Finally, our longstanding partnership with Good Technologies continue to grow. With the Treo GoodLinks solution now being deployed in nearly 8,000 companies to date. New customers through Good include the Government of the District of Columbia, Macromedia, MedPointe Pharmaceuticals, Crowley Maritime, and DMX Music, to name just a few. Looking ahead, we will measure our progress against our fifth objective, by market share growth in the enterprise and continued success in small and medium business markets. Our five objectives, and the proof points and strategic actions to reach them that I’ve shared today give me confidence we’re doing the right things to serve carrier customers and users and partners, and I believe our momentum will accelerate and deliver increasing shareholder value over the near and long term. Now I’ll turn the call over to Andy who will review our financial results.
Andrew J. Brown, Chief Financial Officer
Thanks, Ed, and good afternoon, everyone. Our second quarter fiscal ‘06 financial results exceeded our expectations. Revenues were 444.6 million, an increase of 18% year-over-year. Smartphone products showed strength ahead of the upcoming Treo 700w launch, and handheld products were strong in front of the holiday gift giving season. Gross margin of 30.5% was an increase from 29.2% in Q2 of ‘05. This was due mostly to a larger portion of our revenue mix being smartphones, and increased product cost reductions. We expect to see gross margin improvement as we move into the second half of our fiscal year, which I will elaborate on in a few minutes. Operating expenses on a GAAP basis were 101.1 million, and on a non-GAAP basis 97.1 million. During the quarter, we restructured our European operations to better align with the business opportunity. This action resulted in a charge to earnings of 2 million, which is reflected in the GAAP results, but not in the non-GAAP results.
On a GAAP basis, operating income was 7.8% of revenue, and earnings per diluted share were $5.02. The provision for taxes includes a partial reversal of the deferred tax asset valuation allowance as discussed on the last earnings call. On a non-GAAP basis, our operating income was 8.7% of revenue, and earnings per diluted share were $0.47 which excludes restructuring charges, amortization of intangible assets, and deferred stock-based compensation, and assumes an effective tax rate of 40%.
Revenue mix for the quarter was 61% smartphones, and 39% handhelds. This compares with 39% smartphones and 61% handhelds for the year ago quarter, and 67% smartphones and 33% handhelds in the first quarter of fiscal ‘06. Smartphone revenue of 269.2 million, increased 86% year-over-year. We shipped 602,000 Treo smartphones during the quarter. The increasing popularity and robust demand for smartphones drove lower volume based pricing with our larger carriers, which in turn reduced smartphone ASP sequentially. The Treo 650, $50 mail-in rebate program announced in November with Verizon and Sprint for the holiday season also contributed to the lower smartphone ASPs. The rebate is expected to have a minimal impact on third quarter fiscal ‘06 ASPs. Treo sell-through for the quarter was 435,000 units, a 129% increase year-over-year. Treo smartphone sell-through declined slightly from the prior quarter as inventories of older models such as the Treo 600 depleted, and as some customers delayed future purchases in order to evaluate the upcoming Treo 700w.
In addition, international sell-through was weaker as we focused on restructuring the operations mid-quarter to better capture future opportunities in calendar 2006. We consider the inventory held by our carrier partners to be at appropriate levels given the current demand environment and the upcoming new product launch. Handheld revenue for the quarter was 175.4 million, down 24% year-over-year on shipments of 958,000 units. As expected, ASPs decreased sequentially from last quarter as the mix to lower priced unit, excuse me, as the mix moved to lower priced units in advance of the holiday buying season. Handheld sell-through of 708,000 units represented a decline of 21% year-over-year. As Ed mentioned earlier, we are focusing on the 99 to 299 sweet spot of the handheld market, where we have seen a year-over-year decline in sell-through of only 11%.
Geographic revenue mix for the second quarter fiscal ‘06 continue to see strong demand, strong US demand, particularly for Treo smartphones. The revenue mix was 73% for the US, and 27% for the rest of the world.
Looking at the balance sheet, cash, cash equivalents, and short-term investments ended the second quarter at approximately 437 million. Cash flow from operations in the quarter was 26.6 million and 75.1 million for the first half of fiscal ‘06. We are comfortable with the current cash balance, and believe the best use of our cash is to invest in future growth opportunities.
Net accounts receivable ended the quarter at 203.5 million and DSOs were 41 days versus 34 days in Q1 of ‘06 and 52 days in the year-ago period. The increase in net accounts receivable and DSOs from the prior quarter is reflective of the increased level of revenue and the timing of shipments within the quarter. Inventories decreased by 7.3 million from Q106 to 31 million and inventory turns were 36 times.
Now for the guidance into the next quarter, we expect revenues to be in the range of 370 to 375 million. We are currently seeing strong initial orders for the Treo 700w, which we expect to launch in early calendar 2006. With the increased product mix shift to smartphones, we believe our business is becoming less seasonal. Gross margins should see significant improvement in Q3. With the combination of the Treo smartphone expansion, better than expected product cost reductions, and an increasing mix shift towards smartphones, we expect gross margins to be in the 33 to 33.5% range.
We anticipate that our operating expenses will be between 100 and 102 million on a GAAP basis and between 99 and 101 million on a non-GAAP basis. The increase in spending on a non-GAAP basis will come from increased R&D spend, which will be partially offset by lower spending of approximately 3.5 to 4 million in SG&A reflecting a normal seasonal decline.
The expected sequential increase in R&D spending of between 6.5 and 7.5 million is primarily due to the timing of prototype and other non-recurring engineering costs associated with the, excuse me, the development of smartphone products built on two distinct operating systems and aimed at different segments of the market. As Ed had mentioned earlier, we expect to launch four new smartphones in the next 12 months, delivering on our commitment of offering a family of smartphones as we exit calendar 2006. At this point in time we expect a lower level of R&D spending in the fourth quarter of fiscal ‘06, declining sequentially by 1.5 to 2 million.
While we believe our go-forward tax rate will be approximately 40%, our tax provision on a GAAP basis for fiscal 2006 will be at a lower rate. This is due to the requirement that we allocate a portion of the reversal of the deferred tax asset valuation allowance to each of the last three quarters of fiscal ‘06. However, we will base our non-GAAP earnings per share on a 40% tax rate as we believe this is more reflective of our future tax rate. Based on this guidance, we expect our Q3 fiscal ‘06 earnings per diluted share to be between $0.46 and $0.49 on a GAAP basis and between $0.31 and $0.33 on a non-GAAP basis.
At the start of our fiscal year we provided operating metrics as a guide to our expected financial performance for fiscal 2006. As we move into the second half of the fiscal year, I would like to update you with our current expectations. In each case these metrics reflect our expectations for all of fiscal 2006. Revenue growth will be in the range of 22 to 23% on a year-over-year basis. Gross margins should increase to 31.5 to 32% primarily the result of gross margin expansion in the second half of the fiscal year for the reasons I mentioned earlier. Our investment in R&D will be higher than we had originally anticipated with the new range being 8.4 to 8.6% of revenue compared with the 8 to 8.5% range that I have previously shared with you at our Analyst Day. The increase is driven by additional smartphones being added to the product roadmap since the beginning of the fiscal year in an effort to better capitalize on the growing opportunity worldwide. Sales, marketing, and G&A will continue to be in the range previously guided, that being 12.7 to 13% for sales and marketing and between 2.8 and 2.9% for G&A.
As I mentioned earlier, although our actual tax rate will be affected by the reversal of the deferred tax asset valuation allowance, we will report our non-GAAP EPS based on a tax rate of 40%. At this time I would like to turn the call over to the operator for your questions. Bill?
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